Fiscal Economics

Unit I
Introduction
The term “fiscal economics” is a new one; the old popular term of the subject is
“Public Finance”. The study of public expenditure, public revenue, public debt and financial
administration of the government activities.
The purview of public finance is considered to be threefold, consisting of governmental
effects on:
1. The efficient allocation of available resources.
2. The distribution of income among citizens and
3. The stability of the economy.
Definitions of fiscal economics
“Fiscal economics” is the study of how government taxation and spending influence a
country’s economic performance, income distribution, and resource allocation.
According to Richard A Musgrave, “Fiscal economics or public finance deals with the
income and expenditure activities of governments and their impact on the economy”.
According to Adam Smith, “Fiscal economics is an investigation into the nature and
principles of the state’s revenue and expenditure”.
Concepts in fiscal economics
1. Public revenue
How governments raise money through various forms of taxation (income tax,
corporate tax, VAT, etc.) find other sources like fees and fines.
2. Public expenditure
How governments spend money on services like health care, education,
infrastructure, defense, and social welfare programs.
3. Fiscal policy
The use of government revenue and spending to influence the economy. This
includes:
a) Expansionary fiscal policy
Increasing spending or cutting taxes to boost economic growth.
b) Contractionary fiscal policy
Decreasing spending or increasing taxes to control inflation.
4. Budgeting and deficits
a) Government budget
A government’s plan for revenue and expenditure over a specific.
b) Balanced budget
Revenues = expenditures
c) Budget surplus
 Revenues > expenditures
d) Budget deficit
When government spending exceeds its revenue.
e) Public debt
Accumulation of past deficits, financed through borrowing.
5. Economic stabilization
How fiscal tools are used to stabilize the economy during recessions or booms.
6. Types of government expenditure
a) Capital expenditure
Infrastructure, education, etc. (long term investments)
b) Current expenditure
Salaries, subsidies, etc. (recurring expenses)
7. Taxation
a) Direct taxes
Income tax, corporate tax.
b) Indirect taxes
VAT, sales tax.
c) Tax policy
Tax policy effects income distribution, and consumption behavior.
8. Multiplier effect
Govt spending can have a multiplied impact on national income through
increased consumption and investments.
9. Crowding out
When government borrowing raises interest rates and reduces private
investments.
10. Automatic stabilizers
Features like unemployment benefits or progressive taxes that automatically
counter economic fluctuations without new policy actions.
Goals of fiscal policy:
1. Economic growth
2. Full employment
3. Price stability (Control of inflation)
4. Reduction of income inequality
5. Balanced regional development
Applications:
1. Designing budgets
2. Planning stimulus packages (e.g. COVID-19 Fiscal responses)
3. Assessing national debt sustainability
4. Evaluating tax reforms
Nature, scope, objectives and instruments:
 Fiscal economics also known as public finance is the study of the role of governments
in the economy, specifically focusing on government revenue, Expenditure, And Debt. Its
analysis how governments raise and spend money to provide public services, manage the
economy, and achieve social goals.
Nature of fiscal economics
1. Normative and positive analysis
Fiscal economics encompasses both positive analysis (examining “what is”
And “what will be”) And normative analysis examining “What ought to be”. For
example, it analyzes the effects of a tax increase in desirable (Normative).
2. Govt’s role
It explores the economic functions of governments at all levels (national, State
and local) including providing public goods and services, regulating markets, and
stabilizing the economy.
3. Resource allocation
Fiscal economics examines how governments allocate resources through
taxation, Spending and borrowing.
4. Economic stabilization
It investigates how fiscal policy (Govt spending and taxation) can be used to
influence aggregate demand, promote economic growth, and control inflation or
recession.
5. Welfare maximization
Public finance also considers how government policies can improve social
welfare and reduce income inequality.
6. Interdisciplinary
Fiscal economics draws on various other fields, such as economics, political
science, and public administration to understand the complexities of government
finance.
Scope of fiscal economics
1. Public revenue
This includes the study of different sources of government revenue, such as
taxes, fees, and borrowing. It also involves analyzing the principles and effects of
various tax systems.
