What are the major objectives of Fiscal Policy?

Collection of revenue and the use of government expenditure which affect the economy is termed as fiscal policy. Fiscal policy can be distinguished with the major sort of macroeconomic policy, monetary policy, which stabilizes the economy by controlling rate of interest and supply of money. Two major objectives of fiscal policy are taxation and expenditure of government Transforming in the level , composition of taxation and government expenditure can force on the following variables in an economy :

Aggregate demand and the level of economic activity;

The pattern of resource allocation;

The distribution of income.

Aggregate demand and the level of economic activity:

At a given time the price level and the total demand for goods and services in an economy(Y) is called aggregate demand (AD) . [1]. It is the quantity of goods and services in an economy that will be obtained at all probable price levels.[2] When inventory levels are static the demand for the gross domestic product of an economy is termed as aggregate demand. It is also called effective demand although at other times this term is differentiated. It is often quoted that the aggregate demand curve is downward sloping as at lower price levels a larger amount is demanded.

Components of Aggregate demand and the level of economic activity:

An aggregate demand curve is the summation of individual demand curves for different sectors of the economy. The aggregate demand is generally expressed as a linear sum of four divisible demand sources.[3]

where

is consumption (may also be known as consumer spending) = ac + bc(Y Ã¢Ë†â€™ T),

is Investment,

is Government spending,

is Net export,

is total exports, and

is total imports = am + bm(Y Ã¢Ë†â€™ T).

The pattern of resource allocation:

Resource allocation is generally used to allot the resource available in an economy in an economic way. How limited resources are allocated among producers, and how limited goods and services are distributed among consumers , this study takes into observation the accounting cost, economic cost, opportunity cost, and other costs of resources and goods and services. Allotment of resources is a vital idea in economics and is related with economic effectiveness and maximization of utility.

The distribution of income:

Amongst the population of a nation how the nation’s total economy is allocated is termed as income distribution. It has always been a major concern of economic policy and economic theory. The allocation of income between the vital factors of production, land, labor and capital are considered to express income distribution.

Fiscal policy is a vital factor for the economic development of a country. In Bangladesh fiscal policy consists of activities, which the country carries out to attain and utilize resources to afford services while ensuring optimal efficiency of the economic units. This policy controls the behavior of economic forces throughout the public finance. The main factors to attain these goals are variation in public expenditure, variation in public revenue, and management of public debt. These are revealed in the financial planning operations of the government, set up and executed on year-on-year basis.

Literature Review

For the overall economic development of a country fiscal policy and its management exert greater influence on economic activity. To boost up an economic infrastructure many research and study have been done by economists and policymakers. In this section literature abounds on the effectiveness and importance of fiscal policy in developed and developing countries of the world.

Developing countries are facing dual challenges while undertaking fiscal adjustment policies. One arises from the increasing demand for public expenditures for

Infrastructure and social sector investment, and the other arises from the lack of capacity

to raise revenue from domestic sources to finance the increased expenditure, primarily

due to narrow tax base. To boost competitive capacity of the country in a rapidly

globalizing world, the governments of developing countries have to invest a large portion of their revenue in building physical infrastructures. In addition, the low income

developing countries also need to spend a major portion of their development

expenditures in providing social services to the poor such as health, education etc. On

the other hand, as Khattry (2003: 402) pointed out, “the structural characteristics of low

income countries, combined with prevalence of unsophisticated tax administration limit their ability to raise taxes from domestic sources, namely income and domestic indirect

taxes”. Also, the existence of a large informal sector and the underground economy

constrains the government’s capacity for revenue growth.

