Previous Year Question

An Economic Recession involves a decline in output, employment, investment and Aggregate Demand. An Expansionary Fiscal Policy adopted by the Government to revive economic activity under such conditions is called Fiscal Stimulus.

Aggregate Demand is expressed as:

Where:

C = Consumption

I = Investment

G = Government Expenditure

X-M = Net Exports

Fiscal Stimulus principally seeks to increase C, I and G.

Statement 1 is correct

A reduction in Tax Rates can increase household Disposable Income:

Disposable Income = Personal Income - Direct Taxes

If Income Tax is reduced, households retain more money for consumption and savings.

A reduction in Corporate Tax or investment-related taxation may:

• Increase post-tax corporate profits;

• Provide more Internal Funds;

• Raise expected returns on investment; and

• Encourage production and hiring.

Lower Indirect Taxes may reduce the prices of some products and stimulate consumption demand.

Therefore, tax-rate reductions can form part of a Fiscal Stimulus.

Statement 2 is correct

Higher Government expenditure directly increases Aggregate Demand.

The Government may increase expenditure on:

• Roads, railways and housing

• Rural infrastructure

• Health and education

• Employment programmes

• Income support

• Grants to States

Government spending generates income for workers, contractors and suppliers. When they spend a portion of this income, it can produce a Multiplier Effect.

In a simple Keynesian model:

If the Marginal Propensity to Consume—MPC is 0.75:

The actual multiplier may be smaller because of taxes, savings and imports, but Government spending can support output and employment during a recession.

Statement 3 is incorrect

Abolishing subsidies may:

• Reduce Government expenditure;

• Reduce beneficiaries’ Disposable Income or purchasing power;

• Increase the prices of subsidised goods; and

• Weaken consumption demand.

It may constitute a Fiscal Consolidation measure, but is not ordinarily part of a Fiscal Stimulus during a recession.

Rationalising subsidies is different from abolishing them. Better targeting and reduced leakage can improve fiscal efficiency, but the statement specifically refers to complete abolition.

Fiscal Stimulus versus Fiscal Consolidation

Therefore, Statements 1 and 2 only constitute a Fiscal Stimulus package.