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The term, fiscal policy, includes the tax and expenditure policies of the government or in alternate words; itmeans how government receive (raise) money and spends it. Thus, fiscal policy operates through the controlof government expenditures and tax receipts. It encompasses two separate but related decisions; publicexpenditures, and the level and structure of taxes. The amount of public outlay, the incidence and effects oftaxation, and the relation between expenditure and revenue exert a significant impact upon the free enterprise

economy.

Broadly speaking, the taxation policy of the government relates to the programme of revenue generation andresource mobilization, however, over the time the revenue generation in itself has become an important policy

instrument to address growth and development. Expenditure policy, on the other hand, deals with the channelsby which government resources are pumped into the private economy.

Government spending on new goods and services directly adds to aggregate demand in the economy andindirectly increases income through secondary spending, which takes place on account of the multiplier effect.

Multiplier Effect

The fiscal multiplier effect occurs when an increase in government spending into the economy causes a biggerfinal increase in national income.

For example, if the government increases spending by Rs 1 billion, there would be an initial increase in

Aggregate Demand of Rs 1bn. However, if this spending eventually causes real GDP to increase by Rs. 2billion, then the multiplier would have a value of 2.0.

Multiplier = Change in Real GDP/Change in government spending

Example of How the Multiplier Effect Works

If the government spent an extra Rs 2 billion on the contractual labour for infrastructure projects, this wouldcause salaries / wage to increase by Rs 2 billion, therefore National Income will increase by Rs 2 billion.

However with this extra income, workers will spend, at least part of it, in other areas of the economy. Forexample, if they spent 50% of the extra income there would be another Rs 1 billion injected into theeconomy, e.g., shopkeepers would earn money from increased sales. This extra spending would cause an

increase in output, therefore firms would employ more workers and pay higher salaries.

Therefore, these workers will also increase their spending. This will lead to another injection into the economy,causing higher Real GDP. In other words, if you increase salaries in the NHS, it isn’t just contractual labour,who benefit from higher incomes. It is also related industries and service industries who see some benefits.

Taxation, on the other hand, operates in reducing the level of private spending (on both consumption andinvestment) by reducing the disposable income (income available after paying taxes and social security, suchas PF) and the resulting savings in the community. Hence, under the budgetary phenomenon, public expenditure

and revenue can be combined in various ways to achieve a desired stimulating or deflationary effect onaggregate demand.

Fiscal policy has a quantitative as well as a qualitative aspect. Changes in tax rates, the structure of taxation,and its incidence, influence the volume and direction of private spending in the economy. Similarly, changesin government’s expenditure and its structure of allocation will also have quantitative and redistributive effectson income, consumption and aggregate demand of the community.

As a matter of fact, all government spending is an inducement to increase the aggregate demand (both volumeand components) and has an inflationary bias (increasing demand without increasing actual production) in the

FISCAL POLICY: An Overview

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sense that it releases funds for the private economy, which are then available for use in the course of trade andbusiness.

Similarly, a reduction in government spending has a deflationary bias and it reduces the aggregate demand (itsvolume and relative components in which the expenditure is curtailed). Thus, the composition of publicexpenditure and composition of public revenue not only help to mould the economic structure of the country,but may also be expected to exert certain effects on the economy at certain times and a quite different impactat other times.

It was Keynes who popularized the interest in fiscal policy as a measure attaining macro-economic goals likeincreasing the level of employment and income in an economy. Prior to Keynes, the classical economistsbelieved in the principle of sound finance in which small and balanced budget was considered to be the idealone. Keynes, for the first time, stressed the need of State intervention in the economic field and advocated foran unbalanced budget in times of low aggregated demand.

Objectives of Fiscal Policy

The following are the objectives of fiscal policy:

1. To maintain and achieve full employment.

2. To stabilize the price level.

3. To stabilize the growth rate of the economy.

4. To maintain equilibrium in the balance of payments.

5. To promote the economic development of underdeveloped countries.

1. Fiscal Policy for Full Employment

Keynes regarded public finance as compensatory finance ordained to attain and maintain full employment inthe economy.

To pursue this goal, Keynes suggested that:

(i) Taxation should be devised to promote and sustain consumption and investment.

(ii) To raise the level of effective demand and to overcome depressionary forces, budget should be in deficitand it should have deficit financing.

(iii) Public expenditure has to be compensatory one. It has to be in a planned way to finance public worksprogrammes and provide social security measures.

(iv) Direct taxes should be lowered to encourage savings and investments directed towards creation of moreemployment opportunities.

(v) Public expenditure should be meant for uplifting the level of aggregate demand, investment and employment.

(vi) Public borrowings should be on a large scale to finance productive public expenditure.

Once full employment level is reached, it has to be constantly maintained by adopting appropriate fiscalmeasures from time to time.

In a developing economy, fiscal policy has also to solve the problem of disguised unemployment. Hence, publicworks programmes have to be undertaken at village level to provide alternative employment opportunities.

2. Fiscal Policy and Economic Stabilization

Economic stability is another prime aim of a sound fiscal policy. This goal implies maintenance of fullemployment with relative price stabilization. Price stability here means relative price stability. Inflation shouldbe curbed and deflation should be avoided.

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In short, economic growth and stability are the twin objectives jointly pursued by a developing country’s fiscalpolicy. The forces stimulating growth process should be given a boost at a time while inflationary pressures areto be curbed.

In a growing economy, when huge investment is undertaken to construct social overhead capital, infrastructureof the economy and development of heavy industries, on account of long gestation period, returns are notimmediate, as scarcity of consumption goods is felt. This leads to a rising price spiral. A demand-pull inflationthereby causes wages etc. to go up and a cost-push inflation is provoked. The vicious circle of inflation hasto be checked through appropriate fiscal measures.

3. Fiscal Policy and Economic Growth

Poor countries are entangled in the vicious circle of poverty. It should be broken. Thus, rapid economic growthis the fundamental objective of fiscal policy in a developing economy.

Fiscal policy as a means of encouraging growth process has the following objectives:

a. To realize and mobilize potential resources into the productive channels. For this fiscal policy should aimat improving marginal propensity to save and the consequent incremental saving ratio.

The following methods can be used for raising the incremental saving ratio:

(i) Imposition of additional taxes.

(ii) Direct physical control.

(iii) Revenue of public enterprises.

(iv) Increase in the rates of taxation.

(v) Public debt.

(vi) Deficit financing.

b. To accelerate the rate of economic growth. In this regard, fiscal measure must be conducive to growthprocess. In no way should fiscal policy should adversely affect the ability and willingness to work hard,save more and invest.

c. To induce and stimulate private sector investment.

d. To promote investment into socially desirable channels.

e. To alter the pattern of investment and production in such a way as to improve the general economicwelfare and sustain egalitarian goals like equity in distribution and eradication of poverty.

4. Fiscal Policy and Social Justice

A welfare state should provide social justice by giving equitable distribution of income and wealth. Fiscalpolicy can serve as an effective means of achieving this much desired goal of socialism in developed as wellas developing countries. Progressive tax system can be of much use in realizing this objective. Moreover, publicexpenditure helps in redistributing income from the rich to the poor section of the society.

Thus, fiscal policy insists that in a budget, growing allocation should be made for programmes like free medicalcare, free education, subsidized housing, subsidized essential commodities like milk, etc.

From the above discussion, it follows that the objectives of fiscal policy are not conflicting but complementaryto each other.

Compensatory Fiscal Policy

The compensatory fiscal policy aims at continuously compensating the economy against chronic tendenciestowards inflation and deflation by manipulating public expenditures and taxes. It, therefore, necessitates theadoption of fiscal measures over the long-run rather than once-for-all measures at a point of time.

