Government Budget and Fiscal Policy

Government Budget — Meaning And Its Components

The Government Budget is a comprehensive annual financial statement that presents an estimate of the government's expected revenue and anticipated expenditure for the upcoming fiscal year. In India, the fiscal year runs from 1st April to 31st March. It is a detailed plan of the government's financial operations, reflecting its policies, objectives, and priorities.

The budget is more than just a statement of accounts; it is a crucial tool for economic management and a reflection of the government's socio-economic vision for the country. It is presented in the Parliament and requires its approval before it can be implemented.

Objectives Of Government Budget

The government budget is prepared with several key objectives in mind, which guide its allocation of resources and fiscal policies.

• Reallocation of Resources: The government aims to reallocate resources in accordance with the economic and social priorities of the country. It can influence resource allocation through:
  • Tax Concessions and Subsidies: The government discourages the production of harmful goods (like liquor, cigarettes) by imposing heavy taxes and encourages the production of essential goods or those produced by socially beneficial sectors (like Khadi) by providing subsidies or tax reliefs.
  • Direct Production: If the private sector is not interested in certain essential services (due to low profitability), the government can directly undertake their production and provision (e.g., water supply, sanitation, railways).
• Reducing Inequalities in Income and Wealth: The government aims to reduce the gap between the rich and the poor. It uses fiscal instruments to achieve this by:
  • Imposing higher taxes on the rich (e.g., progressive income tax) and lower taxes on the poor.
  • Spending more on social welfare schemes that benefit the poor, such as providing subsidised food grains, free education, and healthcare.
• Economic Stability: The government budget is used to prevent business fluctuations of inflation and deflation.
  • During Inflation (excess demand): The government can pursue a surplus budget policy by reducing its own expenditure or increasing taxes to curb aggregate demand.
  • During Deflation/Recession (deficient demand): The government can pursue a deficit budget policy by increasing its expenditure or decreasing taxes to boost aggregate demand and combat unemployment.
• Management of Public Sector Undertakings (PSUs): The government manages numerous public sector enterprises. The budget provides financial resources for their operation and expansion, ensuring they contribute to the country's economic growth.
• Economic Growth: A key objective is to promote rapid and balanced economic growth. The budget encourages saving and investment in the economy by providing infrastructure and various incentives. Mobilising resources for investment in the public sector is a crucial part of this objective.

Classification Of Receipts

Government receipts refer to the estimated money receipts of the government from all sources during the fiscal year. They are broadly classified into Revenue Receipts and Capital Receipts.

1. Revenue Receipts

These are receipts that neither create any liability nor cause any reduction in the assets of the government. They are regular and recurring in nature.

• Tax Revenue: This is the primary source of income for the government.
  • Direct Taxes: The liability to pay the tax and its burden falls on the same person. Examples: Income Tax (tax on individual incomes), Corporation Tax (tax on company profits).
  • Indirect Taxes: The liability to pay the tax is on one person, but the burden can be shifted to another. Examples: Goods and Services Tax (GST), Customs Duties (taxes on imported goods).
• Non-Tax Revenue: These are receipts from sources other than taxes.
  • Interest Receipts: Interest received on loans given by the central government to state governments, UTs, and PSUs.
  • Profits and Dividends: Profits from public sector undertakings (PSUs) and dividends from the government's investments.
  • Fees and Fines: Revenue from various fees like license fees, registration fees, and court fees, as well as fines collected for breaking the law.
  • Escheat: Income that arises out of property left by a person without a legal heir.
  • Grants: Grants received from foreign governments and international organisations.

2. Capital Receipts

These are receipts that either create a liability or cause a reduction in the assets of the government. They are non-recurring in nature.

• Debt-Creating Capital Receipts:
  • Borrowings: This is the main source of capital receipts. The government borrows from the public (market borrowings), the Reserve Bank of India (RBI), and the rest of the world. These borrowings create a liability for future repayment.
• Non-Debt-Creating Capital Receipts:
  • Recovery of Loans: The government recovers loans it had previously extended to state governments or UTs. This reduces the government's financial assets.
  • Disinvestment: This refers to the government selling off a part or whole of its shares in selected Public Sector Undertakings (PSUs). This leads to a reduction in the assets of the government.

Classification Of Expenditure

Government expenditure refers to the estimated spending by the government on various developmental and non-developmental programmes during the fiscal year. It is classified into Revenue Expenditure and Capital Expenditure.

