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Economics. Fiscal policy

Fiscal policy is decisions made by government on taxation and government spending, with the goals of full employment, price stability, and economic growth. The government uses various tools mobilizing asset of the state and planning expenditure. As a result, fiscal policy involves such decisions as government budget income and expenditure, controlling liabilities of the state, transfer between various departments of the state, selling wealth of the state, leasehold or purchase, borrowing from enterprises and financial institutions or lending for them, funds of retirements and other social allowances. Fiscal policy is also related to activities that may not be reflected in the budget but has a big influence on opportunities of state financing. It involves determination of tariffs of public utilities that are provided by enterprises and immunity from paying some particular taxes by enterprises. Furthermore, fiscal policy is responsible for procedural issues due to regulation of finance.
As a result, we can distinguish three main tools of fiscal policy:
  • Taxation;
  • Government purchases;
  • Government expenditure due to transfer allowances.
It has to also be highlighted that the main target should be not the balance of state budget but employment and stable prices.
The aim of this paperwork is to analyze the main tools of fiscal policy as well as its targets in order to prove the importance of fiscal policy in state governance seeking to maintain stable and developing economy. A part of the paper covers the problems in implementing fiscal policy as it is very difficult to find trade-off taking into account expansionary and restrictive fiscal policies. The paper also includes analysis of financial situation in Lithuania and how fiscal policy is carried out in the country.
Actually, it was a bit complicated to distinguish the most important theoretical aspects that both types of fiscal policy, that is discretionary and non-discretionary, would be described taking into account the main tools and targets of fiscal policy. It was pursued to sort the information for the theoretical part from the economic books seeking to find the most appropriate definitions and also to have the main references how the analysis of fiscal policy should be reflected.  Also various reports, graphs and tables as well as publications made by the government institutions were reviewed as they provide important and newest information for this topic.

Discretionary fiscal policy

Discretionary fiscal policy is deliberately handled changes of taxation and expenditure by government seeking to affect real national product size, employment and control inflation.
Fiscal policy can be used to stabilize economy. If economy distinguishes by recession, that is to say real national product is lower than potential, the government will implement expansionary fiscal policy. It covers increase of government expenditure, decrease of taxation, and finding trade-off between these tools. However, increasing budget deficit is inevitable result of expansionary fiscal policy.  
As a result, the government will seek to offset the budget deficit by borrowing lacking asset from residents. In this way, government issues bonds in the stock market. Those who buy these bonds become government creditors. When this method of government deficit budget financing is used, the government liability is entirely increasing: government is creating new money. As a result, this method can foster a sudden increase in prices in the state. Actually, issuing bonds in the stock market results in increase in interest rate that leads to decreasing investment expenditure because a part of planned investments become loss-making.
If the economy is distinguished by low unemployment rate but rapidly increasing inflation rate, the government will implement restrictive fiscal policy. It covers decrease of government expenditure, increase of taxation and finding trade-off between these tools as well as in the expansionary fiscal policy. On the other side, restrictive fiscal policy leads to budget surplus. Budget surplus can be used to reduce government liabilities or it can be withdrawn from the circulation and not used temporarily.
When redundant cash is withdrawn from the circulation, a big anti-inflation effect is being done. Government paying up its liabilities pays back government securities from the residents. As a result, redundant asset that has been accumulated in the budget is put into circulation again.
From the other side, discretionary fiscal policy is being criticized recently as a policy that fosters economic instability. When discretionary policy is put into practice, some states face to increasing volume of activities and some states increase their liabilities.