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When there are deflationary tendencies in the economy, the government should increase its expendituresthrough deficit budgeting and reduction in taxes. This is essential to compensate for the lack in privateinvestment and to raise effective demand, employment, output and income within the economy.

On the other hand, when there are inflationary tendencies, the government should reduce its expenditures byhaving a surplus budget and raising taxes in order to stabilise the economy at the full employment level.

The compensatory fiscal policy has two approaches:

(1) Built-in stabilisers; and

(2) Discretionary fiscal policy.

(1) Built-in Stabilizers:

The technique of built-in flexibility or stabilizers involves the automatic adjustment of the expenditures andtaxes in relation to cyclical upswings and downswings within the economy without deliberate action on the partof the government. Under this system, changes in the budget are automatic and hence this technique is alsoknown as one of automatic stabilization.

The various automatic stabilizers are corporate profits tax, income tax, excise taxes, old age, survivors andunemployment insurance and unemployment relief payments. As instruments of automatic stabilization, taxesand expenditures are related to national income. Given an unchanged structure of tax rates, tax yields varydirectly with movements in national income, while government expenditures vary inversely with variations innational income.

In the downward phase of the business cycle when national income is declining, taxes which are based on apercentage of national income automatically decline, thereby reducing the tax yield. At the same time, governmentexpenditures on unemployment relief and social security benefits automatically increase. Thus there would bean automatic budget deficit which would counteract deflationary tendencies.

On the other hand, in the upward phase of the business cycle when national income is rising rapidly, the taxyield would automatically increase with the rise in tax rates. Simultaneously, government expenditures onunemployment relief and social security benefits automatically decline. These two forces would automaticallycreate a budget surplus and thus inflationary tendencies would be controlled automatically.

Merits

Built-in stabilizers have certain advantages as a fiscal device:

1. The built-in stabilizers serve as a cushion for private purchasing power when it falls and lessen thehardships on the people during deflationary period.

2. They prevent national income and consumption spending from falling at a low level.

3. There are automatic budgetary changes in this device and the delay in taking administrative decisionsis avoided.

4. Automatic stabilizers minimize the errors of wrong forecasting and timing of fiscal measures.

5. They integrate short-run and long-run fiscal policies.

Limitations

1. The effectiveness of built-in stabilizers as an automatic compensatory device depends on the elasticity oftax receipt, the level of taxes and flexibility of public expenditures. The greater the elasticity of taxreceipts, the greater will be the effectiveness of automatic stabilizers in controlling inflationary anddeflationary tendencies. But the elasticity of tax receipts is not as high as to act as an automatic stabilizereven in advanced countries like America.

2. With low level of taxes even a high elasticity of tax receipts would not be very significant as an automaticstabilizer doing a downswing.

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3. The built-in stabilizers do not consider the secondary effects of stabilizers on after-tax business incomesand of consumption spending on business expectations.

4. This device keeps silent about the stabilising influence of local bodies, state governments and of theprivate sector economy.

5. They cannot eliminate the business cycles. At the most, they can reduce its severity.

6. Their effects during recovery from recession are unfavorable. Economists, therefore, suggest that built-instabilizers should be supplemented by discretionary fiscal policy.

Elasticity of Tax Revenue

It is the extent to which tax collection is affected with a unit change in national income, i.e., change in tax/GDP ratio w.r.t a unit change in GDP. This is important from government policy’s point of view as itdetermines how tax revenue would be affected with increase in national income.

(2) Discretionary Fiscal Policy:

Discretionary fiscal policy requires deliberate change in the budget by such actions as changing tax rates orgovernment expenditures or both.

It may generally take three forms:

(i) Changing taxes with government expenditure constant

When taxes are reduced, while keeping government expenditure unchanged, they increase the disposableincome of households and businesses, further increasing private spending. But the amount of increase willdepend on of whom the taxes are cut, to what extent, and on whether the taxpayers regard the cut temporaryor permanent.

If the beneficiaries of tax cut are in the higher middle income group, the aggregate demand will increase much.If they are businessmen with little incentive to invest, tax reductions are temporary. This policy will again beless effective. So this is more effective in controlling inflation by raising taxes because high rates of taxationwill reduce disposable income of individuals and businesses thereby curtailing aggregate demand.

(ii) Changing government expenditure with taxes constant

The second method is more useful in controlling deflationary tendencies. When the government increases itsexpenditure on goods and services, keeping taxes constant, aggregate demand goes up by the full amount ofthe increase in government spending. On the hand, reducing government expenditure during inflation is not soeffective because of high business expectations in the economy which are not likely to reduce aggregatedemand.

(iii) Variations in both expenditures and tax simultaneously

The third method is more effective and superior to the other two methods in controlling inflationary anddeflationary tendencies. To control inflation, taxes may be increased and government expenditure be raised tofight depression.

It’s Limitations:

The discretionary fiscal policy depends upon proper timing and accurate forecasting:

1. Accurate forecasting is essential to judge the stage of cycle through which the economy is passing. It isonly then that appropriate fiscal action can be taken. Wrong forecasting may accentuate rather thanmoderate the cyclical swings. Economics is not an exact science in correct forecasting. As a result, fiscalaction always follows after the turning points in the business cycles.

2. There are delays in proper timing of public spending. In fact, discretionary fiscal policy is subject to threetime lags.

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i. There is the “decision lag,” the time required in studying the problem and taking the decision. The laginvolved in this process may be too long.

ii. Once the decision is taken, is an “execution lag.” It involves expenditure which is to be allocated forthe execution of the programme. In a country like the USA it may take two years and less than a yearin the U.K.

iii. Certain public work projects are so cumbersome that it is not possible to accelerate or slow them downfor the purpose of raising or reducing spending on them.

Despite the higher multiplier effect of government spending as against changes in tax rates, the latter can beoperated more promptly than the former. Emphasis has thus shifted to taxation as the best fiscal device forcontrolling cyclical fluctuations. Thus when the turning point of a business cycle is already underway, discretionaryfiscal action tends to strengthen the built-in stabilizers, as has been the experience of developed countries likethe USA.

Role of Fiscal Policy in Developing Countries

The fiscal policy in developing countries should be conducive to rapid economic development. In a poorcountry, fiscal policy can no longer remain a compensatory fiscal policy. It has a tough role to play in adeveloping economy and has to face the problem of growth-cum-stability.

The main goal of fiscal policy in a newly developing economy is the promotion of the highest possible rateof capital formation. Underdeveloped countries are encompassed by vicious circle of poverty on account ofcapital deficiency; in order to break this vicious circle, a balanced growth is needed. It needs accelerated rateof capital formation.

Since private capital is generally shy in these countries, the government has to fill up the lacuna. A mountingpublic expenditure is also required in building social overhead capital. To accelerate the rate of capital formation,the fiscal policy has to be designed to raise the level of aggregate savings and to reduce the actual and potentialconsumption of the people.

Another objective of fiscal policy, in a poor country is to divert existing resources from unproductive toproductive and socially more desirable uses. Hence, fiscal policy must be blended with planning for development.

An important aim of fiscal policy in a developing economy is to create an equitable distribution of incomeand wealth in the society. Here, however, a difficulty arises. The aims of rapid growth and attainment ofequality in income are two paradoxical goals because growth needs more savings and equitable distributioncauses reduction of aggregate savings as the propensity to save by the richer section is always high and thatof the poor income group low.

As such, if high economic growth is the objective, the question arises as to what extent inequalities should bereduced. Of course, many a time, under the goal of socialism, the government unduly resorts to reduction ofinequalities at the cost of growth which may lead to the distribution of poverty rather than prosperity. Areconciliation of these two contradictory goals of growth and reduction of inequalities can definitely bring forthbetter results.

