Fiscal Policy and Its Instruments

Each student of Economics is very well aware of with the concept of Fiscal Policy. Instruments of Fiscal Policy which is adopted by the govt. of any country to influence the govt. expenditures, taxes, and govt. borrowings etc., for the purpose of economic stabilization and economic development. Thus it means that fiscal policy can be exercised by the govts. of the respective countries with the help of govt. expenditures, and govt. revenues so that the objectives of stability and growth could be attained.

The fiscal policy has the instruments of govt. expenditures, taxes (direct as well as indirect), govt. borrowings (borrowings from public, borrowings from non–bank public and borrowings from external sources), and printing of new notes.

The fiscal policy got much more importance after 1930s Great Depression when increase in public expenditures gave the desirable results of removing deflation and unemployment. But after 30 to 40 years when the developed countries have attained the higher growth rates they have to face the problem of maintenance of such growth rate without inflation and deflation — the so called steady growth rate. So it means that fiscal policy has to perform its stabilization role as far as the developed countries are concerned.

However, this is not the case with the poor and developing countries. The nature of their unemployment is different. Moreover, the phenomenon of inflation also differs in case of UDCs. Above all the UDCs characterized with poor incomes wish to remove their poverty and want to attain economic development within the minimum possible time. Accordingly, the poor countries want to use fiscal policy as an instrument of econoi.lic development. All such reveals that role of fiscal policy is different both in DCs and UDCs, which is discussed below.


During 1930’s Great Depression fiscal policy was highly advocated by Keynes and his followers. Keynes was of the view that if the economy is possessing unemployed resources (as it was the case with UK and US in 1930s) or unused resources the increase in govt. expenditures through deficit financing will have the effect of increasing the level of income and employment. Thus he was of the opinion that by printing new notes etc. govt. should launch public works programme and employ the unemployed people. Consequently, on the one side the employment level will increase, and other side, the aggregate demand will increase, crushing the phenomenon of unsold goods etc. Accordingly, the deficit financing will become helpful to raise real output and savings when the economy is having under utilized resources. This was the role of savings in the situation of less than full employment.

Now we take up the case of full employment. It means how the mature economies of America and Europe can maintain full employment. In this respect a lot of ‘Growth Models’ have been presented like Harrod—Domar model, Solow—Swan model, J.E. Meade model, Kaldor model and Mrs. Joan Robinson model etc. These models present different proposals to raise the savings_____ hence investment_____ expenditures______ and the maintenance of full capacity growth rate. The H — D model is of the view that the saving ratio, capital—out put ratio, and capital—labor ratio are fixed. Accordingly, the mature economies are furnished with inherent instability as there is hardly any chance of equality between growth of output, growth of labor and growth of capital.

The S — S model is optimistic in nature as it also keeps in view the constancy of saving ratio. However, this model is of the view that through factor substitution and changing the capital—labor ratio the equality between natural growth rate and warranted growth can be brought.

Mrs. Joan Robinson presented what is known as ‘Golden Rule’ of economic growth. This rule states that for the sake of ‘steady economic growth’ we will have to increase the proportion of profits in the distribution of income i.e., the flow of income should be re­directed to the rich class as the savings out of profits are more than the savings out of wages.

Thus in the light of these models and many other proposals, the developed countries at the level of full employment will have to increase the savings through fiscal measures. The changes in taxes and govt. expenditures should influence consumption expenditures through real balance effect; there should be a re—distribution of income from low savers to high savers; and as well as there should be the operation of money illusion.


As told earlier that the UDCs are desirous to attain economic development as soon as possible, but they have the shortage of resources. The fiscal policy can be applied to remove the shortage of resources as well as for capital resource mobilization. Now we see how fiscal policy will be used for capital formation and resource mobilization for the sake of economic development.

