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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Government Budgeting and Theories of Budgeting

Government Budgeting


Concept and History of Budgeting


Governments undertake different social, economic and political activities and policy measures, which involve finance. The mechanism to manage financial resources for this can be termed as budgeting. Government budget is the nerve center of the public economy. The word budget has been derived from the French word ‘bougette' which literally means a leather bag containing financial proposals of the government.

Some Definitions:


According to Bastable, “The term budget has come to mean the financial arrangements for a given period with the usual implication that they have been submitted to the legislature for approval.”

According to Due and Friedlander, “ A budget may be defined as a financial plan that serves as the basis for expenditure decision making and subsequent control of expenditure. Budget usually contains financial data for the previous year, revised estimated figures for the current year and recommended figures for the coming year, for both the expenditures and revenues.”

According to Philip Taylor, "The budget is the master financial plan of a government. It brings together the anticipated revenues and proposed expenditures for the budget period, and from these estimates the activities to be undertaken and the means of financing can be inferred."

According to World Bank, "The annual budget is usually the legal authority for public spending. It is usually one year slice of a medium term expenditure plan."

Features of a Budget

  1. It is a financial plan or programme guided by the socio-economic policy of the government for coming year;
  2. It is a plan of action with the approval from the legislature;
  3. It is an annual plan being guided by and intended to achieve the socio-economic objectives of the medium plan;
  4. The budgetary process involves formulation, approval, execution, and monitoring & evaluation; and 
  5. It should be comprehensive, and include all estimated revenues and expenditures.

Objectives of Budget

Different writer have pointed out the objectives of budget in different ways. 

According to Musgrave - 
  1. Adjustment of resource allocation for economic growth;
  2. Adjustment of distribution of national income and wealth; and
  3. Maintenance of economic stability.

According to Prem Chand - 
  1. Integration of expenditure decisions with the specified policy objectives and resource at present and future;
  2. Integrate the major budgetary decision with national economic situation;
  3. Make certainty in efficient and effective implementation of governmental programmes; and 
  4. Help in legislative control on different phases of budgetary process.

According to Richard Goode -
  1. Prepares policy formulation structure in the selection of competing objectives;
  2. Means of policy implementation;
  3. Means of legal control of abuse of authority and use of fund extravagantly; and
  4.  Document of public information on governmental activities in past, present and future.

History of Budgeting


History of evolution of budgeting dates back to the promulgation of the Magna Carta by King John in 1215 AD in England. This limited the discriminatory authority of the king over public property. In 1689 AD the Bill of Rights authorized the need for parliamentary approval on raising tax, debt and donations by the government. It was only in 1733 AD the first budget was presented in the parliament in England. The budget practice was introduced in different countries at different times. In Nepal, the first national budget was made public in 1952 AD (2008 BS) after the overthrowing of the Rana regime.

Theories of Budgeting


1. The Classical Approach (Balanced Budget)


The Classical economists favored balanced budget annually. Among the Classical writers there were two opinions regarding the interpretation of the balanced budget. One view relates the balanced budget with the total expenditures and total revenues, and there should be no government borrowings at all. The second view held that the balanced budget relates only with the current or regular expenditures of the government, and they must be covered up only by the current revenues. But the capital expenditures like on the self-liquidating projects, and the emergency expenditures may be financed through borrowings.

The Classical approach of balanced budget was based on the assumption that full employment is the normal condition in the economy. They were of the view that a deficit budget is to be financed only by borrowings. Government borrowings in a situation of full employment withdraw resources from more productive and efficient uses in the private sector to most likely unproductive use in the public sector. The Classical writers were against the expansion of governmental activities, They were of the view that a deficit budget leads to devaluation of the currency. So they always emphasized on the small size of the government and a balanced budget.

The Classical view did not recognize the prevention of unemployment and control of economic fluctuations through the use of budgetary actions. But the Keynesian view held that full employment is not a normal condition, and there remains some frictional or under employment in the economy. So, to ensure higher level of employment and control the economic fluctuations, a flexible budgetary policy is needed.

