What is Fiscal Policy?
Social Science is an important subject for students that helps them learn more about the people and the planet. This also helps them understand and socialise with how the law and order of the world works. In this regard, there are four main parts of social science for students namely, History, Geography, Civics and Economics.
Economics is the branch of social science that provides the financial knowledge of how money, industries are organised and run at each level. Students are required to read and understand this subject with utmost importance because this knowledge helps students to deal with and manage their finances in a better way. In reference to the syllabus, economics holds relevance for students especially from classes 9 to 12.
What is Fiscal Policy?
The policy that determines how much the government will spend and how much taxes the citizens have to pay is called the Fiscal Policy. These two things help the government proactively monitor and influence the economy of the country. The government uses Fiscal Policy either to curb recession and unemployment or to decrease inflation. Most of the time, Fiscal Policy is used in conjunction with Monetary Policy.
How Does Fiscal Policy Work?
To understand how Fiscal policy works and what fiscal policy does, let us consider two scenarios…
Scenario 1
Suppose, you don’t have a job now because there is no job opening. So you don’t buy too many things from your neighbourhood shopkeeper. As a result the income of the shopkeeper also dips. So, he, in turn, defers buying the smartphone that he has been eyeing. The smartphone manufacturer, because of the downturn, doesn’t hire any new employees. This is roughly what we see in a recession - low economic activity and high unemployment.
Recession and unemployment are bad - both from a citizen’s point of view and from the political point of view. So, the government tries to reverse this recessionary trend. How does it do that? It can be two things (either or both) -
Increase government spending
Decrease taxes
So, how does increasing government spending decrease recession and unemployment? For that, you need to understand what government spending means. Government spending is spending that it does to acquire goods and services for current or future use.
Now, let’s go back to the example mentioned above. Suppose the government starts spending a significant amount of money to build more hospitals, schools and to help the construction sector. As a result, new jobs will open up in these areas. So, now you can apply for a job in these sectors. When you get a job, you will start earning money. From your salary, you will spend a portion of your money to buy things from your neighbourhood shopkeeper. This will increase his income as well. As a result, he can now buy that smartphone. So the smartphone manufacturer will see an increase in activity and revenue. It will hire new employees to manage the extra workload. This chain-reaction is called the ripple effect in Economics. Thus, government spending boosts the entire nation’s economy.
Similarly, if the government reduces taxes, you will take home more percentage of your salary. So you can spend more. Again, if the taxes levied on the goods are lessened, their prices will come down too. The people will thus get encouraged to buy more goods.
Scenario 2
Now suppose, you and your friend both are working. You both need new earphones. Your neighbourhood shopkeeper has just one left. You both race against each other to grab the last earphone. What your shopkeeper does is - he decides to sell the earphone to the person who will pay more. Your friend offers Rs.200. But you offer Rs.300 and the shopkeeper agrees to give it to you. But just then a rich man arrives. The clever shopkeeper further increases the price of the earphone to Rs.500. The man pays the amount and walks away with the earphone. This is roughly how inflation works - your money can’t buy the same thing that it could buy yesterday - you need more money.
Here too, The Government Changes The Fiscal Policy to
Decrease government spending
Increase taxes
Decreasing government spending will create a contraction in job opportunities. As a result, people can become jobless or their salaries can decrease. On the other hand, an increase in taxes means the government will eat more from your salary. So you will take home less money. As a result, you will spend less. The demand for goods and services will come down. As a result, their prices will climb down too.
The History of Fiscal Policy
Now that you know what is meant by Fiscal Policy, let’s turn the pages of history. When you learn what is Fiscal Policy in Economics, you will come across a name - John Maynard Keynes. He was the one to come up with the idea of Fiscal Policy. Before Keynes, the earlier Economists believed that there should not be any government intervention in the Economic sphere of a nation. If the economy is seeing a downturn - it will correct itself in the long run. But the fallacy in their argument was that - in the intervening period before the correction happens, there could be thousands of job losses. The economy will be left in shambles.
Keynes says that there is no reason to wait and watch the destruction of the economy. The government can take proactive measures to curb the downturn and heal the economy. To understand more comprehensively what do you mean by Fiscal Policy, you also need to know the negative aspects of the Fiscal policy too which we have discussed in the FAQs section.
What Does Fiscal Policy Include?
The Fiscal Policy mainly includes two things:
Government Spending - Either increase or decrease.
Taxes - Either increase or decrease.
That’s all that is there in Fiscal Policy to understand what is the meaning of Fiscal Policy or what is Fiscal Policy Economics.
Did You Know?
India’s response to the economic downturn due to Covid19 is interesting. We see an overlapping of Fiscal and Monetary Policy. The AtmaNirbhar Package that the central government announced includes measures that will increase liquidity in the market (a product of monetary policy) and improve the job situation (a product of Fiscal Policy).
