Government Budget — Meaning and Its Components

In a mixed economy, where both the private sector and the government play significant and complementary roles, the government's economic functions are primarily executed through its budget. The government budget is a comprehensive financial statement that outlines the government's estimated receipts (income) and estimated expenditures for a forthcoming financial year.

In India, this is a constitutional mandate under Article 112, which requires the government to present an 'Annual Financial Statement' to the Parliament for each financial year, running from 1 April to 31 March. The budget is not merely an accounting exercise; it is the government's primary tool for implementing its economic policies and a powerful statement of its national priorities.

The budget is structured into two main accounts to distinguish between transactions that have a short-term impact and those that affect the government's long-term financial position:

1. Revenue Account (or Revenue Budget): This account deals with receipts and expenditures that are of a current or recurring nature. These transactions relate only to the current financial year and do not create any future assets or liabilities for the government.
2. Capital Account (or Capital Budget): This account deals with receipts and expenditures that concern the government's assets and liabilities. These are non-recurring transactions that have a long-term impact on the government's financial standing.

Objectives of the Government Budget

The government uses its budget as the principal instrument to intervene in the economy and enhance the welfare of its people. The budget is designed to achieve several key objectives.

1. Allocation Function: Reallocation of Resources

The government budget plays a crucial role in allocating resources in the economy, particularly for the provision of goods and services that the free market mechanism fails to provide efficiently. These are known as public goods.

Public goods are fundamentally different from private goods (like food, clothes, or cars) due to two distinct characteristics:

• Non-Rivalrous in Consumption: The consumption of a public good by one individual does not reduce its availability to others. For example, when one person benefits from national defence or a street light, it does not diminish the benefit another person can receive. Multiple people can enjoy the benefits simultaneously without rivalry.
• Non-Excludable: It is technically difficult or prohibitively expensive to exclude anyone from enjoying the benefits of a public good, even if they do not pay for it. For instance, it is impossible to prevent a non-paying citizen from benefiting from national defence or clean air.

This non-excludability leads to the 'free-rider problem': individuals have an incentive to consume the good without contributing to its cost. Since private firms cannot profitably charge for public goods due to this problem, they have no incentive to produce them. The government must therefore step in to provide these goods, financing them through its budget (i.e., through taxation). It's important to distinguish between public provision (where the government finances the good) and public production (where the government itself produces the good).

2. Redistribution Function: Reducing Income and Wealth Inequalities

The market mechanism, left to itself, often results in a distribution of income and wealth that may be considered socially or ethically unfair. The government uses the budget to influence this distribution and reduce inequality. This redistribution function is carried out through both the revenue and expenditure sides of the budget:

• Through Taxes (Revenue Side): The government employs a progressive income tax system, where the tax rate increases as income increases. This places a higher burden on the wealthy and a lower burden on the poor. Indirect taxes can also be designed to be progressive by levying higher taxes on luxury goods consumed by the rich and lower or zero taxes on essential goods consumed by the poor.
• Through Transfers and Subsidies (Expenditure Side): The government uses the revenue collected to make transfer payments and provide subsidies that benefit the lower-income sections of society. This includes social security benefits (like old-age pensions), unemployment allowances, and subsidies on essential items like food, LPG, and education.

By taxing the rich and spending on the welfare of the poor, the government works to achieve a more equitable distribution of disposable income.

3. Stabilisation Function: Maintaining Economic Stability

Capitalist economies are prone to natural fluctuations in aggregate economic activity, known as business cycles (periods of boom and recession). The government uses its budget to moderate these fluctuations and maintain economic stability. This is known as the stabilisation function, implemented through counter-cyclical fiscal policy.

• During a Recession (period of deficient demand): When aggregate demand is low, leading to high unemployment and low output, the government can implement an expansionary fiscal policy. It can increase its expenditure (e.g., on infrastructure projects) or cut taxes to increase households' disposable income. Both measures boost aggregate demand, stimulate economic activity, and help reduce unemployment. This typically leads to a budget deficit.
• During a Boom (period of excess demand/inflation): When aggregate demand is too high, leading to inflationary pressures, the government can implement a contractionary fiscal policy. It can reduce its expenditure or increase taxes. Both measures curb aggregate demand and help to control inflation. This can lead to a budget surplus.