Furthermore, fiscal policy in a poor country has an additional role of protecting the economy from highinflation domestically and unhealthy developments abroad. Though inflation to some extent is inevitable in theprocess of growth, fiscal measures must be designed to curb inflationary forces. Relative price stability constitutesan important objective.

The approach to fiscal policy in an economy which is developing must be aggregative as well as segmental.The former may lead to overall economic expansion and reduce the general pressure of unemployment; butdue to the existence of bottlenecks though general price stability may be maintained, sectoral price rise mayinevitably be found.

These sectoral imbalances are to be corrected by appropriate segmental fiscal measures which would removefrictions and immobility’s turn demands into proper directions, seek to eliminate bottlenecks and other obstaclesto growth.

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For less developed countries such as India the following main objectives of fiscal policy may be restated as:

(i) To increase the rate of investment and capital formation, so as to accelerate the rate of economic growth.

(ii) To increase the rate of savings and discourage actual and potential consumption.

(iii) To diversify the flow of investments and spendings from unproductive uses to socially most desirablechannels.

(iv) To check sectoral imbalances.

(v) To reduce widespread inequalities of income and wealth.

(vi) To improve the standard of living of the masses by providing social goods on a large scale.

For the purpose of development, not only an expansionary budget but a deficit is desirable too in a developingcountry. The government expenditure on developmental planning projects must be increased.

It may be financed even by means of deficit financing. Deficit financing, here, refers to the creation of newmoney by printing additional notes by the government or by borrowing from the central bank which ultimatelymeans creation of additional money supply. However, the government must use the technique of deficitfinancing cautiously. An excessive dose of deficit financing may lead to inflation which may endanger economicgrowth.

Public borrowing also is an important means of getting resources for development of the public sector. Externalloans are useful to some extent when the country has to import machines, capital goods, etc., from a foreigncountry and the country has a scarcity of foreign exchange.

Anyway the effectiveness of fiscal measures in promoting development in a poor country depends on theincentives administered to the strategic points in the productive set up by virtue of the consequences oftaxation and public spending.

It must be noted that fiscal policy in a developing economy has to operate within a framework influenced bysocial, cultural and political conditions and institutions, which may inhibit the formulation and implementationof good economic policies.

Further, fiscal policy in a poor country may be used to reduce inequalities in income and wealth distributionby means of taxes and government expenditure. Taxation has to be progressive and government spending mustbe welfare-oriented.

In short, for promoting economic growth, the fiscal policy must be first formulated in such a way that it willincrease the rate of volume of investment in the public and private sectors. The tax policies must discourageunproductive and speculative investment. Second, fiscal policy must mobilise more and more resources forcapital formation. Hence, taxation must be used to curb excessive consumption. Third, it must encourage aninflow of foreign capital.

Fiscal policy, however, cannot be effective when there are loopholes in the taxation laws and the tax administrationis corrupt so that there is large-scale tax evasion. Again, if the government is extravagant in spending on non-developmental items, then a technique such as deficit financing may prove to be inflationary. Again, marketimperfections, bottlenecks, shortages of raw materials, and lack of entrepreneurial skills, do not allow fiscalpolicy to be effective.

A high population growth, and an orthodox society also come in the way of development and without acoordinated, sound, physical plan and its proper implementation, fiscal policy cannot be very effective inreaching its goal of rapid economic development with stability.

Nonetheless, of all economic policies, fiscal policy today assumes unique importance in realising generaleconomic goals, depending on the size of the fiscal measures adopted and their timing. The exact changeeffected in the national economy will depend on the form and the magnitude of public revenue, especially, therates and structure of taxation and the mode of public spending by the government.

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Further, when prices are rising, government has to adopt a surplus budget at an appropriate time in order toavoid secular inflation. But, there is practical difficulty in knowing the changing conditions or appearance ofprice stability; hence it is very difficult to forecast perfect timing.

Political and administrative delays tend to aggravate the problem and the desired effect of fiscal programmemay not be realised. Sometimes, even if the fiscal action is taken at a right time, in quantitative or qualitativeterms, it may not be adequate or appropriate.

Quite often, trade union activities come in the way of operating fiscal measures. The workers may resentcertain taxation measures or may demand high wages during inflation, and when the government is forced toraise the wage level on account of demand-pull inflation, cost-push inflation may also emerge to make thesituation worse.

Role of Fiscal Policy in Depression

The role of fiscal policy in a developed economy is to function as an anti-cyclical measure. It assumes abalanced position only in a normal price stability period. During recession or depression, however, the governmentmust adopt a deficit budget policy, while a surplus budget policy is to be followed to combat inflation.

During a depression, a deficit budget can be created in the following ways:

(i) The level of public expenditure is kept unchanged but the taxation rates are reduced.

(ii) Taxation rates are kept unchanged but public expenditure is increased.

The second method is regarded as more significant as an anti-depressionary measure. This excess of expendituremay be financed through public borrowings plus deficit financing, i.e., creation of new money.

Fiscal Policy and Objectives of Indian Government

The provisions made in the budgets, when read together, bring out the guiding philosophy of the new fiscalpolicy and the objectives that the government intends to achieve.

(i) Restoring Fiscal Equilibrium

A very important feature of the government’s efforts is to attain a match between the revenue receipts andrevenue expenditure with the ultimate aim of securing surpluses on revenue account for capital expenditure.

Towards this end, three types of measures have been taken. The first concerns expenditure. This has been toslow-down the growth-rate in it, despite increase in the absolute amounts. Second concerns tax-revenues.

The aim is to increase it, but unlike in the past when high taxes prevailed, the policy now is to seek larger taxreceipts through moderately low rates of taxes on a wider base. Third the government has made efforts to raiseprofits of the public sector undertakings.

(ii) Reforming Tax-structure

The approach towards the tax system is to design it in such a manner that it becomes growth elastic and getsin line with the tax-systems of other fast-growing and developed countries. To ensure better compliance andless incentive for tax-evasion, the government has lowered the tax rates both in respect of direct taxes andindirect taxes.

At the same time schemes have been introduced to widen the base of the tax. These together with lower taxand a wider base are very likely to raise the yield of taxes. And with growth in the activities and income ofthe economy, the tax receipts will increase.

This approach is totally different from the one pursued so far on the premise of a high tax-rate on a narrowbase. The new tax-regime will reduce and if pursued further eliminate the difference between the domestic tax-rates and the tax rates in other country.

This will help in integrating the Indian economy with the world economy. The benefits to the country will bean increase in exports and a larger inflow of foreign direct investment. The competitive strength and efficiencyof the Indian economy will also improve.

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(iii) Promoting Socially Desirable Activities:

The Government in the new fiscal policy has also provided larger expenditure, tax concessions and otherincentives for the expansion of socially important sectors. These are the sectors which are normally theresponsibility of the government. The development of infrastructure is one such field of key significance forthe economy.

While most of it is to be undertaken by the Government, several incentives have been extended to seek privatesector’s involvement in some areas like power to ensure that the supply of infrastructural services becomesadequate.

Tax concessions in the form of tax holiday have been given to encourage the private sector to set up industriesin the backward regions. Similar incentives have also been given to industries producing pollution-controlequipment.

Provision has also been made for the development of R&D (Research and Development) to upgrade thetechnological base of the economy. Besides public expenditure, tax concessions have been given to the privatesector for this purpose.

(iv) Market-oriented Development:

The new fiscal policy in line with the new economic policy aims at promoting allocation of resources largelyin terms of the market prices. The government has already dismantled a significant part of state-interventionand enlarged the field for the private sector. The fiscal policy has carried this process further by offering moneyincentives through lower tax-rates and tax-concession to the private sector.

