The Link between Fiscal policy and Economic Growth - Literature review Example

? The Link between Fiscal Policy and Economic Growth Task: Overview A nation’s economy is very significant in the developmentof that particular nation in diverse areas. Every nation has the manoeuvre to better its economy in a bid to better the livelihood of its citizens and to increase independence. Prior to the United States’ great depression, economy was approached by the laissez faire approach. However, after World War II, the government had the need to act proactively, towards regulating the rates of inflation, the value of the currency, business cycles and unemployment rates. This called for strategic approaches towards influencing the economy positively. As a result, many approaches have been used to influence the nations’ economy in different ways, for instance, the use monetary policy, macroeconomic policy and fiscal policy, which are applicable in many countries. In some instances, some economic goals are met through a combination of several policies, depending on the nature of the goals to be met. Generally, fiscal policy is the process of influencing macroeconomic conditions through policies of government spending. The practice involves influencing a nation’s economy through the collection of revenue, borrowing and using government’s expenditure. In this case, the government engages in adjusting the levels of its spending in a bid to track and influence the economy of the nation. The policies of government spending often affect the interest and tax rates alongside the government’s spending (Barro and Redlick, 2011, 57). Just like other policies of influencing a nation’s economy, fiscal policy is applicable directing the economic goals of the country. The main goal is always the stability of the country’s economy through the control of spending and interest rates. The Concept of Fiscal Policy John M. Keynes, a British economist, came up with theories that are currently applicable in fiscal policy. His theories state that governments and nations, through the increase or decrease of public spending and the level of taxes, can influence the levels of macroeconomic productivity (Barro and Jin, 2011, 1568). The theory suggests further that such influences can further maintain the value of the currency at levels that are healthy, increase employment and curb inflation. The point of focus in the modern economics is the growth theory. This theory addresses the implications of economic growth regarding to wealth (Brzezinski and Dzielinski, 2009, 244) besides addressing the factors triggering economic growth. The system of economics can be stimulated through learning-by-doing mechanisms, which are essential for self-sustainable economic growth. These mechanisms can be induced into the economy by the government acts. Similarly, endogenous growth theory relates to fiscal policy, given that the outcome of the process involves the issue of losers and winners. With regard to neoclassical growth models formulated by Swan and Solow (Solow, 1956, 67), the exogenous rate of progress in technology is the backbone of growth income per capita, in its steady state. Every policy is characterised by the need of growth, even though the economy’s steady level of operation will be affected by the policy. In this case, the rate of economic growth will only be influenced by the economic policy when the economy is being transited to a steady state. Endogenous growth theory’s distinguishing characteristic that is crucial in fiscal policy is the visualisation of the nature of knowledge (Tcherneva, 2010, 27). This standard framework of making fiscal policy has been deduced from this model, with regard to taxation and government spending. Thus, this explains why many researches focus on the roles of governments in influencing the economy through dividing and stabilising the cake as opposed to enlarging the economy. Primarily, the study of the link between fiscal policy and economic growth has had the focus on the relationship between taxation and government spending. Thus, there are three possibilities in the stances of fiscal policy, which include contractionary (when taxation rate exceeds government spending), expansionary (when government spending precedes rate of taxation) and neutral stance (when revenue from taxation funds government spending fully, leading to a neutral effect on economic activities). Any changes in the rates of taxes levied to citizens and spending of any nature corresponds to some level of economic growth (Midthjell, 2011, 28). Therefore, assumptions from various parameters are a characteristic of fiscal policy calculation, and the assumptions are normally oriented on peoples’ income and the levels of interest. Fiscal policy bears many effects to the economy of a nation meaning that several deductions may be produced for the relationship with the economic growth. The policy serves as an instrument utilized by the government in the economic manipulation concerning a given or proposed objective. The relation connecting fiscal policy and financial developments occur in cases where the policy is utilized for economic augmentation objectives (Horton & El-Ganainy 2009, 52). Similarly, fiscal guidelines can in addition be utilized in instances where demand requires reduction. Fiscal policy is usually applied via utilization of two imperative factors, which include; government expenditure and taxation. Government expenditure can be regarded a technique utilized in fiscal policy and economic growth usually transpires when the administration regulates its expenditure through increment or decreases producing pertinent outcomes. The expenditure by the government arises from different governmental undertakings such as education and payment for its workers. The government utilizes different strategies in the stimulation of a monotonous financial growth. One of the approaches is the increased expenditure and decrease in the tax paid by the populace where eventually instigates an augment in the consumer expenditure. A decrement in the payable taxes to the populace often leaves the consumers, with lot more resources to spend. Similarly, disbursement of monetary resources into the economy through augmented spending augments the quantity of monetary resources circulating within a country’s economy. In return, the populace gains access to anticipated funds that they can utilize in the different purchases. The objective in these actions is to promote the cumulative demand for commodities that is merchandise and services within the financial system (Tanzi 2007, 2). This provides the link that exists between the growth of the