Classification of the Budget Components

The government budget is systematically organized into two main parts: receipts and expenditures. Each of these is further classified into a revenue account and a capital account, based on whether the transaction affects the government's long-term assets and liabilities.

Classification of Budget Receipts

Budget receipts refer to the estimated money that the government receives from all sources during a financial year. They are classified into two main categories.

1. Revenue Receipts

Revenue receipts are those inflows of money that neither create a corresponding liability for the government nor lead to a reduction in its assets. These are regular, recurring, and non-redeemable sources of income for the government. They are further divided into:

• Tax Revenue: This is the primary and most important source of government revenue. Tax revenue consists of the proceeds from taxes and other duties imposed by the government.
  • Direct Taxes: These are taxes whose liability and burden fall on the same person. They are levied on the income and property of individuals and firms. The taxpayer pays them directly to the government. Examples include Personal Income Tax, Corporation Tax (tax on the profits of companies), and Capital Gains Tax.
  • Indirect Taxes: These are taxes whose liability to pay falls on one person, but the burden can be shifted to another. They are levied on goods and services. The most significant indirect tax in India is the Goods and Services Tax (GST). Other examples include Customs Duties (taxes on imports and exports) and Excise Duties (though most are now subsumed under GST).
• Non-Tax Revenue: This includes all revenue receipts of the government from sources other than taxes. Major sources include:
  • Interest Receipts: Interest received on loans given by the central government to state governments, union territories, or public sector enterprises.
  • Dividends and Profits: Income earned from the profits of Public Sector Undertakings (PSUs) and dividends from the government's investments, including the surplus transferred by the RBI.
  • Fees and Other Receipts: Revenue from administrative services like fees for licenses, permits, registration, and fines.
  • Grants: Cash grants-in-aid received from foreign countries and international organisations.

2. Capital Receipts

Capital receipts are those inflows of money that either create a liability for the government or cause a reduction in its financial assets. These receipts are generally non-recurring in nature.

• Debt-Creating Capital Receipts: These are essentially the borrowings of the government. They are called "debt-creating" because they create a future liability for the government to repay the principal amount along with interest. Sources of borrowing include:
  • Market borrowings (selling bonds and Treasury bills to the public and financial institutions).
  • Loans from the Reserve Bank of India (RBI).
  • Loans from foreign governments and international bodies like the World Bank and IMF.
  • Small savings schemes (like Post Office deposits and National Savings Certificates).
• Non-Debt Creating Capital Receipts: These receipts reduce the government's assets but do not create any future repayment liability. The main sources are:
  • Recovery of Loans: The repayment of loans that the central government had previously extended to state governments or other entities.
  • Disinvestment Proceeds: The money raised from the government selling its shares in Public Sector Undertakings (PSUs) to the private sector.

Classification of Budget Expenditure

Budget expenditure refers to the estimated spending of the government during a financial year. It is classified into two main categories.

1. Revenue Expenditure

Revenue expenditure is the expenditure that neither creates any physical or financial assets for the government nor causes a reduction in its liabilities. It is short-term in nature and is incurred for the normal functioning of government departments, the provision of various services, and to meet recurring expenses.

The main items of revenue expenditure include:

• Interest Payments: This is the single largest component of revenue expenditure and represents the interest paid on the government's past and current debt.
• Expenditure on General, Social, and Economic Services: This includes spending on defence services, salaries of government employees, pensions, health, and education.
• Subsidies: Financial assistance given by the government to producers or consumers to promote welfare (e.g., subsidies on food, fertilisers, and LPG).
• Grants: Grants given to state governments and other parties (even if some grants are used by the recipient to create assets, for the central government, it is a revenue expenditure).

2. Capital Expenditure

Capital expenditure is the expenditure that either creates a physical or financial asset for the government or causes a reduction in its financial liabilities. This type of expenditure is long-term and developmental in nature. It adds to the capital stock of the economy and enhances its future productive capacity.