Another source of fiscal problem arises with the process of trade liberalization that

requires reduction of taxes on international trade together with the elimination of

quantitative restrictions and other forms of trade barriers. Therefore countries have to

resort to domestic sources to compensate the revenue loss emanating from trade

liberalization. As the scope of domestic sources of revenue is limited due to the narrow

tax base and structural constraints in the low income countries, this may lead to a

vulnerable fiscal position. In principle, a well functioning VAT system on import

combined with broad based low tariffs) can recoup some of the revenue loss due to the greater inflow of imports that eventually follows trade liberalization. National Strategy for Accelerated Poverty Reduction (NSAPR) of Bangladesh (2005) recognizes that, as

government revenue is heavily dependent on trade taxes, and tariff liberalization

typically results in tariff revenue loss, alternative sources of revenue must be ensured in

order to prevent a sudden rise in budget deficit (which is already high). In order to

recoup revenue losses due to tariff liberalization government is trying to increase

revenue from direct taxes. It is also envisaged that “indirect taxes such as VAT and

supplementary duty are applied uniformly on both domestic production and imports, it

would both reduce anti-export bias and increase government revenue by widening the

tax-net” (NSAPR, 2005, p.86).

Trade liberalization may thus lead to a ‘fiscal squeeze’ as a result of re duced revenue

and simultaneous increase in expenditure. According to Khattry (2003) fiscal squeeze

led some countries to reduce expenditure on physical capital, while that on social

services (e.g. health and education) has been financed by acquiring additional debt. However, it has been empirically substantiated that government capital expenditure plays an important role in enhancing economic growth. Bose et al (2003) investigated a

panel of thirty developing countries over the decades of 1970s and 1980s, and found

that, the share of government capital expenditure in GDP is positively and significantly

correlated with economic growth though current expenditure is insignificant.

The purpose of this paper is to evaluate the relationship between revenue and

expenditure and its implication for managing the budget deficit. In order to do this a

three variable model is formulated comprising government expenditure, revenue and

GDP. Firstly, existence of a long-run relationship among these three variables is tested

by using Johansen (1991, 1995) co integration approach. Granger causality test is

applied on the corresponding vector error correction model to examine short-run causal

relationship between the variables The goal of fiscal policy is to enhance economic growth and employment and to bring

stability in economic outcome variables such as the real GDP growth rate. Under the above circumstances, the nature and objectives of fiscal policy may differ with the level of development of the countries. Long run outcome of expansionary fiscal policy depends on the nature of distribution of public resources as the same amount of public money can generate different growth pay-offs in different sectors, and the overall growth of the economy depends on the combined growth of these sectors When the government takes expansionary fiscal policy (expenditure surpassing revenue) either through increasing expenditure or reducing taxes or both, it has to borrow from internal and external sources to finance the deficit. The concept of deficit

budget was popularized by Keynes and his followers -the principal argument is that

government can boost up economic growth by increasing government expenditures in

the short run. Again the government has to shrink its expenditures during the time of growth as excessive aggregate demand can generate inflation. In contrary to the above theory some economists argue that budget deficit negatively affects economic growth According to the advocates of the latter view, lowering budget deficit reduces interest rate thereby increasing investment, which in turn enhances economic growth The risk of expansionary fiscal policy is that, it leads to public debt growth, where it is envisaged that the growth of the economy will be significant enough in the subsequent periods so that the government will have a larger revenue base to finance its enhanced debt obligations. However, failure to generate enough economic growth may force the government into a deficit trap. Therefore the government has to borrow again to finance its deficit -this time may be in greater volume due to increase in the expenditure for repaying principal and interest of previous period’s debt even if the magnitude of public sector activities remains unaltered. There is also a risk that, government borrowing from domestic sources may crowd out private investment by raising the rate of interest. Constraining private investment in this fashion and expending the same amount of money in less productive sectors of the economy can negatively affect overall growth of the economy. As mentioned by Carneiro et al (2004, p.9), “if economic agents are non Recording due to credit constraints and overlapping generation, public deficit can have a negative impact on growth as public deficits can hamper growth by competing with private physical capital for individual savings”. Conversely, in developing countries public investment can be influential to crowd in private investment as shown by Binswanger et al (1993); infrastructure accessibility and the rural banks are crucial factors for increasing private investment in agriculture, which requires substantial government intervention in facilitating private investment. Given excess liquidity in the system (as it is the case in

Bangladesh), in spite of significant public borrowing from the banking system over the last 4-6 months, private credit actually proceeded at its usual pace. This however need not be true all the time.

