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Use of Fiscal Policy for Economic Development (4 Methods)


In underdeveloped countries, following methods of fiscal policy may be pursued to bring economic development.

1. Taxation Policy:

The government should adopt such a taxation policy as may:

(i) Promote capital formation. Taxation system should provide incentive to all those people who save to invest or who are keen to invest,


(ii) curb consumption expenditure to boost saving. Increased saving can be used to increase investment,

(iii) mobilize economic surplus.

According to Prof. Raja.J. Chelliah, main thrust of taxation policy is to mobilize economic surplus and divert the same into productive channels which may promote economic development. As we know that there are few people who are rich and possess economic surplus. Therefore, efforts should be made to check their conspicuous consumption.

It is important to mobilize such surpluses through progressive taxation system and utilized for productive activities of the economy. If people do not part with their savings voluntarily then compulsory savings schemes may be used for economic development. For this purpose, there should be built-in-flexibility in the taxation system. This is best possible by levying more taxes on consumer goods having more income elasticity. Direct tax should be progressive as far as possible.


Here, one must be careful that progressive taxation system may not adversely affect savings. More direct taxes should be imposed on those persons who spend their income on non-productive activities. The coverage of indirect taxes should be large. Special measures should be taken to check tax evasion, as it leads to the generation of black money and inflation.

Therefore, taxation system in less developed countries should be such that it should:

(i) help the government in mobilizing resources for capital formation

(ii) increase the ratio of saving


(iii) reduce the consumption of luxury goods and

(iv) help diminish inequalities in the distribution of income,

(v) help to control inflation and

(vi) bring economic stability with growth.

2. Public Expenditure Policy:

In underdeveloped countries, public expenditure policy is adopted. Generally these countries face the problem of capital which is the basic requirement of economic development. It cannot be expected from private sector alone. Thus, public investment is made in different sectors like expansion of means of transport and communication, irrigation, supply of power projects, health and human capital.

Public expenditure can be made in a reverse manner i.e.:

(i) Development of public enterprises,

(ii) Encouragement to private sector, and

(iii) Development of infrastructure. Let us explain it in detail.

(i) Development of Public Enterprises:


The less developed countries generally suffer from acute shortage of basic and key industries. Heavy capital investment is urgently required for setting up these industrial unit. Moreover, such units involve risks. Ordinarily, private sectors are unable to start these units. Therefore, Government should set up such industries through public expenditure. Even public utility industries like supply of water, power houses, bridges, and hospitals etc. should be established in the public sector.

(ii) Encouragement to Private Sector:

In order to accelerate the pace of economic development in under developed countries, Governments should encourage the private sector.

Fiscal policy here can play significant role by the way of:

(i) providing subsidies


(ii) reducing taxes and

(iii) making available free technical know-how to industries.

(iii) Creation of Infra-structure:

Public Investment can be encouraged by creating infra-structure in the country. Infra-structure refers to the development of railways, roads, electricity, transport, hospitals, bridges etc. Their construction involves huge capital investment which is only possible through public investment.

3. Public Debt Policy:

Resources collected through tax are not sufficient to meet the development requirement of the underdeveloped countries. Tax collection is very poor due to poverty of the common masses and it adversely affects the saving and investment. Thus, it becomes necessary to mobilize resources through public debt.


Public debt is of two types:

(i) Internal debt and

(ii) External debt.

(i) Internal debt:

Internal debt is floated within the country. In a less developed country, it should be so mobilized that it does not have adverse effect on private investment. In fact, it is beneficial to get loans by the method of small saving. Small saving can be attracted by giving encouragement to the common people which in turn helps to raise capital formation. As a result of small savings, people’s propensity to save also increases. In rural areas, there is good scope for small savings.


Therefore, Government should take measures to attract small savings more and more. Moreover, public borrowing should be made from those people who are prepared to spend large amount on comforts and luxury goods. But at the same time, precaution must be taken that such loans may not adversely affect capital formation in private sector.

(ii) External Debt:

When internal debt alone is not sufficient to meet the requirements of under developed countries then they have to borrow from external sources. Therefore, external debt refers to funds which are floated in other countries. These types of loans are voluntary in nature. External debts are particularly helpful in the initial stages of economic development of underdeveloped countries. Such debts bring in foreign capital, technology, technical know-how and capital goods.

However, external debts may create the problem of repayment of such borrowings. Therefore, such loans should be utilized strictly for productive purposes. According to Bachnan and Ellis, external debt and internal debt are complementary to each other but unless their use and the process of saving, institutions mobilizing resources, legal structure, lending and investing activities are made favourable to capital formation, external assistance can be of advantage only for a short time.

In short, public debt occupies significant place in economic development of under developed countries in more than one way:

(i) It encourages propensity to save

(ii) It helps capital formation for economic development

(iii) It helps to control inflation

(iv) It can be repaid out of the increased national income,

(v) Useful for meeting emergencies and war expenditure;

(vi) Better allocation of resources and

(vii) Useful for social services.

However there are many obstacles to the mobilization of public debt in under-developed countries e.g.:

(i) Lack of organised money and capital markets

(ii) Lack of saving

(iii) Use of saving in unproductive activities.

Therefore, efforts should be made to overcome these difficulties so that such borrowings maybe utilized for the uplift of the underdeveloped countries.

4. Deficit Financing:

Today, deficit financing has emerged as an important tool of fiscal policy. It means the gap caused by the excess of government expenditure over its receipts through the creation of new money. Generally, deficit financing is done by the method of borrowing from central bank, withdrawal of its cash balance from the central bank and issuing of new currency and putting into circulation. This type of fiscal policy was specially advocated by Lord Keynes. In underdeveloped countries, there is low level of income.

It further lowers the taxable capacity, power to save and hence, low capital formation. To overcome these problems, deficit financing is considered the best solution. Deficit financing is also favoured on account of its usefulness for quick command over resources for development activities like irrigation, transport, power generation and other big projects, war expenditures, encouragement to private investment and mobilization of domestic resources.

On the other hand, deficit financing leads to inflationary trends in the economy and other hardships. Consequently, profits of the producers go up and they are induced to produce more. Under inflationary conditions, income of the entrepreneurial and business classes increases substantially. These classes have a high propensity to save and low propensity to consume.

The main defect of deficit financing is that beyond a particular limit it may lead to excessive rise in prices. This adversely affects the economic development of the country. Thus, there must be some limit to deficit financing. At the same time, Government should make efforts to mobilize the resources and control prices. Unproductive expenditures may be checked and production of the public sector should also be raised.

In order to accelerate the rate of growth, the government may follow a strategy to raise productivity of capital through the use of selective subsidies and manipulation of the composition of the rate (t). In the long run period, fiscal measures must help to increase the rate of capital formation and check a misallocation of productive resources with a balanced sectoral growth.

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