2. Public expenditure
This involves analyzing the principles of government spending, the
classification and justification of different types of public expenditure, and the impact
of spending on the economy.
3. Public debts
This area focuses on the management of government debt, including the
issuance of bonds and other securities, and the implications of public debt for the
economy.
4. Fiscal policy
 This encompasses the use of government spending and taxation to influence
the economy including stimulating economic growth, controlling inflation, and
managing unemployment.
5. Financial administration
This involves studying the organization and administration of government
financial activities including budgeting, accounting, and financial reporting.
6. Fiscal federalism
This area examines the division of fiscal powers and responsibilities between
different levels of government (e.g. federal, State, and local)
7. Economic stabilization and growth
Fiscal economics also analyses how government’s policies can be used to
stabilize the economy, promote sustainable growth and achieve other macroeconomic
objectives.
Objectives of fiscal economics
1. To secure adjustments in allocation of resources
It is the responsibility of the government to provide for social wants and
earmark resources for the satisfaction of some of the important wants that could not
be satisfied by the market economy. The market economy is governed by the
exclusion principle. According to this principle, those who cannot afford to pay for
goods and services must do without them. Social wants like police, defense, etc.,
Must therefore be satisfied fully through budget only.
We know that resources are limited and the government has to draw priorities
and targets with available resources. The allocation of resources and proper
adjustment between different sectors and regions of the economy should be the
primary objective of fiscal economics.
2. To secure adjustments in the distribution of income
The revenue and expenditure of the government and the consequent development
should be properly monitored and seen that the extra income due to development
does not fall on the laps of the rich but on the poor. The government should try to
reduce the disparities in the distribution of income and wealth. Professor Musgrave
points out that redistribution may be implemented directly through the following
measures:
a) A tax transfer scheme, Combining progressive income taxation of high-
income group with a subsidy to low-income group.
b) Progressive income taxes to finance public services like public housing, etc.
c) A combination of taxes on goods purchased mainly by high income groups
and subsidies to other goods which are purchased mainly by low-income
groups.
3. To secure economic stabilization
The fiscal activities of the government should ensure economic stability and it
should remove economic fluctuations and distortions in the economy. If there is
unemployment, The public expenditure should be increased and the level of
employment should be raised and the level of taxation should be reduced.
 4. To accelerate economic development
The long-term objective of the fiscal measures should be ensuring economic
development and increase in per capita national income. In underdeveloped
countries, the ‘Vicious circle of poverty’ should be broken and the level of income of
the people should be raised. This can be done by heavy capital investment and
imported technology, as well as undertaking labor intensive projects.
5. Distributive justice
Wide disparities in the distribution of income and wealth in the economy make
the problem serious. It is not only economic but also a social problem. The
government through its fiscal measures should ensure distributive justice and prevent
the exploitation of the poor by the rich.

Objectives of fiscal policy in India

1. To mobilize additional resources into socially necessary lines of development.
2. To achieve and maintain economic stability.
3. To stabilize the price level.
4. To maintain the growth rate of the economy.
5. To maintain equilibrium in the balance of payments.
6. To reduce extreme inequality in income and wealth.
7. To provide the necessary incentives to the private sector for its healthy growth etc.
Fiscal policy instrument
1. Public debt
It's how the government finances deficits, Resorting to Instruments like bonds
and savings schemes.
2. Govt expenditures
This category spans, subsidies, welfare, public constructions, and
administrative salaries. It is crucial for Social and economic support.
3. Govt revenues
Comprises taxes, interest, and various fees collected by the government.
These form the financial backbone of public services and investments.
Major fiscal functions
There are four major fiscal functions of governments. Allocation, distribution, Economic
growth and stabilization
1. Allocation
The provision for social goods or the process by which total resources use is
divided between private and social goods and by which the mix of social goods is
chosen. This provision may be termed as the allocation function of budget policy.
