Fiscal Policy: Role and Evolution of Fiscal Policy

Fiscal Policy: Concept

Governmental financial policies and operations, concerning the raising and disbursement of funds, influence the economic behaviors and activities, and so the national income, employment, income distribution, price situation, international trade, etc. This realization has led to make deliberate adjustments in governmental income and expenditure policies and programs to attain the economic objectives. Such an adjustments is called the fiscal policy. So fiscal policy is concerned with the adjustments in the operation of the treasury to solve and attain economic problems and objectives.

Arthur Smithies defines fiscal policy as, "a policy under which the government uses its expenditure and revenue programs to produce desirable effects and avoid undesirable effects on the national income, production and employment."
According to Due and Friedlander, “By fiscal policy we refer to the governmental determination of the level and structure of taxes and expenditures, and the manner of financing a budgetary surplus or deficit to achieve the various macro-economic goals of full employment, price stability, growth, balance of payments equilibrium, and so forth.”
Ursula Hicks defines, “Fiscal policy is concerned with the manner in which all the different elements of public finance may collectively geared up to forward the aims of the economic policy.”
J. M. Keynes defines, “Fiscal policy is a policy that uses public finance as a balancing factor in the development of the economy.”

Evolution of Fiscal Policy


Since late 18th. Century until 1930’s, the ‘Laissez-faire’ policy guided public finance to make least possible interference on the functioning of free market mechanism. Then the ideals of sound public financial policy were:
  1. reduction of public expenditure to the minimum possible limit;
  2. tax structure be designed in such a way so that the market or price mechanism be disturbed to a little extent as far as possible; and
  3. budget to be annually balanced.
The traditional belief did not recognize the possible effects of taxes and expenditure upon the level of national income and employment. Taxes were considered only a means to finance government expenditure, and not a means to regulate the economy. Similarly, borrowings to finance government expenditures in maintaining economic stability were not realized.

The Great Depression of 1930’s was a milestone in the evolution of fiscal policy with the operation public financial operation in influencing the economic activities. At that time, governments were to provide relief to the unemployed people and to revive the economy from depression by increasing the effective demand. J.M. Keynes advocated the use of public financial operation in this regard.

In 1940’s. the followers of Keynes like Lerner, Hansen, Dalton, and Beveridge added new dimension to fiscal policy to control inflation as well. Then the flexible or managed budgetary policy was realized and practiced as needed by the economic situation.

After the Second World War the importance of fiscal policy was further recognized in the developing countries. The urge for fast economic growth led to adopt planning in most of the developing countries. This led to the need for increasing governmental investments and regulate the private sectors’ investment activities in consistent with the plan objectives. In the late 1960’s, the significance of fiscal policy to promote distributive justice was realized. And in the 1970’s, the need for maintaining ecological balance (environmental protection) also became the part of fiscal policy.

Role of Fiscal Policy


1. Fiscal Policy and Economic Growth

In a simple way economic growth can be understood as the increase in the level of national production, and thus the national income. It is measured as the increase in Real GDP/GNP or Real Per Capita Income. Economic growth has a process. For growth the productive capacity of the economy should be increased, which is possible with the increase in capital formation. Capital formation needs increase in national investments. To increase national investments there is necessity to mobilize domestic savings by both the private and government sectors. Besides, attraction of foreign capital also helps in this concern.

Growth (G) = Investment Ratio (I) / Incremental Capital Output Ratio (ICOR)

So, economic growth depends on the size of the national investments and the size of the incremental capital output ratio. In the underdeveloped countries the necessary amount of savings and investments can not be generated only by the market system. And the government is to play the leading role with functioning as an investor, facilitator and regulator of the economy by using necessary fiscal policy.

Increase in national savings includes both the private savings and government savings (in the form of revenue surplus). Private savings can be increased and mobilized with establishment and expansion of the financial institutions of different nature supporting through expenditure (including subsidies), and tax incentives as tax-holidays, concessions, depreciation allowances, carry-over losses, expansion of business activities, etc. for the private sector.

National savings can also be increased with the imposition of taxes generating maximum potential revenue and minimizing the recurrent expenditure of government with substantial amount of revenue-surplus, borrowings and creation of extra money. Resource gap in development finance can be supplemented by receiving foreign aids as well as attracting private foreign investments. 

The public income from different sources may be used as expenditures on production activities by government itself, creation of physical infrastructures, research activities, promotional activities to increase the productive capacity of the economy. These investments also attract private investments.

2. Fiscal policy and Distributive Justice

In the underdeveloped countries there is wide inequality in the distribution of national income. One of the basic objectives of a welfare state is to minimize the inequality in national income distribution. For this, people in the lower income strata and underprivileged should be enabled to earn more. Fiscal policy can help in this concern.

Higher income in the UDCs largely goes on luxurious consumption and unproductive investments. Progressive taxes on higher income and wealth, luxurious consumption and unproductive investments generate substantial revenue for the government. At the same time, low rate of taxes or exemptions on production and consumption of mass consumption goods, if necessary even on imports and subsidy increases income of the low income people in an indirect way with reduction or control of prices.

Public expenditure on socio-economic upliftment of the poor people with the provision of free or subsidized education and training, health, safe drinking water and sanitation, housing, subsidy on financial support and special development programs help in enabling their earning capacity.

Similarly, priority for labor intensive technology helps to increase employment opportunities. Public expenditure on different developmental activities using labor intensive technology is desirable. Along with this, tax incentives for private sector absorbing more labor also help in this regard.

