Imbalances in the budgetary arrangements of developing countries lead to unemployment and inflationary gaps lead to many social problems. These symptoms tell the tale of gaps in the stabilisation polices of the government. The subject requires serious study of arrangements which are made by the government in its Public Finance Policies.
A person's real income is the value of all goods and services accruing to him from all sources during a year. Income defined in this way may be a measure of consumption possibilities. More specifically, the real income accruing to a person or family during some period is:
I = M-T + H+G P Where M is the money income accruing to the person or family from all sources, including cash transfers from the government. T is tax payments other than sales and excise taxes, which are in-built in the prices and are paid at the time of purchase. P is an index of the prices paid for goods and services purchased in the market including the indirect taxes. H is the real value of commodities that people produce themselves or obtain in barter for goods that they have produced. And G is the real value of public goods and services.1 With these definitions (M - T)/P is the real disposable income and that is the real value of the goods and services.
Individual household's income is the measured net of the costs of generating it.2 It includes income from wages, interest, dividends, rents, capital gains, gifts, and inheritances, if we apply the broadest definition of income. The variables I, G, M, and H are stated as rupee amounts per period, usually per year. We can observe that increased taxes and increased government spending in respect of services does not cause reduction per se in real income, however, taxation and other government spending cause decrease in real income represented by the private sector output. And in this way an individual's ability to pay stands arrested.
Ability to pay depends on a person's need for goods and services, but some expenditure is non-discretionary where a particular standard of living is to be maintained. It may thus be noted that all income is not subject to taxation under the ability-to-pay principle. Instead, taxes are levied only on discretionary income - income in excess of non-discretionary expenditures. Non-discretionary expenditures will depend on family or household size etc So, in defining discretionary income and ability to pay, the question of what is the proper taxpaying unit - family or individual - become relevant.
In a very general term, trade links the economies of virtually all nations, although the linkages are strongest when exports and imports are large relative to the size of the nation's economy. Because of these linkages, economies tend to move up and down together. An increase in aggregate demand in one country tends to spill over into other countries, increasing the demand for their production, similarly decreases in demand likewise spills over.
More specifically, when foreign trade is possible, part of any increase in aggregate demand, especially private demand for consumer and investment goods tends to be met by imports, that is, the purchase of foreign-produced goods and services. Imports represent a "leakage" of demand out of a country. Thus, with foreign trade, some of the increase in aggregate demand due to an increase in value of public service or decrease in taxes is filled by foreign goods. And a fiscal change of a given amount has a smaller ultimate effect on domestic output, employment, and prices with trade than without it. That is, import leakages reduce the multiplier for changes in value of public goods and taxes.
The fiscal as well as monetary policies affect aggregate demand, employment, and prices. The policies of large nations, such as the United States, bring a greater international impact than those of smaller nations. For example, when the government increases aggregate demand in the country by decreasing taxes or increasing value of public goods, it also increases aggregate demand in other countries. The reason is that residents of one country buy more foreign-produced goods. Conversely, when the government takes restrictive fiscal measures, it decreases aggregate demand in other countries because domestic residents import less. The reason is that employment, output, and prices in each nation are affected by the policies of other nations; international co-ordination of stabilisation policies becomes an important factor. Indeed, economic conditions in small countries with large trade sectors, such as the Sri Lanka and the United Kingdom, may be dominated by the policies of other countries, in which case stabilisation objectives are unlikely to be achieved without the co-operation of major trading partners.
INFLATIONARY AND DEFLATIONARY GAPS Aggregate demand fluctuates considerably from year to year for a variety of reasons: technological change, changes in economic conditions, wars, changes in expectations of businesses and households, and variability in monetary policy, government spending and taxation. Whatever their cause, demand fluctuations either decrease or increase the aggregate demand, whereas capacity tends to change gradually and steadily. The demand also determines the quantum of production, which is either to decrease or increase the same.
Where aggregate demand falls short of capacity, there is said to be a deflationary gap. In Figure I potential national income is Y. But with aggregate demand as given by the E' schedule, the equilibrium level of GNP is Y' rather than the full-employment or potential level of Y. Unless demand is increased, national income will fall below its potential by Y - Y'. An upward shift in the aggregate demand schedule to E is required to bring demand in line with the economy's capacity to produce. The magnitude of this required increase measures the deflationary gap. Such an increase in aggregate demand can be achieved by increasing real value of public goods or decreasing taxes or doing both.
An inflationary gap is said to exist when aggregate demand exceeds productive capacity, as shown by E" in Figure I. At prevailing prices, aggregate demand exceeds capacity by the vertical distance between E" and E, which measures the inflationary gap. Unless it is eliminated, such excess demand leads to price increases (inflation). Excess demand can in principle be eliminated by decreasing value of public goods and services or increasing taxes or doing both.3
Thus, potential for fiscal stabilisation that is, changing real value of public goods and taxes to bring aggregate demand into line with existing capacity exists when there is either a deflationary or inflationary gap. However, despite such potential, it can not be assumed that the government should try to stabilise the economy with fiscal policy, as other adjustment mechanisms exist which may eliminate inflationary and deflationary gaps.