1. Revenue Expenditure

This is expenditure that neither creates any asset nor causes a reduction in any liability of the government. It is incurred for the normal functioning of government departments and provision of various services. It is recurring in nature.

Examples include:

• Interest Payments on past government debt.
• Expenditure on salaries, pensions, and subsidies.
• Defence expenditure on salaries and maintenance.
• Grants given to state governments and other bodies.

2. Capital Expenditure

This is expenditure that either creates a physical or financial asset or causes a reduction in a liability of the government. It is non-recurring and contributes to the economy's capital stock.

Examples include:

• Expenditure on acquiring fixed assets like land, buildings, machinery, and equipment.
• Investment in shares and construction of infrastructure like roads, bridges, and hospitals.
• Loans granted by the central government to states and UTs (creation of a financial asset).
• Repayment of borrowings (reduction of a liability).

Balanced, Surplus And Deficit Budget

Based on the relationship between total estimated receipts and total estimated expenditure, a government budget can be classified into three types:

• Balanced Budget: A budget is said to be balanced when the government's total estimated receipts are exactly equal to its total estimated expenditure.

  $$ \text{Total Receipts} = \text{Total Expenditure} $$

• Surplus Budget: A budget is said to be a surplus budget when the government's estimated receipts are greater than its estimated expenditure. This implies the government is taking more money from the economy than it is injecting back. It is a tool to combat inflation.

  $$ \text{Total Receipts} > \text{Total Expenditure} $$

• Deficit Budget: A budget is said to be a deficit budget when the government's estimated expenditure exceeds its estimated receipts. This is the most common type of budget in modern economies, especially developing ones, as it helps in financing development activities and combating recession.

  $$ \text{Total Expenditure} > \text{Total Receipts} $$

Measures Of Government Deficit

A budget deficit signifies a gap that must be financed, usually through borrowing. In India, several measures are used to assess the magnitude and implications of the government deficit.

1. Revenue Deficit

The revenue deficit refers to the excess of the government's revenue expenditure over its revenue receipts.

$$ \text{Revenue Deficit} = \text{Revenue Expenditure} - \text{Revenue Receipts} $$

Implications: A revenue deficit is a serious concern because it indicates that the government's own revenue is insufficient to meet the expenditures on its normal functioning. It implies that the government is dis-saving and is using up the savings of other sectors of the economy to finance its consumption expenditure. To cover this gap, the government has to resort to borrowing or selling its assets, which are capital receipts. This means borrowing is being used for consumption purposes rather than for investment, which increases the future burden without creating any future assets.

2. Fiscal Deficit

The fiscal deficit is the difference between the government's total expenditure and its total receipts, excluding borrowings.

$$ \text{Fiscal Deficit} = \text{Total Expenditure} - (\text{Revenue Receipts} + \text{Non-debt Creating Capital Receipts}) $$

Crucially, the fiscal deficit shows the total borrowing requirements of the government. The amount of the fiscal deficit must be financed by borrowing.

$$ \text{Fiscal Deficit} = \text{Total Borrowings} $$

Implications:

• Debt Trap: Borrowing to finance the deficit leads to the accumulation of public debt. The government has to make interest payments on this debt, which increases its revenue expenditure, potentially leading to a larger deficit and more borrowing in the future, creating a vicious cycle or a debt trap.
• Inflation: If the government borrows from the RBI, the RBI may print new currency to finance the deficit. This increases the money supply in the economy and can lead to inflationary pressure.
• Crowding Out: When the government borrows heavily from the financial market, it can raise the interest rates. This makes it more expensive for private businesses to borrow and invest, thus 'crowding out' private investment and hampering economic growth.
• Future Burden: The debt accumulated imposes a burden on future generations, who will have to pay higher taxes to service the debt.

3. Primary Deficit

The primary deficit is the fiscal deficit of the current year minus the interest payments on previous borrowings.

$$ \text{Primary Deficit} = \text{Fiscal Deficit} - \text{Interest Payments} $$

Implications: The primary deficit indicates the borrowing requirement of the government, excluding the interest component. It shows how much of the government's borrowing is going to finance its current expenditures other than interest payments. A zero primary deficit means that the government is borrowing only to pay the interest on its existing loans and is not adding to the debt for any other current spending. It is a key indicator of current fiscal discipline.

Answer:

Fiscal Policy

Fiscal policy refers to the use of government spending and taxation to influence the economy. It is the primary tool through which the government implements its budget objectives, particularly the objective of economic stability. By adjusting its levels of spending and taxation, the government can directly influence aggregate demand and thereby manage economic fluctuations like inflation and recession.