FAQs on Fiscal Policy: What It Means and Why It Matters
1. What is fiscal policy and what are its main components as per the CBSE Class 12 syllabus?
Fiscal policy is the use of government spending and taxation to influence the economy. It is a key tool used by the government to achieve its macroeconomic objectives. According to the CBSE syllabus for the 2025-26 session, its main components are part of the government budget and include:
- Revenue Receipts: Income received by the government, such as taxes (income tax, GST) and non-tax revenue (fees, fines).
- Capital Receipts: Receipts that create a liability or reduce an asset, such as borrowings, disinvestment, and recovery of loans.
- Revenue Expenditure: Spending that does not create assets, like salaries, pensions, and interest payments.
- Capital Expenditure: Spending that creates physical or financial assets, such as building infrastructure like roads and hospitals.
2. What are the main objectives of fiscal policy in an economy like India?
The primary objectives of fiscal policy in India are aimed at achieving stable and equitable economic growth. The main goals include:
- Economic Growth: Promoting a sustainable rate of economic growth by mobilising financial resources for investment.
- Price Stability: Controlling inflation and deflation to ensure that prices do not fluctuate wildly, which can harm both consumers and producers.
- Full Employment: Creating job opportunities and reducing unemployment by encouraging investment in labour-intensive sectors.
- Equitable Distribution: Reducing income and wealth inequality through progressive taxation and targeted welfare spending.
- Exchange Rate Stability: Maintaining a stable exchange rate to promote foreign trade and investment.
3. What are the key instruments or tools of fiscal policy?
The government uses four main instruments to implement its fiscal policy:
- Taxation Policy: This involves decisions about direct taxes (like income tax) and indirect taxes (like GST). The government can increase or decrease tax rates to influence consumption and investment.
- Government Expenditure Policy: This includes spending on infrastructure, defence, education, healthcare, and subsidies. Increased spending can boost economic activity, while decreased spending can curb it.
- Public Debt Policy: This pertains to managing the government's borrowings from the public, banks, and foreign sources to finance its deficit.
- Deficit Financing: When expenditure exceeds revenue, the government may resort to borrowing from the central bank (Reserve Bank of India) or printing new currency to cover the gap.
4. What are the different types of fiscal policy?
There are two primary types of fiscal policy, used to address different economic situations:
- Expansionary Fiscal Policy: This is used during a recession or economic slowdown. The government increases its spending and/or decreases taxes. The goal is to increase aggregate demand, boost production, and create jobs.
- Contractionary Fiscal Policy: This is used during times of high inflation. The government decreases its spending and/or increases taxes. This reduces aggregate demand, which helps to control rising prices.
5. How does fiscal policy differ from monetary policy?
Fiscal policy and monetary policy are two distinct tools used to manage a nation's economy, but they differ in key ways:
- Administering Body: Fiscal policy is managed by the Government of India (Ministry of Finance), while monetary policy is managed by the country's central bank, the Reserve Bank of India (RBI).
- Tools Used: Fiscal policy uses tools like taxation and government spending. Monetary policy uses tools like interest rates (repo rate), reserve requirements (CRR, SLR), and open market operations.
- Objective: While both aim for economic stability, fiscal policy directly influences aggregate demand through spending and taxation. Monetary policy primarily controls the supply of money and credit in the economy.
6. What are some real-world examples of expansionary and contractionary fiscal policy?
A real-world example of expansionary fiscal policy was the government's response to the COVID-19 pandemic. It launched the 'AtmaNirbhar Bharat' package, which included increased spending on public health, food security for the poor, and financial support for businesses to prevent economic collapse. A classic example of contractionary fiscal policy would be if the government, facing high inflation, decides to raise income tax rates and reduce subsidies on fuel to decrease the overall money supply and curb spending.
7. Why is fiscal responsibility important for a country's long-term economic health?
Fiscal responsibility refers to the government's ability to manage its finances sustainably without accumulating excessive debt. It is crucial because high levels of public debt can lead to several problems, such as:
- Increased Interest Burden: A large portion of tax revenue goes towards paying interest on past borrowings, leaving less money for development projects.
- Crowding Out: Excessive government borrowing can increase interest rates, making it more expensive for private businesses to borrow and invest, thereby 'crowding them out' of the market.
- Inflationary Pressure: If the government finances its deficit by printing more money, it can lead to hyperinflation.
The FRBM (Fiscal Responsibility and Budget Management) Act in India is an example of a legal framework designed to enforce fiscal discipline.
8. What are the potential limitations or criticisms of implementing fiscal policy effectively?
While powerful, fiscal policy has several limitations that can reduce its effectiveness:
- Time Lags: There are significant delays in implementing fiscal policy. There's a lag in recognising the economic problem, a lag in implementing a policy response (political process), and a lag before the policy's effects are felt in the economy.
- Political Constraints: It is often politically difficult to implement contractionary policies like increasing taxes or cutting popular spending programs, even when economically necessary.
- Crowding Out Effect: An expansionary policy financed by borrowing can raise interest rates, which may discourage private investment, partially offsetting the policy's positive impact.