Public expenditure on social welfare activities like old-age pension and other allowances, operation of charitable institutions also promotes distributive justice. 

Minimization of regional disparities and rural-urban disparities through the creation of socio-economic infrastructures, fiscal incentives, subsidy and special development programs help in attracting economic ventures, creation of employment opportunities and utilization of local resources, and promote economic status of the relatively less developed regions.

3. Fiscal policy and Balanced Development

Development in totality refers to simultaneously development of all sectors (at least the major sectors) of the economy. It needs balanced development of the all sectors. There is interdependent relationship among the different sectors in the economy, which is indicated by the Input-Output Analysis. The output of a sector is used as inputs by different sectors, and for the output of a sector it needs the output of other sectors or industry as inputs.

So with the information about the inter-industrial or sectoral relationship from the Input-Output analysis, fiscal policy can help in maintaining balanced development of the economy. For this, fiscal policy in the form of tax incentives like holidays, concessions, depreciation allowances for both the input supplying and absorbing sectors or industries is desirable. Similarly, public expenditure on creation of infrastructures and provision of subsidy also help in this concern. 

The next aspect of balanced development is the proportional development of different regions or areas of the country to minimize the disparities in economic prosperity. Fiscal policy, in consistent with the regional planning strategy, can help in this concern. Discriminator tax-policies favoring or providing incentives to the investors in relatively less developed areas along with public expenditure on creation of infrastructures and provision of subsidy may attract and promote economic activities in such regions. This will lead to prosperity of the less developed areas, and will promote the proportional balanced development of all regions of the country.


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Planning Programming Budgeting System (PPBS)

Planning Programming Budgeting System: Background


The traditional budgeting system (i.e. the Line-Item and Incremental) has been unsuitable and ineffective in the effective utilization of limited governmental resources as well as in the context of planning. There are some shortcomings or weaknesses of the traditional budgeting system as follows:
  1. emphasize on the objectives of control and accountability rather than allocation of limited resources on programmes and projects;
  2. provides information on the objects of expenditures, not the objectives of expenditure;
  3. does not help in analyzing and assessment of the impact of budget on the economy;
  4. emphasize on the incremental approach without due consideration of the necessity;
  5. emphasize on the financial performance rather than the physical;
  6. does not relate the current expenditure with the future budgetary repercussions

Success of planning needs improvements in budgeting system including others. John Beyer emphasizes that improvements in economic planning need, at first, a budgetary innovation to translate the plan decisions into reality. Similarly Caiden and Wildvasky have stated that planning is not worth much attention until the annual budget is made more meaningful.

History and Concept of Planning Programming Budgeting System (PPBS)


An innovation in the budgeting system is the planning programming budgeting system (PPBS). It is equally called the Performance and Programming Budgeting System as well as the Planning Programming Budgeting System. The Performance Budget was the outcome of the recommendation of the First Hoover Commission, 1949 in the USA. The Performance Budget is defined as;

“A performance budget is one which presents the purposes and objectives for which funds are requested, the costs of programmes proposed for achieving these objectives, and quantitative data measuring the accomplishments and work performance under each programme.” - Jesse Burkhead.

Performance budget is mainly to evaluate the work performance of government expenditures. Later, the term ‘programme’ was coined with the performance budgeting in 1957 as per the recommendation of the Second Hoover Commission. The Programme budget emphasizes on the need for budgetary management in the light of long term objectives.

PPBS was first introduced in the Defense Department in the USA in 1961 by Robert McNamara, and in all departments in 1965 until 1975. This system of budgeting is in practice in the form of Programme Budget in most of the countries mainly in case of development budget (introduced in Nepal since 2026 B.S. 

Stages of Planning Programming Budgeting System (PPBS)

  1. Specification of Objectives - The objectives of the programmes are to be specified in consistence with the long term goals in quantitative terms as far as possible.
  2. Systemic Analysis - The possible alternative projects to achieve the programme objectives are analyzed in a systematic way with the use of cost-benefit and cost-effectiveness analysis.
  3. Functional Classification - The budget is classified on a functional basis like functions, programmes, projects and activities.
  4. Organization - Budget formulation addresses the organizational structure, managerial and administrative procedures of the programs/ projects/ activities.
  5. Evaluation - The mechanism for evaluation of performance on the basis of financial and physical performances to monitor, and take corrective actions, if necessary.

Advantages of Planning Programming Budgeting System (PPBS)

  1. It integrates the process of program/ project formulation, budget allocation and evaluation in a systematic way.
  2. It helps in the choice of programs/ projects, allocation of resources on them and performance evaluation for the executive and legislature.
  3. It integrates the decision makings regarding the choice of program/ projects to achieve the intended objectives.
  4. It attempts to promote maximum social advantage with the prudent (wise-full) use of scarce resources.
  5. It incorporates the future budgetary repercussion (may be 3,5,10 years) as per the nature and size of the projects.

Limitations of Planning Programming Budgeting System (PPBS)

This system of budgeting has not been effective in practice, even in the USA, and so in most of the countries. The reasons are pointed out as follows:
  1. For appropriation and control purposes, expenditures are continued to be classified in the traditional line-item approach. Various objectives budgetary policy makes budgeting complex and confusing.
  2. The problem arises in its application in case of multiple objectives of a program/ project that involves different agencies.
  3. It is difficult to acquire necessary information regarding performance evaluation and cost estimation in an uniform way in all governmental activities.
  4. It emphasizes on physical and financial performance, not on qualitative performance.
  5. It intends to centralize the budgetary decision makings.

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