The main instruments of fiscal policy are:

1. Government Expenditure (G)
2. Taxes (T)
3. Transfer Payments (e.g., pensions, subsidies)

Changes In Government Expenditure

Government expenditure (G) on goods and services is a direct component of aggregate demand ($AD = C + I + G$). Changes in G therefore have a direct and powerful impact on the economy, amplified by the multiplier effect.

Combating a Deflationary Gap (Recession)

During a recession, when AD is low and there is involuntary unemployment, the government can pursue an expansionary fiscal policy. By increasing government expenditure (e.g., on infrastructure projects like roads and bridges), it directly adds to the aggregate demand. This increase in G shifts the AD curve upwards, leading to a higher equilibrium level of income and employment. The total increase in income will be greater than the initial increase in G due to the multiplier effect.

Combating an Inflationary Gap

During a period of high inflation, when AD exceeds the economy's full-employment output level, the government can pursue a contractionary fiscal policy. By decreasing government expenditure, it directly reduces aggregate demand. This shifts the AD curve downwards, helping to close the inflationary gap and control rising prices.

Changes In Taxes

Taxes (T) influence aggregate demand indirectly by affecting the disposable income of households. Disposable income ($Y_d$) is total income minus taxes ($Y_d = Y - T$). Consumption (C) is a function of this disposable income.

Combating a Deflationary Gap (Recession)

To boost AD, the government can cut taxes. A tax cut increases households' disposable income. With more disposable income, people tend to consume more. This increase in consumption shifts the AD curve upwards, raising the equilibrium level of income and employment.

Combating an Inflationary Gap

To curb AD, the government can increase taxes. A tax hike reduces disposable income, which in turn leads to a decrease in consumption spending. This fall in C shifts the AD curve downwards, helping to reduce inflationary pressure.

It's important to note that a change in government spending has a more powerful impact on income than an equivalent change in taxes. This is because the entire amount of government spending directly enters the income stream, whereas a part of any tax cut will be saved (determined by the MPS) and will not contribute to aggregate demand in the first round.

Transfers

Government transfer payments, such as unemployment benefits, pensions, and subsidies, work similarly to taxes but in the opposite direction. They are not included in G because they are not payments for goods or services, but they affect disposable income.

An increase in transfer payments acts like a tax cut. It raises the disposable income of households, leading to higher consumption and an increase in aggregate demand. This is an expansionary measure used during recessions.

A decrease in transfer payments acts like a tax increase. It reduces disposable income, leading to lower consumption and a decrease in aggregate demand. This is a contractionary measure used to fight inflation.

Fiscal Responsibility And Budget Management Act, 2003 (FRBMA)

By the late 1990s, the Indian government's persistent high fiscal and revenue deficits had become a major cause for concern. These deficits led to a large accumulation of public debt and high interest payments, which limited the government's ability to spend on developmental activities. To address this and enforce a path of fiscal discipline, the Indian Parliament enacted the Fiscal Responsibility and Budget Management (FRBM) Act in 2003.

Main Features

The primary objective of the FRBM Act was to make the central government responsible for ensuring inter-generational equity in fiscal management and long-term macroeconomic stability. It established legislative targets for fiscal consolidation.

The original key targets of the Act were:

1. To eliminate the revenue deficit by 31st March 2008 (later extended). This was considered crucial to stop the government from borrowing for consumption expenditure.
2. To reduce the fiscal deficit to no more than 3% of the Gross Domestic Product (GDP) by 31st March 2008 (later extended).
3. To set annual reduction targets for both revenue and fiscal deficits.
4. To prohibit direct borrowing by the central government from the Reserve Bank of India (RBI) from April 2006, except under special circumstances. This was to control the monetisation of the deficit and its inflationary impact.
5. To ensure greater transparency in fiscal operations by requiring the government to place several documents before Parliament along with the annual budget, including a Medium-term Fiscal Policy Statement and a Fiscal Policy Strategy Statement.
6. The Act also included an 'escape clause', allowing a deviation from the targets in the event of a national security threat or a natural calamity.

While the FRBM Act helped in bringing down the deficits initially, the targets have been postponed multiple times due to events like the 2008 global financial crisis and the COVID-19 pandemic.

FRBM Review Committee

In 2016, the government set up a committee under the chairmanship of Shri N.K. Singh to review the working of the FRBM Act and suggest a new framework for fiscal consolidation.

