Chapter 5 Government Budget And The Economy

Government Budget — Meaning And Its Components

The government plays a vital role in a mixed economy (involving both private and government sectors). This chapter focuses on how the government influences economic life through its budget.

In India, the government is constitutionally required (Article 112) to present an 'Annual Financial Statement' to Parliament each financial year (April 1 to March 31). This document is the government budget.

The budget outlines the government's estimated receipts (revenue) and expenditures for the financial year. Its impact extends beyond the current year.

The budget has two accounts:

• Revenue Account (Revenue Budget): Relates to receipts and expenditures that do not affect the government's assets or liabilities in the current year.
• Capital Account (Capital Budget): Relates to receipts and expenditures that affect the government's assets and liabilities (creation of assets or incurrence of liabilities).

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Objectives Of Government Budget

The government uses the budget to enhance the welfare of the people by intervening in the economy through several functions:

• Allocation Function: Government provides public goods (like national defense, roads, government administration) which are not efficiently provided by the market mechanism (exchange between individuals) because of their unique characteristics:
  • Non-rivalrous consumption: One person's consumption doesn't reduce availability for others (e.g., enjoying a public park).
  • Non-excludable: Difficult or impossible to prevent anyone from enjoying the benefits, even if they don't pay ('free-rider' problem). Since consumers won't voluntarily pay, the government must provide these goods.
  Public provision means goods are financed through the budget; public production means they are produced directly by the government.
• Redistribution Function: Government aims to achieve a 'fair' distribution of income and wealth in society, often through progressive income taxation (higher tax rates for higher incomes) and transfer payments (like pensions, scholarships) to disadvantaged groups. This alters the distribution of personal disposable income.
• Stabilisation Function: Government intervenes to correct fluctuations in income and employment caused by variations in aggregate demand (total spending in the economy).
  • During recession (low demand, high unemployment): Government raises aggregate demand (e.g., by increasing spending or cutting taxes).
  • During inflation (high demand, output near full employment): Government reduces aggregate demand (e.g., by decreasing spending or raising taxes).
  This intervention to manage demand fluctuations is the stabilisation function.

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Classification Of Receipts

Government receipts are classified into revenue receipts and capital receipts:

• Revenue Receipts: Receipts that do not create a liability for the government or reduce its assets. They are non-redeemable.
  • Tax Revenue: Compulsory payments to the government. Includes direct taxes (income tax, corporation tax) and indirect taxes (excise duties, customs duties, service tax, GST). Direct taxes can be progressive (income tax) or proportional (corporation tax). Indirect taxes can be used for redistribution (lower taxes on necessities, higher on luxuries/harmful goods).
  • Non-Tax Revenue: Receipts other than taxes (interest on loans, dividends/profits from government investments, fees, grants from foreign entities).
• Capital Receipts: Receipts that either create a liability for the government or reduce its financial assets.
  • Create liability: Borrowings (domestic or international loans).
  • Reduce assets: Recovery of loans given by the government, sale of government assets (disinvestment of PSUs).
  Capital receipts can be debt-creating (borrowings) or non-debt creating (loan recoveries, disinvestment).

Table 5.1 provides a summary of Central Government receipts and expenditures as a percentage of GDP.

S.No.	Item	2018-19 (PA) (As % of GDP)
1.	Revenue Receipts (a+b)	8.2
	(a) Tax revenue (net of states’ share)	6.9
	(b) Non-tax revenue	1.3
2.	Revenue Expenditure of which	10.6
	(a) Interest payments	3.1
	(b) Major subsidies	1.0
	(c) Defence expenditure	1.0
3.	Revenue Deficit (2–1)	2.3
4.	Capital Receipts (a+b+c) of which	3.9
	(a) Recovery of loans	0.1
	(b) Other receipts (mainly PSU disinvestment)	0.4
	(c) Borrowings and other liabilities	3.4
5.	Capital Expenditure	1.6
6.	Non-debt Receipts [1+4(a)+4(b)]	8.8
7.	Total Expenditure [2+5=7(a)+7(b)]	12.2
	(a) Plan expenditure	–
	(b) Non-plan expenditure	–
8.	Fiscal deficit [7-1-4(a)-4(b)]	3.4
9.	Primary Deficit [8–2(a)]	0.3

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Classification Of Expenditure

Government expenditure is classified based on whether it creates assets/reduces liabilities or is for general functioning.