financial structure and the fiscal policy. This can be explained better, through the consumer demand that serves to boost a stagnant economy. The government can also, make the choice of extra expenses through the provision of jobs within the economy. In instances where the government makes choices on spending more than usual through the prologue of job creating project impacts positively to the economy. The job created by such projects reduces unemployment within a nation presenting a positive impact on that people utilizes the money obtained in the acquisition of merchandise and services. Similarly, an overactive economy can be regulated through augmentation of taxes and a reduction in the government spending in an attempt to clear up any excess monetary resources in the economy. Fiscal policy serving as the budgeting process for the government is usually utilized in the making reasonable decisions concerning projected spending on various government undertakings. However, the government has to keep a balance in both the spending and revenue which can be regarded an imperative decision. Various opinions have been developed in an attempt to support the issues of spending. In the expansionary policy, the government strategizes on increasing its expenditure beyond the revenues although temporarily (Zagler 2003, 398). These governments suppose that the move profits the country in the long run and augments the prospect tax revenues. Contrarily to the policy is the contract policy where the expenditure is lesser than tax revenue and this serves to repay debts and create reserves. In cases where the expenditure exceeds taxes, a government borrowing is usually deliberated but for a government, certain decisions are made to furnish these deficits. Taking such measures can markedly influence choices made in regards to fiscal policy and government expenditure. Taxes can be considered system fiscal policy utilized in the control of the economy to induce a preferred upshot. This system of fiscal policy is reliant on the precise objective that the administration aims at accomplishing. The fiscal policy is utilized usually in the supervision of the overall demand rate for final merchandise and services within an economy. The government may deliberate an augment in the in taxes to regulate the intensity of consumption within the populace (Ali 2005, 18). Taking such, a tactical move will serve to reduce the available money in the economy by holding some of the money obtained through increased taxes. Consequently, a deficit of the monetary resources in the economy will ultimately lead to reduced cumulative demand. Taxes and fiscal policies have links in the way taxes are utilized to manipulate commerce. The government controls business undertaking in different ways such as the increment or reduction of taxes. The augments and decrease brings different reaction for the involved parties in ways that they undertake business. The actions undertaken for instance provision of opportunities for people in such companies serves to improve the economy. The government may utilize tax incentives to encourage companies to undertake in certain business ventures. The government can also utilize taxation in encouraging productivity within the economy by reducing the taxation imposed on individual income. The ways in which governments spend resources bears effects to the economic growth. Expansive allocation of monetary resources significantly affects growth rates due to disparities that occur where different undertakings encourage growth than the rest. Additionally, the allocated resources may be utilized efficiently or ineffectively (Gray, Tracey & Varoudakis 2007, 7). Strengths and Weaknesses of Fiscal Policy Generally, for the influences to work as desired there should be an appropriate balancing of the influences. This is due to the fact that, there is a higher risk of inflation rising when an economy that is stagnant is stimulated, since an increased supply of money corresponds to an increased customer demand, which can possibly lead to a decrease in the value of the currency (Favero, Giavazzi and Perego, 2011, 654). For instance, when the government approaches a slowed down economy through pumping of money into the economy, reducing rates of taxation and increasing the government spending through the purchase of services, levels of unemployment will go down considerably. This is a major strength of fiscal policy in influencing a nation’s economy. Furthermore, when the policymakers adjust the government’s spending, the move might only affect specific groups of people. As an example, when a road is being constructed in an area, job opportunities and income will be directed to the construction workers, who will be in a greater number. However, from a critical analysis, the scenario of an economy having more money and taxes paid are less, the demand for services and goods will increase. At extreme levels, when the process is not controlled and productivity is significantly increased, the market will have excess money, which will lead to a decrease in its value and a hike in the prices of goods and services due to a high demand. This will be another cause of inflation, thus is a major weakness of fiscal policy. Moreover, even though the use of fiscal policy in influencing economy may be beneficial to the government as a whole, its effects are not always similar to every player in the market. For instance, a cut on tax may affect the largest economic groups (middle class) most often, with regard to policymakers’ goals and political orientations. This fact brings the implication that the middle class are the typical group that pays more tax as opposed to the upper class that is wealthier, when the economy declines or tax rates are raised. Similarly, when the government initiates a technical project, such as building a space shuttle, the job opportunities and more come will be directed to a group of experts with specialised knowledge, which in this case will not contribute much in increasing the level of employment. Summary Fiscal policy effects are the main key to a stable and growing economy, Barro stated that public activities are the pillars of a strong and stable economy in production. Public capital and stock variable introduced by futagami et al led to transitional dynamics. Public capital and services are introduced as the final goods that show the optimal fiscal policy in economy according to Ghosh and Roy. This depends on both tax rate and apportionment of tax between accumulated capital and public services. Composition of government expenditure and growth are considered productive services in flows and