Bangladesh’s fiscal policy is closely linked to its monetary policy because public budget deficits are mainly financed by increases in money supply. Theoretically, expansionary fiscal policy would generate an increased supply of high-powered money in the face of frequent adjustment in the budget deficit and can provoke price spiral if there is no excess capacity in the economy (Friedman 1956; Friedman and Kuttner 1992). However, increasing government borrowing from central bank is seen as highly inflationary in the case of Bangladesh. But it should be noted that under the situation of chronic slow down of general demand (i.e. a general glut in the economy) higher public expenditure can create higher economic activity by protecting the falling trend in demand which is financed by increased public borrowing (Kiguel 1989). However, there is a general consensus among economists and policy-makers that regulating the growth of money stock is necessary to achieve a fairy stable price level and full employment of an economy (Sims 1972)

Blanchard and Perotti (2002) use information about the elasticity of fiscal variables to identify the automatic response of fiscal policy, and find that expansionary fiscal shocks increase output, have a positive effect on private consumption, and a negative impact on private investment. More recently, using sign restrictions on the impulse-response functions and identifying the unexpected variation in government spending by a positive response of expenditure for up to four quarters after the shock, Mountford and Uhlig(2005) find a negative effect in residential and non-residential investment Similar studies applied to other countries are relatively scarce, largely due to the limited availability of quarterly public finance data, and, in addition, do not provide a consensual view. Perotti (2004) investigates the effects of fiscal policy in Australia Canada, Germany and the U.K., and finds a relatively large positive effect on private consumption and no response of private investment. Biau and Girard (2005) find a cumulative multiplier of government spending larger than one, and positive reactions of private consumption and private investment in France. De Castro and HernÃ¡ndez de Cos2006) use data for Spain and show that, while there is a positive relationship between government expenditure and output in the short-term, in the medium and long-term expansionary spending shocks only lead to higher inflation and lower output. Heppke- Falk et al. (2006) use cash data for Germany, and find that a positive shock in government spending increases output and private consumption, although the effect is relatively small. Giordano et al. (2007) show that, in Italy, government expenditure has positive and persistent effects on output and on private consumption.

Analysis

The People’s Republic of Bangladesh, state of southern Asia, in the northeastern portion of the Indian subcontinent, edged on the north, east and west by India, on the southeast by Burma (Myanmar), and on the south by the Bay of Bengal. The total area of the country is 147,570 sq km with a population of 126 million. It lies roughly between 20Â°34′ and 26Â°36′ North latitude and between 88Â°01′ and 92Â°41′ east longitude. The capital and leading city of Bangladesh is Dhaka. The economy of Bangladesh is comprised by that of a developing country. Its per capita income in 2008 was est. US$1,500 (adjusted by purchasing power parity) significantly lower than India, Pakistan, both which are also lesser than the world average of $10,497. According to the gradation by the International Monetary Fund, Bangladesh ranked as the 48th largest economy in the world in 2008, with a gross domestic product of US$224.889 billion. The economy has grown at the rate of 6-7% p.a. over the past few years. More than half of the GDP belongs to the service sector; nearly half of Bangladeshis are employed in the agriculture sector, with RMG, fish, vegetables, leather and leather goods, ceramics, rice as other essential produce. The aim of the government’s fiscal management is striking a weighing balance between government revenue and expenditure. One more foremost goal is to uphold shortage in the existing budget as much as reasonable for advanced investment in the public division. As a result of cautious fiscal policy and strengthening of fiscal management, overall fiscal deficiency through the current decade remained unchanged.

To formulate and execute sound fiscal policy is one of the most significant functions of the government. It puts importance on sustaining macroeconomic constancy through balancing public expenditure management. There is no substitute to sound fiscal management in overall economic governance as a fair public income and expenditure management that assures private sector institutions and individuals a steady macroeconomic background. The vital source of government revenue is tax. Public revenue mainly consists of direct and indirect taxes which accounted for more than 80 percent of total government revenue. The government collects the rest of the public revenue from different non-tax collection such as fee, charge, toll etc. The level of revenue assortment is a vital indicator to establish the step of economic development of a country. The economy of a country becomes more stable if it collects large amount of revenue.