Key Recommendations of the N.K. Singh Committee

The committee recommended a shift away from rigid annual targets towards a more flexible approach focused on the long-term goal of debt sustainability.

• Debt as the Primary Anchor: The committee recommended using the debt-to-GDP ratio as the main long-term anchor for fiscal policy. It suggested a target of a 60% debt-to-GDP ratio by 2023 (40% for the central government and 20% for the states combined).
• Fiscal Deficit as Operational Target: The fiscal deficit should remain the key operational target. It recommended reducing the central government's fiscal deficit to 2.5% of GDP by the fiscal year 2022-23.
• Revenue Deficit Target: The revenue deficit should be reduced progressively to 0.8% of GDP by 2022-23.
• Escape Clause: The committee recommended replacing the old escape clause with a more precise one. Deviations from the fiscal deficit target could be allowed, but only on grounds of national security, acts of war, national calamity, or a collapse of the economy with a fall in real output growth of at least 3 percentage points below the average of the previous four quarters.

The government has accepted many of these recommendations and amended the FRBM Act to incorporate a more flexible glide path for fiscal consolidation.

GST: One Nation, One Tax, One Market

The Goods and Services Tax (GST) is the most significant tax reform in India's history. It was launched on 1st July 2017 with the aim of simplifying the complex indirect tax structure and creating a unified common market in India. GST is a comprehensive, multi-stage, destination-based indirect tax that is levied on every value addition.

How GST Works

• Comprehensive: It has subsumed almost all indirect taxes at the central and state levels, such as Central Excise Duty, Service Tax, VAT, Octroi, and Entry Tax.
• Destination-Based: Unlike previous tax regimes (like VAT) which were origin-based, GST is a destination-based tax. This means the tax revenue goes to the state where the goods or services are finally consumed, rather than the state where they are produced.
• Value Addition: GST is levied on the value added at each stage of the supply chain. This mechanism, facilitated by an input tax credit system, eliminates the cascading effect (tax on tax) of the previous system.

Components of GST

GST has a dual structure, where both the Centre and the States levy tax simultaneously on a common base.

1. CGST (Central GST): Levied and collected by the Central Government on intra-state (within the same state) transactions.
2. SGST (State GST): Levied and collected by the State Government on intra-state transactions.
3. IGST (Integrated GST): Levied and collected by the Central Government on all inter-state (between two states) transactions of goods and services. The IGST collected is then apportioned to the destination state.

For example, if the GST rate on a product is 18% and it is sold within a state, it will be subject to 9% CGST and 9% SGST. If it is sold from one state to another, it will be subject to 18% IGST.

Benefits of GST

• Creation of a Common National Market: By removing inter-state tax barriers, GST has unified the country into a single market.
• Elimination of Cascading Effect: The input tax credit system ensures there is no tax on tax, which helps in reducing the cost of goods and services.
• Simpler Tax Regime: GST has replaced a multitude of indirect taxes with a single tax, making compliance easier for businesses.
• Increased Transparency and Compliance: The entire GST process, from registration to filing returns, is online, which has improved transparency and reduced tax evasion.
• Boost to 'Make in India': By making the Indian market more competitive, GST is expected to boost domestic manufacturing and exports.

Debt

When a government runs a fiscal deficit, it must finance this gap by borrowing. The accumulation of these past borrowings constitutes the government debt. While fiscal deficits are a flow concept (measured over a year), government debt is a stock concept (measured at a particular point in time). The issue of how much debt a government can sustainably hold is a central topic in macroeconomics.

Perspectives On The Appropriate Amount Of Government Debt

The Classical View: Ricardian Equivalence

The traditional or classical view, articulated by economist David Ricardo, suggests that government debt can be burdensome. A more modern version of this view is the theory of Ricardian Equivalence. This theory argues that it does not matter whether a government finances its spending with debt or a tax increase. The reason is that rational taxpayers will anticipate that government borrowing today will need to be repaid with higher taxes in the future. Therefore, when the government runs a deficit and issues debt, households will save more to be able to pay these future taxes. This increase in private saving will offset the public dis-saving (the deficit). As a result, fiscal policy will have no effect on aggregate demand, interest rates, or the level of output.

While theoretically elegant, the Ricardian Equivalence proposition is often criticized for its unrealistic assumptions, such as perfectly rational and far-sighted consumers and the absence of liquidity constraints.

