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suggest that budgetary effects on demand increase as the level of expenditure increases and as the level of tax decreases.
In summary, in public finance, fiscal policy is needed for stabilization, since full employment and price level stability do not come about automatically in a market economy. Without it the economy tends to be subjected to substantial fluctuations, and it may suffer from sustained periods of unemployment or inflation. It can lead to stagflation where unemployment and inflation exist simultaneously. The market might have no solution to this. Therefore, stabilization policy of the government may proffer solution.
Nevertheless, according to Smithies (1946), stabilization policy can lead to three categories of government actions:
1. Measures to bring about institutional or structural changes in the private economy itself. Put formally, this means changes in parameters of the structural factors determining the behavior of the private economy. Once the change is accomplished it is hoped that the private economy will function more effectively without further government intervention.
2. Measures to provide government control over endogenous (or internally control-able) variables in the private economy where such control is needed for stabilization purposes though, this category cannot be clearly distinguished from (1 above).
Suppose the government were to assume temporary control over the price of diesel, that action may be described either in terms of controlling the variable or as substituting a new structural relation for the old one.
3. Measures to compensate changes in the private economy through the government's conduct of its own program, particularly in the budgetary and monetary fields. This type of action involves public control of variables exogenous (or external) to the private economy.
4. In addition to the three, in less a developed country like Nigeria, stabilization policy may include incentives to rural dwellers which may include social infrastructure like
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hospitals, electricity, clean water and roads. Government may also provide agriculture equipment and high yield seeds. These reduce rural-urban migration and crime rate. Government can then leave the function to the market when institutions are established.
Apart from price level and interest rate, other factors government considers in stabilization policy include:
• Exchange rate
• High taxes or tax increase
• Balance of trade and balance of payments
• Global trend in financial market
• Deficits/Surplus
The Concept of Deficit Spending: This is when government expenditure exceeds its income. It occurs when government borrows to finance its spending. This becomes a problem especially when the deficit shows rapid upward movement and continue for a long time. It is common for government to finance its expenditure through deficit. In other words, government expenditure can be controlled through prudential deficit spending.
If we assume:
Government expenditure or deficit (spending) = G Government tax = T;
Government Revenue = R, Therefore;
Deficit = G – T > 0 Surplus = G – T < 0
OR
G – R < 0 = Deficit (financing) G – R > 0 = Surplus
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Similarly,
G > T = Deficit (deficit spending).
G < T = Surplus
However, as said earlier on, in a federal system, the use of fiscal policy to manage economic stability is usually best done at the central government level. When fiscal policy is utilized at the regional or local level, economic spillovers are often realized across decentralized jurisdictions resulting in economic distortions (Voorhees, 2005). For instance, when one state lowers tax rates, this action tends to stimulate that state’s economy at the expense of the neighboring states.
Factors adversely working against government (fiscal policy) functions in developing countries are highlighted below:
➢ Poor macroeconomic framework.
➢ Poor money supply management by the apex bank.
➢ Divided political parties’ agenda/manifesto.
➢ Lack of harmony among the tiers of governments.
➢ Domestic economy devoid of safety-net to resist external shocks.
➢ External debt overhangs threatening policy reversals.
➢ The need for increase in current/re-current expenditure aggravating balance of payments position.
Self-Assessment Exercise
Explain the stabilization function of fiscal policy 3.1.4 Economic Growth Function of Fiscal Policy
Fiscal policy function also includes promoting economic growth. Looking at growth specifically, it refers to the neo-classical economic growth, that is, the growth theories
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associated with capital formation; savings/investment. These include Harrod-Domar model, Solow model, endogenous growth model etc. These growth models are related with action to create and increase capital formation. In the system of national accounting (SNA), capital formation represents savings out of national income. This is required in the national economy to step up growth. Growth means a process of building capacity. If an economy should grow, it must build its environment to certain capacity, and this is called the process of capital formation. In most underdeveloped countries, capacity building is mainly the responsibility of government via its fiscal policy to achieve stability and promoting economic growth.
The neoclassical theories earmarked the private sector as the engine of growth capable of building capital. Government is required to create enabling environment to strengthen the private sector and increases its productive capacity. Relative to economic growth, government can embarked on the following fiscal actions to boost capital formation:
▪ Subsidy to reduce input cost or price of output.
▪ Concessionary interest rate which enables firms to obtain fund for output expansion.
This is called fiscal stimulus.
▪ Tax holidays encourage new investors (firms) to operate for a specific number of period without paying tax. This allows them to consolidate.
▪ Increase the percentage of capital expenditure in the annual budget.
▪ Provide incentives to national savings. For instance, in Nigeria, government may set aside certain percentage of oil revenue as savings over time and invest on both human and physical capital.
▪ Declaration of import substitution policy. This may have long run implication on government income. A successful import substitution may result in decrease import duty, but it puts the nation in a position of self-reliance. It shield the nation against external shocks.
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The challenges of fiscal policy function is not only maintaining high employment or of curtailing inflation within a given level of capacity output. The effects of fiscal policy upon the rate of growth of potential output must also be allowed for. Fiscal policy may affect the rate of savings and the willingness to invest and may thereby influence the rate of capital formation. Capital formation in turn affects productivity growth, so that fiscal policy is a significant factor in economic growth.
Succinctly, the four major fiscal policy functions can be stated as follow:
➢ Allocation function: It refers to apportionment of resources, goods and services evenly among various constituent states or the tiers of government.
➢ Distribution Function: This is concerned with national wealth or income distribution to reduce inequality.
➢ Stabilization Function: It means keeping fiscal policy within the society production capacity to restraint economic cyclicality.
➢ Economic Growth Function: This refers to all fiscal actions leading to the growth rate of output (GDP). A substantial and stable growth for a long time is required for economic development.
Self-Assessment Exercise
1. Briefly highlight the four functions of fiscal policy.
2. Explain the meaning of capacity building.