Supply constraints in the market have also been caused by several fiscal measures. Reduction in custom dutieson the import of capital goods to modernise domestic production is one such measure to step-up the supplyof goods and services.

The lowering of the rates of indirect taxes on the consumer goods including luxury items like electronics goods,cars, etc., will encourage a growth-pattern largely based on the expansion of consumer goods industries.

The market orientation of development is also sought to be promoted by providing a demand stimulus to theeconomy. How direct taxes will mean larger disposable income with the people. Low indirect taxes will resultin lower prices. Both of these will increase demand.

Impact of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort toachieve economic objectives of price stability, full employment, and economic growth. Keynesian economicssuggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand.This can be used in times of recession or low economic activity as an essential tool for building the frameworkfor strong economic growth and working toward full employment. The government can implement thesedeficit-spending policies to stimulate trade due to its size and prestige. In theory, these deficits would be paidfor by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

Governments can use budget surplus to do two things: to slow the pace of strong economic growth and tostabilize prices when inflation is too high. Keynesian theory posits that removing funds from the economy willreduce levels of aggregate demand and contract the economy, thus stabilizing prices.

Some classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is knownas the Treasury View, which Keynesian economics rejects. The Treasury View refers to the theoretical positionsof classical economists in the British Treasury, who opposed Keynes’ call in the 1930s for fiscal stimulus. Thesame general argument has been repeated by neoclassical economists up to the present. From their point ofview, when government runs a budget deficit, funds will need to come from public borrowing (the issue ofgovernment bonds), overseas borrowing, or the printing of new money. When governments fund a deficit withthe release of government bonds, interest rates can increase across the market. This is because governmentborrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD),contrary to the objective of a budget deficit. This concept is called crowding out; it is a “sister” of monetarypolicy.

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In the classical view, fiscal policy also decreases net exports, which has a mitigating effect on national outputand income. When government borrowing increases interest rates it attracts foreign capital from foreign investors.This is because, all other things being equal, the bonds issued from a country executing expansionary fiscalpolicy now offer a higher rate of return. In other words, companies wanting to finance projects must competewith their government for capital so they offer higher rates of return. To purchase bonds originating from acertain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows intothe country undergoing fiscal expansion, demand for that country’s currency increases. The increased demandcauses that country’s currency to appreciate. Once the currency appreciates, goods originating from that countrynow cost more to foreigners than they did before.

1. Effects on Ability to work

Taxes reduce disposable income. As such, the buying capacity and consumption expenditure are curtailed.These cause the standard of living to deteriorate. Consequently, efficiency and ability to work is adverselyaffected.

This happens in the case of low income group people. For the rich, however, the ability to work is not so muchaffected by taxation. To avoid the ill-effects of taxation, it is essential to grant exemption limits in income taxfor the benefit of poor and middle income groups. Similarly, it is also necessary to avoid indirect taxes onessential commodities of mass consumption.

Again, there are some taxes which carry a beneficial impact on the ability to work. For instance, taxes on goodslike liquor, cigarettes, opium, etc. which prohibit their consumption will lead to an improvement in generalhealth and efficiency of those who are now addicted to them.

2. Effect on the Ability to Save

All taxes always have an adverse effect on one’s saving capacity. Ability to save is adversely affected bytaxation as taxes fall on income and saving is the function of disposable income. As disposable income declines,savings tend to decline.

Though normally, taxation is on the surplus income (the income which is in excess of the minimum standardof consumption level), the ability to save will be reduced proportionally to the amount of taxation, as it willadversely affect the marginal propensity to save by reducing the surplus income out of which saving isgenerated.

Hence, taxation would cause a reduction in the saving potentiality. Especially, the rich, having a high marginalpropensity to save, are affected most due to progressive taxation based on the ability to pay criterion. Aprogressive taxation substantially reduces the ability to save of the rich class.

Ability to save is also reduced by indirect or commodity taxation, because these taxes cause a rise in priceswhich induces a higher spending from a given income, thus, resulting in less saving.

Similarly, the corporate savings (that of business firms), too, are reduced by corporate taxation. Corporateability to save is, however, less affected than a wealthy individual’s ability to save since equity does not demandprogression generally in the taxation of corporate income.

But, when government spends the tax income for the benefit of the poor, then their ability to save is enhanced.So, while evaluating the effects of a tax, the effects of public expenditure should also be taken into considerationto appraise the correct position in the economic system.

It is equally true that when direct taxes are imposed, they absorb the excessive purchasing power of thecommodity, cause a deflationary effect which in turn enhances the real income of the common people and theircapacity to save.

3. Effect on Ability to Invest

Ability to invest in the private sector evidently falls on account of the reduced saving ability caused by thetax imposition. Hence, all taxes have the immediate effect of reducing the amount of resources available forinvestment in the private sector.

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In fact, taxation leads to a vicious circle in that when a tax is imposed, ability to save is reduced, less savingresources are available for investment in capital formation of the private sector, so there will be reduction incapital which in turn would lead to low productivity and low income, causing a further reduction in the abilityof the people to save. As such, it may be stressed that to maintain and improve the investment function ina free economy, it is necessary to ensure that the rate of savings is not discouraged by taxation.

This gloomy picture of effect of taxation is, however, painted without taking into account the beneficial effectsof public expenditure. In fact, public spending compensates and tends to surmount the adverse effects oftaxation. The reduction in ability to work and save caused by taxation is more than mitigated by the amenitiesof life provided by State expenditure.

When the overall social benefits of expenditure exceed the social sacrifice involved in taxation, the net benefitsof public spending will produce a favorable effect on the ability to save and work. Similarly, the reduction inprivate investment caused by taxation is more than offset by the public investment programmes.

In fact, the public sector investment may fill the investment gap of effective demand of the community andwith due capital formation, can accelerate the tempo of economic development. Public investment may bedesigned to break the vicious circle of poverty in an underdeveloped economy. Thus, though analytically, theeffects of taxation are discussed separately from those of public expenditure, in practice economic consequencesof a fiscal policy can hardly be segregated.

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The problem of developed countries is to stabilize the rate of economic growth by maintaining high effectivedemand and for that fiscal policy aims at reducing the savings of the people and increasing their propensity(tendency) to consume. The problem of under-developed countries is however different.

They need more savings so as to increase the rate of capital formation (though increase in investment) andthereby achieve higher rate of economic development. But in these countries the general level of incomes ofthe people is low and their propensity to consume is high and hence the rate of savings is small. The fiscalmeasures in these countries, therefore, should aim at raising the investment by reducing consumption andencouraging people to save more.

Since the per capita incomes at present is so low that for most of the population hardly manages to avail thebasic necessities, it would be unsuitable to expect people to save much in such living conditions, except somemoney for emergency use, thus, people must be incentivized to save.

The crucial determinant of economic growth is the rate of savings and, therefore savings cannot be left tothemselves to grow automatically. On the contrary, fiscal measures have to be adopted to increase the savingsof the people and to mobilize them for productive purpose. Fiscal policy, assumes a new significance in theface of the problem of capital formation in under-developed countries.

The backward countries are caught in the vicious circle of low income, high consumption, low savings, andlow rate of capital formation and therefore, low incomes. To get out of this vicious circle of poverty, thefiscal policy can play a constructive and dynamic role for the economic development of the underdevelopedcountries. Thus in poor countries, the importance of fiscal policy lies in raising the rate and volume of savingsand to divert them into the desired channels.

In this connection, the UN report on Taxes and Fiscal Policy says, “Fiscal policy is assigned the central taskof wresting from the pitifully low output of under-developed countries sufficient savings to finance economicdevelopment programmes and to set the stage for more vigorous private and public investment activity.”