The main items of capital expenditure include:

• Expenditure on the acquisition of assets like land, buildings, machinery, and equipment.
• Investment in shares of companies.
• Construction of infrastructure such as roads, bridges, and hospitals.
• Loans and advances given by the central government to state governments, PSUs, and foreign governments.
• Repayment of the principal amount of loans.

Balanced, Surplus, and Deficit Budget

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

• A Balanced Budget is a situation where the government's total estimated expenditure is exactly equal to its total estimated receipts. While it suggests fiscal discipline, a balanced budget may not be suitable for a developing country that needs to make large public investments, nor is it ideal during a recession when the government needs to increase spending.
• A Surplus Budget is a situation where the government's total estimated receipts exceed its total estimated expenditure. This indicates that the government is extracting more money from the economy than it is injecting back. A surplus budget is a useful tool during periods of high inflation to reduce aggregate demand.
• A Deficit Budget is a situation where the government's total estimated expenditure exceeds its total estimated receipts. This is the most common feature of government budgets, especially in developing economies. A deficit budget is a key instrument of expansionary fiscal policy, used to stimulate economic growth and combat unemployment.

Measures of Government Deficit

When a government's spending is more than its revenue, it incurs a budget deficit. There are several ways to measure this deficit, and each measure provides different and important insights into the government's fiscal health and its implications for the economy.

1. Revenue Deficit

The revenue deficit focuses exclusively on the revenue account of the budget. It is the excess of the government's revenue expenditure over its revenue receipts.

Revenue Deficit = Revenue Expenditure – Revenue Receipts

Implications of a Revenue Deficit:

• It signifies that the government's own current revenue is insufficient to cover the expenses of its normal day-to-day functioning and services.
• It indicates that the government is dissaving, meaning it is using the savings of other sectors of the economy (like households and firms) to finance its consumption expenditure.
• To cover this deficit, the government has to resort to borrowing. This means the government is borrowing not for productive investment, but to pay for its recurring consumption needs.
• This leads to an accumulation of debt and a growing burden of future interest payments, which in turn increases future revenue expenditure, potentially creating a vicious cycle. To manage this, the government may be forced to cut productive capital expenditure or essential welfare spending, which can harm long-term growth and social welfare.

2. Fiscal Deficit

The fiscal deficit is the most comprehensive measure of a government's fiscal imbalance. It is defined as the difference between the government's total expenditure and its total receipts, excluding borrowings.

Gross Fiscal Deficit = Total Expenditure – (Revenue Receipts + Non-debt Creating Capital Receipts)

(Non-debt creating capital receipts are items like the recovery of loans and disinvestment proceeds).

Implications of a Fiscal Deficit:

• The most crucial implication is that the fiscal deficit is exactly equal to the total borrowing requirement of the government from all sources—be it borrowing from the domestic public (through bonds), from the central bank (RBI), or from abroad.
• Debt Trap: A high fiscal deficit leads to a large amount of borrowing. This increases the government's total debt stock, which in turn leads to higher interest payments in the future. These higher interest payments increase revenue expenditure, which can lead to a larger fiscal deficit in subsequent years, creating a potential debt trap.
• Inflation: To finance its deficit, the government might borrow from the central bank (RBI). The RBI may print new currency for this purpose, which increases the money supply in the economy and can lead to inflationary pressures.
• Crowding Out: When the government borrows heavily from the domestic market, it absorbs a large share of the economy's savings. This reduces the pool of savings available for private businesses, potentially driving up interest rates and "crowding out" private investment.

3. Primary Deficit

The fiscal deficit includes the amount of money the government needs to borrow to cover its interest payments on previously accumulated debt. The primary deficit is a measure that isolates the deficit of the current year's fiscal operations, excluding these past obligations. It is calculated by subtracting net interest liabilities from the gross fiscal deficit.