1. In case of UDCs because of lower incomes etc. the savings are very low. While the poor people with lower incomes have higher propensity to consume. On the other side, the rich Class is found of Conspicuous consumption. They lavishly spend on palacious houses, jewellery and imported luxuries etc. Moreover, the people of UDCs (both poor and rich) have a strong bias to divert their resources to unproductive fields like lavish spending on the performance of marriage and funeral ceremonies, purchase of lands, gold and foreign currencies and making of expenditures on palacious houses etc. Accordingly the saving rates in the UDCs remain very poor. Thus, the fiscal policy can be used to raise the savings. Such can be done by imposing as well as changing the taxes (direct and indirect).

2. As told above that in case of UDCs there exist greater disparities in the distribution of income. The rich are getting rich while the poor are getting poor. This all is creating an atmosphere which is anti—developmental. Therefore, fiscal policy will be us( d to remove the income disparities as well as regional imbalances. This can be done by imposing heavy taxes on the rich class and exempting the incomes of the poor people from taxes. This can also be done by granting concessions and facilities to the poor class and poor regions of the country.

3. The UDCs have a wide—spread unemployment _______________  both open and disguised. Therefore, fiscal policy will have to be applied in UDCs in such a way that the problem of unemployment could disappear. This can be done by giving tax exemptions, tax credits, tax holidays, subsidies and reduction in import duties on the imports of machinery and raw material. Moreover, to remove unemployment the unemployment allowances can also be given to the unemployed, and the public works programmes of Keynesian nature can also be initiated, under the fiscal devices.

4. The UDCs have to face the ‘Twin Deficits’ —the deficit in budgets and the deficit in BOP. Fiscal policy can be applied to remove both the deficits by changing the taxes, import duties and subsidies etc.

Now we discuss them in detail i.e., how fiscal policy can be used to increase the savings, decrease the consumption, remove the disparities in income distribution increase the level of employment or remove unemployment, remove balance of payment, deficits, budget deficits and regional imbalances.


The capital formation in any country depends upon savings which can be promoted through: (1) Direct physical controls, (2) Raising the profits of public enterprizes, (3) Increasing the rates of taxes, (4) Imposing the new taxes, (5) Public borrowings, and (6) Deficit financing etc.

The public borrowings are attached with crowding—out having negative impact on investment. Moreover, the public borrowings and deficit financing are the inflationary devices — they may thwart the process of development. The state—owned firms hardly give any profits to generate savings.

Therefore, the only alternative with the UDCs is to impose physical controls on the use and consumption of luxurious goods. The old taxes be changed and new taxes be imposed. Now we see the role of taxes to boost the savings. It has been found that tax revenue as a percentage of GNP is typically low in UDCs, which is about 15 % as compared with 30 % in DCs. The taxes on income are a minor source of tax revenue compared with indirect taxes. The proportion of population that pays income tax in UDCs is correspondingly low, just about 3 %, as compared with 60 to 80 % of population in DCs. As in India the direct taxes (personal, corporate and property taxes) has the proportion of 16.6 %. While the indirect taxes (foreign import and export duties and domestic excise taxes) has the proportion of 80.4 %. In Pakistan the ratio of direct taxes to total taxes is 18.9 % as compared with ratio of indirect taxes to total taxes which is 81.1 %. These figures reveal that there exists the scope of imposing taxes as well as raising taxes, particularly the taxes on income, wealth, property and luxurious consumption. In this way the resources derived could be used for capital formation. The tax on consumption (lavish expenditures on consumption goods) will have the effect of transferring the resources from consumers to the govt. The same will be the case in respect of income, wealth and property tax. Such taxes will not only reduce unnecessary consumption, but they will also redistribute the resources to the govt. which could be utilized for economic development.

But the taxation system in UDCs is furnished with the following problems :

(1)   The UDCs have a rudimentary nature of taxation structure which in itself is a reflection of the stage of development which UDCs are having. Consequently, there exist reduced chances of raising revenues from such tax systems.

(2)  There exists a lot of difficulties of defining and measuring the tax base and of assessing and collecting the taxes in circumstances where the population is scattered and primarily engaged in producing for subsistence, and heavy illiteracy exists.

