In importance and comprehensive coverage of the economy straddling all sectors, fiscal policy takes its place next to planning. When development planning called the shots, both in socialist command economies and mixed economies of developing countries, fiscal policy was its handmaiden, responsible for resource mobilisation. Allocation of resources and utilisations in command economies among various sectors were, however, beyond its remit, the decision having been made by the plan. In mixed economies, directions of plans in these regards were confined to the projects undertaken as part of implementing the plan, and this practice has been continuing at present in countries where development plan is still in operation. In developed countries fiscal policy is categorised into two: automatic stabilisers and discretionary fiscal policy. The former is used to stabilise disposable income, consumption and consequently real gross domestic product (GDP). The discretionary fiscal policy, on the other hand, requires the deliberate manipulation of government purchases (spending), taxation and transfers to promote macro economic goals like full employment, price stability and economic growth. In developing countries the goals are also the same except that price stability is more a responsibility of the central bank. In both developed and developing countries fiscal policy involves earning revenue through tax, fees, etc., and expenditures on recurrent and non-development activities and development (including welfare) programmes. Unlike households which decide on expenditure according to their income, governments are obligated to undertake various expenditures on the basis of which revenue earnings and resource utilisation from other sources like borrowing, printing of money are determined. Households also can borrow but not to the same degree as governments. Though governments constantly endeavour to balance their budgets, more often than not deficits become inevitable because of increasing demands for resources. Globally, expenditures incurred by government almost routinely outstrip their income from revenue and as a result borrowing from national and international sources become unavoidable. But unlimited or regular borrowing proves problematic because of debt servicing capacity and creeping inflation that threatens to go out of control. The greatest challenge to keep deficits within reasonable limit is to avoid default, ramping of inflation and crowding out the private sector.
Fiscal policy has become important because it affects macro economic variables such as real GDP, employment, inflation, exports and imports and growth rate. But this has not been always the case. Before 1930s fiscal policy was seldom used to influence the macro economy in developed countries. Most of the developing countries being their colonies or in a state of underdevelopment had fiscal policy in terms of budgets that addressed requirements of recurrent expenditures on non-development activities. The promotion of economic development through government intervention came in vogue only after they (colonies) became independent. Accelerating development to break the vicious cycle of poverty became pressing on political grounds. In the developed countries fiscal policy was shaped by views of classical economists who advocated laissez-faire. They did not deny that recessions and unemployment occurred from time to time but it was argued that the sources of such crisis lay outside the market. The classical approach implied that natural market forces through flexible prices, wages and interest rate could address the shock caused by factors outside the market and move the economy toward potential GDP. There appeared to be no need for government intervention according to this view. Government was expected to function within its income. The idea of government running a deficit was considered as immoral. The prolonged depression of the 1930s strained the belief of economists in the ability of the market to restore the health of the economy through the operation of its forces. The stark contrast between the actual market adjustments prescribed by classical economists and the years of high unemployment during the Great Depression represented a collision of theory and fact. In 1936 John Maynard Keynes of Cambridge University challenged the view of classical economists and recommended fiscal measures that later came to be known as Keynesian Revolution or less dramatically, Keynesian economics. Keynes' main difference with classical economists was that prices and wages did not seem to be flexible enough to ensure the full employment of resources. He also believed that business expectations might at times become so grim that even very low interest rates would not spur firms to invest all that consumers might save. Keynes thought that economy could get stuck well below its potential, requiring the government to increase expenditure to bolster aggregate demand that would in turn boost output and employment.
Prior to Great Depression the dominant fiscal policy was to have a balanced budget. In the wake of Keynes' General Theory and the World War II policy makers became more receptive to the idea that fiscal had a pre-eminent role to improve economic stability and promote growth. The objective of fiscal policy was no longer seen to balance the budget but to promote growth and employment with price stability even if that resulted in a deficit budget.
Fiscal policy based on Keynesian economy relied primarily on the demand side, not the supply side. The problem of 1970s in developed economies like America, was however, stagflation, the double crisis of higher inflation and higher unemployment resulting from a decrease in aggregate supply. The aggregate supply decreases because of various external factors like Organisation of the Petroleum Exporting Countries (OPEC)-driven oil price spike and other adverse supply shocks. Demand management through fiscal policy was considered as ill-suited in developed countries to address stagflation because increase in aggregate demand would increase inflation whereas a decrease in aggregate supply would worsen unemployment. In America, tax cuts of the early 1980s were introduced as a way of increasing aggregate supply. But government spending grew faster than tax revenue increasing budget deficits. The tax cuts, in effect, resulted in an expansionary fiscal policy. But despite job growth that resulted from this policy government revenues did not increase enough to offset the combination of tax cuts and increased government spending. The recession of 1990s pushed deficits up to 5.0 per cent of GDP compared to 1.0 per cent before 1980. The cumulative deficits resulted into a huge national debt in America, doubling from 33 per cent in 1981 to 64 per cent in 1992. It has risen still higher since then. The huge deficit discouraged expansionary fiscal policy as a way of stimulating aggregate demand further but success in reducing the deficit in 1990s spawned renewed interest in expansionary fiscal policy based on demand management characterised by tax cuts and spending programmes beginning in 2001. Tax cuts and new spending helped fight recession of 2001 and strengthened a recovery during 2000-2004. After the financial crisis of 2007-2008, monetary policy was pressed into service, more than fiscal policy, exposing the limitation of fiscal policy in addressing the financial crisis. Recently, the present American administration has opted for contracting fiscal policy through tax cuts and reduction in public expenditure hoping that the expansionary monetary policy would lay the foundation for recovery and growth of the economy. The experience in the rest of the capitalist developed countries is more of less the same. Overall, the swing to supply side management through tax cuts, reduce expenditure and expansionary monetary policy appears to be ruling the roost in developed countries. In contrast, expansionary fiscal policy continues to be the 'weapon of choice' or preferred policy instrument for accelerating economic growth. Growing budget deficits have led governments to rely more on borrowing rather than contracting fiscal policy. In tandem the monetary policy has also been expansionary to encourage private sector investment. As a result, inflation is on the rise in most of the developing countries, though not yet dangerously high. In contrast to developed countries, the major problem faced by fiscal policy is lower revenue earning through taxes, etc., by the government than is potentially possible. Exacerbating the problem is greater reliance on indirect tax which has aggravated income inequality as the incidence of these is more on middle class and poor. Unlike developed capitalist countries austerity measures have not been adopted through reduced government expenditures. At the same time rise in prices of essential items has fostered a different kind of austerity, self-imposed by consumers, resulting in an incipient reduction of their standard of living. In spite of this, fiscal policies in developing countries are likely to be expansionary in the foreseeable future because of its use as a means of accelerating growth. The choice for policy makers committed to achieving higher GDP growth rate, along with promoting welfare of people, is thus limited in the developing countries to expansionary fiscal policy.
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