Non – discretionary fiscal policy

Government interference to the economy changing government expenditure and taxation is not the only tool to stabilize economy. Economic system has also self-contained stabilizers that smooth cyclical fluctuations.
Self-contained stabilizers are budget policy tools operating themselves which increase aggregate demand when economy is in recession and slow down the increase of aggregate demand when economy is increasing. The main self-contained stabilizers are taxes (income tax, profit tax, value-added tax) and transfer payments (unemployment relief, pensions and other income supports).
If there is increase in economy, national income also increase that leads to the growing size of collected taxes in the government budget. As a result, it decreases consumers’ income and slows down the increase in aggregate demand.
Consequently, when national income increases, government budget receipts increase automatically. Budget deficit decreases and budget surplus occurs.
Conversely, if the recession in economy prevails, budget receipts automatically reduce. It in turn slows down the decrease of aggregate demand and smoothes the recession. So, when national product decreases, budget receipts also decrease, state budget surplus decreases and budget deficit occurs.
The similarity of self-contained stabilizers compared to the discretionary policy is that these stabilizers are operating themselves when the government does not make any decisions in advance. On the other side, self-contained stabilizers cannot eliminate undesirable product equilibrium fluctuations. They only smooth the amplitude of economic fluctuations.
It is clear that when active fiscal policy is handled, in the recession period budget deficit increases and in the period of increase of economy there is budget surplus. Unbalanced budget thus is justifiable if the government handles an appropriate fiscal policy.
But it would be wrong to claim that appealing to the government budget balance it is possible to decide on the fiscal policy handled by the government. Self-contained stabilizers will determine increasing budget deficit in the recession period even if the government does not take any actions to foster economic increase.
If private investments will decrease for some reasons, equilibrium national product will also decrease. When tax system is unchanged, the size of government expenditure is the same, budget deficit will occur. Budget deficit that occurs in the recession period of the economy is called cyclical budget deficit. This deficit is the result of self-contained economic stabilizers. If the budget deficit is affected not by economic cycle but by government handled discretionary budget policy tools, then such kind of budget is called structural.

So, it is not permitted to assume that government undertook some tools to stabilize economy according only to the fact of the existence of budget deficit. A concrete budget deficit or surplus reflects not only the expenditure and taxation changes handled by the government but also the level of national product equilibrium.
Trying to find the criterion which would help to evaluate the legitimacy of fiscal policy handled by government, full employment budget concept was created.
Full employment budget shows, what surplus or deficit of budget would be if economy operated at a full employment. It is needed to determine hypothetical full employment budget to evaluate policy handled by the government. We have to calculate what budget balance would be if economy operated at a natural unemployment rate when the level of government expenditure is given and present tax system is operating. If full employment budget is in surplus, it is obvious that the government is handling not stimulating but restrictive fiscal policy which even increases economic recession.
Conversely, if full employment budget were in a deficit, it would show that the government is handling stimulating fiscal policy that helps to overcome the economic recession.

Targets of fiscal policy

The main targets of fiscal policy are low unemployment rate, stable economic growth, stable prices and supply of communal commodities. Government fiscal powers operate in pairs: buying of commodities or selling stock, taxes or concessions, budget deficit or surplus. Purchases made by government as a consumer stimulate economy and selling increases supply and decreases prices. Moreover, increase of taxation decreases income and concessions foster economic growth. At last, budget deficit stimulates economy and budget surplus usually turns it down.
Government also operates transfer payments that act as fiscal stabilizers. These payments significantly increase in the period when demand decreases and they are reduced in the period of economic increase.
A well-known economist Richard Musgrave claims that the roles of fiscal policy could be separated into three main areas: stabilization, providing social welfare and redistribution of income.
Stabilization is the government efforts to maintain low unemployment, seeking for full employment and balance of payments.
Providing social welfare means supplying common consumption goods and services. Here government interference is taken into account to smooth market imperfections and negative social appearances that occur due to activities in private sector.
Income redistribution is the overall government activities transferring income and possibilities from one social class, generation, region or group to other social classes, generations, regions or groups.
When government is operating these three functions, social values, economic and financial standards determine the form and format of fiscal policy. Over time these values and standards are changing and the practice of fiscal policy also changes.
Nowadays it is especially important to increase fiscal flexibility increasing along responsibility and control, especially when monetary policy is strictly restricted and economy is quite often affected by external sudden fluctuations and it is committed to seek for three microeconomics targets: rapid increase, low inflation and stable exchange rate.
If fiscal responsibilities are clearly divided between political, technical and operating institutions, the desirable results will be achieved faster. At first, it is needed to divide functions more clearly between Seimas, Government, Financial Department and other departments. Political choices should be done after detailed technical analysis which is usually performed or coordinated by Financial Department. Seimas should also put more efforts by performing supervision seeking to improve accountability, participation of the society and information fluidity. The most difficult target for the Government in fiscal policy is to determine medium-term fiscal priorities precisely, cohesively and without consistency. Medium-term priorities have to constitute balance between departments and political sectors and guarantee that economical development is clear and understandable.
As a result, clarity and precise forecasting are especially important targets of fiscal policy that requires lots of years to create confidence and agreement on reforms of fiscal policy.
John Maynard Keynes stated that too big saving can reduce expenditure that is needed to reach and maintain full employment. His models proved that budget policy is the most important full employment determinant because full employment of the country depends on aggregate demand. Aggregate demand was admitted as the main market economy tendency but not as only temporary or even cyclical market economy deviation. As a result, one of the targets of fiscal policy is full employment.


