Page 311 - DECO502_INDIAN_ECONOMIC_POLICY_ENGLISH

Unit 24: Fiscal Federalism in India

The government can, by using its statutory powers, change the magnitude and composition of inflows Notes
and outflows and thereby the magnitudes of macroeconomic variables—aggregate consumption
expenditure and private savings and investment. The magnitude and composition of inflows and
outflows can be altered by making changes in taxation and government spending. The policy under
which these changes are made is called fiscal policy.
The scope of fiscal policy comprises the fiscal instruments and the target variables. Fiscal instruments are
the variables that government can use and maneuver at its own discretion to achieve certain economic
goals. Fiscal instruments include taxation (direct and indirect), government expenditure, transfer
payments (grants and subsidies) and public investment. The target variables are the macro variables
including disposable income, aggregate consumption expenditure, savings and investment, imports
and exports, and the level and structure of prices. The fiscal policy instruments and target variables
are discussed below in detail.

Compensatory Fiscal Policy
Another variant of stabilizing policy is compensatory fiscal policy. The compensatory fiscal policy is a
deliberate budgetary action taken by the government to compensate for the deficiency in, and to
reduce the excess of, aggregate demand. The compensatory action is taken by the government in the
form of surplus budgeting or deficit budgeting. In this kind of fiscal policy, the government uses a
greater degree of discretion than in automatic stabilization policy and compensatory fiscal policy can
be revised from time to time as per need of the country. Besides, the policy of surplus budgeting is
adopted when the government is required to control inflation and policy of deficit budgeting is
adopted when the objective is to control deflation.
The policy of deficit budgeting is adopted to fight depression in the economy. During the period of
depression, the government is required to boost up the aggregate demand, especially when the economy
is facing depression due to lack of effective demand. The government in this case is required to take
compensatory fiscal measures. The compensatory measures may be in the form of tax reduction and
enhanced government spending. This kind of fiscal measures increases aggregate demand. Increase in
aggregate demand leads first to the rise in price level. It adds to the producers’ profit with a time lag in
increase in costs. This increase in profits creates an optimistic environment. Therefore, both opportunity
and incentive to invest increase. This is supposed to push up the level of employment and output. This
is the kind of fiscal policy that most countries affected by the recent global recession had adopted.
The policy of surplus budgeting is adopted by the governments during the period of high rate of
inflation, especially when inflation is caused by excessive demand. Surplus budgeting is a powerful
tool to control the aggregate demand. Under this policy, the government keeps its expenditure lower
than its revenue. If necessary the government may resort to a higher rate of taxation and cut its
expenditure further down. Taxation reduces disposable income. As a result, the aggregate demand
decreases at the rate of tax multiplier. On the expenditure side, a cut in the government expenditure
reduces the aggregate demand at the rate of expenditure multiplier. The two-prong attack on the
aggregate demand helps reducing the demand pressure and, thereby, the inflation.
Discretionary Fiscal Policy
A discretionary fiscal policy is one in which ad hoc changes are made in the government expenditure
and taxation system and tax rates at the discretion of the government as and when required. In
discretionary fiscal policy, the government makes deliberate changes in (a) the level and pattern of
taxation, (b) the size and pattern of its expenditure, and (c) the size and composition of public debt.
The discretionary changes in these fiscal instruments are made with a view to achieving certain
specific objectives. The discretionary changes in taxation and government expenditure and their effects
on the target variables are described here briefly.
(a) Changes in Taxation : The discretionary changes in taxation include such changes in both
direct and indirect taxes as (i) increasing or decreasing the tax rates, (ii) imposition of new taxes
or abolition of existing taxes, and (iii) imposition of taxes on new tax bases. All these kinds of
changes in taxation result in either the flow of household incomes to the government or to reduction
in such flows. Tax changes that reduce disposable incomes of the housholds cause a decline in

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