Government’s fiscal policy has big role in stabilizing the economy during business cycles. The two important phases of business cycles are boom and recession. A recession should not be allowed to grow into a deep recession. Similarly, a boom should not explode bigger. We may say that amplifying the business cycle is dangerous (growing boom and deepening recession).
Practically fiscal policy responses using taxation and expenditure can go in two ways in response to the business cycle: Countercyclical and procyclical.
What is countercyclical fiscal policy?
A counter-cyclical fiscal policy refers to strategy by the government to counter boom or recession through fiscal measures. It works against the ongoing boom or recession trend; thus, trying to stabilize the economy. Understandably, countercyclical fiscal policy works in two different direction during these two phases.
Countercyclical fiscal policy during recession
Recession is a business cycle situation where there is slowing demand and falling growth in the economy. Here, the Government’s responsibility is to generate demand by fine-tuning taxation and expenditure policies. Reducing taxes and increasing expenditure will help to create demand and producing upswing in the economy.
Countercyclical fiscal policy during boom
In the case of boom, economic activities will be on upswing. Amplifying the boom is disastrous as it may create inflation and debt crisis and the government’s responsibility here is to bring down the pace of economic activities. Increasing taxes and reducing public expenditure will make boom mild. Thus, slowing down demand should be the nature of countercyclical fiscal policy during boom.
Procyclical fiscal policy
Procyclical is the opposite of countercyclical. Here, fiscal policy goes in line with the current mood of the business cycle; amplifying them. For example, during the time of boom, government makes high expenditure and doesn’t hike taxes. Thus, boom grows further. Such a policy is dangerous and brings instability in the economy.
Boom: total government spending as a percentage of GDP goes up and tax rates go down, increasing government deficit.
Recession: total government spending as a percentage of GDP goes down and tax rates go up, decreasing government deficit.
So procyclical fiscal policy is undesirable for the economy.
History shows that governments follows often procyclical fiscal policy more during boom. Such a situation increases government debt and creates inflationary pressure especially in developing countries.
The Economic Survey 2017 also acknowledge some procyclicality during boom periods in India. “… India’s fiscal stance has an in-built bias toward higher deficits, because spending rises pro-cyclically during growth surges, while revenue and spending are deployed counter-cyclically during slowdowns.”
