Fiscal policy is an attempt by the local government to influence the direction of economy through taxation and government spending. The overall purpose of the fiscal policy is to stabilize economy by controlling taxation and government spending. Usually many governments use two main economic policies to affect the performance of the economy namely monetary and fiscal policies. “Fiscal policy can be contrasted with monetary policy which is a move by the government to influence economic direction through money supply and interest rates.” (Joseph, 2000) Tax personal income, corporate profits, value added taxes are to mention a few forms of taxation. Government expenditures are among them provision of public good and services to its citizens and transfer of funds to other levels of government.
In democratic societies governments are usually faced with conflicting objectives which require sound policies to achieve them. As result government uses economic policies to streamline national income so as to keep down the effects of business cycles on the economy and increase the national income. Changes in government spending and taxation have impact in the following economic variables: Resource allocation, income distribution and aggregate demand. Taxation and government expenditure refer to the effect of budget on economic activities. Through fiscal policy the government can maintain its budget in three stances namely; stable, expansionary and contractionary. A neutral budget is where government spending equates revenue. Revenue from taxes fully funds government spending-the outcome being a neutral effect on economic activities. Expansionary stance refers to increase in government expenditure through either increased government spending or reduced tax revenue. This will lead to a deficit in government budget. “Contractionary fiscal policy is where government expenditure is reduced may be due to increased tax revenue or reduced spending or combination of both.” (Richard, 1973) If previously government had balanced budget contractionary fiscal policy will lead to surplus or a lower deficit.
In an effort to achieve economic objective of economic growth, price and stability and full employment, government uses fiscal policy to affect the aggregate level of demand in the economy. “According to Keynesian economists suggest that aggregate demand is stimulated through adjusting taxation and spending. “ (Boettke, 2002) For example during time economic contraction, increased spending by government will stimulate economy and increase consumer confidence while during economic boom reduced government spending will curtail economic activities. In most democratic economies the functions of fiscal policy is conducted by the legislative arm of the government together with the executive. Preparation of the government budget is left to the finance ministry and its approval is done by the legislative arm. Most decision on funding the government budget or approving government spending is done b y the legislators. For instance if the budget is at deficit and the government want to borrow through open market operations, the legislature has first to approve the move before the government borrows. To some extend politicians do determine what system of taxation should the government adopt; either progressive or regressive. The legislative arm of the government can also decide on where the public money should be spent and where it should not be.
Boettke, P. J, Heyne, P. T., and Prychitko, D. L. (2002): The Economic Way of thinking (10th Ed). Prentice Hall.
Joseph E. Stiglitz (2000). Economics of the Public Sector, 3rd ed. Norton.
Richard A. Musgrave and Peggy B. Musgrave (1973). Public Finance in Theory and Practice.