May 2016 Q3 a.

Fiscal policy involves the use of taxation and government spending mainly to manipulate aggregate demand with a view to influencing the economy in a particular way. Monetary policy involves the manipulation of monetary variables such as money supply and interest rate to achieve certain economic targets such as reduction in inflation.
The distinction between the two is in the variables that are used to achieve the economic target. In the case of fiscal policy, taxation and government spending are manipulated to achieve results whilst economic variables are manipulated to achieve the objectives of monetary policy.

A contractionary fiscal policy involves increasing tax revenue while either maintaining or cutting the level of government spending.
Adverse effects of contractionary fiscal policy on businesses include the following:

• Reduction in sales revenue and consequently, profit: Contractionary fiscal policy involving increases in income tax rate reduces disposable income and thus aggregate demand falls. With other factors of demand remaining the same, the reduction in disposable income will result in reduction in demand for goods and services.
• Reduction in profit that can be reinvested: Increase in income tax rates will take more cash from businesses and thus reduce the amount of cash from operations that would be available for reinvestment. Firms will have to raise funds from external sources with higher costs and risks.
• Restriction on flexibility in taking credit decisions: Higher sales or consumption taxes rate (e.g. VAT rate) reduces businesses’ flexibility in granting credit. As VAT is payable when due regardless of whether payments have been received from customers or not, businesses that grant credit for periods longer than the grace period for payment of consumption taxes over the tax authority will have to pay the amount due from their own resources or with borrowed funds.
• Reduction in profit of firms facing price elastic demand: When rates of indirect taxes such as VAT and excise duty are increased, firms facing price elastic demand will have to either, absorb the additional cost and risk lower profits or pass on the additional cost to consumers in higher price to risk lower demand. In either case, the profit of such businesses will drop.
• Reduction in loanable funds: Contractionary fiscal policy reduces disposable income, and households will have little left to save in banks and/or invest in securities. This reduces the amount of surplus funds from households that can be channelled to businesses. However, if the reduction in aggregate demand results in reduction in inflation, interest rates might drop and cost of capital will be lower.