Social goods, as distinct from private goods, cannot be provided for through the
market system. The basic reasons for the market failure in the provision of social
goods are: firstly, because consumption of such products by individuals is non rival,
 in the sense that one person’s partaking of benefits does not reduce the benefits
available to others. The benefits of social goods are externalized. Secondly, the
exclusion principle is not feasible in the case of social goods. The application of
exclusion is frequently impossible or prohibitively expensive. So, the social goods
are to be provided by the government.
2. Distribution
Adjustment of the distribution of income and wealth to assure conformance
with what society considers a ‘fair’ or ‘just’ state of distribution. The distribution of
income and wealth determined by the market forces and laws of inheritance involve a
substantial degree of inequality. Tax transfer policies of the government play an
important role in reducing the inequalities in income and wealth in the economy.
3. Stabilization
Fiscal policy Is needed for stabilization, since full employment and price level
stability do not come about automatically in a market economy. Without it the
economy tends to be subject to substantial fluctuations, and it may suffer from
sustained periods of unemployment or inflation. Unemployment and inflation may
exist at the same time. Such a situation is known as stagflation.
The overall level of employment and prices in the economy depends upon the
level of aggregate demand, relative to the potential or capacity output valued at
prevailing prices. Government expenditures add to total demand, while taxes reduce
it. This suggests that budgetary effects on demand increase as the level of
expenditure increases and as the level of tax revenue decreases.
4. Economic growth
Moreover, the problem is not only one of maintaining high employment or of
curtailing inflation within a given level of capacity output. The effects of fiscal
policy upon the rate of growth of potential output must also be allowed for. Fiscal
policy may affect the rate of saving and the willingness to invest and may thereby
influence the rate of capital formation.
Capital formation in turn effects productivity growth, so that fiscal policy is a
significant factor in economic growth.

Market failure
It is generally believed that allocation of resources in the economy will be very
efficient if there is free-enterprise, as the activities in the economy is guided by market
mechanism. But it should be realized that the free-market mechanism is neither totally
efficient, nor will it work under all conditions of the economy. They will miserably fail in the
case of pure public goods. Allocation of resources will not be equitable and just in a
capitalistic economy Where there will be enormous mal distribution of wealth and income.
There are several reasons for the market failure and we shall briefly discuss about the concept
of market failure and the need for production of public goods under public sector.
What is meant by market failure? This connotes that’s the available market
mechanism in the economy couldn’t work efficiently to allocate the resources of the economy
and produce the commodities required in optimal quantities. There will be either
overproduction or underproduction or no production at all. Market failure refers to the
difference or divergent between the price of resources and their price that would exist, if there
were markets for them and if they were supplied Optimally. This market failure arises
because of the externality factor in the process of production and consumption of goods
relating to environmental commodities and also commodities that are essentially required by
the weaker sections of the society.
Let us discuss briefly about the several causes that induce market failure in the
economy.
1. Distribution of income
Efficient allocation of resources is possible only when there is very minimal
inequalities of income and wealth. If there is gross inequalities, the resources would
be diverted in the production of comfort and luxury goods demanded by the wealthier
classes and the essential requirements of the poor will not be produced under the
private sector, as the private sector is purely guided by the profit motive and the
ability to pay the price for the commodity demanded. On account of this, the
economy would be producing more of yachts, Five-star hotels and beauty parlors
instead of bread and butter and houses to live in. since the market fails to produce the
essential goods needed for the majority poorer sections of the society, the need arises
for the government to allocate adequate resources in the budget to produce essential
goods under the public section.
2. Allocation of resources under decreasing costs
Secondly, pure public goods have the characteristic feature that they are
subject to law of decreasing costs. Decreasing costs occur when there are high
overhead or fixed costs, as in the case of transportation, power generation and postal
services and also water supply. If the production of these is left in the hands of
private sector, due to operation of decreasing costs there will be under-production and
high prices in the economy in the case of these commodities. Again being lumpy, it
would be subject to economies of scale. If public goods, like these are provided in
small quantities, the average cost is likely to be much more. This will hinder the
welfare of the society. Hence, pure public goods which is subject to decreasing cost
conditions should be produced in the public sector, as there will be market failure
under the private sector. There will be exceptions in the case of discriminatory
pricing.
