Fiscal Policy: Tools, Effects & Nepal’s Budget

TAKEAWAYS:

• Fiscal policy is the deliberate use of government spending and taxation to influence aggregate demand, economic growth, and stability.
• Expansionary fiscal policy (increased spending or lower taxes) boosts economic activity but risks inflation, while contractionary fiscal policy (reduced spending or higher taxes) cools an overheated economy but may slow growth.
• Nepal’s budget process (annual budget, revenue collection, and expenditure) directly implements fiscal policy, with tools like subsidies, grants, and tax incentives shaping economic behavior.
• Automatic stabilizers (e.g., unemployment benefits, progressive taxation) work without policy changes to counteract economic fluctuations.
• Crowding out occurs when government borrowing raises interest rates, reducing private investment—a key trade-off in fiscal policy.
• Public debt sustainability depends on debt-to-GDP ratio, interest rates, and economic growth; Nepal’s debt levels (currently ~85% of GDP) require careful management.

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1. Definition and Objectives of Fiscal Policy

Fiscal policy refers to the government’s use of taxation, public spending, and borrowing to achieve macroeconomic goals. Unlike monetary policy (controlled by central banks), fiscal policy is discretionary—decided by elected governments—and operates through the budget.

Key Objectives

Fiscal policy aims to:

• Stabilize the economy: Smooth business cycles (recessions and booms).
• Promote economic growth: Increase aggregate demand (AD) to boost GDP.
• Achieve full employment: Reduce cyclical unemployment.
• Control inflation: Prevent demand-pull inflation by reducing AD when needed.
• Redistribute income: Use progressive taxation and subsidies to reduce inequality.

Types of Fiscal Policy

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2. Tools of Fiscal Policy

Governments use three main tools to implement fiscal policy:

A. Government Spending (G)

Government spending includes:

• Capital expenditure (CAPEX): Infrastructure (roads, hospitals, schools).
• Current expenditure (OPEX): Salaries, subsidies, grants.
• Transfer payments: Pensions, unemployment benefits, scholarships.

Worked Example: Nepal’s Road Construction Boom (2023)

• Scenario: The government increases spending on Pradhan Mantri Ghar Dinero Yojana (subsidy for poor households) by Rs. 50 billion.
• Effect:
  • Direct impact: Poor households have more disposable income → ↑ Consumption (C).
  • Indirect impact: Construction workers earn more → ↑ Investment (I) in housing.
  • Multiplier effect: Total AD increases by more than Rs. 50 billion (depends on multiplier = 1/(1-MPC), where MPC = Marginal Propensity to Consume).
  • Visual:

B. Taxation (T)

Taxes affect disposable income (Yd = Y – T) and thus consumption:

• Direct taxes: Income tax, corporate tax (affect disposable income directly).
• Indirect taxes: VAT, customs duty (increase prices, reduce consumption).
• Progressive vs. Regressive:
  • Progressive: Higher income → higher tax rate (e.g., Nepal’s income tax brackets).
  • Regressive: Flat rate (e.g., VAT at 13% hurts poor more).

Worked Example: Nepal’s VAT Increase (2022)

• Scenario: Government increases VAT from 13% to 15% to reduce budget deficit.
• Effect:
  • ↓ Consumption (C): Higher prices reduce demand for goods like Khalti transactions and Daraz purchases.
  • ↓ Aggregate Demand (AD): Shifts left, reducing inflationary pressure.
  • Impact on inequality: Poor spend a larger % of income on taxed goods → regressive effect.
  • Visual:

C. Public Debt and Borrowing

• Deficit financing: Government spends more than it collects in taxes → borrows.
• Debt instruments: Treasury bills, bonds, loans from World Bank/IMF.
• Risk: Crowding out (higher interest rates reduce private investment).

