Fiscal policy refers to the use of government revenue and expenditure to influence the economy.
It refers to the government’s strategy for raising and spending funds, both in quantitative terms (how much) and qualitative terms.
Qualitative Aspects of Fiscal Policy
Fiscal policy is concerned not just with how much is raised/spent, but how effectively and responsibly:
Is revenue raised via taxes or borrowing?
Are taxes progressive or regressive, rational or excessive?
Is spending productive (e.g., capital formation) or wasteful?
It also highlights populist expenditures—spending aimed at short-term political gain with little economic logic (e.g., unsustainable subsidies like free power to farmers).
The Union Budget is the primary instrument through which fiscal policy is implemented.
Sources of Fiscal Receipts
Fiscal receipts include both earned and borrowed resources:
Revenue Receipts: Taxes (direct and indirect), user charges (power, water, transport), fees, and dividends.
Capital Receipts: Disinvestment proceeds, borrowings (internal and external).
Not all receipts are considered “revenue”—only what is earned is classified as such; the rest are treated as borrowings or capital inflows.
Classification of Government Finances
Government finances are divided into:
Revenue Account: Day-to-day income and expenditure.
Capital Account: Long-term assets, liabilities, and investments.
Article 112 of the Constitution refers to “revenue and other expenditure” but does not explicitly mention the capital account.
How does fiscal policy work?
When governments aim to influence the overall performance of an economy, they primarily rely on two broad tools: monetary policy and fiscal policy.
Central banks influence economic activity indirectly by managing the money supply through tools such as interest rate adjustments, changes in reserve requirements, and open market operations involving government securities and foreign exchange. In contrast, governments impact the economy by altering the structure and level of taxation, the scale and nature of public spending, and the extent and method of borrowing.
A fundamental framework used to understand national income—expressed through the expenditure method of calculating GDP—is:
GDP = C + I + G + NX
Here, GDP represents the total value of goods and services produced. The components on the right indicate aggregate demand: C stands for private consumption, I for private investment, G for government expenditure, and NX for net exports (exports minus imports). The government directly influences GDP through G and affects other components—C, I, and NX—indirectly via taxation, subsidies, transfers, and regulation.
When a government increases public spending or cuts taxes to stimulate demand, it is said to pursue expansionary fiscal policy. Conversely, reducing public expenditure or raising taxes to control inflation or reduce deficits is known as contractionary fiscal policy.
Beyond economic stabilization, fiscal policy serves various purposes. In the short run, it is used to manage economic fluctuations—for instance, boosting expenditure to revive a sluggish economy or tightening spending to curb inflation or external imbalances. In the long run, fiscal tools are used to promote growth, reduce poverty, and enhance productivity through investments in infrastructure, health, education, and human capital.
The priorities of fiscal policy vary across countries and timeframes. For example:
A developing country may focus on social sector spending to improve healthcare and primary education.
An advanced economy might emphasize pension reforms to tackle fiscal stress due to an aging population.
In resource-rich countries, fiscal policy may aim to smoothen expenditures by saving during boom periods and maintaining essential spending during downturns.
Ultimately, fiscal policy is a dynamic instrument that must be tailored to the specific economic, social, and developmental contexts of each nation.
Objectives of Fiscal Policy
Economic Growth
Stimulate sustainable and inclusive economic development by promoting investment, infrastructure, and productive sectors.
Price Stability
Control inflation and curb deflation by adjusting spending and taxation patterns.
Full Employment
Encourage job creation through targeted public spending and employment-generating schemes.
Redistribution of Income and Wealth
Reduce income inequalities via progressive taxation and welfare-oriented public expenditure.
Resource Allocation
Direct resources toward priority sectors like health, education, defence, and rural development.
External Stability
Manage fiscal deficits and public debt to ensure a stable balance of payments and investor confidence.
Capital Formation
Encourage savings and investment in the economy, both by the government and private sector.
Counter-cyclical Role
Act as a stabilizing tool during economic fluctuations—expansionary during recession and contractionary during boom periods.
Gender Empowerment and Social equity.
Budgetary allocations for women-centric schemes such as Beti Bachao Beti Padhao, PM Matru Vandana Yojana, and Self-Help Group financing.
Environmental Sustainability
Fiscal incentives for clean energy, afforestation, and pollution control.
Taxes or levies on environmentally harmful activities (carbon tax, cess on coal).
These objectives collectively aim to ensure macroeconomic stability, social justice, and economic resilience.
Types of Fiscal Policy
Types of Fiscal Policy
Expansionary Fiscal Policy
Objective: To boost aggregate demand during economic slowdown or recession.
Measures:
Increase in government spending on infrastructure, education, health, etc.
Reduction in tax rates to enhance disposable income.
Effect:
Creates jobs and raises consumption.
Revives investment and production.
Example:
During high unemployment and low demand, government may initiate large-scale public works and reduce taxes — a strategy known as pump priming.With increased money supply and lower tax burdens, consumer demand for goods and services rises, thereby revitalizing business activity and transforming the economy from stagnation to growth.
Contractionary Fiscal Policy
Objective: To curb inflation and reduce excess demand in the economy.
Measures:
Cutting down public expenditure.
Increasing tax rates to reduce disposable income.
Effect:
Lowers consumer spending and demand for goods.
Helps bring down inflationary pressures.
Fiscal Policy and Business Cycles
Role in Stabilization
Fiscal policy plays a key role in mitigating extreme phases of the business cycle:
Recession: Use expansionary policy to revive demand.
Boom: Use contractionary policy to prevent overheating.
Counter-Cyclical vs Pro-Cyclical Fiscal Policy
Counter-Cyclical Fiscal Policy
Moves against the current economic trend to stabilize the economy.
During boom: Reduce expenditure and increase taxes.
During recession: Increase expenditure and cut taxes.
Purpose: Smoothens the fluctuations and maintains macroeconomic stability.
Pro-Cyclical Fiscal Policy
Moves in the same direction as the business cycle, thereby amplifying economic fluctuations.
During boom: Increased spending and stable or lower taxes (fuels inflation).
During recession: Reduced spending and increased taxes (deepens the slowdown).
Effect: Leads to economic instability and fiscal vulnerability.
The Economic Survey 2016–17 noted that India’s fiscal stance inherently leans toward higher deficits, as government spending tends to increase pro-cyclically during periods of growth, while both revenue and expenditure are adjusted counter-cyclically during economic slowdowns.