Gross Primary Deficit = Gross Fiscal Deficit – Net Interest Liabilities

Implications of the Primary Deficit:

• It indicates the borrowing requirement of the government to finance its current expenditures, excluding interest payments.
• A low or zero primary deficit is a sign of good fiscal health. It suggests that while the overall fiscal deficit might be high due to a large burden of past debt, the government's current revenue and expenditure policies are sustainable. A rising primary deficit, on the other hand, indicates a deterioration in the current fiscal stance.

Fiscal Policy and its Impact

What is Fiscal Policy?

Fiscal policy is the primary tool through which a government influences the macroeconomy. It refers to the deliberate use of government's spending and revenue-raising activities—namely, government expenditure (G) and taxes (T)—to achieve its macroeconomic objectives. As conceptualized by Keynes, the main purpose of fiscal policy is to stabilize the level of output, income, and employment by managing the level of aggregate demand in the economy.

Fiscal policy can be of two types, depending on the state of the economy:

• Expansionary Fiscal Policy: This policy is implemented to combat a recession, high unemployment, or a situation of deficient demand. The government aims to increase aggregate demand by either increasing its expenditure (G) or cutting taxes (T). An increase in G is a direct injection of spending into the economy, while a tax cut increases households' disposable income, thereby stimulating consumption (C). This policy typically results in a budget deficit.
• Contractionary Fiscal Policy: This policy is used to combat high inflation, which is caused by excess demand. The government aims to reduce aggregate demand by either decreasing its expenditure (G) or increasing taxes (T). Both measures reduce the overall level of spending in the economy, helping to control price rises. This policy can lead to a budget surplus.

The Government Expenditure and Tax Multipliers

Just like private investment, changes in government spending and taxes have a magnified or multiplier effect on the equilibrium level of national income. This is because they alter the circular flow of income, setting off a chain reaction of spending and income generation.

Changes in Government Expenditure and the Government Expenditure Multiplier

An increase in government purchases (G) represents a direct, autonomous injection of spending into the economy. This initial expenditure immediately becomes income for households and firms. This new income is then partly consumed, creating a second round of income, and so on. This leads to a final increase in equilibrium income that is much larger than the initial increase in G.

The government expenditure multiplier is the ratio of the change in equilibrium income to the change in government spending. Its formula is identical to the investment multiplier:

$ \text{Government Expenditure Multiplier} = \frac{\Delta Y}{\Delta G} = \frac{1}{1 - MPC} = \frac{1}{MPS} $

This is because a change in G, like a change in I, is a direct change in autonomous aggregate demand.

Changes in Taxes and the Tax Multiplier

The effect of a change in taxes is more indirect. A tax cut ($\Delta T$ is negative) does not directly increase aggregate demand. Instead, it first increases households' disposable income ($Y_d = Y - T$). Households will then spend only a fraction of this additional disposable income, as determined by their MPC. The initial increase in consumption, and thus the initial injection into the circular flow, is only $MPC \times (-\Delta T)$.

Because the initial impact on spending is smaller, the tax multiplier is weaker than the government expenditure multiplier. The formula for the tax multiplier is:

$ \text{Tax Multiplier} = \frac{\Delta Y}{\Delta T} = \frac{-MPC}{1 - MPC} = \frac{-MPC}{MPS} $

The tax multiplier is negative (because a tax increase reduces income, and a tax cut increases it) and is always smaller in absolute value than the government expenditure multiplier.

The Balanced Budget Multiplier

This concept addresses the question: What happens to national income if the government increases its spending (G) and finances it by an equal increase in taxes (T), such that the budget remains balanced ($\Delta G = \Delta T$)?

Intuitively, one might think the net effect is zero. However, because the government expenditure multiplier is stronger than the tax multiplier, there is a net positive effect on income. The balanced budget multiplier is always equal to 1.

This means that if government spending and taxes are both increased by ₹100 crore, the equilibrium national income will also rise by exactly ₹100 crore. The initial injection of ₹100 crore from G is more powerful than the initial withdrawal of spending caused by the ₹100 crore tax hike (which is only $MPC \times 100$).

Automatic Stabilisers and Proportional Taxes

Some elements of the fiscal system are designed to automatically cushion the economy from the shocks of the business cycle without any new, discretionary policy action by the government. These are known as automatic stabilisers.

