The Role of Fiscal Policy in Shaping Market Trends

Fiscal policy is one of the commonest terms you will likely hear during economic discussions. Experts and market participants often use this term while decoding various aspects of the economy and budget. Fiscal policy formulated by the government plays a key role in shaping market trends. How? Let's find out.

Fiscal policy meaning: Understanding fiscal policy

Fiscal policy refers to the government's policy with respect to public expenditure, taxation, and public debt. Through it, the government adjusts its spending levels and tax rates to influence the economy. Based on the principles of Keynesian economics, the objectives of fiscal policy are to:

• Achieve and maintain economic stability
• Stabilise price levels
• Maintain the economy's growth rate
• Reduce inequality in income and wealth
• Raise the standard of living for citizens
• Maintain equilibrium in the balance of payments

Mechanism of fiscal policy and its impact

There are various tools through which the government formulates fiscal policy. Fiscal policy tools include:

• Public expenditure

It includes subsidies, welfare programmes, public works, etc. By increasing or decreasing its spending, the government directly influences economic activities. For example, when the government spends more, it can lead to higher output and employment generation, and vice versa.

• Taxation

Another major fiscal policy mechanism is taxation. A reduction in taxes can leave individuals and businesses with more income to spend and invest, boosting economic growth. Similarly, increasing taxes can reduce disposable income and cool down an overheated economy.

• Public borrowing

Public borrowing refers to the ways in which the government finances its expenditures. Through it, the government raises money from various instruments such as bonds, National Savings Certificate, Kisan Vikas Patra (KVP), etc., and uses the funds to finance various projects and welfare schemes.

People often confuse fiscal policy and monetary policy. However, they are quite different. While the Central Government controls fiscal policy, the Reserve Bank of India (RBI) controls monetary policy. Fiscal policy's prime objective is to influence economic conditions, while the latter aims to influence money supply and interest rates and keep inflation under control.

Fiscal policy and stock markets

The government's fiscal policy significantly impacts stock markets. Major changes in fiscal policy can create a ripple effect, impacting stock prices and investors' sentiments. For example, when the government increases public expenditure, it helps create jobs and boosts income. High income can lead to increased consumer spending, which can drive company profits, thereby leading to higher stock prices.

Similarly, when corporates and the common man receive tax reliefs, they have more money to spend. While businesses have more money to drive growth, the common man has more to spend on goods and services, thereby boosting company profits. It pumps up investors' confidence and impacts stock markets positively.

Sectoral impact of fiscal policies

Fiscal policy impacts various sectors in different ways. For example, increased expenditures on infrastructure can boost construction companies and result in increased demand for their services. The same goes for enterprises in other sectors, such as education, defence, power, consumer goods, technology, etc.

However, if the government levies higher taxes on corporates, companies can see their profit margins getting squeezed. Similarly, raising interest rates on public borrowing tools like bonds, NSC, KVP, etc., can generate greater demands for these financial instruments among investors.

Fiscal policy during economic crisis

Fiscal policy plays a vital role during an economic crisis. The government may increase spending across various sectors when the economy is undergoing tough times to spur economic activities.

Additionally, it can cut taxes to help individuals have more disposable income to spend to bolster demand for goods and services. Not only individuals, but even corporates can benefit from lower tax rates by retaining more of their earnings to maintain operations and invest in growth.

Current fiscal policy landscape

In its fiscal policy statement, the government has outlined a comprehensive roadmap that blends fiscal prudence with sustainable economic growth. Despite global uncertainties, the International Monetary Fund (IMF) has raised India's GDP growth forecast by 20 basis points to 7% for FY 25 . The optimistic outlook is supported by a strategic fiscal consolidation plan, where the government aims to reduce fiscal deficit to below 4.5% by 2025-26

In her interim budget presented on 1 February 2024, the finance minister proposed raising the capex target by 11.1% to Rs 11.11 lakh crore for FY 24-25, comprising 3.4% of the GDP . In a major move towards sustainable financing, the government has launched sovereign green bonds, specifically to fund projects that steer India's vision and transition to a low-carbon economy.

Challenges and limitations

While India’s fiscal policy is geared towards economic resilience, there are certain challenges that the government needs to overcome. Despite a high annual growth, the country incurs a high interest bill. The interest bill exhausts around 45 to 50% of the country's annual net tax revenue. Also, geopolitical issues and high inflation levels are a cause of concern.

Conclusion

While India’s economy has largely remained robust due to prudent fiscal policies over the years, there are challenges that need to be addressed. Announcements in the Union Budget 2024 will help us get more clarity on the government’s fiscal policy in the coming days, which will reshape India’s economic growth.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

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