Real-World Example: Nepal’s COVID-19 Debt (2020–2021)

• Nepal’s fiscal deficit widened to 10.5% of GDP (FY 2020–21) due to:
  • ↑ Spending: Free food, cash transfers, healthcare.
  • ↓ Revenue: Lower tax collections (businesses shut).
• Result:
  • Public debt rose to ~85% of GDP (from ~70% pre-pandemic).
  • Interest payments now consume ~30% of total government expenditure.
  • Visual:

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3. Automatic Stabilizers vs. Discretionary Policy

Worked Example: Nepal’s Unemployment Benefit (Hypothetical)

• Scenario: Nepal introduces unemployment insurance (like some developed countries).
  • If unemployment rises to 10%, benefits automatically increase.
  • Effect:
    • ↑ Consumption (C) during recessions (stabilizes AD).
    • No political delay (unlike a stimulus package).

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4. Multiplier Effect

The fiscal multiplier measures how much AD increases from a change in G or T.

Government Spending Multiplier (k)

$$k=\frac{1}{1-MPC}$$

• MPC (Marginal Propensity to Consume): % of extra income spent (e.g., if MPC = 0.8, multiplier = 5).
• Example: If Nepal spends Rs. 100 billion on road construction (MPC = 0.75):
  • First round: Workers spend 75% → Rs. 75 billion in consumption.
  • Second round: Those workers spend 75% of Rs. 75 billion → Rs. 56.25 billion.
  • Total increase in AD: Rs. 100 + Rs. 75 + Rs. 56.25 + ... = Rs. 400 billion (100 × 5).

Tax Multiplier

$$\text{Tax multiplier}=-\frac{MPC}{1-MPC}$$

• Example: If MPC = 0.8 and government cuts taxes by Rs. 100 billion:
  • AD increases by: 100 × (–0.8 / 0.2) = Rs. 400 billion (but opposite effect if taxes rise).

Visual:

Initial Injection (ΔG = +100)
→ Households spend 80% (MPC = 0.8) → +80
→ Next round: 80 × 0.8 = +64
→ Next: 64 × 0.8 = +51.2
...
Total ΔAD = 100 + 80 + 64 + 51.2 + ... = 500

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5. Crowding Out and Public Debt

Crowding Out

When government borrowing raises interest rates, private investment (I) falls.

• Example: Nepal borrows $1 billion from the World Bank to build a hydroelectric dam.
  • ↑ Demand for loans → ↑ Interest rates (from 8% to 10%).
  • Private businesses (e.g., Daraz, Pathao) find borrowing costlier → ↓ Investment.
  • Net effect: AD may not rise as much as expected.

Visual:

Government Borrowing → ↑ Interest Rates → ↓ Private Investment (I) → ↓ AD

Public Debt Sustainability

Key indicators:

1. Debt-to-GDP ratio: Nepal’s ~85% (high but manageable if GDP grows).
2. Interest payments as % of revenue: Nepal spends ~30% of revenue on debt interest.
3. Primary deficit: Fiscal deficit excluding interest payments (Nepal’s primary deficit is ~5% of GDP).

Worked Example: Nepal’s Debt Trap Risk

• Scenario: If GDP growth slows to 3% but debt grows at 8% (due to high interest), debt-to-GDP ratio worsens.
• Solution: Government must:
  • Increase tax revenue (e.g., crack down on tax evasion in Khalti/Daraz transactions).
  • Reduce wasteful spending (e.g., cut subsidies for NTC/Ncell if inefficient).
  • Negotiate lower interest rates with creditors (e.g., IMF/World Bank).

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6. Fiscal Policy in Nepal: Case Studies

A. COVID-19 Stimulus (FY 2020–21)

• Tools Used: ↑ Government spending, ↓ Taxes, direct cash transfers.
• Impact:
  • AD increased (temporarily), but debt rose sharply.
  • Inflation remained high due to supply shocks (not just demand).
• Lesson: Fiscal policy works best when combined with monetary policy (e.g., NRB’s low interest rates).

B. Fuel Subsidy Cuts (2022–2023)

• Scenario: Government reduced fuel subsidies to control fiscal deficit.
• Effect:
  • ↑ Fuel prices → ↑ Cost of goods (e.g., Pathao rides, Daraz deliveries).
  • ↓ Inflationary pressure (but hurt poor households).
  • Political backlash: Protests by transport unions, truck owners.