• Revenue Expenditure: Expenditure that does not create physical or financial assets or reduce liabilities. Includes costs for normal government functioning (salaries, pensions, administrative expenses), interest payments on debt, and grants to states/others (unless specifically for asset creation). Revenue expenditure is further classified into plan (related to development plans) and non-plan (general services like defense, interest payments, subsidies) expenditure. Non-plan expenditure is the larger component.
• Capital Expenditure: Expenditure that leads to the creation of physical or financial assets (acquiring land, buildings, machinery; investment in shares) or reduction in financial liabilities (repaying loans). Capital expenditure is also categorised as plan and non-plan expenditure.

The budget is a significant national policy statement reflecting and shaping economic life. In India, budget documents are accompanied by policy statements mandated by the Fiscal Responsibility and Budget Management Act, 2003 (FRBMA), focusing on fiscal targets, strategy, and macroeconomic outlook.

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Balanced, Surplus And Deficit Budget

Comparing government expenditure to revenue collection results in different budget statuses:

• Balanced Budget: Government expenditure equals revenue collected.
• Surplus Budget: Revenue collected exceeds government expenditure.
• Deficit Budget: Government expenditure exceeds revenue collected. This is the most common situation.

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Measures Of Government Deficit

Various measures quantify the extent of government deficit:

• Revenue Deficit: Excess of revenue expenditure over revenue receipts.
  • Revenue deficit = Revenue expenditure – Revenue receipts.
  A revenue deficit indicates the government is dissaving (using current revenue for consumption) and needs to borrow to finance even its consumption needs, not just investment. This builds debt and interest liabilities.
• Fiscal Deficit: Difference between total expenditure and total receipts excluding borrowing. It represents the total borrowing requirement of the government.
  • Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts).
  Non-debt creating capital receipts (like loan recoveries, PSU disinvestment proceeds) do not add to debt. Fiscal deficit indicates the total amount the government needs to borrow. A large fiscal deficit, especially with a large revenue deficit component, suggests borrowing is financing consumption rather than investment, potentially hindering growth.
• Primary Deficit: Fiscal deficit minus interest payments on previous borrowings. This measures the government's borrowing requirement for current expenditures, excluding past debt obligations. It highlights the current fiscal imbalance.
  • Gross primary deficit = Gross fiscal deficit – Net interest liabilities.
  Net interest liabilities are interest payments minus interest receipts by the government on domestic lending.

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Fiscal Policy

Fiscal policy refers to the government's use of its expenditure and taxation policies to influence the economy, particularly to stabilize output and employment levels. This can involve creating budget deficits or surpluses.

Government expenditure (G) adds to aggregate demand. Taxes (T) and transfers (TR) affect households' disposable income (YD), which influences consumption (C).

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Changes In Government Expenditure

An increase in government purchases (G), with taxes constant, directly increases aggregate demand (AD). This shifts the AD curve upwards. Via the multiplier mechanism (discussed in Chapter 4), the increase in G leads to a larger increase in equilibrium income (Y).

The Government Expenditure Multiplier is $\frac{\Delta Y}{\Delta G} = \frac{1}{1-c}$, where c is MPC. An increase in G by $\Delta G$ increases Y by $\Delta G \times \frac{1}{1-c}$.

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Changes In Taxes

A change in taxes (T) or transfers (TR) affects disposable income (YD = Y - T + TR), which influences consumption (C), and thus aggregate demand (AD).

A decrease in lump-sum taxes ($\Delta T < 0$), with G constant, increases YD at each income level, shifting the consumption function and AD curve upwards. This leads to a larger increase in equilibrium income through the multiplier process.

The Tax Multiplier is $\frac{\Delta Y}{\Delta T} = \frac{-c}{1-c}$. It is negative because a tax increase (decrease) decreases (increases) income. Its absolute value is $\frac{c}{1-c}$.

