Fiscal Effects on Inflation

At a time of dipression fiscal policy accelerates economic activity and increases employment and output without effecting price level significantly. It was actually happened after Great Depression and during world war-II in many countries. For example in USA, public sector promoted from 10 to 45% of GNP, output rose by 50%, unemplyment rate became negligible, and the inflation was quite low. This phenomenon continued up to late sixties when excessive government expenditures to finance Vietnam war set inflationary pressure in the economy. Inflation being a dynamic process perpetuated itself through wage-price-wage spiral. Finally it resulted at stagflation experienced in 1973.

The appropriate policy to get rid of inflation is to increase taxes or cut down govt. expenditures or decrease money supply or a mix of them. It may, however, generate cost-push inflation and unemployment. So tax penalties (irregular taxes) and bugets cuts from non-developmental expenditures are better policy tools in an inflationary period.

The fiscal system was originated to control aggregate but, somehow, it also influences factor markets and capacity output. Any increase in personal taxes may effect the work leisure battitude of the individuals depending taxes usually eat up savings and thus reduce capital formating. Discriminatory tax policy may encourage expenditures on health, education, research and training etc. which improve the quality of labour and pave the way of technological progress.

The difference between tax revenue and pure consumption expenditures is called public savings which can be utilized, partially or fully, for capital formation. A fall in tax revenue maintaining the sme level of current expenditures spares less funds for public investment.