Case of Proportional Taxes

A key example is a proportional income tax system, where the government collects a fixed fraction, $t$, of income in the form of taxes (i.e., $T = tY$). This system has an inherent stabilizing property:

• During an economic boom: As national income (Y) rises, tax revenues ($tY$) automatically increase. This siphons off a portion of the rising income, which dampens the increase in disposable income and, consequently, slows down the growth in consumption spending. This acts as an automatic brake, helping to prevent the economy from overheating and controlling inflation.
• During a recession: As national income (Y) falls, tax revenues automatically decrease. This cushions the fall in households' disposable income, preventing consumption spending from dropping as sharply as it otherwise would have. This acts as an automatic shock absorber, preventing a deeper recession.

A proportional tax system makes the economy less volatile by reducing the size of the multiplier. The new multiplier in an economy with a proportional tax is given by: $ k = \frac{1}{1 - c(1-t)} $, which is smaller than the multiplier with lump-sum taxes ($1/(1-c)$).

Other automatic stabilisers include welfare transfers like unemployment benefits, which automatically increase during a recession (supporting demand) and decrease during a boom.

Government Debt

When a government runs a budget deficit, its total expenditure exceeds its non-borrowed receipts. This shortfall must be financed. While governments can, in theory, print money to cover the gap, the more common method is to borrow. Continuous borrowing over many years leads to the accumulation of government debt, which is the total outstanding amount that the government owes to its lenders.

It is crucial to distinguish between deficits and debt. A budget deficit is a flow concept, measured as the shortfall per year. Government debt is a stock concept, representing the total accumulated borrowings at a specific point in time. Each year's deficit adds to the total stock of debt.

Is Government Debt a Burden? Perspectives on the Issue

The question of whether government debt is a burden on the economy, particularly on future generations, is a central and contentious topic in macroeconomics. There are several competing perspectives on this issue.

Arguments that Debt IS a Burden

• Intergenerational Burden: The most common argument is that by borrowing today, the government is essentially shifting the tax burden to future generations. The government issues bonds to the current generation, but the principal and accumulated interest on these bonds will have to be paid off years later by raising taxes on the next generation of workers and taxpayers. This reduces their future disposable income and consumption, thereby placing a burden on them.
• Crowding Out of Private Investment: When the government borrows heavily from the public by selling bonds, it competes with private corporations and individuals for the limited pool of national savings. This increased demand for loanable funds can drive up interest rates. Higher interest rates make it more expensive for private firms to borrow money for investment in new machinery, factories, and technology. As a result, government borrowing can "crowd out" private investment. This leads to a smaller private capital stock for future generations, potentially resulting in slower long-run economic growth.

Counterarguments (Why Debt May NOT be a Burden)

• Ricardian Equivalence: This sophisticated counterargument, named after the 19th-century economist David Ricardo, suggests that government debt is not a burden. It posits that rational, forward-looking consumers understand that government borrowing today is simply a deferred tax. They anticipate that they or their children will have to pay higher taxes in the future to repay the debt. In response, they will increase their personal savings today to be able to meet this future tax liability. This increase in private saving exactly offsets the government's dissaving (borrowing). As a result, national savings do not fall, interest rates do not rise, and private investment is not crowded out. In this view, financing government spending through debt is "equivalent" to financing it through taxes.
• Internal Debt ("We Owe it to Ourselves"): For debt that is held domestically (owed by the government to its own citizens), the interest payments are merely a transfer of resources from one group of citizens (the taxpayers) to another group (the bondholders). While it is a redistribution of income within the country, it does not represent a net reduction in the nation's overall purchasing power or resources. This argument does not hold for external debt, which is owed to foreigners. Repaying external debt involves a transfer of real goods and services (purchasing power) out of the country, which is a genuine burden.
• Public Investment: The "burden" of debt depends heavily on how the borrowed funds are used. If the government uses the debt to finance productive public investments in infrastructure (roads, ports), education, public health, or research and development, it can significantly increase the economy's long-run productive capacity. If the return on these public investments is greater than the interest rate on the debt, future generations will inherit a more productive and wealthier economy, which will more than compensate them for the higher tax liability.
• Deficits during Recessions: In a Keynesian framework, this is a crucial counterargument. If an economy is in a recession with unutilized resources (high unemployment), a deficit-financed increase in government spending can boost aggregate demand and raise the level of national income and output through the multiplier effect. A higher GDP leads to higher total income and, consequently, higher total savings. In this case, the deficit helps to generate the very savings needed to finance it, and both the government and the private sector can borrow more without necessarily "crowding out" each other.