In this section we are going to analyze the fiscal condition of Bangladesh during the time period from FY-1991 to FY-2008.During these years Prudent fiscal management emerged as a most important challenge facing the country. The Government’s revenue mobilization efforts developed remarkably in the early 1990s following the launch of some major fiscal reforms, mainly introduction of the value-added tax (VAT) in 1991.The VAT provided greater coverage and raised rates than the taxes that it restored (mostly excise duty). The revenue tax to GDP ratio rose from 5.9 percent in FY1991 to 7.3 percent in FY1993, but since then, the proportion has remained steady at about 7 percent. A stagnant tax to GDP ratio reveals lack of improvement in broadening the tax net and in improving the tax management system; in brief, the effectiveness of tax assortment remains fragile and futile. Specifically, the Government has failed to widen the coverage of direct taxes, broaden VAT coverage to high-revenue-yielding trades and services, develop the implementation of import taxes, and bolster tax government. Conversely, nontax revenues are relatively small (a bit less than 2 percent of GDP), and they also festered over much of the 1990s. As consequence, since FY1993, the entire revenue to GDP ratio has altered around 9 percent, making revenue collection of Bangladesh effort one of the weakest in the global economy.

In spite of unsatisfactory revenue collection efforts for much of the 1990s, the Government was capable to uphold the fiscal shortage within 4-5 percent of GDP by keeping spending under control. Government expenditure, both current and capital increased rapidly. Therefore, the fiscal scarcity went up to indefensible levels. With declining alternatives to foreign funding of the deficit, the Government had been compelled to finance the shortfall from domestic sources -from banking sector and domestic borrowing. The ensuing monetary adjustment seriously damaged macroeconomic stability.

Table 4 : Selected Fiscal Indicators

(Percent of Gross Domestic Product)

Because of drop of the revenue to GDP ratio to 9 percent in FY1998-99 from 9.3 percent in FY1997-98, caused by flood-induced disruptions, the Government attempted to reverse the declining trend and projected revenue to GDP ratio of 10 percent in the FY1999-00 budget. In spite of establishing a verified revenue mobilization object, no major efforts were made to apply vital fiscal reforms, reduce the tax structure, strengthen tax management, and extend the tax foundation. Moreover, the hindrance in introducing the reshipment assessment scheme, and slothful growth in imports also added to revenue shortfall. Customs duties collection declined by 10 percent in FY1999-00 compared with FY1998-99, and the share of customs duties in National Board of Revenue portion of taxes declined to 28 percent from 32 percent. Nontax revenue collection was also less than projected due mainly to reduced profit and dividend earnings of state-owned enterprises (SOEs). In FY1999-00, losses of nonfinancial SOEs were estimated at Tk31 billion, or 1.3 percent of GDP. Therefore, actual revenue mobilization in FY1999-00 rotated to be considerably below budget projections, at 8.9 percent of GDP. Government expenditure increased to 13.8 percent of GDP in FY1999-00 from 13.3 percent in FY1998-99, because of a rush in the outlay resulting from flood-induced expenditure, particularly the requirement for extra imports of food grains and post flood rehabilitation outlays. The tendency prolonged in FY1999-00 with overall expenses rising to 15 percent of GDP. Though the Government was capable to Keep up current spending at 7.6 percent of GDP (the same percentage as in the previous year), spending under the annual development program (ADP) went up to 6.7 percent of GDP from5.6 percent in FY1998-99. In the FY1999-00 budget, the Government’s aim was to reduce expenses to 7.4 percent of GDP. It was a determined aim in view of the coming general election (scheduled for October 2001) when the pressures on the Government to accommodate increased expenditure is bound to be considerable.

Findings

Bangladesh is a third world’s developing country. At present it is going through a financial crisis. To analyze any country’s financial condition the key factor is to investigate its fiscal policy and management as fiscal policy has a great impact on the country’s development procedure. In our term paper we have discussed the fiscal condition of Bangladesh in brief.

Financing of regular insufficiency, generally undertaken through borrowings from abroad, from Bangladesh Bank, and from scheduled banks, has become a central characteristic of the fiscal policy of the country. Opportunity of borrowing from the public by the government for financing budget deficiency is very limited in the country as investments capability of the people is very low. Therefore, the opportunity of non-inflationary financing of budget shortfall does not exist here. Availability of foreign borrowing depends on the international liquidity situation and the prevailing circumstances in the international capital market, which is always uncertain and unpredictable for a country like Bangladesh.