Implementing tools of fiscal policy in practice government has to deal with many problems taking into account social, economic and political environment.
Firstly, it is the problem of timing which is needed to evaluate the situation of the state economy. For example, it takes some months to determine existing economic recession or inflation in the country. There are also needed particular periods of time to make important decisions based on economy. In democratic countries the proposed fiscal tools by the government have to comply with legislative. While fiscal policy tools will be adjusted in a democratic way, economic situation can change cardinally in the country and the proposed tools can be absolutely inapplicable. The increase of government expenditure by, for example, building new roads, requires time to draw up a comprehensive plan and the building itself requires even more time. So, if the recession in economy prevails not for a long time (about 6-18 months), it is unlikely that social works financing handled by government can become an effective tool to foster the economy increase. Whereas, implementation of new tax rates does not take so much time, the latter tool is more frequently used implementing discretionary fiscal policy.
Another problem implementing fiscal policy is politics. It has to be highlighted that warranting the economic stability is not the only aim of the government handled policy. Classical example could be war when the government will increase expenditure even it increases inflation. In this case, underlying objective is victory in the war but not the security of stable prices. It is supposed that politicians tend to use expansionary fiscal policy tools. Increasing of government expenditure as well as decreasing of taxation is popular among electors. As a result, politicians seeking to be reelected are not liable to use restrictive fiscal policy tools even when the economy situation in the country requires that, for example big inflation.
Some economists even presume that economic cycle is determined by political reasons. So, intransigents can manipulate on fiscal policy seeking to get as many votes during election as possible. If fiscal policy is used to embody political targets, it becomes the reason of economic fluctuations itself.  

Fiscal policy changes when government changes its expenditure programs or taxation. When taxes are reduced, people have more disposable income, personal saving is encouraged. But the investment will not increase all the time if the saving increases. When overall expenditure is low and unemployment rate is high, fiscal policy has to be expansionary. It means that government should increase expenditure or reduce taxation. These factors increase government budget deficit.
Seeking that government budget would move towards surplus, government should decrease expenditure and increase taxation. Fiscal policy has to be restricted when too big overall expenditure leads to inflation.
To add, beside the discretionary fiscal policy, the non-discretionary fiscal policy also takes an important role in stabilizing the state economy, seeking for full employment and stable prices as well as finding trade-off between budget deficit and budget surplus.
Government of Republic of Lithuania handles various activities related to the Convergence Programme that forecasts stable future for the economy of the country. Although the financial policy of the country is criticized in the European context, Lithuania has made a big progress that can be proved by economical indicators, provided in the Table 1. As it was enacted in the Programme, Lithuania seeks for stable state liabilities in the long-term period and operate effective pensions system reform. To add, not less important is an affective health insurance system and financial stability. Productivity and full employment are also included in the Programme as the factors that are necessary to ensure stable financial sector. The state budget policy will be formed taking into account national and EU priorities and it will be based on reforms that will foster affective distribution of resources.
To conclude, fiscal policy is only a part of the overall state governance, though the governance mechanism will not be stable if any part of it is not operating in the appropriate way. The main aim of fiscal policy is not the balance of state budget but employment and stable prices.
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