Other Perspectives on Deficits and Debt

• Inflationary Impact: A major concern with deficits is that they can be inflationary. When the government increases spending or cuts taxes, it boosts aggregate demand. If the economy is already operating at or near its full capacity, firms will be unable to increase production to meet this higher demand. The result is "too much money chasing too few goods," which leads to a rise in the general price level (inflation). However, as noted above, if there are significant unutilized resources, the deficit may lead to higher output rather than higher prices.
• Financing Method Matters: The inflationary impact also depends on how the deficit is financed. If the government borrows from the central bank (RBI), which then prints new money to finance the loan, it directly increases the money supply and is highly likely to be inflationary. If the government borrows from the public, the inflationary impact is generally less severe.

Deficit Reduction

Concern over the long-term consequences of high debt often leads to calls for deficit reduction. A government can reduce its deficit through two main channels:

1. Increasing Revenue:
   • Taxation: The government can increase tax revenue by raising tax rates or widening the tax base. In India, there has been an effort to increase reliance on direct taxes (like income and corporate tax), which are generally progressive, rather than on indirect taxes, which can be regressive.
   • Non-Tax Revenue: The government can also raise receipts through the sale of shares in Public Sector Undertakings (PSUs), a process known as disinvestment.
2. Reducing Expenditure:

   This is often the main focus of deficit reduction efforts. It can be achieved by:

   • Making government activities and programmes more efficient through better planning and administration to reduce wastage. For example, replacing inefficient subsidies with direct cash transfers.
   • Changing the scope of government by withdrawing from certain economic activities and leaving them to the private sector.

   However, cutting government expenditure is challenging. A large portion of it is "committed expenditure" (like interest payments, salaries, and pensions) that is difficult to reduce. Furthermore, cutting back on crucial spending in areas like education, health, and poverty alleviation can have adverse long-term effects on economic growth and social welfare.

Fiscal Responsibility and Budget Management Act, 2003 (FRBMA)

Rationale for the FRBMA

In a multi-party parliamentary system like India's, there is often a tendency for governments to be influenced by electoral concerns, which can lead to populist expenditure policies and a lack of long-term fiscal discipline. To address this, it was argued that a legislative provision, binding on all present and future governments, was needed to keep deficits under control.

The enactment of the Fiscal Responsibility and Budget Management Act (FRBMA) in August 2003 marked a turning point in India's fiscal reforms. The Act provided an institutional framework to compel the government to pursue a prudent fiscal policy.

The core objectives of the FRBMA are to:

• Ensure inter-generational equity in fiscal management.
• Maintain long-term macro-economic stability.
• Achieve a sufficient revenue surplus over time.
• Remove fiscal obstacles to the effective conduct of monetary policy.
• Ensure effective debt management by placing limits on deficits and government borrowing.

Main Features of the Act

1. Deficit Reduction Targets: The Act originally mandated the central government to reduce the fiscal deficit to not more than 3% of GDP and to completely eliminate the revenue deficit by March 31, 2009 (this deadline has since been revised multiple times).
2. Annual Reduction Path: It required a minimum annual reduction in the fiscal deficit by 0.3% of GDP and in the revenue deficit by 0.5% of GDP.
3. Escape Clause: The specified targets could be exceeded only on exceptional grounds, such as a threat to national security or a natural calamity.
4. Restriction on Borrowing from RBI: The Act prohibited the central government from borrowing directly from the Reserve Bank of India (RBI), except through 'ways and means advances' to meet temporary cash flow mismatches. This was a crucial step to stop the automatic monetization of deficits.
5. Prohibition on Primary Market Subscription: It mandated that from 2006-07 onwards, the RBI must not subscribe to the primary issues of central government securities. This forces the government to raise its borrowings from the open market.
6. Enhanced Transparency: The Act mandated measures to ensure greater transparency in fiscal operations.
7. Mandatory Parliamentary Statements: It requires the central government to lay three key policy statements before both Houses of Parliament along with the Annual Budget:
   • The Medium-term Fiscal Policy Statement: Sets three-year rolling targets for fiscal indicators.
   • The Fiscal Policy Strategy Statement: Outlines the government's fiscal priorities.
   • The Macroeconomic Framework Statement: Assesses the prospects of the economy.

