Business, Legal & Accounting Glossary
Fiscal neutrality is a public finance idea or objective that states that a government’s fiscal policies (taxing, spending, or borrowing) can or should not impact economic decisions made by businesses, workers, and consumers. In either a macroeconomic or microeconomic meaning, a policy change might be considered neutral to the economy (or both).
In macroeconomic terms, a fiscally neutral policy is one in which taxation and government expenditures neither stimulate nor depress demand. In a microeconomic sense, a fiscal neutral policy does not incentivise (promote or discourage) any form of transaction or economic conduct in comparison to others. Fiscal neutrality may also relate to a policy change’s financial impact in that it neither increases nor decreases a projected budget deficit or surplus.
Because the concept of fiscal neutrality can be utilised in a variety of contexts and purposes, understanding its meaning requires an understanding of the context and purpose for which it is being used.
Strict budgetary neutrality occurs when a policy change has no net effect on a government entity’s total budgetary balance. Any new spending introduced by a fiscally neutral policy change is projected to be totally offset by higher revenues earned; the net effect of the policy change is neutral with respect to the government’s budget balance.
For instance, providing tax credits for new automobile purchases in conjunction with an increase in the fuel tax may be financially neutral if the tax rise is adequate to cover the cost of the tax credits.
This may be regarded as a positive characteristic, as it increases the likelihood of a policy change being accepted and becoming law. Pay-as-you-go legislative regulations may promote or even require that some or all new policy measures be fiscally neutral in this respect.
Government deficit spending, or budget surpluses, are promoted in the area of macroeconomic fiscal policy as a means of increasing or decreasing aggregate demand in the economy in order to stabilise macroeconomic growth and avoid recessions. A fiscal deficit occurs when government expenditure exceeds tax collection, requiring the government to borrow money to make up the difference. A fiscal surplus occurs when tax collections exceed spending, and the additional money can be invested for future use.
A balanced budget is an example of fiscal neutrality, in which government spending is almost entirely covered by tax revenue – in other words, tax revenue equals government spending. In this context, fiscal neutrality means that the government’s overall fiscal policy is neutral in terms of aggregate demand in the economy. Because the government has neither a surplus nor a budget deficit, Keynesian economics predicts that this sort of fiscal policy will neither boost nor reduce aggregate demand.
Continuing with the example of an auto tax credit combined with an increase in gasoline taxes, it is clear that such a policy is fiscally neutral in a macroeconomic sense because the increased demand for new automobiles is offset by the decreased demand for gasoline, resulting in no net change in aggregate demand.
Fiscal neutrality, in a microeconomic sense, is based on the premise that government policy can impact individual economic behaviour. In this view, a neutral fiscal policy is one that gives individuals the freedom to choose whether to work, consume, save, invest, or engage in other economic activities.
This sort of fiscal neutrality focuses on taxation systems because it is impossible for government spending to have no effect on microeconomic activity. When the government spends money to buy actual products and services, the pricing of those commodities and services are inevitably influenced, and they are removed from the market or other users and uses, influencing the behaviour of other market participants.
Continuing with the previous example (an auto tax credit offset by a fuel tax), such a policy is clearly not fiscally neutral in a microeconomic sense because it induces customers to change their economic behaviour by purchasing more new cars and paying higher gasoline prices.
Fiscal neutrality is the impact of fiscal measures on an economy. Desirable fiscal neutrality implies normal functioning of economic forces even after the introduction of new taxes or tax structures. The introduction of new taxes ideally should not destabilize normal economic activity.
Any fiscal measure creates distortions in an economy, even negligibly. For instance, sales tax has a negative effect on the consumption of any good or service. Income tax will tend income earners to move away from an income bracket that is being taxed. Manipulation of income is a common practice to avoid paying income tax. Other effects of fiscal regulation are the movement of income earners from the workforce, and the proliferation of the black economy.
A major impact of fiscal neutrality is the formation of a permanent under-privileged class discouraged by existing tax structure to take up better employment opportunities. They rely on welfare remedies provided by the government. To achieve fiscal neutrality, many governments impose a marginal tax which is based on an additional income above a fixed threshold. A larger margin leads to a greater tax rate. So, in effect, after paying for taxes, disposable income remains similar, even after a rise in earnings.
Some fiscal distortions are deliberate in nature to prevent consumption of certain goods or services like tobacco and alcohol. Prohibition is an alternative way of preventing the consumption of such articles, but it leads to crime. The carbon tax is another example of a fiscal measure aimed at preventing the emission of industrial waste.
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This glossary post was last updated: 7th January, 2022 | 0 Views.