(3)  The incomes of majority of the people are so low that they will remain out of the scope of income tax.

(4)  There rises a question, when taxes are raised or imposed, whether such increase in taxes will be financed out of people’s consumption or out of people’s savings. It has been estimated that the tax revenues which are highly elastic to income are mostly met through savings and they will have the discouraging effects on incentives. The tax planners will also have to calculate the income effect and substitution effect of imposing income tax. If the SE is greater than 1E of tax imposing it will discourage the work effort. This is the reason that better it would be to impose the expenditure tax on luxurious consumption, rather progressive income tax. But if the expenditure tax discourages consumption and raises savings, then govts. will be able to collect greater revenues. If people work to consume and price of consumption is raised, work effort will be curtailed if the substitution effect of the change outweighs the income effect.

Thus in order to promote the work effort, savings and investment in most of the developing countries the income tax is imposed with great care. More particularly, following Arthur. B. Laffer if the income taxes on the people are decreased they work more. In case of greater income tax people will prefer leisure over work. Consequently, the supply of labor and productivity of labor will decrease. Therefore, for the sake of long run effects on output and supply the tax—cuts are granted all over the world, and this idea got popularity after Laffer curve and Reagonomics. The ‘Trickling—Down Economics’ is being applied again where the incomes of the rich are being promoted rather, taxing them.

(5)  If govt. imposes taxes on the people having more propensity to consume, it can also. acquire the resources. But the people having higher propensity to consume are mostly the poor, and on the equity considerations the consumer goods cannot be heavily taxed. Moreover, in case of UDCs the indirect taxes are already imposed in a big proportion and there does not exist any further scope to raise these taxes, even on political grounds etc.

(6)  The most of UDCs have a plenty of lands and other natural resources. Therefore, they provide the scope for taxation. Accordingly, the UDCs should depend upon agri. taxation to raise tax revenues and transfer the resources from those who earned a lot through increase in prices of land or through a greater stimulus in the demand for food staples and cash crops (due to rise in population), to govt. which could use them for capital formation. But as far as practical imposition of agri. taxes (land taxes, agri. income tax, agri. export tax etc.) is concerned no UDCs has been successful uptill now. A lot of problems exist regarding the estimation of crops, valuation of land and agri. incomes etc. Agri. in most of UDCs it is still characterized with uncertainty etc. Again, taxing the agri. will discourage the big farmers and there may rise corruption and disincentives in agri. leading to shortages of foods etc.

(7)  There have been the complaints about the role of tax as an instrument of capital formation. As it is said that in most of UDCs taxes are imposed to finance public. expenditures i.e. to finance an expanding programme of essential, non—revenue yielding public—service like health education, transport, communications and other components of the economic and social infra—structure. Moreover, in most of UDCs the govts. are involved in the economic activities of their nations through their ownership and control of public corporations and state trading agencies like Utility Store Corporation, Wapda, Sui—gas, and Pakistan Railway etc. in Pakistan. The direct and indirect taxes enable the govts. to finance the capital and recurrent expenditures of these public enterprises, many of which often operate at a loss.

(8)  In most of UDCs the tax machinery is outdated and corrupt. Thus the tax system does not provide the chances of raising enough revenues even the income taxes are imposed or enhanced. It means that the tax evasion will have the effect of reducing the tax revenues. Then how taxes can be used as a source of resource mobilization.

As in this respect Kaldor writes. “In many UDCs the low revenue yield of taxation can only be attributed to the fact that the tax provisions are not properly enforced, either on account of the inability of the administration to cope with them, or on account of straight forward corruption. No system of tax laws, however carefully conceived, is proof against collusion between the tax administrators and the tax—payers: an efficient administration consisting of persons of high integrity is usually the most important requirement for , obtaining maximum revenue, and exploiting fully the taxation potential of a country”.

(9)  The imposition of sales tax, excise duties and tariff on the luxuries may have the effect of raising tax revenues. But again, if such taxes are paid out of savings; they will also reduce work effort; and they are also furnished with corruption and evasion. In such situation the problems pertaining with indirect taxes would also handicap the revenue raising measures trough taxes.


