What is tax policy and how does it work?



This is a series of indicators to educate and inform observers of the economy. In association with CRISIL as a knowledge partner.

Governments tax, borrow and spend.

How, when, at what level is the mandate of fiscal policy.

Essentially, the goal of fiscal policy is to support economic growth. By adjusting the level and type of spending, borrowing and changing tax rates, governments influence the consumption and investment demand of individuals and businesses.

Decision-makers have two tools to influence this demand: budgetary and monetary. The monetary policy used by central banks changes the money supply and influences market interest rates.

Fiscal policy can be expansionary or restrictive.

a expansionist the policy encourages demand by fueling spending, reducing taxes, or both. A contraction policy seeks to reduce demand by doing the opposite.

Theoretically, in the short term, the size or direction of spending depends on what the government is trying to stabilize. It can become expansionary when it perceives demand as weak, or contract when inflation soars.

Remember the national income accounting equation from our first article in the series. We measured the country’s gross domestic product (GDP) on the demand side as:

GDP = C + I + G + (XM)

Where C = private consumption expenditure, I = investment (both private sector and government), G = government consumption expenditure, X = exports of goods, M = imports.

This equation also helps us track how fiscal policy is making its way through the economy.

A change in G can directly change the GDP. Or, it can indirectly influence C, I and (XM). Here’s how:

Let’s say the government allocates more funds to the rural employment guarantee works program. The idea is to create more jobs in rural areas, more wages in the hands of workers, and more consumption by them (“C” increases). Or, if the government reduces taxes on a particular class of goods, it also has the same effect. Increased public spending on infrastructure (eg roads, bridges) may lead to increased demand for intermediate inputs (cement, steel) from the private sector (“I” increases).

Governments are supposed to be limited in the extent to which they can increase their spending, as this spending is funded by the revenues they collect (mainly through taxes). Governments usually have to spend far more than they earn in revenue — this gap is called a budget deficit. Of course, he can borrow in the financial markets to fill that gap, but that also increases his level of debt. High levels of debt and the need to service it can reduce the government’s ability to spend in the future.

As a result, most countries have instituted “fiscal rules” that stipulate the size of deficits or the level of debt that is eligible. For example, India’s 2003 Fiscal Responsibility and Fiscal Management Act limits the central government’s budget deficit to 3% of its GDP in a given year, subject to economic conditions. However, this objective has often been rejected.

As the pandemic struck, the central government announced its Atmanirbhar package aimed at reducing financial stress among the most affected segments of society. Food rations, money transfers to the poor, accelerated payments to farmers under PM-KISAN, unsecured credit for businesses (including micro, small and medium enterprises) and capital injection have were some of the immediate steps.

Other measures followed in the second half of fiscal year 2021 targeting consumption and public investment, in the form of interest-free advances to government employees, an incentive scheme linked to production, additional subsidies, capital expenditure and additional support for rural employment.

In sum, measures above the government line, i.e. direct additional spending or revenue losses, amounted to 3.5% of GDP in 2020 (IMF Fiscal database Monitor, July 2021). This was lower than the 4.1% of GDP spent on average by emerging market economies (EMEs). India’s response focused on below-the-line measures (equity injections, lending and guarantees), which totaled 5.2% of GDP (compared to 2.6% for the EME average. ).

This is the second part of a BQ learning series on basic economics concepts.


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