Here, some major key findings which has a great influence on Bangladeshi economy that we noted out from the analysis section are added :

# Introduction of Value Added Tax (VAT) in early 1990’s is one of the key fiscal reforms to develop a effective fiscal administration.

# The revenue tax to GDP ratio rose from 5.9 percent in FY1991 to 7.3 percent in FY1993

# Because of drop of the revenue to GDP ratio to 9 percent in FY1998-99 from 9.3 percent in FY1997-98, caused by flood-induced disruptions, the Government attempted to reverse the declining trend and projected revenue to GDP ratio of 10 percent in the FY1999-00 budget

# Customs duties collection declined by 10 percent in FY1999-00 compared with FY1998-99, and the share of customs duties in National Board of Revenue portion of taxes declined to 28 percent from 32 percent

# In FY1999-00, losses of nonfinancial SOEs were estimated at Tk31 billion, or 1.3 percent of GDP. Therefore, actual revenue mobilization in FY1999-00 rotated to be considerably below budget projections, at 8.9 percent of GDP

# In FY1998-99 there had a rush in the outlay resulting from flood-induced expenditure, particularly the requirement for extra imports of food grains and post flood rehabilitation expenses

# In the FY1999-00 budget, the Government’s aim was to reduce expenses to 7.4 percent of GDP. It was a determined aim in view of the coming general election (scheduled for October 2001) when the pressures on the Government to accommodate increased expenditure is bound to be considerable.

# In FY 1999-00revenue/GDP ratio was 8.47 percent, which step by step went up to 10.79 percent in FY2005-06. In FY 2007-08 the revenue/GDP more went up to 11.17 percent and the growing trend of revenue-GDP ratio further increased to 11.24 percent in FY2008-09.

# From the beginning of the FY2008-09 the revenue objectives of fiscal year came under challenge because of the impact of worldwide financial crisis.

# In FY 2008-09, though the entire revenue collection by NBR source fell diminutive of the goals but overall revenue collection stood at TK. 52525.61 crore, which is TK. 5236.49 crore higher than the assortment of the previous fiscal year showing an 11.07 percent increase. In FY 2007-08, total revenue collection placed at TK. 47289.12 crore, which was Tk. 10,069.8 crore or27.06 percent higher than the assortment of the previous year. In FY 2006-07, the total revenue collection under NBR amounted to Tk. 37219.32 crore which was Tk. 3,216.89 crore or 9.46 percent higher than that of the previous year. Item-wise tax collection from FY2006-07 to FY2008-09

# The average genuine cost against the adjusted allotment of ADP was around 90 percent during the time from 1999-00 to 2005-06. In FY2006-07 and FY 2007-08, the utilization of ADP is about 83 and 82 percent correspondingly. In FY 2008-09 the short-term expenditure records 85.7 percent utilization of revised allotment.

# The tendency of budget shortage in Bangladesh obviously shows that shortage remains under 5 percent of GDP except for those years when there were natural catastrophes.

The findings stated above had great influence on Bangladeshi economy during the time period from 1991 to 2009. After having a look on the key factors that indicates the fiscal condition of Bangladesh for some previous years of we have found out that the government’s spending the overall fiscal discrepancy experienced a huge variability all the time. The overall scenario may be illustrated as such that the fiscal policies of the past could not be applied as an adequate tool for ‘fine-tuning’ the economy on the way to achieve macro-economic strengthens and elevated economic growth.

Policy Recommendation

The Bangladeshi government is crafting fiscal motivation packages for countering financial crisis. Policymakers of our country realize that they need a broad range of policies to contain the ongoing fiscal deficit. Fiscal policy is clearly in the minds of all The main feature of this recession, namely, the emergence of widespread credit constraints, is a strong argument in favor of fiscal policy. The reason is that the monetary policy transmission becomes weaker and more uncertain when credit markets are dysfunctional. Moreover, as our economies have become more open, international coordination of fiscal expansions is increasingly necessary to achieve the maximum impact without worsening trade balances.