The UDCs are characterized with rising unemployment_______ both open and disguised. Such unemployment is associated with rising population and socio—economic rigidities. Therefore, need is to utilize the unemployed resources (especially manpower). This can be done by increasing the public expenditures both on Social Overhead Capital (SOC) and Directly Productive Activities (DPA).

The SOC consists of roads, rail roads, power houses, bridges, water supply, water sanitation, health and education etc. If investment is made on these socio—economic fields not only employment opportunities will increase but such all facilities will be helpful to promote economic development in future. In addition to SOC, the public expenditures can be made to start the state-owned enterprises so that the unemployed people could be absorbed. This can be done by starting labor—intensive projects in the villages.

But to finance these expenditures the UDCs have to face following problems.

(1)  The resources at the disposal of govts. of UDCs are meagre.

(2)  The state—owned enterprises are often employment creating, but they hardly give rise to profits. They often work on losses.

(3)  The biggest problem rises regarding the availability of the financial resources. From where the huge resources will come to finance the social over head expenditures and directly productive expenditures. The taxation structures of UDCs are inefficient and furnished with avoidance and evasion. Accordingly, enough revenues could not be raised through taxation. If expenditures are increased by printing new notes the whole process of economic development will be jeopardized because of acceleration of inflation. If expenditures are financed through public borrowings they may lead to crowdingout whereby the private investment will be decreased leading to reduce national income. If foreign aid is invited to meet the public expenditures it will be furnished with higher interest rates, political intervention and conditionalities.

(4)  The establishment of SOEs is being discouraged in the present time, as the world is heading towards economic and financial liberalization. The philosophy of state—monopoly has come to an end and SOEs are being privatized. The establishment of SOEs is rejected on the basis of efficiency, resource allocation and surplus creation.


As it is evident that the capitalistic system is basically an unjust system when it is furnished with market imperfection. It does reward the people who have the scarce resources (money), monopolies and superior intelligencia (skill, expertise and competence). Accordingly, the people who have more money, greater physical resources and superior skill are often awarded more as compared with the people who lack them. In such state of affairs the income and wealth are unevenly distributed, particularly in case of UDCs.

The unequal distribution of income leads to reduce the efficiency of the factors of production who are less rewarded. The disparities create resentment amongst deprived people. They encourage the socio—economic evils like smuggling, black-marketing, corruption, adulteration, kidnapings, robberies and work shirking etc. All such will have a negative effect on economic growth. Therefore, the need is realized to have a fairer distribution of income and wealth. For this purpose fiscal policy can play it role through a mixture of taxation and public expenditures.

The rich for whom the marginal utility of money has gone down should be taxed — both on their lavish and conspicuous consumption and ever—rising incomes due to windfall gains or monopoly capitalism. Whereas the flow of expenditures (public) on the rich segments of the society be decreased. The public utilities be provided over to the rich at higher costs. In this way, the resources released should be utilized for the economic progress. Whereas the poor sections of the economy should be given tax relief, tax exemption and the flow of expenditures to them be increased. The poor people be provided with the basic necessities of life at subsidized rates. The food stamp schemes, free medical and free education like facilities be provided to the low income classes. Such all will create self which is an important component of eco. growth.

But practically, there are a lot of problems in the way of creation and restoration of equality in the distribution of income

They are as:

(1) The physical and mental qualities of men differ. Accordingly, the differences in the remuneration of workers is something natural.

(2)  The fairer distribution of income is attached with the removal of Market Imperfections. It means that the markets — goods market, labor market and credit market, — be made perfect; the monopolies be abolished; the illiteracy be removed; the information system be made viable; and the transportation facilities be improved. But the UDCs are unable to remove such all bottlenecks. Then how an equality can be brought about.