C. Infrastructure Spending (Pradhan Mantri Ghar Dinero Yojana)

• Goal: Reduce poverty by transferring Rs. 500 billion to poor households.
• Effect:
  • ↑ Consumption in rural areas (e.g., more Khalti payments for goods).
  • Multiplier effect: Local businesses (e.g., Daraz sellers) benefit.
  • Challenge: Leakage (money not reaching intended beneficiaries).

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7. Advantages and Disadvantages of Fiscal Policy

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8. Fiscal Policy vs. Monetary Policy

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## In the Real World

1. Khalti and Daraz (E-Commerce)

   • Idea Used: Taxation and subsidies
   • How? Nepal’s 13% VAT on online transactions affects Khalti/Daraz’s revenue. If VAT rises, consumers spend less, reducing AD. Conversely, subsidies for digital payments (e.g., cashback schemes) boost usage and economic activity.

2. NTC and Ncell (Telecom Sector)

   • Idea Used: Government subsidies and regulation
   • How? The government subsidizes telecom services in remote areas to increase connectivity and economic participation. However, over-subsidization leads to NTC/Ncell’s high debt, requiring fiscal adjustments.

3. Nepal Rastra Bank (NRB) and Fiscal-Monetary Coordination

   • Idea Used: Complementary policies
   • How? During COVID-19, the Finance Ministry (fiscal policy) increased spending while the NRB (monetary policy) cut interest rates. This synergy prevented a deeper recession but also led to high inflation (10.5% in 2022).

4. Pathao and Transport Unions (Subsidies vs. Inflation)

   • Idea Used: Fuel subsidies and crowding out
   • How? When the government reduced fuel subsidies in 2022, Pathao ride prices rose, hurting low-income users. Meanwhile, transport unions protested, showing how fiscal policy affects daily life.

5. Nepal’s Budget Process (Annual Fiscal Plan)

   • Idea Used: Discretionary fiscal policy
   • How? Every year, the Finance Ministry presents a budget with:
     • Revenue targets (e.g., Rs. 1.5 trillion from taxes).
     • Expenditure plans (e.g., Rs. 2 trillion on infrastructure).
     • Deficit financing (borrowing Rs. 500 billion).
   • Example: The FY 2023–24 budget aimed to reduce the deficit to 6% of GDP by cutting wasteful spending.

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## Exam Tip

Fiscal policy is a high-scoring topic in PU exams. Focus on these key patterns:

1. Diagrams Are Mandatory

   • Always draw AD-AS shifts for expansionary/contractionary policy.
   • Example:

     AD1 → AD2 (Right shift: ↑G or ↓T)
     AD1 → AD3 (Left shift: ↓G or ↑T)
     

2. Worked Examples = Extra Marks

   • Always use Nepal-specific data (e.g., debt-to-GDP, VAT rates, COVID-19 stimulus).
   • Example Question: "If Nepal’s MPC is 0.75 and the government increases spending by Rs. 200 billion, calculate the change in AD." Answer: ΔAD = 200 × (1/0.25) = Rs. 800 billion.

3. Compare Fiscal vs. Monetary Policy

   • Exams often ask: "Which policy is better for Nepal’s current inflation/recession?"
   • Use the table above to structure your answer.

4. Debate Pros and Cons

   • Questions like "Should Nepal increase taxes to reduce debt?" require:
     • Pros: Lower debt, more investor confidence.
     • Cons: ↓ Consumption, slower growth.

5. Real-World Application (5 Marks Guaranteed)

   • Link theory to Nepal’s budget, COVID-19, or inflation control.
   • Example: "Nepal’s fiscal deficit widened in 2020 due to COVID-19. Discuss the tools used and their impact on AD." Answer:
     • Tools: ↑ Government spending (healthcare, cash transfers), ↓ Taxes (VAT relief).
     • Impact: ↑ AD temporarily, but debt rose to 85% of GDP.
     • Trade-off: Short-term growth vs. long-term debt sustainability.

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Final Advice: Fiscal policy is all about AD, multipliers, and trade-offs. Master the AD-AS shifts, multiplier calculations, and Nepal’s budget examples—this will fetch you full marks in PU exams.