Reviewed by Sep 30, 2020| Updated on
Fiscal neutrality refers to a situation where neither the government’s public expenditure nor the tax policy affects the demand in an economy. The consumer demand is not influenced by the tax laws or the government’s welfare programs.
Similarly, the business decisions of business enterprises are not influenced by the tax policy of the government or granting of subsidies or incentives by the government.
Fiscal neutrality can be achieved through a balanced budget, where the total revenues are equal to or exceed the expenses. The budgeting process includes a forecast of the government’s revenues and expenditure for the full year.
The government’s revenues consist of direct and indirect tax revenues. Direct tax revenues are collected as an income tax charged on the annual income of the taxpayers. Indirect taxes consist of goods and services tax, customs duty, professional tax, and any other tax or levy collected by the government from various business enterprises.
In a case where the government’s expenditure exceeds the revenues, their difference is called a fiscal deficit. The government has to make good fiscal deficit through borrowings. In a case where the revenues exceed expenditure, the difference is called a fiscal surplus. A government can invest the fiscal surplus for the future of the economy.
The theory of fiscal neutrality emphasises that the tax policy of the government should not influence the economic behaviour of taxpayers. The income tax levy may influence the number of working hours of a worker. An income tax levy may be different for different levels of income. Hence, the tax is distortionary in nature and is likely to influence economic behaviour.
Fiscal neutrality is based on tax-neutral behaviour. For example, a poll tax levied at a flat rate on all vehicles passing through a tollgate is not distortionary in nature. Such tax is called efficient since they facilitate tax collections without altering the economic behaviour of taxpayers.
While conducting the annual budgeting exercise, a government must focus on having tax policies which are fiscally neutral. The policies should help raise tax revenues without influencing the economic behaviour of the residents of the country. However, it is nearly impossible to achieve fiscal neutrality due to globalisation and different types of tax policies in different countries.