The government
without doubt plays a critical role in the economy. Given its volume and
domineering presence, one cannot ignore the centrality of the government in
giving direction to the macroeconomic plane. The role of course has been
controversial and subject to many debates. There exists little consensus on the
ideal nature of governmental role. While the classicalists believed the role of
government in the economy to be minimal with focus on ensuring law and order,
the Keynesians emphasised the centrality of the government intervention. While the
classicalists favoured the supply creating its demand, it found its limitations
in the Great Depression of 1929; John Keynes formulation was there was lack of
demand and the government must step in to create the demand that became the foundation
for macroeconomics and thus greater fiscal intervention. While the monetary
school emphasised the role of money thus favouring a greater role of the
Central Bank in framing the economic trajectory, the fiscal school wanted
direct government intervention. While the supply-siders favoured tax cuts as an
instrument for government intervention in setting into motion the direction for
consumption and investment, the Keynesians wanted the intervention to be explicit
in terms of increase or decrease in government expenditure (G) to increase or
decrease aggregate demand.
The government
intervention usually takes place through direct fiscal intervention, either
through increase or decrease in government expenditure or increase or decrease
in tax rates or alternatively through monetary intervention carried out by the
Central Bank. This post will focus on the former. While the latter is supposed
to be autonomous, invariably, the Central Bank will carry out the wishes of the
government which is the elected executive. The government policies of course
are subject to its priorities framed by the electoral and ideological
considerations. While Margret Thatcher for instance claimed Hayek to guide her
economic philosophy, there are others who used Marx as the guiding principle. In
the contemporary India, while the direction is more towards market orientation,
Modi’s economics is not certainly doctrinaire, but subject to Indian realities.
The government
expenditure manifests in certain characteristics. It is not a straight-jacketed
outcome but rather a product of complex bargains involving multiple stakeholders
who often having conflicting interests and perceptions on various economic
dynamics. The government represents multiple interests and constituencies. Each
of them have their own interests. There would be naturally at times conflicting
interests. The macroeconomic outcomes are thus negotiated products of these reconciliation
of interests. The more heterogeneous the government structure is, the more
bargaining is likely to happen. Therefore, it would be natural to find the
coalition governments usually spending more relative to single party majority governments.
The coalitions would of course be glued by the common denominator of power
sharing would thus have to please more interests and therefore naturally would
be inclined to spend more. The higher quantum of spending on various
constituents would thus result in higher deficits but at times lower taxes. Tax
increases are usually an outcome of ideological considerations. The governments
leaning to socialist or communist thinking are likely to impose higher taxes
relative to those favouring market interventions or ideologically pre-disposed
towards the likes of Hayek or Smith. Thirdly, the government are usually found
to increase the government expenditure while reducing taxes closer to the
elections. The first year after the elections is where the government usually
takes the hard decisions. This is primarily they have the fresh mandate besides
the next cycle is pretty long. Of course in countries like India, where elections
are around the corner almost every six months to some assembly or local body,
this would be an interesting proposition to test.
There is of
course the discretionary element to the government spending. In times of crisis
like economic slowdown, there would be increase in government expenditure as
the number of unemployed increased. The population vulnerable to the economic
fluctuations downwards would be high and thus government intervention is
essential in terms of social security allowances or other compensation to
overcome their loss of livelihood. This is evident in terms of the government
doles and handouts during the pandemic crisis induced over the last ten months
or so. Across the board, without exception, it is the fiscal intervention that
has mattered. In India, the government through its various cash transfer
schemes has sought to provide the cushion to the vulnerable as they seek to
overcome the temporary setback due to COVID lockdowns. This is something
evident even in US where the country handed large cash transfers to its
population in the early period of the pandemic. The social security net
existing in various degrees across countries is the fiscal stabiliser during
the times of slowdown or economic downturn. During times of boom, when incomes
rise, the job creation is high relative to job destruction, the uncertainty
over income is low, thus the vulnerable sections also decline in numbers. Therefore,
evidently, the expenditure by the government in cushioning the vulnerable
sections of the society also declines.
The government can
use the tax rates to increase or decrease the consumption as also investment. Yet
while it controls the tax rates, it does not control the tax revenue which is
subject to the size of household income and size of corporate profits, both
outside the government control. An increase in tax rates would increase tax
revenues to certain point beyond which the cost of compliance would be higher
relative to cost of evasion. The Laffer curve thus comes into picture and at
very high level of tax rates, the tax revenues would come closer to zero. Apart
from the increase in black money perhaps exponentially, there would also be a
serious decline in the entrepreneurship in the economy. The government would
run under deficit if its expenses are higher than the revenues. Yet rather than
the deficit per se, it is its application whether on capital expenditure or
revenue expenditure that would determine the efficacy. Advocates of deficit
financing believe capital expenditure financed through deficit is good for the
economy. Yet the presence of revenue deficit results in deficit financing being
used for revenue expenditure, something that is non-productive. Furthermore,
the financing of deficit either through monetization- potential cause of
inflation or market borrowings-cause for crowding out of private investment,
are also critical in understanding the implications of the size of the deficit.
The above is a
note on the broader dynamics and features of the fiscal policy. There requires a
deeper engagement to discern the broader implications of each of these
features. Yet, this post will only serve the purpose of introduction and leave
further discussions to a later point of time.
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