The role of fiscal policy in economic development cannot be overemphasized. The importance of fiscal policyas an instrument of economic development was first envisaged by Keynes in his General Theory wherein heshowed that the total national income was an index of economic activity and brought out the relation ofeconomic activity of total spending.

The direct and indirect effects of fiscal policy on aggregate spending in the community were clearly establishedand as a result the budgetary policy of the government as a weapon of economic control and developmentcame into prominence.

The fiscal policy can affect the rate of economic development in a variety of ways such as by increasing therate of saving and investment, affecting the allocation of resources, controlling inflation, promoting economicstability. We now discuss them in detail.

To Increase the rate of saving and Investment:

Shortage of financial resources is the main obstacle in the way of economic development of under-developedcountries. There are certain forces operating in these countries which increase consumption and reduce savings.The first among them is the population pressure.

Besides, the high income groups spend much of their income on conspicuous consumption and their propensityto consume is further reinforced by the ‘demonstration effect’. A large part of the meager savings is dissipatedin unproductive channels—real estate, hoarding, gold, jewellery, speculation, etc.

The fiscal policy can be employed effectively to divert savings of the people into productive channels. It shouldaim at raising the incremental saving ratio through taxation and forced loans and make funds available forinvestment purposes in the public and private sectors of the economy.

BASIC CONCEPTS OF FISCAL POLICY

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This can be done by checking conspicuous consumption and preventing the flow of funds for unproductivepurposes. For this, high taxes on personal and corporate incomes and commodity taxation on articles of widestuse and conspicuous consumption should be imposed to check the actual and potential consumption of thepeople.

In this connection, report of the Taxation Enquiry Commissions, Government of India, observes, “A taxsystem, which on the whole, promotes capital formation in is two aspects of saving and investment fulfills anessential desideration”.

It should be borne in mind that the purpose of taxation should not be merely to transfer funds from privateto public use but to enlarge the total volume of savings available for investments. This requires that the generalemphasis should be on curtailing and restraining consumption and thereby increasing the volume of saving inthe community.

In Japan, for example, agricultural productivity was doubled between 1885 and 1915 and the instruments oftaxation was used effectively and much of the increase was taken away from the farmers by imposing higherrents and taxes on them and the resources thus collected were channeled into productive investments.

Forced loans were also imposed on the business community to mop up surplus funds for economic development.In USSR also, collective farms were heavily-taxed and agricultural surplus were siphoned off by raising theprices of manufactures relating to farm products.

As an innovator, the Government should spend on research and experimentation and stimulate innovations andnew techniques of production. This will reduce the costs of production and encourage investment. Besides, theGovernment can encourage innovations by giving subsidies and tax-relief to those firms and industries whichmay introduce them of their own.

The government has an important role to play as income redistributors and for that fiscal measures can go along way in reducing economic inequalities. A broad-based progressive tax structure can serve as a potentweapon in the hands of the state to secure equitable distribution of income and wealth.

However, there is a limit to which taxation can be carried for resource mobilisation. If the taxes are excessivethey will adversely affect people’s desire and ability to work, save and invest. This will obviously retard the paceof economic development. To avoid such a situation, the gap in resources required for economic developmentmay be covered by mobilizing savings through voluntary loans.

Financing of economic development through borrowings is not harmful if loans are used for productiveprojects. Further, unlike taxes, borrowing is not harmful if loans are raised from the public because it does notadversely affect people’s desire to work, save and invest as lending is voluntary and the lenders not only getback the amount lent but also earn interest on it. Instead Public borrowing may add to the incentive of thepeople to save and invest more as the lure of interest is there.

However, public borrowing is beset with certain limitations in under developed countries and as such muchreliance cannot be placed on it. The general masses are poor and their propensity to consume is very high andhence they have limited lending capacity. The rich generally do not like to lend to the government but insteaddivert their invisible resources into speculative channels as they can earn more from there.

Besides, the lack of organised money and capital markets coupled with inadequate banking facilities and lackof confidence in the financial and political stability in the governments of most of the underdevelopedcountries are some of the other obstacles in the way of public borrowing programme.

Therefore, steps may be taken to remove these and other obstacles and all out efforts must be made to educatepeople and persuade them to save more in the wider interest of the community.

Those people who spend the major portion of their income on conspicuous consumption and divert theirresources into unproductive channels or those who stand to be benefitted from particular development projectsmay be forced to invest in government bonds.

But it may be noted that no democratic government can rely on forced loans except for a short period and forcertain specified projects. Ultimately, it is the voluntary lending by the people that matters and the Government

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must be prepared to increase its domestic borrowing when the income and saving of the people increase as aresult of economic development and make public borrowing an important tool of resource mobilisation.

Similarly, Public expenditure is one the most potent weapons in the hands of the state to secure economicdevelopment of the underdeveloped. In underdeveloped countries, there is lack of basic facilities such astransport, power, irrigation, education etc. and also of basic and key industries. Thus, public expenditure shouldaim at creating basic facilities and establishing basic and key industries and encourage the development ofagriculture and industry by giving loans, grants, subsidies, etc.

Thus, a carefully and wisely planned public expenditure by creating social and economic overheads can go along way in creating necessary environment for the growth of the economy. But public expenditure can achieveits wider objective of development only if it conforms to certain well-defined principles of public expenditure.

The expenditure on the armed forces must not be overdone and other wasteful and excessive expenditure onadministration must be avoided. Public enterprises must conform to the principle of economic efficiency sothat costs fall and profits increase.

Care should be taken that public expenditure does not adversely affect people’s desire to work, save and investand for that people should not be provided with direct money help but with goods and services in the formof free education, free medical facilities etc. This will go a long way in increasing the efficiency and productivecapacity of the people. Thus public expenditure can play an important role in economic development.

The following methods may be adopted to increase the volume of domestic savings to meet the financialrequirements of economic development:

(i) Direct controls

The process of economic development inevitably leads to inflationary pressures in the economy, because itgenerates additional effective demand without an immediate and corresponding increase in the production ofconsumption goods.

Direct physical controls can be used most effectively to curtail consumption and check socially undesirableinvestment and thereby releasing resources for economic development. For example, rationing on consumptionof certain products say liquor, wherein no one is able to buy more than 2 bottles per month, this would restrictthe money spent on liquor consumption by people, provided tough administration prevents black marketing andsmuggling.

Though direct physical controls are not compatible with maintenance of democratic freedom and may bedifficult to administer in an underdeveloped economy, yet they are sometimes adjunct to a developmental fiscalpolicy.

(ii) Increase in the rate of existing taxes

(iii) Imposition of new taxes

(iv) Surplus from public enterprises

In some countries profits made in public enterprises bring the government closer to economic realities andenable it to measure the efficiency and taxpaying capacity of their counterparts and in the private sector.

It is desirable that the government itself starts highly profitable enterprises and utilises the surplus from themfor economic development. But the scope for any large surplus from public enterprises in underdevelopedcountries is limited due to high cost of production, in the initial stages of economic development and alsobecause of limited number of such enterprises.

(v) Deficit financing

A mild dose of deficit financing is very useful for the employment of unemployed economic resources but itsscope is limited in underdeveloped countries because of its inflationary impact resulting from the lags in thesupply of consumer goods.

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Similarly, public borrowing cannot be expected to bring in adequate resource in the absence of properlydeveloped capital markets in most of the underdeveloped countries. Besides a vigorous programme of publicborrowing may push up interest rates and affect investments adversely.

Fiscal policy can also provide fiscal concessions, such as investment and depreciation allowances, provisions offinance and foreign exchange, tax-holiday, development rebates, subsides, etc. These can contribute materiallyto the growth of investment in the private sector of the economy. Thus the first role of fiscal policy is to makeavailable maximum resources for economic development.

