Role of Fiscal Policy in Economic Development of Under Developed Countries!

The various tools of fiscal policy such as budget, taxation, public expenditure, public works and public debt can go a long way for maintaining full employment without inflationary and deflationary forces in underdeveloped economies.

Obviously, taxation and public expenditure is a powerful instrument in the hands of public authority which greatly affect the changes in disposal income, consumption and investment.

An anti-depression tax policy increases disposable income of the individual, promotes consumption and investment. This will ultimately result in increase in spending activities which in turn, increase effective demand of the people. On the contrary, during inflation, anti-inflationary policy measures help to plug the inflationary gap.


During inflation, such measures are adopted which help to wipe off the excessive purchasing power and consumer demand. Tax burden is raised in such a manner as it may not retard new investment. Keeping in view all facts in mind, it is stated that fiscal policy plays very significant role for promoting economic development and stability of under developed countries.

It is illustrated by the following points:

1. To Mobilize Resources:

The foremost aim of fiscal policy in underdeveloped countries is to mobilize resources in the private and public sectors. Generally, the national income and per capita income is very low due to low rate of savings. Therefore, the governments of such countries through forced savings pushes the rate of investment and capital formation which in turn accelerates the rate of economic development.


It also undertakes the policy of planned investment in the public sector. Private investments have the favourable effect of increasing investment, the curtailment of conspicuous consumption and investment in unproductive channels can help to check the inflationary trend in the economy. Moreover, these countries face the problem of foreign capital. Thus the remedy lies in increasing the incremental saving ratio, the marginal propensity to save through public finance, taxation and forced loans.

To some extent, progressive taxation, heavy duty on luxury imports, ban on the manufacture of luxury and semi-luxury goods are other measures which help to mobilize the resources, Therefore, progressive taxation on windfall gains, on unearned incomes on capital gains, on expenditure and real estates etc. can go a long way in equitable distribution of wealth.

2. To Accelerate the Rate of Growth:

Fiscal policy helps to accelerate the rate of economic growth by raising the rate of investment in public as well as private sectors. Therefore, various tools of fiscal policy as taxation, public borrowing, deficit financing and surpluses of public enterprises should be used in a combined manner so that they may not adversely affect the consumption, production and distribution of wealth.


In order to achieve balanced growth in different sectors of the economy, according to Prof. J. Chelliah, the most fruitful line of advance lies along the path of a balanced development of agriculture and industry. In short, investment in basic and capital goods industries and in social overheads is the pillars of economic development in an underdeveloped economy. Thus, top priority to such investment should be given to accelerate the all round growth of an economy.

3. To Encourage Socially Optimal Investment:

In underdeveloped countries, fiscal policy encourages the investment into those productive channels which are considered socially and economically desirable. This means optimal investment which promotes economic development and avoids wasteful and unproductive investment.

In short, aim of the fiscal policy should be to make investment on social and economic overheads such as transportation, communication, technical training, education, health and soil conservation. They tend to raise productivity and widen the market to enjoy external economies. At the same time, unproductive investment is checked and diverted towards productive and socially desirable channels.

4. Inducement to Investment and Capital Formation:

Fiscal policy plays crucial role in underdeveloped countries by making investment in strategic industries and services of public utility on one side and induces investment in private sector by giving assistance to new industries and introduces modern techniques of production. Thus, investment on social and economic overheads are helpful in increasing the social marginal productivity and thereby raising the marginal productivity of private investment and capital formation. Here, optimum pattern of investment can also go a long way to yield fruitful results of economic development.

Economic development is a most dynamic process which involves changes in the size and quality of population, tastes, knowledge and social institutions. Keeping all factors in mind, if social marginal productivity in socially desirable projects is low, fiscal policy should be framed to raise social marginal productivity and to divert resources to that productive channels where the social marginal productivity is the highest.

5. To Provide more Employment Opportunities:

Since in less developed countries, population grows at a very fast rate, the aim of fiscal policy in such countries is to make high doses of expenditures which are helpful to raise employment opportunities. Generally under developed economies suffer from unemployment.