The Keynesian View

In contrast, the Keynesian perspective argues that government debt is not necessarily bad, especially when the economy is in a recession. When there is deficient aggregate demand and high unemployment, a tax cut or an increase in government spending financed by debt can stimulate the economy. The resulting increase in output and employment is seen as a greater benefit that outweighs the cost of the increased debt. From this viewpoint, worrying excessively about the deficit during a downturn can be counter-productive (the paradox of thrift).

Other Perspectives On Deficits And Debt

The Burden of Debt

A key concern is that government debt imposes a burden on future generations. The future generation inherits the liability to pay interest and principal on the debt, which may require them to pay higher taxes or receive fewer government services. However, if the debt was used to finance productive investments (like infrastructure or education) that increase the economy's future productive capacity, then the future generation also inherits the benefits of these assets, which may offset the burden of the debt.

Crowding Out

As discussed earlier, large-scale government borrowing can compete with private borrowers for the limited pool of savings in the economy. This can lead to higher interest rates, which makes it more expensive for private firms to invest. In this way, government spending 'crowds out' private investment, potentially leading to slower long-term economic growth.

Deficit Reduction

Concern over the negative consequences of high deficits and accumulating debt often leads to calls for deficit reduction. The government can reduce its deficit through two primary means:

1. Increasing Taxes: Raising taxes on individuals and corporations can increase government revenue. However, this can also slow down economic activity if not implemented carefully.
2. Reducing Expenditure: The government can cut its spending on various programmes, subsidies, or administrative costs. This is often politically difficult as it affects various sections of society. A major component of expenditure, interest payments, cannot be reduced without defaulting on the debt, which is not a viable option.

A sustainable path for deficit reduction usually involves a combination of these measures, along with policies aimed at boosting economic growth, which automatically increases the tax base and improves the debt-to-GDP ratio.

Key Concepts

• Government Budget: An annual statement of the estimated receipts and expenditures of the government for a fiscal year.
• Revenue Receipts: Receipts that neither create a liability nor reduce an asset of the government (e.g., taxes, interest).
• Capital Receipts: Receipts that either create a liability (e.g., borrowings) or reduce an asset (e.g., disinvestment).
• Revenue Expenditure: Expenditure that neither creates an asset nor reduces a liability (e.g., salaries, subsidies).
• Capital Expenditure: Expenditure that either creates an asset (e.g., infrastructure) or reduces a liability (e.g., repayment of loan).
• Revenue Deficit: The excess of revenue expenditure over revenue receipts.
• Fiscal Deficit: The excess of total expenditure over total receipts excluding borrowings. It represents the total borrowing requirement of the government.
• Primary Deficit: The fiscal deficit minus interest payments. It shows the borrowing needed for current expenses other than interest.
• Fiscal Policy: The use of government spending and taxation to influence the economy.
• Disinvestment: The sale of public sector equity by the government to the public.
• FRBM Act: A law enacted by the Indian Parliament to institutionalise fiscal discipline.
• Goods and Services Tax (GST): A comprehensive, destination-based indirect tax on the supply of goods and services.
• Government Debt: The total outstanding borrowings of the government accumulated over time.
• Ricardian Equivalence: A theory suggesting that financing government spending through debt is equivalent to financing it through taxes.

Summary

The government budget is a crucial annual document that outlines the government's financial plans, detailing its estimated receipts and expenditures for the coming fiscal year. It serves multiple objectives, including reallocating resources, reducing inequality, maintaining economic stability, and promoting economic growth. The budget's components are divided into the Revenue Budget (covering recurring receipts and expenditures like taxes and salaries) and the Capital Budget (covering non-recurring items like borrowings and infrastructure spending).

When expenditures exceed receipts, the government runs a deficit budget. The key measures of deficit in India are the Revenue Deficit, Fiscal Deficit, and Primary Deficit. The fiscal deficit, which equals the total borrowing requirement of the government, is the most comprehensive measure and has significant implications for debt accumulation, inflation, and private investment.

The government uses the budget to conduct fiscal policy. By adjusting government spending and taxes, it can manage aggregate demand to combat recessionary gaps (through expansionary policy) or inflationary gaps (through contractionary policy). To ensure long-term fiscal stability, India enacted the FRBM Act, which sets targets for deficit reduction. A major recent reform has been the implementation of the Goods and Services Tax (GST), which has simplified the indirect tax system and created a common national market.

Finally, persistent deficits lead to the accumulation of government debt. The debate over the appropriate level of debt involves contrasting views, from the Keynesian emphasis on its utility during recessions to the classical concerns about the burden on future generations and the "crowding out" of private investment.