The tax multiplier is smaller in absolute value than the government expenditure multiplier ($|\frac{-c}{1-c}| < \frac{1}{1-c}$) because a change in taxes first affects consumption (by $c \times \Delta T$), which then goes through the multiplier process, whereas a change in G directly affects aggregate demand by $\Delta G$.

A balanced budget increase (equal increase in G and T) leads to an increase in income equal to the increase in G (balanced budget multiplier is 1). $\Delta Y = \Delta G$.

With proportional taxes (T = tY, where t is the tax rate), the consumption function becomes $C = \bar{C} + c(Y - tY + \bar{TR}) = \bar{C} + c(1-t)Y + c\bar{TR}$. The MPC out of income is now $c(1-t)$, which is lower than c. The AD curve is flatter.

The multiplier with proportional taxes is $\frac{1}{1-c(1-t)}$, which is smaller than $\frac{1}{1-c}$. Proportional taxes act as an automatic stabiliser: when income rises, tax collection increases automatically, dampening the rise in disposable income and consumption, thus moderating the upward fluctuation in the economy. Similarly, in a recession, tax collection falls, cushioning the drop in disposable income and consumption.

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Transfers

An increase in transfer payments (TR), with taxes and G constant, also increases disposable income (YD) and thus consumption (C), shifting the AD curve upwards and increasing equilibrium income. Transfers are similar to negative taxes in their impact on YD.

The Transfer Multiplier is $\frac{\Delta Y}{\Delta TR} = \frac{c}{1-c}$. Like the tax multiplier, it is smaller than the government expenditure multiplier ($ \frac{c}{1-c} < \frac{1}{1-c} $) because a change in transfers affects AD indirectly through consumption.

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Fiscal Responsibility And Budget Management Act, 2003 (FRBMA)

The FRBMA in India is a legislative framework aimed at promoting fiscal prudence and stability by setting targets for reducing government deficits.

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Main Features

The Act mandates the central government to reduce fiscal deficit to 3% of GDP and eliminate revenue deficit over a period. It specifies annual reduction targets and allows deviations only under exceptional circumstances (national security, natural calamity).

It restricts government borrowing from RBI (except temporary advances) and prohibits RBI from subscribing to primary issues of government securities.

The Act requires increased transparency in fiscal operations and the presentation of specific policy statements (Medium-term Fiscal Policy, Fiscal Policy Strategy, Macroeconomic Framework) alongside the annual budget.

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FRBM Review Committee

A review committee was formed to evaluate the FRBMA's effectiveness and suggest revisions to align with India's changing economic context and future growth path, considering whether the framework should be retained or revamped.

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GST: One Nation, One Tax, One Market

Goods and Services Tax (GST), implemented in India from July 1, 2017, is a comprehensive indirect tax on the supply of goods and services. It replaced numerous central and state indirect taxes, creating a unified national market.

GST is based on the principle of value-added taxation, with Input Tax Credit (ITC) available at each stage of the supply chain. This avoids the cascading effect of taxes present in the old system where taxes were levied on total value including taxes paid on inputs.

Key aspects of GST:

• Single tax for one type of goods/service across the country.
• Subsumed major central and state indirect taxes/cesses.
• Destination-based consumption tax.
• Mechanism of ITC to tax only the value addition at each stage.
• Standardised rates (0%, 3%, 5%, 12%, 18%, 28%).
• Simplified tax structure, procedures, and online compliance.
• Facilitates free movement of goods/services, reduces business costs, makes Indian products more competitive.
• Expected to expand tax base and boost GDP growth.

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Debt

Government deficit (fiscal deficit) is a flow variable that adds to the stock of government debt (what the government owes). Persistent borrowing to finance deficits leads to accumulation of debt and increasing interest payment obligations.

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Perspectives On The Appropriate Amount Of Government Debt

Debate exists on whether government debt is a burden and how it should be financed.

