This article on Government Budget and Economy will be useful for all those IAS aspiring candidates who want to brush up their concepts dealt in this chapter. I have tried to include all the important points mentioned in the chapter and have made efforts to summarize them as much as I could. Have a Happy Learning!
Public goods, as distinct from private goods, are collectively consumed. Two important features of public goods are – they are non-rivalrous in that one person can increase her satisfaction from the good without reducing that obtained by others and they are non-excludable, and there is no feasible way of excluding anyone from enjoying the benefits of the good. These make it difficult to collect fees for their use and private enterprise will in general not provide these goods. Hence, they must be provided by the government.
Public goods:
National defence, roads, government administration, etc.
Benefits of public goods are not limited to one particular consumer, as in the case of private goods, but become available to all. There is no feasible way of excluding anyone from enjoying the benefits of the good (they are non-excludable).
Private goods :
Clothes, cars, food items, etc.
In case of private goods anyone who does not pay for the good can be excluded from enjoying its benefits.
Mixed Economy – Functions of government
The three functions of allocation, redistribution and stabilisation operate through the expenditure and receipts of the government.
Allocation Function: Public Goods cannot be provided through the market mechanism, i.e. by transactions between individual consumers and producers and must be provided by the government.
Distribution Function: The government affects the personal disposable income of households by making transfer payments and collecting taxes and, therefore, can alter the income distribution.
Overall level of employment and prices in the economy depends upon the level of aggregate demand which is a function of the spending decisions of millions of private economic agents apart from the government.
Public Provision:
They are financed through the budget and made available free of any direct payment.
These goods may be produced directly under government management or by the private sector.
Government borrowing to cover deficits leads to debt accumulation – what the government owes.
Components of Government Budget
Article 112: Annual Financial Statement (Budget):
1. A statement of estimated receipts and expenditures of the government tin respect of every financial year which runs from 1 April to 31 March.
2. Presented before the Parliament
3. Budget comprises of the (a) Revenue Budget and the (b) Capital Budget.
The Revenue Account
Shows the current receipts of the government and the expenditure that can be met from these receipts.
Revenue Receipts:
Receipts of the government which are non-redeemable, that is, they cannot be reclaimed from the government.
They are divided into tax and non-tax revenues.
Tax revenues consist of the proceeds of taxes and other duties levied by the central government – comprise of direct taxes – which fall directly on individuals (personal income tax) and firms (corporation tax), and indirect taxes like excise taxes (duties levied on goods produced within the country), customs duties (taxes imposed on goods imported into and exported out of India) and service tax.
Other direct taxes like wealth tax, gift tax and estate duty (now abolished) have never been of much significance in terms of revenue yield and have thus been referred to as ‘paper taxes’.
Firms are taxed on a proportional basis, where the tax rate is a particular proportion of profits – Corporate Tax
With respect to excise taxes, necessities of life are exempted or taxed at low rates, comforts and semi-luxuries are moderately taxed, and luxuries, tobacco and petroleum products are taxed heavily.
Note:
Service Tax: a tax on services like telephone services, stock brokers, health clubs, beauty -parlors, dry cleaning services etc – introduced in 1994-95 to correct the disparity in taxation between goods and services.
Non-tax revenue – interest receipts on account of loans by the central government, dividends and profits on investments made by the government, fees and other receipts for services rendered by the government. Cash grants-in-aid from foreign countries and international organizations are also included.
Revenue Expenditure:
Expenditure incurred for purposes other than the creation of physical or financial assets of the central government.
It relates to those expenses incurred for the normal functioning of the government departments and various services, interest payments on debt incurred by the government, and grants given to state governments and other parties (even though some of the grants may be meant for creation of assets).
Plan Revenue Expenditure: relates to central Plans (the Five-Year Plans) and central assistance for State and Union Territory plans.
Non-plan Expenditure: Covers a vast range of general, economic and social services of the government.
The main items of non-plan expenditure are interest payments, defense services, subsidies, salaries and pensions.
Interest payments on market loans, external loans and from various reserve funds constitute the single largest component of non-plan revenue expenditure.
Defense expenditure, is committed expenditure in the sense that given the national security concerns, there exists little scope for drastic reduction.
Subsidies are an important policy instrument which aim at increasing welfare. Apart from providing implicit subsidies through under-pricing of public goods and services like education and health, the government also extends subsidies explicitly on items such as exports, interest on loans, food and fertilizers.
The Capital Account
Account of the assets as well as liabilities of the central government, which takes into consideration changes in capital.
It consists of capital receipts and capital expenditure of the government.
Capital Receipts:
All those receipts of the government which create liability or reduce financial assets are termed as capital receipts.
The main items of capital receipts are loans raised by the government from the public which are called market borrowings, borrowing by the government from the Reserve Bank and commercial banks and other financial institutions through the sale of treasury bills, loans received from foreign governments and international organisations, and recoveries of loans granted by the central government.
Other items include small savings (Post-Office Savings Accounts, National Savings Certificates, etc), provident funds and net receipts obtained from the sale of shares in Public Sector Undertakings (PSUs) [This is referred to as PSU disinvestment].
Capital Expenditure:
Result in creation of physical or financial assets or reduction in financial liabilities.
This includes expenditure on the acquisition of land, building, machinery, equipment, investment in shares, and loans and advances by the central government to state and union territory governments, PSUs and other parties .
Capital expenditure is also categorized as plan and non-plan in the budget documents.
Plan capital expenditure, like its revenue counterpart, relates to central plan and central assistance for state and union territory plans.
Non plan capital expenditure covers various general, social and economic services provided by the government.
Measures of Government Deficit
When a government spends more than it collects by way of revenue, it incurs a budget deficit.