Given target unemployment and inflation rates, a GNP target can be defined for each point in time. The object of stabilisation policy then becomes that of generating a time path of aggregate demand that corresponds to the time path of GNP. In principle, both built-in and discretionary fiscal changes can be helpful in keeping aggregate demand on a desired path. But a number of problems arise.
Built-in changes in taxes and government spending occur quickly and continuously in response to changes in economic activity. These changes are stabilising in that they reduce fluctuations in aggregate demand. They are helpful in; they cushion downturns and slow demand growth during booms. But the features of the tax expenditure system that give rise to these stabilising built-in changes also create fiscal drag. Over time, as incomes increases because of real economic growth or inflation or both, the quantum of tax also increases. This automatic long-run rise in taxes is called fiscal drag because it reduces aggregate demand. If not offset by demand growth from other sources, either increases in value of public goods or in private demand, the fiscal drag gradually increases unemployment and reduces capacity utilisation. Fiscal drag can also be reduced by periodic tax cuts.
Discretionary fiscal changes are necessary to eliminate fiscal drag. They may also be useful for moderating cyclical fluctuations. However, time is required to implement such changes. And time is then required for the changes to have their desired effect on aggregate demand. Therefore, undesired fluctuations in aggregate demand must be predicted six to eighteen months before their occurrence if they are to be offset by discretionary fiscal changes. The implementation and response lags, and the need for prediction that they imply, greatly reduce the usefulness of discretionary fiscal policy. Indeed, because of these lags, discretionary changes may sometimes, if not frequently, prove destabilising.
The possibility of destabilising fiscal changes has led to proposals that discretionary changes be abandoned in favour of rules, usually balanced-budget rules. The rule with the greatest current appeal is that of balancing the full-employment budget. The difficulty with these rules is that employment and price level targets will sometimes, perhaps frequently, be missed, especially if monetary policy is similarly shackled by a steady growth rate rule. The advantage of the rules is that discretionary policy may sometimes produce even worse results.
Formula flexibility and stand-by authority for the parliament to change taxes are often advocated as means of reducing implementation lags and the probability of destabilising changes. If adopted, such measures would weaken the case for balanced-budget or other rigid rules.
Either government purchases or net taxes may be changed to achieve a desired change in aggregate demand. However, relying primarily on tax changes for stabilisation allows government purchases to be determined on efficiency grounds. Thus, low-priority, low-value public projects ("leaf-raking") need not be undertaken simply to assure full employment. And high-value projects need not be curtailed simply to reduce aggregate demand.
While fiscal changes can, in principle, limit demand-pull inflation, they are basically ineffective in controlling cost-push inflation. (The same is true for monetary measures.) The reason is that cost-push inflation is not due to excess demand; instead, it reflects pressures from the supply side on wages and other costs and prices.
Both monetary and fiscal policies affect aggregate demand; hence, they are to an extent substitutes. But they differ in effectiveness. Fiscal policy is more effective than monetary policy in stimulating demand when interest rates are low and there is excess capacity. Fiscal policy is relatively ineffective in stimulating demand when interest rates and the income velocity of money are high.
Monetary and fiscal policies may also differ in their effects on economic growth and balance-of-payments equilibrium. These side effects on other economic objectives may be relevant when choosing between monetary and fiscal measures for stabilisation.
Since monetary changes may either reinforce or offset fiscal changes, monetary and fiscal changes should be co-ordinated. At present, co-ordination is informal and varies with administrations because fiscal decision-making in public policy is controlled by the government.
1. A person's net payment to government is the tax payment minus the cash transfers received from government. In-kind income (G and H) increases a person's ability to pay, even though taxes are usually paid in cash, because in-kind income reduces the need to use money income to buy the particular goods and services it represents.
2. For example, a farmer may raise 1,000 bushels of wheat and sell it for Rupees 4 per bushel. The farmer's net income from wheat production is the gross income - Rupees 4,000 - minus the costs of fertiliser, seed, labour, gasoline, etc, that were incurred to produce the wheat. Similarly, wage earners often incur costs in the earning of income - costs of uniforms, tools, transportation to work, etc. The wearing out of factory machines and buildings in the production process is also a cost of generating income. And these costs must be subtracted from gross income to obtain net income. Since the costs of generating income reduce a person's ability to pay taxes, income taxes are usually levied on net rather than gross income.
3. Eliminating inflationary gaps does not necessarily eliminate inflation because it is not always due to excess aggregate demand. There are other varieties of inflation, such as cost-push. Inflation that is not caused by excess demand may occur even when there is a deflationary gap or as the deflationary gap is closed.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)