The unemployment is of two types:

(I) Cyclical unemployment and

(II) Disguised unemployment.

(I) Cyclical Unemployment and Fiscal Policy:


Cyclical unemployment is caused by external factors in underdeveloped countries. These countries mostly export their raw materials. When demand for these raw materials falls due to cyclical depression, then under developed countries also have to face the problem of unemployment in the primary industries. In order to remove this type of unemployment, the government may increase public expenditure. But it is not likely to have any favourable effect. As public expenditure increases, the people may spend on imports or conspicuous consumption.

Thus, expenditure on imports fails to generate employment in the country. Expenditure on conspicuous consumption will lead to rise in prices instead of increasing output and employment. It is because production capacity in under-developed countries is limited. It is not capable of meeting rising demand. Thus, the objective of fiscal policy should be to modernize and diversify the economy.

It implies that public investment should be directed towards the setting up of new industries, promoting the growth of private industries and developing agriculture. Besides, Govt. should provide tax concessions, tax holidays, bonus and subsidies etc. This will help to reduce the problem of unemployment.

(II) Disguised Unemployment and Fiscal Policy:


Unemployment in under-developed countries is disguised in nature. It is found in agricultural sector. It implies that more number of people are engaged in production activity than are actually needed. To remove this kind of unemployment, it is necessary to increase the rate of capital formation. Thus, the main objective of fiscal policy in under-developed countries should be to foster the maximum rate of capital formation without inflation. Stability is the pre-requisite of development.

This will help to raise the rate of savings. By increasing the ratio of saving to income, the economy would not only be able to reduce unemployment but also maintain economic stability in the long run. According to Raja J.Chelliah, “The main goal of fiscal policy in an underdeveloped country may be the promotion of the highest possible rate of capital formation without inflation. Stability is necessary for progress but the maintenance of stability does not require a fall in the rate of saving…………..” Therefore, the fiscal operations of the government for promoting the economic development of less developed countries are as of an investor, as a stabilizer, as a saver and as an income redistributor.

6. Promotion of Economic Stability:

Still another role played by the fiscal policy in developing countries is of maintaining reasonable internal and external economic stability. Generally, a developing country is prone to the efforts of international cyclical fluctuations. Such countries mainly export primary products and import manufactured and capital goods. However, in order to minimize the effects of international cyclical fluctuations, fiscal policy should be viewed from a longer perspective.

It must aim at the diversification of all sectors of the economy. For bringing balanced growth and reducing the effects of cyclical fluctuations, a contra-cyclical fiscal policy of deficit budgeting in depression and surplus budgeting in inflation are most suitable measures.

In a recession, public works programme through deficit financing brings fruitful results. No doubt, injection of additional purchasing power would tend to inflationary pressures which can be controlled with preventive measures. On the contrary, such a policy should be supplemented by appropriate monetary measures.


7. To Check Inflationary Tendencies:

Inflationary tendencies is one of the main problems of developing countries as these countries make heavy doses of investment for their development activities. Thus, there is always an imbalance between the demand for and the supply of real resources.

With additional injection of purchasing power, the demand rises and supply remains inelastic on account of its structural rigidities, market imperfections and other bottlenecks which in turn lead to inflationary pressures on the economy. Aggregate demand as a result of rise in the income of the people exceeds the aggregate supply. Capital goods and consumption goods fail to keep pace with the rising income.

Fiscal policy, therefore, can take several steps to control inflationary forces in the economy. They are:

(i) Reducing the purchasing power of the people through Compulsory Deposit Scheme

(ii) Mobilizing resources through public debt


(iii) Levying of Expenditure Tax

(iv) Imposing more taxes on rentier class

(v) Raising the rate of Capital Gains Tax

(vi) Encouraging the habit of saving among the people

(vii) Raising the percentage deduction of provident fund

(viii) Making of public investment in such production projects as have short gestation period,


(ix) Encouraging more production

(x) Mobilizing more resources by way of public borrowing and using the same in production projects.