Ensuring Optimum Pattern of Investment

An underdeveloped country can ill-afford the diversion of her limited resources into socially undesirablechannels. The fiscal measure can be used to secure the pattern of investment which is in conformity with thecriteria of social marginal productivity.

High taxes on land value increments on capital gains and other windfalls should be imposed to prevent the flowof funds into unproductive channels such as land, buildings, inventories and other investments of speculativenature.

The tax system can provide positive inducement to productive and socially desirable investment in the privatesector. This can be done by differential rates of taxation and the grant of tax exemption in selected cases.

Investment in economic and social overheads, viz. transport, power, soil conservation, education public health,technical training facilities, etc., is of vital importance for attaining optimum pattern of investment because theprovision of these basic facilities is essential for speeding up development.

Such an investment widens the extent of the market; helps reduce cost of production and raise productivityby creating external economies. Private enterprise cannot be expected to provide such basic facilities as theinvestment involved in them is very huge and they are low and slow yielding projects.

Therefore, Governments of under-developed countries should take upon themselves the responsibilities to theexecution of these basic facilities. However, such projects should be financed through taxation and not withborrowed funds, because they do not yield direct returns necessary for the repayment of these debts.

Further these objectives can be summarized as below:

Objectives of Fiscal Policy

1. Development by effective Mobilisation of Resources

The principal objective of fiscal policy is to ensure rapid economic growth and development. This objectiveof economic growth and development can be achieved by mobilisation of Financial Resources.

The central and the state governments in India have used fiscal policy to mobilise resources.

The financial resources can be mobilised by :-

1. Taxation : Through effective fiscal policies, the government aims to mobilise resources by way of directtaxes as well as indirect taxes because most important source of resource mobilisation in India is taxation.

2. Public Savings : The resources can be mobilised through public savings by reducing government expenditureand increasing surpluses of public sector enterprises.

3. Private Savings : Through effective fiscal measures such as tax benefits, the government can raise resourcesfrom private sector and households. Resources can be mobilised through government borrowings by waysof treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by deficitfinancing.

2. Efficient allocation of Financial Resources

The central and state governments have tried to make efficient allocation of financial resources. These resourcesare allocated for Development Activities which includes expenditure on railways, infrastructure, etc. WhileNon-development Activities includes expenditure on defence, interest payments, subsidies, etc.

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But generally the fiscal policy should ensure that the resources are allocated for generation of goods andservices which are socially desirable. Therefore, India’s fiscal policy is designed in such a manner so as toencourage production of desirable goods and discourage those goods which are socially undesirable.

3. Reduction in inequalities of Income and Wealth

Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections

of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower

income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly

consumed by the upper middle class and the upper class. The government invests a significant proportion of

its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor

people in society.

4. Price Stability and Control of Inflation

One of the main objective of fiscal policy is to control inflation and stabilize price. Therefore, the government

always aims to control the inflation by reducing fiscal deficits, introducing tax savings schemes, productive use

of financial resources, etc.

5. Employment Generation

The government is making every possible effort to increase employment in the country through effective fiscal

measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties

on small-scale industrial (SSI) units encourage more investment and consequently generates more employment.

Various rural employment programmes have been undertaken by the Government of India to solve problems

in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified

persons in the urban areas.

6. Balanced Regional Development

Another main objective of the fiscal policy is to bring about a balanced regional development. There are

various incentives from the government for setting up projects in backward areas such as Cash subsidy,

Concession in taxes and duties in the form of tax holidays, finance at concessional interest rates, etc.

7. Reducing the Deficit in the Balance of Payment

Fiscal policy attempts to encourage more exports by way of fiscal measures like exemption of income tax on

export earnings, Exemption of central excise duties and customs, exemption of sales tax and octroi, etc.

The foreign exchange is also conserved by providing fiscal benefits to import substitute industries, imposing

customs duties on imports, etc.

The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance

of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on

imports or by giving subsidies to export.

8. Capital Formation

The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the

rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly

on account of capital deficiency. In order to increase the rate of capital formation, the fiscal policy must be

efficiently designed to encourage savings and discourage and reduce spending.

9. Increasing National Income

The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the

capital formation. This results in economic growth, which in turn increases the GDP, per capita income and

national income of the country.

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10. Development of Infrastructure

Government has placed emphasis on the infrastructure development for the purpose of achieving economic

growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the

government’s revenue is invested in the infrastructure development. Due to this, all sectors of the economy get

a boost.

11. Foreign Exchange Earnings

Fiscal policy attempts to encourage more exports by way of fiscal measures like, exemption of income tax onexport earnings, exemption of sales tax and octroi, etc. Foreign exchange provides fiscal benefits to importsubstitute industries. The foreign exchange earned by way of exports and saved by way of import substituteshelps to solve balance of payments problem.

Types of Fiscal Policy

Neutral Fiscal Policy:  This implies a balanced budget where (Government spending = Tax revenue). It furthermeans that government spending is fully funded by tax revenue and overall the budget outcome has a neutraleffect on the level of economic activity.

Contractionary (restrictive) Fiscal policy: This policy involves raising taxes or cutting government spending,so that (Government spending < Tax revenue) it cuts up on the aggregate demand (thus, economic growth) andto reduce the inflationary pressures in the economy.

Expansionary Fiscal Policy: It is generally used for giving stimulus to the economy, i.e., to speed up the rateof GDP growth or during a recession when growth in national income is not sufficient enough to maintain thepresent standards of living. A tax cut and/or an increase in government spending would be implemented tostimulate economic growth and lower unemployment rates.  This is not a sustainable policy, as it leads tobudget deficits and thus, should be used with caution.

Various combinations of fiscal policies

(i) Reduction in Government Spending and no Change in Tax Rates (Contractionary fiscal policy)

This policy is useful in moderate inflation, which though is part of government’s priority, is not theforemost objective. This would affect the growth little and sometimes even boost growth due to cut ininflation.

(ii) Reduction in Government Spending and Increase in Tax Rates (Contractionary fiscal policy)

This policy is useful in high inflation, when curbing inflation is the foremost objective, even above theeconomic growth in the short run.

(iii) Rigid Government Spending and Increasing Tax Rates (Contractionary fiscal policy)

This is used when economy is overheated (When a prolonged period of good economic growth and activity causeshigh levels of inflation as producers overproduce and create excess production capacity in an attempt to capitalize onthe high levels of wealth) due to too much excitement on the part of investors. Increase in taxes and interestrates (through monetary policy) would curb the investments in short-run and prevent economy from goinginto recession after over-heating.

(iv) Reduction in Government Spending and an Equivalent Reduction in Taxes (Balanced Fiscal Policy)

This, is a balanced budget approach, when a government decides to reduce its size and level of itsintervention in economy, then this policy can be adopted. It simply means government is managing lessmoney and hence less impact on markets and business.

(v) Increase in government spending and tax rates (Balanced fiscal policy)

This would be opposite to the previous policy as it would increase the size of government. A governmenton the path of socialization would adopt such policy.

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(vi) Increase in government spending and decrease in tax rates (Expansionary fiscal policy)

This would be adopted to give economy a stimulus though injection of funds, first the governmentdecreases taxes and leaves more income with people to spend and invest, then it also spends more to givefurther boost to demand through additional income generated through government work. This is onlypossible in short-run as this policy leads to massive deficits and thus, should be used when situation isalarming.

(vii) Increase in government spending and no change in tax rates (Expansionary fiscal policy)

This is also a stimulus policy (through public sector), but a more moderate one, which can be used for abit longer compared to previous.

(viii) Rigid Government spending and decrease in tax rates (Expansionary fiscal policy)

This policy is usually adopted to give incentive to private sector to invest and boost growth. Again, a short-run stimulus policy like previous two.

