Monday, August 24, 2009

Compensatory Fiscal Policy

It is possible that monetary policy, taken alone may not suffice to check cyclical business fluctuations. It is therefore suggested monetary policy should be properly integrated with a suitable fiscal policy to achieve the desired results. Keynes and Keynesian economists, like Hansen and others, have recommended compensatory finance or compensatory fiscal policy to bring about stabilization of business activity. According to Keynes explanation, trade cycle is primary caused by disequilibrium between saving and actual investment. If therefore, the capital outlays of the state and public bodies could be adjusted to the varying private (business) investments disequilibrium can be prevented from arising and thus economic stability ensured. And if disequilibrium has some who come about, it can be rectified by adjusting public spending. Public spending has thus, to be varied according to the exigencies of business situation.

In the year of depression, that is, when private investment is at low ebb, the deficiency in investment will have to be made up by large capital outlay by the state, and conversely during the upward swing of the cycle, the state will have considerably to cut down its spending programme. Thus during the depression years, the state must be ready to spend beyond its current revenues.

In other words, the state should be prepared to have deficit budgets during depression. Conversely there should be surplus budgets during the years of prosperity. To put it in another way instead of having balanced budgets every year, the state should aim at budget-balancing over a series of years. On the revenue side, rates and taxes should be lowered during depression, while they should be raised during boom years. To stimulate business investment during depression, not only the rates of taxes should be lowered but also more liberal allowances for depreciation and obsolescence etc should be granted. Thus fiscal policy, which is also called the contra-cyclical management of public finance, may be operated both through public revenues and public expenditure. Between these two, the expenditure method is far more effective in stimulating business activity more over revenue method leaves the entire initiative to the business community and is also not capable of directing expenditure into channels which may be particularly desired. However best result will be achieved if both of them are combined.

Public spending or public works policy, in view of its greater efficacy, deserves rather a detailed treatment. We shall begin with its theory. When during depression, economic activity is at low ebb, and consequently there is considerable unemployment, the propensity to consume is naturally low. One important thing apart from lowering the rate of interest is to increase this propensity to consume. If some how additional employment could be created by starting public works and thus purchasing power increased through the wages paid to the newly employed, propensity to consume will rise and in turn stimulate private business investment, on the principles of multiplier and acceleration. The Government expenditure on its public works will, thus have brought about many times greater investment and thus contributed greatly towards all-round economic recovery. The public works expenditure of the state will have, thus performed the function of priming pump of economic activity in the country.

This is to fight depression, when it has already occurred or is developing. But there is another function that public spending programme may be made to perform namely that of stabilizing economic activity over a long time, and making it free from booms and depression. This long term aim can be achieved, as has been mentioned already, be constantly and appropriately adjusting public investment to the changes in private investment. The function is called the compensatory action of fiscal policy.

In the words of American Economic Association “In a system where the great majority of workers are in private employment, government stabilization policy consists primarily in altering the great economic climate so as to migrate or offset developing fluctuations in private business”. Among the measures that a government may adopt to even out cyclical fluctuations, their report mentions the following.

(i) Alternative in tax rates and in the design of tax structure to bring about changes in incentives to individuals.

(ii) Changes in government contribution to the income stream through transfer payments i.e. employment benefits etc.

(iii) Change in public expenditure on public works and other government purchases.

(iv) Monetary control to bring about a change in the cost and availability of bank credit.

(v) Public debt or monetary policy to bring about changes in the financial assets and liabilities of the public.

(vi) Timely announcement of clearly defined government policy with a view to influencing investment decisions as well as those relating to current scheduling output and employment.

Two strategic principles have been recommended for the achievement of economic stability.

(1) Government tax revenue should be higher relative to government expenditure in periods of high employment than in periods of substantial unemployment.

(2) Money credit should be relatively tight in periods of high employment and relatively easy in periods of substantial employment.

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