• Burden on Future Generations: Borrowing today might require raising taxes on future generations to repay the debt, potentially reducing their disposable income and consumption. Government borrowing may also reduce savings available for private investment, hindering capital formation and growth.
• Ricardian Equivalence (Counter-argument): Consumers are forward-looking and understand that government borrowing implies future taxes. They might increase current savings to offset expected future tax liabilities, neutralising the impact of government dissaving on national savings. Tax finance and deficit finance are seen as equivalent in their economic impact if consumers are rational and future-oriented.
• "We owe it to ourselves": Debt held domestically (owed to citizens) might not seem a burden as purchasing power stays within the nation, just transferred between generations. Debt owed to foreigners, however, is a burden as resources flow out of the country for interest payments.

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Other Perspectives On Deficits And Debt

• Inflationary Impact: Deficits can be inflationary if they lead to increased aggregate demand that exceeds the economy's capacity to produce at existing prices. However, if there are unutilised resources, deficits can stimulate demand and output without causing inflation.
• Crowding Out: Government borrowing in financial markets might compete with private borrowers for limited savings, driving up interest rates and potentially reducing (crowding out) private investment. However, if deficits increase output and income, total savings may increase, allowing both government and industry to borrow more.
• Investment in Infrastructure: If government debt finances productive investments (e.g., infrastructure), it can boost future output and growth, potentially making the debt less burdensome over time if investment returns exceed interest rates.

The appropriate level of deficit and debt is debated, influenced by these various perspectives and the specific economic context. Deficit reduction can involve increasing taxes or cutting expenditure, with debates over the impact of cutting spending in vital social sectors.

Larger deficits don't always mean expansionary fiscal policy; deficits can rise automatically in a recession due to falling tax revenues, even without policy changes.

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Key Concepts

Public goods

Automatic stabiliser

Discretionary fiscal policy

Ricardian equivalence

Government budget

Revenue budget

Capital budget

Revenue receipts

Capital receipts

Revenue expenditure

Capital expenditure

Plan expenditure

Non-plan expenditure

Budget deficit

Revenue deficit

Fiscal deficit

Primary deficit

Government debt

Fiscal policy

Government expenditure multiplier

Tax multiplier

Balanced budget multiplier

Proportional taxes

Transfer payments

GST

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Summary

• Government provides public goods (non-rivalrous, non-excludable) not efficiently supplied by markets.

• Government budget outlines receipts (revenue, capital) and expenditures (revenue, capital), serving allocation, redistribution, and stabilisation functions.

• Revenue receipts don't create liability/reduce assets (tax, non-tax). Capital receipts create liability (borrowings) or reduce assets (loan recovery, disinvestment).

• Revenue expenditure doesn't create assets/reduce liabilities (salaries, interest, subsidies). Capital expenditure creates assets/reduces liabilities (investment in infrastructure, shares, loan repayment).

• Budget can be balanced, surplus, or deficit (expenditure > revenue).

• Deficit measures: Revenue Deficit (revenue exp. > revenue rec.), Fiscal Deficit (total exp. > total rec. excluding borrowing), Primary Deficit (Fiscal Deficit - interest payments).

• Fiscal deficit = total borrowing requirement. Revenue deficit implies dissaving.

• Fiscal policy (changing G or T) affects AD, output, employment. Government Expenditure Multiplier = $\frac{1}{1-c}$. Tax Multiplier = $\frac{-c}{1-c}$. Transfer Multiplier = $\frac{c}{1-c}$.

• Government expenditure has a larger direct impact on AD than taxes/transfers.

• Balanced budget multiplier is 1 (equal increase in G and T increases Y by same amount).

• Proportional taxes (T=tY) reduce the multiplier, acting as automatic stabilisers.

• Deficits add to government debt. Burden of debt is debated (on future generations, crowding out private investment, inflationary risk).

• Ricardian equivalence suggests deficit finance and tax finance are equivalent if consumers save for future taxes.

• Deficit reduction requires increasing revenue (taxes, disinvestment) or cutting expenditure. Efficiency gains or changing government scope can help.

• GST (Goods and Services Tax) is a comprehensive indirect tax system replacing multiple taxes, based on value-added taxation principles.

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Exercises

Exercises are excluded as per user instructions.

Suggested Readings

Suggested readings are excluded as per user instructions.