Tools of Fiscal Policy

Components of Spending

Maintenance (including staff salaries): This component can’t be altered in short-run and hence is hardly a partof policy making, however, in long-run, through VRS and reducing new jobs in public sector or vice versa, thisexpenditure can be altered.

Loan payments: This again is a component, which can’t be touched in short-run, however, governments in long-run can reduce these payments or eliminate them by running the budget surplus.

Subsidies: This component is a major part of policy as it can be altered in short-run, but unfortunately, subsidiesas policy instrument, have been abused in India. These are used by politicians as poll promise and politicalinstruments to gain more popular support. Ideally only meritorious subsidies shall be in operation and all thewasteful subsidies must be phased out, for example, fertilizer subsidy and power subsidy benefits the large farmholder and capitalist farmers instead of the needy ones. Similarly, the recent example of Aam Aadmi Partymanifesto is a good example, how subsidies should not be used. In place of these, subsides for health programs,renewable energy, public transport shall be encouraged to ensure good health and sustainable growth.

Welfare schemes: These are one of the policy options that once introduced can’t be removed due to theirpopulist nature. Similarly, in most of the cases these are necessary too and important instrument of socialwelfare and economic growth. However, it is the implementation part, which is key, as these schemes generallysuffer from poor implementation and massive corruptions and loopholes. Thus, despite being meritoriousexpenditure in nature, these at time appears as waste.

Wasteful expenses: Needless to say these are the expenditures that must be curbed with immediate effect;however, no government in world has neither shown the intention to curb them, though there are efforts toreduce them from time to time under public pressure. For example, full page government advertisements innewspaper to generate favorable public opinion.

Components of Earning

Tax: single: Single most important source of government revenue is also a very important policy measure aselaborated in the policy combinations above.

Borrowing: Borrowing is a necessary source of funds, though not a desirable one. Particularly, in developingcountries, as tax/GDP ratio is low due to less per capita income. However, it becomes an important part ofmonetary policy as well due to its impact on interest rates and credit creation and thus, overall money supply.

Proceeds from sale/lease of assets: This is a both a one-time and regular source of income. For example,lending government buildings for private use, or other assets such as telecom spectrum or lease of a mine blockfor certain years, is a regular source of income, whereas sale of PSUs is a onetime income. These however, aregood sources of revenue, as they provide government more room to spend without increasing taxes.

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Profits from PSU: Profits from PSUs can also be a potential source of revenue, however, since most of PSUs

are generating losses, Indian government usually ends up subsidizing them. At times PSUs are deliberately kept

in losses to keep prices low and ensure wider outreach for social welfare, example, PSU banks in pre-reform

era and post-offices. Similarly, at other times, they are in losses due to inefficiency and wasteful expenditure.

Most striking case in India, is of ministerial corruption to keep PSUs in loss deliberately to benefit private

sector, for example, CAG report says that, Indian Airlines was deliberately kept in losses by avoiding flights

on profitable routes to benefit private airlines during UPA government’s rule. Similarly, in previous NDA

government, BSNL was deliberately pushed into loss, by increasing tariffs to provide competitive edge to a

newly launched company by one of the biggest business conglomerate in India.

Important budgetary terms and fiscal concepts

Government Revenues & Spending...

Government’s budget is largely about revenues and expenditure. These are divided under two heads: Revenue

and Capital. Spending is also split into plan and non-plan.

Revenue Receipt/Expenditure: All receipts, such as taxes, and expenditure, like salaries, subsidies and interest

payments that in general do not entail sale or creation of assets, fall under the revenue account.

Capital Receipt/Expenditure: Capital account shows all receipts from liquidating (e.g., selling shares in a public

sector company) assets and spending to create assets (e.g., lending to receive interest).

Revenue/Capital Budget: The government has to prepare a Revenue Budget (detailing revenue receipts &

revenue expenditure) and a Capital Budget (capital receipts and capital expenditure).

1. Revenues

Gross tax revenue: The total tax received by the government from which it has to pay the states their share

as mandated by the relevant finance commission. The balance is available to the Union government.

Non-tax revenue: The main receipts under this head are interest on loans given by the government, and

dividends and profits received from PSUs. The government also earns from various services, including public

services, it provides. Of this, only the Railways is a separate department, though all its receipts and expenditure

are routed through the Consolidated Fund of India.

Capital receipts: These include recoveries of loans and advances.

Miscellaneous capital receipts: These are primarily receipts from PSU disinvestment.

2. Expenditure

Before we understand government spending, it is important to know the concept of plan and non-plan spending

and the Central Plan

Gross budgetary support: The Five-Year Plans are split into five annual plans. The funding of the Plan is split

almost evenly between government support (from the budget) and internal and extra-budgetary resources of

state-owned enterprises. The government’s support to the Plan, which includes state plans, is called Gross

Budgetary Support.

Plan expenditure: This is essentially the budget support to the annual plans. This is typically considered

developmental spending (on health, education, infrastructure and social goals). Like all budget heads, it is also

split into revenue and capital components.

Non-plan expenditure: This is in the nature of consumption expenditure, broadly corresponding to revenue

expenditure: interest payments, subsidies, salaries, defence & pensions. Its ‘capital’ component is small, the

largest chunk being defence.

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Deficits

When government’s expenditure exceeds its receipts, it has to borrow to meet the shortfall. This deficit hasmaterial implication for the economy as bridging it increases public debt and eats up revenues through higherinterest payments.

Public debt: The money borrowed by the government is eventually a burden on the people of India, and is,therefore, called public debt. It is split into two heads: internal debt (money borrowed within the country) andexternal debt (funds borrowed from non-Indian sources).

The major instruments covered under Internal Debt are as follows:

• Dated Securities: Primarily fixed coupon securities of short, medium and long term maturity which havea specified redemption date. These are the single-most important component of financing the fiscal deficitof the Central Government (around 91 % in 2010-11) with average maturity of around 10 years.

• Treasury-Bills: Zero coupon securities that are issued at a discount and redeemed in face value at maturity.These are issued to address short term receipt-expenditure mismatches under the auction program of theGovernment. These are primarily issued in three tenors, 91,182 and 364 day.

• 14-Day Treasury Bills.

• Securities issued to International Financial Institutions: Securities issued to institutions viz. IMF, IBRD,IDA, ADB, IFAD etc. for India’s contributions to these institutions etc.

• Securities issued against ‘Small Savings’: All deposits under small savings schemes are credited to theNational Small Savings Fund (NSSF). The balance in the NSSF (net of withdrawals) is invested in specialGovernment securities.

• Market Stabilization Scheme (MSS) Bonds: Governed by a MoU between the GoI and the RBI, MSS wascreated to assist the RBI in managing its sterilization operations. GoI borrows under this scheme from theRBI, while proceeds from such borrowings are maintained in a separate cash account with the latter andis used only for redemption of T-bills /dated securities raised under this scheme.

Fiscal deficit: The money borrowed by the government is eventually a burden on the people of India, and is,therefore, called public debt. It is split into two heads: Internal debt (money borrowed within the country) andExternal debt (funds borrowed from non-Indian sources). Usually the government spends more than what itearns through various sources. This shortfall, which is met with borrowed funds, is called fiscal deficit. Technically,it is the excess of government expenditure over ‘non-borrowed receipts’ — revenue receipts plus loan repaymentsreceived by the Govt. plus miscellaneous capital receipts.

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Fiscal deficit can be either ‘gross’ or ‘net’. The Central government makes capital disbursements as loans tothe different segments of the economy. In the developing countries, a large part goes as loans to other sectors-States and local Governments, public sector enterprises and the like. Net fiscal deficit can be arrived at bydeducting net domestic lending from gross fiscal deficit.

