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Cyclicality of Indian Fiscal Policy: Review of Literature

Cyclicality of fiscal policy indicates whether the government’s revenues and expenditures move in the same direction or in the opposite direction with output. A fiscal policy is called pro-cyclical if it is expansionary in good times (economic booms) and contractionary in bad times (economic recessions). Opposite is the case for a counter-cyclical policy. It is generally perceived that while the fiscal policies in the advanced economies tend to be counter-cyclical, the same in the developing countries are to a large extent pro-cyclical in nature. The cyclicality of fiscal policy received considerable attention during the global financial crisis in US economy. The large scale economic downturn accompanying the financial crisis led to activation of counter-cyclical fiscal policy measures of unprecedented magnitude. The fiscal measures focused on improving the balance sheet of the financial and corporate sectors as reflected in large scale bailouts in the US and other advanced economies. In addition, several countries used discretionary fiscal policy measures to boost economic growth. For instance, most of the OECD countries had adopted broad ranging stimulus programmes involving tax and expenditure adjustments. Indian government also responded with counter-cyclical measures including tax cuts and increases in expenditures to combat the rapid slowdown of economic growth (Mohanty, 2011).

 

The Keynesian view supports the role of discretionary fiscal policy as a counter-cyclical measure to boost aggregate demand and support growth. From a Keynesian perspective, public expenditure should act as a stabilizing force and move in a counter-cyclical direction. This implies that ideally, the fiscal policy should lower taxes and increase expenditure during the downswing of business cycle, to increase the aggregate demand. On the other hand, it should reduce expenditure and increase savings during the upswing of the business cycle. There is difference in fiscal cyclicality between developed and developing economies. The differential in the cyclicality in fiscal policy between developed and developing economies arises from: (i) restrictions on access to domestic (Caballero and Khrishnamurthy, 2004) and/or international credit markets (Gavin and Perotti, 1997; Calderón and Schmidt-Hebbel, 2008); (ii) institutions or political structures (Alesina et al., 2008; Thornton, 2008; Talvi and Végh, 2000). According to the credit restrictions problem, developing countries find it difficult to smooth the business cycle due to limited access to international credit markets, which prevents them from borrowing during bad times. Regarding institutional structure, Alesina et al. (2008) found that fiscal policy is more pro-cyclical in countries where corruption is more widespread. In contrast, Thornton (2008) finds that less corruption actually leads to more pro-cyclical fiscal policy in a sample of 37 African countries. Telvi and Végh (2000) found that the ability to run budget surpluses in good times is severely hampered in the developing countries due to political pressures to spend more.

 

 

More over cyclicality across various components of government revenue and spending differ significantly across countries but it is also been observed that cyclicality of certain components of fiscal policy are same across the countries. For instance, Tax revenue tends to increase during business cycle upturns and fall during recessions, reflecting pro-cyclicality. This is because GDP acts as a major determinant of collection of tax revenue during a year. Components used to measure cyclicality in various studies are: Government Expenditure, Government Revenue, and National Income. This review of literatures in Indian context to examine the cyclicality of fiscal policy in India; literature discusses about different variables like development and non-development expenditure, government revenue and many more. But literature has not incorporated certain variables which can impact the fiscal policy like FRBM Act and Globalisation. The review try to create model for examining the government expenditure in India and to check it cyclical trend.

Key Words: Fiscal Policy, Fiscal Cyclicality, Counter Cyclicality, Pro-Cyclicality, Government Expenditure, Fiscal Discipline.

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