8. National Income and Proper Distribution:

The importance of increasing national income and removing inequalities of income and wealth can hardly be exaggerated. According to Prof… Raja J. Chelliah, a mere increase in per capita income does not necessarily lead to an increase in the welfare of all sections of the people, unless an equitable distribution is usually taken to mean a reduction in the existing inequalities of income and wealth.

The existence of extreme inequalities in income and wealth create social cleavages, lead to economic and political instability and the biggest hindrance in the way of economic development of an economy. As a result, few rich roll in wealth and misuse their income on conspicuous consumption and inventories, real estate, gold and speculation, while poor masses grow under poverty and misery.

9. Subsidies in Consumption and Production:


Fiscal instruments are also used in under developed economies to provide subsidized food and production inputs to the poor people. Government programmes like public distribution system, price support policy, procurement of food grains, marketing facilities to the producers, input supply schemes, etc. are all directed to help the poorer sections to enable them to be more productive so that the income level is raised. For example, in India, many of poverty alleviation programmes like IRDP, NREP, RLEGP etc. have been directed to improve the position of the poorer sections and to create permanent community assets in order that the national and per capita income can grow with the passage of time.

10. Reallocation of Resources:

Allocation of resources are not proper in the underdeveloped countries. Much of the resources in private sector are directed to the production of those goods which meet the need of richer sections of society and yield higher profit. It is very important that the fiscal tools are employed in such a way as to divert resources from less useful production to more useful channels. This can be done by various tax incentive measures and government subsidy programmes.

11. Incentive to Production:

Increase in production and productivity can be influenced by fiscal policy to a greater extent. Through grant of tax holiday or tax concessions relating to output produced from desirable lines of production, the industrial activity can be enhanced. On the other hand, discriminatory fiscal policy against the output on undesirable lines of business activity will help more essential commodities to grow because the resources will be released for their use in such production.

12. Balanced Growth:

Most of the underdeveloped countries suffer acutely from regional imbalance in the matter of economic development. Private sector in these countries normally concentrates its production on those luxury goods which are consumed mostly by richer sections who live in the urban areas. Hence, backward areas will not be developed unless government interferes into the decision making relating to industrial location. By providing fiscal incentives to the private sector and by setting up industries in the public sector in these geographical areas, the government can achieve balanced development of the country.

13. Reduction of Inequality:

Since inequality of income and wealth is vast in the underdeveloped countries, fiscal policy has an important role to play in reducing inequality. Taxation of income and property at progressive rates, imposition of heavy taxes on goods consumed by the rich and exemption from tax or tax concession granted to commodities of mass consumption, government expenditure on relief programmes, supply of inputs for small industries and agricultural farms, provision of essential commodities to the poor at subsidized prices, etc. are the fiscal measures directed to the reduction of the gap between poverty and prosperity. Hence, the role of fiscal policy becomes significant to frame such policy to remove these inequalities of income and direct these misused resources into productive channels for economic development.

To conclude, the main objective of fiscal policy in underdeveloped countries should be promoting capital formation, raising national income, reducing disparities of income and wealth, proper allocation of resources, controlling inflation and achieving of full employment.

Limitations in U.D.C:

In under-developed countries, there are other several limitations which act as an obstacle in the successful working of fiscal policy.

They are summarized below:

1. Existence of Barter Economy:

In UDC’s, there exists non-monetized sector i.e. barter system prevails in the economy. This sector remains unaffected by the fiscal policy.

2. Lack of Elasticity:

Taxation system in underdeveloped countries is not modern, rational and elastic. Tax evasion leads to the generation of black market. It becomes difficult to earn sufficient revenue by the way of taxes which hinders the development activities.

3. Inadequate Data:

Generally, in less developed countries, there is inadequate statistical data. In the absence of accurate data, the scope of fiscal policy is minimized.

4. Illiteracy:

Lack of knowledge and proper understanding on account of illiteracy, the scope of fiscal policy becomes limited. The common people are unable to recognize the significance of fiscal policy.

5. Lack of co-operation:

In U.D.Cs lack of confidence and non-cooperative attitude among people hinders the significance of fiscal policy.