As we have analyzed the fiscal condition of Bangladesh in the previous section, we have found out that there are some lackings in the overall system of the fiscal management. The fiscal policy should be evaluated to develop a sound fiscal infrastructure. Some policies are recommended here that may be considered:

Develop budgetary management together with improved accountability and intelligibility of financial management is needed to improve the fiscal management.

Implementation of VAT more effectively, rationalization of public expenditure, improvement of public expenditure management is must to create a sound fiscal infrastructure

Develop tax administration (enlargement of the tax base)

Expand the economy,

The performance of fiscal policy could be more flexible in accordance with the types of aid (i.e. temporary versus permanent)

Close monitoring of the impact of foreign help on the export sector.

Develop climate of investment

Decrease cost of running business and increase productivity for private sector development,

Raise human capital development, access to land

Development of physical infrastructure

As a necessary condition to realize sound fiscal policy public debt management and monetary policy should be recognized

To take up foreign help ,the fiscal policy has to be strengthened

Tax reforms policy ought to link up with fiscal objectives

To utilize funds gradually and efficiently by taking into account so that the absorptive capacity of the country being developed the government may consider a pooling system

Spread out the exports sector

Continue modifications to enable the private sector to boom

Improvement of the trade balance to a significant degree in order to lessen external vulnerability.

The efforts toward an open trade administration should be followed along with a deliberation of a suitable exchange rate management.

The flexible exchange rate regime facilitates cushion the external and domestic shocks, but need to handle appropriately

Foreign reserves could be enhanced to more comfortable stages over the medium term

Such a financing plan will help sustaining the expenditure plans by firms and households who are currently not credit-constrained, and who therefore immediately respond to long-term fiscal prospects. Admittedly, a commitment to decrease expenditure in the future may lack credibility, especially in a situation like today, when the uncertainty about the length and the overall fiscal implications of the crisis is enormous.

Actually, our recommended policies provides support to the idea of including some specific items for national policy cooperation, that is, the opportunity of pursuing fiscal plans where current expansions are matched in part by offsetting correction of spending down the line.

Conclusion

Fiscal policy is often discussed in a framework in which there is no issue of aggregate demand failure and in which the economy adjusts in a stable mode toward a supply-side equilibrium. Fiscal policy has an important role to play for the development of an overall economic progress of a country. For developing a sound macroeconomic infrastructure the government should give emphasis on creating a fruitful fiscal policy.

In this present financial crisis, Bangladesh faces two major challenges to fiscal policy if it desires to create a sustained higher economic growth for the nation. The first challenge is in financing and sustaining stimulus packages. In the current crisis, our country also faces a challenge with the collapse in demand for exports. Many economies face the problem of insufficient financial resources to carry out programs to expand domestic demand. The second challenge is how to make the motivation programs effective and productive. Policy makers are confronted with a choice of stimulus programs to ensure that they have high multiplier effects and that they will not impair the government’s fiscal position in the medium or long term. During the critical period of this crisis, although the recovery is primarily based on fiscal incentive, there is no scheme to assist our country facing funding deficiencies. Fiscal policy support is essential because funds have to be disbursed quickly in order to arrest rapid economic decline. No such mechanism, however, is available for short-term financing for fiscal stimulus. It is timely for the government to consider setting up a fiscal assistance coordination scheme to help countries facing short-term funding shortages in future economic crises.

As Bangladesh is a developing country it may require larger deficits to boost its economy and build capacity and fiscal caps can seriously hamper its policy flexibility. The two crises that have hit our country -the 1998 and 2008 crises-have demonstrated the importance of immediately available financial support to mitigate the impact of massive externally-induced pressures. It is the most important factor to establish a cooperation mechanism at the highest political level to spearhead some fruitful initiatives. Political coordination and endorsement is important and this can be done through implementation of some crucial policies. Governments must play a larger multifaceted role in setting up a framework for the reduction of expenditures in non profitable sectors.

One of the major obstructions that the policymakers face is to decide how much participation the government should have in the economy. Without a doubt, there have been a variety of degrees of interference by the government over the years. However, the most crucial part is to accept that a degree of government involvement is necessary to sustain an excellent economy, on which the economic welfare of the population is dependent.

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