(3) The collapse of Socialism and disintegration of Russia has rejected the philosophy of equal distribution. It is the period of reversal of capitalism, as ‘Trickling—Down’ Economics’ is considered to be the only solution for raising outputs, production, savings, investment and even employment. It means that the deliberate efforts be made to raise the incomes of rich. Once, they get rich and their ‘Bowls’ are filled up they will ‘Trickle Down’ and whole of the society will be benefitted from such trickled affluence and wealth. Alas it could happen!

(4) The equal distribution of income and maximization of income are the conflicting objects which the UDCs have to face. If the policies are devised to maximize the income they may lead to generate surplus which could be used for capital formation. On the other hand the equal distribution of income will hardly yield any surplus. Hence, nothing will be available for capital accumulation. The societies which wish to maximum income, output and employment in future, perhaps will prefer unequal income distribution. While the societies which want to maximize the present satisfaction will prefer to have equal distribution of income.


The UDCs have to face ever—rising external disequilibrium which is associated with the followings:

(1)  The UDCs export primary and agri. goods while their imports are capital goods as well as consumer durable goods. The price and income elasticity of demand for the imports of UDCs are higher while they are reverse in case of exports of UDCs.

(2)  The terms of trade of UDCs are going against them. It means that the prices of exports of UDCs are falling while those of imports are rising.

(3)  The exports from UDCs have to face a lot of quantitative and qualitative restrictions like tariff, quotas, anti—dumping laws, child labor and pollution control devices etc.

(4)   The exports from UDCs have to face severe competition with artificial substitutes like nylon, polyester, and acrylic etc. which have reduced the exports of UDCs.

(5)  Because of structural rigidities, technical and administrative reasons the UDCs are unable to generate enough export—surplus. Accordingly, they are failing to raise satisfactory amount of export earnings.

(6)  Day by day the competition at world level is increasing which is severely affecting those countries whose goods have close substitutes. The intensive competition is becoming responsible for decreasing the exports of those countries who are unable to compete. As a result the export yields of these countries is decreasing.

(7)  Because of population growth and economic growth the import requirements of UDCs are increasing. As a result, the import bill of UDCs is rising very sharply. More broadly, for the sake of economic development and to meet the needs of rising population the UDCs have to import consumer durables, oils, iron, steel, manufactured goods, automobiles and what not. In such situation the foreign payments of UDCs are rising.

(8)  The UDCs have to make a lot of international payments like repayment of loans and debt services; have to make military expenditures; there is illegal flight of capital; and the MNCs take back the profits to their home countries. In this way, the payments of UDCs at capital account are increasing.

Thus the international payments of UDCs are increasing and their international receipts are decreasing giving rise to deficit in their BOP. Accordingly, to remove such deficit in BOP the fiscal policy can be helpful. The removal of disequilibrium in BOP can make the foreign trade sector more volatile and contributing towards economic growth. Thus to remove deficit the strict fiscal pqiicy is advocated whereby the govt. expenditures be decreased and taxes be increased to restore deflation. This will decrease the incomes and pries. As a result, the imports will decrease and exports will increase.

Again to check imports the tariff rates on the imports be increased. This should be done, especially, in case of luxurious imports. Whereas the subsidies be granted to the exporters in the form of rebates, cheaper credits, tax exemptions and cut in tariffs on the imported raw material. As a result, the exporters will get more incentives and will be pleased to boost the exports.

Thus the measures to increase the exports and decrease the imports through fiscal policy will be helpful to remove deficit in BOP, and foreign trade sector may serve as an engine of economic growth.

But the efficacy of fiscal policy in foreign trade sector is restricted on the following grounds.

(1)  The deflatibn restored on the ground of strict fiscal policy will discourage the investors — both domestic and foreign. Accordingly, the deflation will also jeopardise the process of development.

(2) The strict fiscal policy can hardly influence international demonstration effect and advertisements etc. which have made the demand for consumer durables etc. less elastic.

(3)  The imposition of higher tariffs on imports and granting of export subsidies are being considered something unwanted after the implementation of rules of game as presented by WTO (World Trade Organization).

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