variables, subsequently expenditure with excess productive type may not raise the growth rate if its previous share is too high. devarajan et al idea was to study optimal fiscal policy instead of complying with government decision that could be a “fruitful extension” of their work. Empirical results indicates that apart from the current spending, capital has contributed to economic development, determining that current spending flourished compared to capital spending hence prove more productive and results show that both educational and health spending have a negative effect on growth while operations and maintenance components has a positive effects on growth and development. Tax revenue, non-tax revenue and budget deficit are incorporated within the government. Devarajan et al suggests that productive expenditures, which are normally productive, could be unproductive if there is excessive number of them. For example, capital spending squeezing current is spending at the given margin. In addition, countries have allocated funds towards capital and away from current spending for some other reasons apart from productivity considerations, thus corruption erupts. In analytical frame work, key equations of Devarajan et al are characterized in Optimal fiscal policy then CES technology is considered by authors as where y= output, k= private capital and g1,g2 are types of government spending. Government agenda in decentralized economy is to meet nation’s interest via running public sector severally than a private sector. Comparative statics has key variables: optimal growth rate, optimal tax rate and ratio of optimal shares of two public services (Ghosh and Gregoriou, 2008, 490), which correspond to the productivity parameter, this states that two public spending are equal then the rise at the margin does not affect optimal rate. As far as positive results are concerned, restriction of our parameter choice is paramount for a growth and development of stable economy. Empirical analysis aims at the connection of government expenditure and economic growth in developing countries, though establishment of this connection includes optimal fiscal policy, where public input has higher productivity and a larger share in production activities. History has it that; investment in core infrastructure in U.S.A increases productivity of private capital for almost 40 years leading to a higher and rapid growth hence transport and communication investment has direct impact on growth of a countries economy. These analysis uses panel data and choice of variables to examine links between components of government expenditure and growth welfare-maximization perspective, ‘Black market premium’ were used to capture other effects of domestic policies. In methodology exogenously given shares can be captured by OLS fixed effects model, though GMM single equation model can captures endogeneity aspects of the model better, given cross country heterogeneity in the data. In a case where the shares of the more and the less productive inputs are randomly fixed fiscal policy is captured by OLS fixed effects, models or GMM equation. Robustness test checks whether results of the previous contributions of capital and current spending are robust to the given country samples. Empirical estimates were on low-income countries only while the ideal was to include more low-income to the sample. The test involves empirical outcome with respect to components of government capital expenditure though capital expenditure may show a negative relationship growth while other capital spending might have done better in terms of contributing to growth: overall capital spending might be unproductive, the case of increasing expenditure on components is possible and vice versa for current spending. Conclusion When the issue of a healthy economy is raised in the context of a nation’s economy, the major nightmare for policymakers is the decision, regarding to the level of the government’s involvement in economy. Fiscal policy has been implemented in many nations and the rates of economic growth have been visible in such nations. However, many players in the market have been affected either marginally or adversely by fiscal policy as a result. Controversies have been raised with regard to how and to what extent, the government has to be involved in the nation’s economy regulation. Nevertheless, it is widely accepted that for the realisation of a sustainable vibrant economy – one that is depended on by the population’s economic well being, the involvement of the government in the regulation of issues related to economy is vital. It is therefore logical to assert that fiscal policy is necessary for economic growth, even though it is characterised by some shortcomings. Again, the policy should be used together with other policies so as to fill the gaps that fiscal policy leaves out. Reference List Ali, A. M. (2005). Fiscal Policy and Economic Growth: The Effect of Fiscal Volatility. Accessed at: Barro, R. and Jin, T., (2011). On the size distribution of macroeconomic disasters. Econometrica, 79(5), pp.1567-1589, doi: 10.3982/ECTA8827. Barro, R. and Redlick, C., (2011). Macroeconomic effects from government purchases and taxes. Quarterly Journal of Economics, 126(1), pp.51-102. Brzezinski, M. and Dzielinski, M., (2009). Is endogenous growth theory degenerating? Another look at Lakatosian appraisal of growth theories. Journal of Economic Methodology, 16(3), pp.243-263, doi: 10.1080/13501780903121675. Favero, C., Giavazzi, F. and Perego, J., (2011). Country heterogeneity and the international evidence on the effects of fiscal policy. IMF Economic Review, 59(4), pp.652-682, doi: 10.1057/imfer.2011.25. Ghosh, S. and Gregoriou, A. (2008). The composition of government spending and growth: Is current or capital spending better? Oxford Economic Papers, pp.484–516, doi:10.1093/oep/gpn005. Gray, C., Tracey L. & Varoudakis, A. Fiscal Policy And Economic Growth. Accessed at: . Horton, Mark & El-Ganainy, Asmaa. (2005). What Is Fiscal Policy? Accessed at: Midthjell, N., (2011). Fiscal policy and financial crises - what are the actual effects of fiscal policy? Economic Bulletin, 82, pp.24-38. Solow, R., (1956). “A contribution to the theory of economic growth”, Quarterly Journal of Economics, 70, pp.65-94. Tanzi , V. (2006). Fiscal Policy: When Theory Collides With Reality.Accessed at: . Tcherneva, P., (2010). Fiscal policy: The wrench in the new economic consensus. International Journal of Political Economy, 39(3), pp.24-44. Zagler, M. & Durnecker, G. (2003). Fiscal Policy and Economic Growth. Accessed at: < http://www.wu.ac.at/inst/vw1/zagler/docs/2003joes.pdf>. Read More