2. The Modern Approach (Managed Budget)


It has been accepted now that the annual balanced budget as favored by the Classical writers, is irrelevant in a situation of unemployment and other economic instabilities as well as in context of the developing countries. Economists like Keynes, Hansen, Lerner, Dalton and Beveridge argued that the budgetary policy should aim at attaining the optimum level of employment of resources and steady growth of the economy. For this, they advocate a managed approach in budgeting as per the need of the economy.

The Modern approach of budgetary theory developed with the contemporary interest in the problems of economic cycles. The modern approach held that government should not be worried to balance the budget annually. It may be balanced over the entire period of the business cycle. Thus during the period of depression or recession a deficit budget is desirable. Taxes should be decreased and expenditure be increased with mainly by borrowings to stimulate the economy by increasing effective demand. While in the situation of prosperity and boom, a moderate surplus budget is desirable. In such situation, taxes should be increased and expenditure be decreased as far as possible, and the debts are to be repaid with the surplus budget.

So far as the budgeting in the developing countries is concerned, the modern approach relates it with the development objectives. Budget in the developing countries is preferred to be deficit to a considerable extent so as to promote financial resource mobilization and increase investments on greater and productive utilization of the productive resources.

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Debt Management: Concept and Principle of Debt Management

Debt Management: Concept


Debt management is concerned with the determination of the structural characteristics of public debt. They are the size, types, proportions, terms, maturities, ownership patterns of public debt and the methods of its redemption. Debt management should help to achieve the economic objectives and should not have adverse effects on the economy.

Debt management even being a part of fiscal policy, should be well coordinated with the monetary policy as it has direct effects on the monetary system

Principles of Debt Management

Debt management should be guided by the following principles:
  1. The interest cost of debt-servicing should be minimized as far as possible;
  2. The need of the investors of different nature should be satisfied;
  3. The objectives of economic stability and growth should be achieved; and
  4. There should be minimization of the need to enter the market in a situation of inconveniency.

Debt Redemption Methods


Debt redemption refers to be getting rid-off the liability to repay the debt. There are different methods used in practice for this. The liability to repay the debt may be postponed or ended with the actual repayments.

1. Repudiation- It is the total refusal to repay the debt and was practiced after the great political revolutions immediately after the American Independence in 18th century and Bolsovik Revolution of 1917 in the USSR.

2. Postponement of the liability- The liability to pay the debt may be postponed without changing the size of the debt. The methods are:
  • Refunding- In this method government repays the debt to the existing holders by raising the debt from new security holders. Government will have the liability to pay the debt to the new security holders instead of the earlier holders.
  • Conversion- At the time of maturity, when the market rate of interest is lower than the existing rate of interest on the securities, the old loans are converted into the new loans, if the security holders agree.

3. Actual Payment- For actual payment of public debt following methods are in practice:
  • Sinking fund- It is a fund where certain amount of revenue is deposited each year for the repayment of the outstanding debt. The balance in the fund can be invested, and the interest or other income from them is also accumulated in the fund until the debt is matured.
  • Buying up loans- In a situation when government can generate budgetary surplus, mostly in a situation of prosperity, the surplus is used to clear the debt off gradually. It used to be practiced in case of the Console.
  • Capital Levy- This method uses heavy taxes on property and income above certain value as the speculators and other business groups enjoy a huge profit mainly after the war.
  • Serial Bond Redemption- This is the most common method of debt redemption. Government issues the securities maturing at different periods. The maturing securities are determined in a serial order by lottery or fixing certain maturity dates. The maturing securities are repaid with making budgetary provisions every year. 

Redemption of External Debt

The external debt is to be repaid with the increase in foreign exchange reserves. It is possible with increasing the export earnings and/or reducing import payments. So, external loans should be used on productive investments which increase the production of export goods and services and/or import substitution goods and services that increase the foreign exchange reserves. However, some of the foreign loans are converted into grants as debt relief programs for the least developed countries facing financial problems.

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