3. Allocation of resources and imperfect market conditions
According to Musgrave, the present-day aggressive advertisements in the
media rob the consumers of their sovereignty and they do not get real or complete
information of the market. This would lead to wrong choice of the consumer and
distortions in his preference. According to Prof P.E. Taylor, “Individual consumption
decisions are inferior because of inadequate knowledge and the market principles
result in allocation of resources to other than the best users”.
 Imperfect market conditions, aggressive advertisements and consequence distortions,
loss of consumer sovereignty and poor choice will lead to faulty allocation of
resources in the economy.
4. Market failure in the case of public wants
In the case of satisfying public wants, market cannot allocate the resources in
an efficient manner and satisfy the public wants, as all the people in the economy
may not be capable of paying the price for the commodity or services which are
classified as ‘public wants’. It becomes inevitable on the part of the government to
provide the necessary public wants to all the people, whether they are capable of
paying the price for the same or not. For example, National Defense, protection
against health hazards, etc., come under this category. A similar situation arises in the
case of public wants like education, sanitation, etc., where the benefits may not be
wholly dispersed. The specific beneficiaries are those who attend school. However,
the society will become more educated and culturally advanced due to widespread
public education. A system of exclusively private schools operating on a tuition basis
would of course provide schooling for those whose parents believe that the specific
benefits justify the price. But, this may leave a large share of population which is not
competent to pay the price, tuition fee. Hence, they would suffer due to lack of
education. Thus, wherever, there are third party benefits involved, which widely
affect irrespective of individual contribution, the market principle will not provide
appropriate allocation of resource. Besides education, there are several public wants
such as adequate health standards, sewage disposal, control of water and air pollution
and prevention of diseases, etc., besides housing, Social Security measures,
prevention of crimes and postal system. Since in such areas as these market
principles, cannot be dependable, the market principle must be abundant in favor of
some others.
5. Profit system and failure of economic stability
Normally, the market system works on the basis of profit and the resources
will be exploited to those channels where the profits will be high and also immediate.
Thus, short-term profits would be looked after in production, rather than long-term
profits. Further, the profit system which is the keel of market mechanism fails to
achieve the social goal of economic stability even under the best of private enterprise
conditions. The reaction of the individual entrepreneur will be to reduce investments
in plant and inventory in areas of declining profits. The boom conditions would
expand business operations through additional investments. Thus, the economy
would be fluctuating between boom and depression and there will not be stability in
the economy. If stability is regarded as social good, then it is the duty of the
government to intervene in the market mechanism through guarantees and subsidies
and direct the allocation of resources in such a way that there will be stability in the
economy.
6. Market failure due to externalities goods
We have already studied about the important characteristics of public goods
and externalities. We know that externality refers to the economic effects which
occur from the production or use of the goods to other parties or economic units.
 These externalities may be public good or public bad. Air pollution is a good
example of this. The factory that emits smoke into the atmosphere does not do so as
an end in itself. It is only an incidental side effect in the process of production.
However, this spillover effect constitutes health hazard to the people in the
neighborhood which is omitted entirely from the factory's calculation of its and costs.
The fact that the business firm running the factory costs adverse externality without
paying any cost, helps to explain the failure of the market mechanism which does an
imperfect job of protecting the environment.
7. Marginal cost of pure public goods are zero
We have studied already that social goods are non-rival in consumption. This
means that the consumption of the benefits of a particular good or service will not
reduce the benefits derived by all others. The same benefits are available to all and
without mutual interference. Therefore, it would be inefficient to apply exclusion
principle, even if this could readily be done. Since P’s partaking in the consumption
benefits does not reduce or hurt Q’s partaking in the consumption the exclusion of
Mr. P would be inefficient. It means the supply of such goods would be inefficient
through the market, since the market can function only in a situation where the
explosion principle applies. Besides efficient resource use requires that price is equal
to marginal cost. But, in the case, marginal cost is zero, and so should be the price.
But market cannot provide such facilities at zero price.