Budget Deficit: In the presence of the system of automatic monetization of deficits through issuance of ad-hoc treasury bills, this measure of deficit, becomes an important target to keep in check.

However, in the year 1997, the government discontinued the issuance of ad-hoc and tap treasury bills. As aresult of this, now, the concept of budget deficit in the traditional sense has lost its significance in public financeand is now not reported in the Budget documents of the Government of India.

Revenue Deficit: It is the excess of revenue expenditure over revenue receipts. All expenditure on revenueaccount should ideally be met from receipts on revenue account; the revenue deficit should be zero. In sucha situation, the government borrowing will not be for consumption but for creation of assets. However, sincegovernment revenues include borrowings, this deficit is misleading and thus, the concept of fiscal deficit is moreimportant as it portrays a relatively correct picture of fiscal health.

Effective revenue deficit: This is an even tighter number than the revenue deficit. It is revenue deficit less grantsfor creation of capital assets.

Primary deficit: It is the fiscal deficit less interest payments made by the government on its earlier borrowings.It excludes the burden of the past debt and shows the net increase in the government’s indebtedness due tothe current year’s fiscal operations. A reduction in primary deficit is reflective of government’s efforts atbridging the fiscal gap during a financial year.

Monetized Deficits: Monetization of deficits, which increases the money supply, is inflationary if the rate ofgrowth of money supply is greater than the rate of increase of the demand for cash balances arising from thegrowth of the economy. Thus, monetized deficits are an important indicator of the inflationary impact of theincrease in government’s budgetary deficits.

Deficit and GDP: Apart from the numbers in rupees, the budget document also mentions deficit as a percentageof GDP. This is because in absolute terms, the fiscal deficit may be large, but if it is small compared to thesize of the economy, and then it’s not such a bad thing, especially if it is being used to create productioncapacities.

FRBM ACT: The Fiscal Responsibility and Budget Management Act was enacted in 2003 and required theelimination of revenue deficit and reduction of fiscal deficit to 3% of GDP. The financial crisis and thesubsequent slowdown had forced the government to abandon the path of fiscal consolidation for a while.

Ways and means advances: When state governments or the centre face temporary mismatches then the RBIhelps them manage these through temporary advances called ways and means advances.

Securities against small savings: The Govt. meets a small part of its loan requirement by appropriating small-savings collection by issuing securities to the fund.

Treasury bills (T-bills): These are bonds (debt securities) with maturity of less than a year. These are issuedto meet short-term mismatches in receipts and expenditure. Bonds of longer maturity are called dated securities.

Taxation

The central government imposes many taxes, but they can be divided into two broad categories: Direct Taxand Indirect Tax

Direct tax

This is the tax that businesses, companies, firms and partnerships and indivduals pay from their income orwealth. It is called direct tax because the person who pays the tax has to also bear the burden of the tax.

• Corporation (Corporate) Tax: It is the tax that India Inc. pays on its profits. It is the single biggest sourceof tax for Govt. Taxes on income other than income-tax paid by ‘non-corporate assesses’ such as individualsand Hindu undivided family (HUF).

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• Securities Transaction Tax (STT): STT is the small tax one need to pay on the total amount one pay orreceive when one buy or sell shares on stock exchanges or transact in mutual funds. This is in the natureof a transaction tax. 

• Wealth Tax: This is the tax individuals pay on their accumulated wealth. It is levied on individuals, HUFsand companies at the rate of 1% on the amount by which the net wealth exceeds.

• Capital Gains Tax: It is the tax levied on profit or gain made on sale of a capital asset such as shares,house, and commercial property. Long-term capital gains tax is levied at 10% & short term at the marginalincome-tax rate of an assesse.

• Dividend Distribution Tax (DDT): Dividends are tax free in the hands of investors but the entity distributingdividends to investors pays DDT to Govt.

• Minimum Alternate Tax (MAT): It is often the case that companies report profits but pay no tax. Suchcompanies have to pay a certain minimum tax on their book profits.

• Withholding Tax: This is a small tax deducted whenever a payment is made that is like an income forthe receiver such as dividends, interest, royalty or even capital gains.

Indirect Taxes

It’s essentially a tax on our expenditure, and includes customs, excise and service tax. It is called indirect taxbecause the tax is paid to the government by the person selling the good or providing service but its final burdenis on the consumer. It is considered a ‘regressive’ tax as the burden is equal whether you’re rich or poor.

• Customs: Anything purchased from another country and brought into India is subject to this tax. It servesa twin purpose, yielding revenues for the government and protecting Indian industry.

• Service Tax or VAT: The Value Added Tax is a form of indirect tax that is imposed at different stagesof production on goods and services. VAT is levied on the imported goods as well and the same rate ismaintained as that of the local produce. Most of the European and non-European countries have adoptedthis system of taxation. The transparent and neutral nature of taxation has prompted VAT to emerge asone of the robust revenue raisers in these countries. Sales tax, as compared to VAT is the percentage ofrevenue imposed on the retail sale of goods. Unlike VAT, sales tax is levied on the total value of goodsand services purchased. 

• Union Excise Duty: This is a duty imposed on goods manufactured in the country.

• Service Tax: It is a tax on services rendered.

• GST: A proposed single tax that will replace the plethora of indirect taxes. This will make tax administrationeffective, compliance easy and evasion difficult. Consumers will benefit from the decline in the incidenceof tax.

Balance Sheet

Govt. prepares its accounts on a cash basis as opposed to accrual basis by companies.

Annual Financial Statement: This document gives details of the Govt.’s receipts and expenditure for thefinancial year. This document is actually the annual budget, as stated in the Constitution. It is divided into threeparts — Consolidated Fund, Contingency Fund and Public Account — each of which provides a statement ofreceipts and expenditure. Expenditure from the Consolidated Fund and Contingency Fund requires the nod ofParliament.

Finance Bill: For most of us, this is the all important budget document. All tax measures are included in it.The memorandum, another document, explains the provisions of the Bill in simple terms.

Contingency Fund: As the name suggests, any urgent or unforeseen expenditure is met from this Rs 500 crorefund, which is at the disposal of the President. The amount withdrawn is returned from the Consolidated Fund.

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Consolidated Fund of India: Under Article 266 (1) of the Constitution of India, all revenues (example, taxrevenue from personal income tax, corporate income tax, customs and excise duties as well as non-tax revenuesuch as license fees, dividends and profits from public sector undertakings, etc.) received by the Union governmentas well as all loans raised by issue of treasury bills, internal and external loans and all moneys received by theUnion Government in repayment of loans shall form a consolidated fund entitled the ‘Consolidated Fund ofIndia’ for the Union Government.

Public Account: This is an account where the government acts more like a banker, as this is a collection ofmoney belonging to others, such as public provident fund. 

Other Terms

Abatement

This is like a discount with reference to taxes. Abatement is given when the tax is not levied on full amount,but on a portion of the transaction.

Resources Transferred to the States

The Centre gives funds to states in two ways: a share in taxes and budget support for their plans. These arelargely in the nature of grants, and include those given to states for managing Centrally-Sponsored Schemes.

Disinvestment

The process of sale of government shares in state-owned entities.

Qualified foreign investors

Foreign individuals, groups or associations that are eligible to invest directly in India. They must be fromcountries that follow global anti-money laundering rules.

Viability-gap funding

Financial support to a public-private partnership (PPP) infrastructure project to make it viable for the private-sector investor.

Direct cash transfer of benefits

It is an administrative initiative to reduce leakages and corruption, under this welfare benefits are given directlyto the poor in cash (in their bank accounts) rather than in the form of subsidies.