Evolution and Review

While the FRBMA was seen as a landmark legislation, the rigid targets have been subject to review and revision over the years, especially in the wake of economic shocks like the 2008 global financial crisis and the COVID-19 pandemic. An FRBM Review Committee was later set up to revamp the framework to incorporate the changing economic scenario in India and to provide a more flexible and realistic path for fiscal consolidation. Despite these changes, the core principle of a rule-based fiscal policy remains a key feature of India's macroeconomic management.

Goods and Services Tax (GST)

Concept: One Nation, One Tax, One Market

The Goods and Services Tax (GST), implemented on July 1, 2017, is the biggest and most significant indirect tax reform in India since independence. It is a single, comprehensive tax levied on the supply of goods and services, right from the manufacturer to the final consumer.

GST is a destination-based consumption tax, which means the tax revenue accrues to the state where the goods or services are finally consumed, rather than the state where they are produced.

Problems with the Pre-GST Tax Regime

The previous indirect tax system was highly fragmented and complex. It suffered from a major flaw known as the cascading of taxes or "tax on tax."

Previously, taxes (like Central Excise Duty and State VAT) were levied at each stage of production on the total value of the commodity, which included taxes paid at the previous stages. The facility to claim credit for taxes paid on inputs (Input Tax Credit) was very limited. This led to a cascading effect, which increased the cost of production and the final price paid by the consumer.

How GST Works: The Value Added Principle and ITC

GST is designed to eliminate the cascading effect. It is effectively a tax on the value addition at each stage of the supply chain. This is achieved through the mechanism of Input Tax Credit (ITC).

• Under GST, tax is levied at every stage of supply (from manufacturer to wholesaler to retailer).
• However, at each stage, the seller can claim a credit for the GST they have already paid on their inputs (raw materials and services).
• This means they only have to pay tax on the value they have added to the product at their stage.

Example: If a retailer buys a good for ₹100 + ₹18 GST (total ₹118) and sells it for ₹150, their output tax liability would be 18% of ₹150 = ₹27. However, they can claim an ITC of ₹18 that they already paid. So, their net tax payment to the government is only ₹27 - ₹18 = ₹9, which is 18% of the value they added (₹50).

Taxes Subsumed by GST

GST has replaced a large number of Central and State indirect taxes.

• Major Central Taxes Subsumed: Central Excise Duty, Service Tax, Central Sales Tax, and various cesses.
• Major State Taxes Subsumed: Value Added Tax (VAT)/Sales Tax, Entry Tax, Luxury Tax, Octroi, Entertainment Tax, and taxes on lottery and betting.

GST Rates and Exclusions

• GST Rates: There are six standard rates applied across the country: 0%, 3% (for gold), 5%, 12%, 18%, and 28%.
• Exclusions: For the time being, five petroleum products (crude oil, petrol, diesel, ATF, natural gas) and alcoholic liquor for human consumption have been kept out of the GST ambit.

Aims and Benefits of GST

• It has simplified the multiplicity of indirect taxes into a single tax system.
• It has standardized tax laws, procedures, and rates across the country, creating a common national market.
• It has eliminated the cascading effect of taxes, reducing the cost of production.
• It aims to make Indian goods and services more competitive in domestic and international markets.
• It is expected to boost economic growth and GDP.
• It has improved tax compliance and transparency through a common online portal (the GST Network - GSTN).
• It has expanded the tax base and is furthering the ease of doing business in India.

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