Budget deficit refers to the excess of total expenditure (both revenue and capital) over total receipts (both revenue and capital).
From the 1997-98 budget, the practice of showing budget deficit has been discontinued in India.
Revenue Deficit:
The revenue deficit refers to the excess of government’s revenue expenditure over revenue receipts.
Revenue deficit = Revenue expenditure – Revenue receipts
The revenue deficit includes only such transactions that affect the current income and expenditure of the government.
When the government incurs a revenue deficit, it implies that the government is dis-saving and is using up the savings of the other sectors of the economy to finance a part of its consumption expenditure – implies that government will have to borrow not only to finance its investment but also its consumption requirements.
Often the government reduces productive capital expenditure or welfare expenditure – implies lower growth and adverse welfare implications.
Fiscal Deficit:
Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing.
Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts)
Non-debt creating capital receipts are those receipts which are not borrowings and, therefore, do not give rise to debt. Examples are recovery of loans and the proceeds from the sale of PSUs.
Non-debt creating capital receipts are obtained by subtracting, borrowing and other liabilities from total capital receipts.
Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad
Net borrowing at home includes that directly borrowed from the public through debt instruments (for example, the various small savings schemes) and indirectly from commercial banks through Statutory Liquidity Ratio (SLR).
Revenue deficit is a part of fiscal deficit (Fiscal Deficit = Revenue Deficit + Capital Expenditure – non-debt creating capital receipts).
The growth of revenue deficit as a percentage of fiscal deficit points to a deterioration in the quality of government expenditure involving lower capital formation.
A large share of revenue deficit in fiscal deficit indicated that a large part of borrowing is being used to meet its consumption expenditure needs rather than investment.
Primary deficit:
The fiscal deficit minus the interest payments
Gross primary deficit = Gross fiscal deficit – Net interest liabilities
Net interest liabilities consist of interest payments minus interest receipts by the government on net domestic lending.
Three policy statements are mandated by the Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) in the budget.
1. Medium-term Fiscal Policy Statement: sets a three-year rolling target for specific fiscal indicators and examines whether revenue expenditure can be financed through revenue receipts on a sustainable basis and how productively capital receipts including market borrowings are being utilised.
2. Fiscal Policy Strategy Statement: sets the priorities of the government in the fiscal area, examining current policies and justifying any deviation in important fiscal measures.
3. Macroeconomic Framework Statement: Assesses the prospects of the economy with respect to the GDP growth rate, fiscal balance of the central government and external balance5.
Gender budgeting(introduced in 2005-06): an exercise to translate the stated gender commitments of the government into budgetary commitments, involving special initiatives for empowering women and examination of the utilization of resources allocated for women and the impact of public expenditure and policies of the government on women.
Fiscal Policy
It is used to stabilise the level of output and employment.
Fiscal Policy creates a surplus (when total receipts exceed expenditure) or a deficit budget (when total expenditure exceeds receipts) rather than a balanced budget (when expenditure equals receipts).
The government directly affects the level of equilibrium income in two specific ways:
1. Government purchases of goods and services (G) increase aggregate demand and taxes (T)
2. Transfers affect the relation between income (Y) and disposable income (YD) – the income available for consumption and saving with the households.
When G exceeds T, the government runs a deficit.
Because G is a component of aggregate spending, planned aggregate expenditure will increase.
Changes in Taxes
A cut in taxes increases disposable income(Y – T) at each level of income.
Because a tax cut (increase) will cause an increase (reduction) in consumption and output, the tax multiplier is a negative multiplier.
Tax multiplier is always one less in absolute value than the government expenditure multiplier.
If an increase in government spending is matched by an equal increase in taxes, so that the budget remains balanced, output will rise by the amount of the increase in government spending.
The tax increase only enters the multiplier process when the cut in disposable income reduces consumption by c times the reduction in taxes.
Equilibrium Income: Final income that one arrives at in a period sufficiently long for all the rounds of the multipliers to work themselves out.
Proportional taxes not only lower consumption at each level of income but also lower the slope of the consumption function.
When income rose as a result of an increase in government spending in the case of lump-sum taxes, consumption increased by c times the increase in income
The proportional income tax acts as an automatic stabiliser – a shock absorber because it makes disposable income, and thus consumer spending, less sensitive to fluctuations in GDP.
Proportional taxes reduce the autonomous expenditure multiplier because taxes reduce the marginal propensity (An inclination or natural tendency to behave in a particular way. inclination – tendency – leaning – proclivity – bent) to consume out of income.
When GDP rises, disposable income also rises but by less than the rise in GDP because a part of it is siphoned off as taxes.
During a recession when GDP falls, disposable income falls less sharply, and consumption does not drop as much as it otherwise would have fallen had the tax liability been fixed. This reduces the fall in aggregate demand and stabilises the economy.
These fiscal policy instruments can be varied to offset the effects of undesirable shifts in investment demand. That is, if investment falls from I0 to I1, government spending can be raised from G0 to G1 so that autonomous expenditure (C + I0 + G0 = C + I1 + G1) and equilibrium income remain the same. This deliberate action to stabilise the economy is often referred to as discretionary fiscal policy to distinguish it from the inherent automatic stabilising properties of the fiscal system.
During boom years, when employment is high, tax receipts collected to finance such expenditure increase exerting a stabilising pressure on high consumption spending; conversely, during a slump, these welfare payments help sustain consumption.
Debt
Budgetary deficits must be financed by taxation, borrowing or printing money.
Public debt is burdensome if it reduces future growth in output.
By borrowing, the government transfers the burden of reduced consumption on future generations. This is because it borrows by issuing bonds to the people living at present but may decide to pay off the bonds some twenty years later by raising taxes.
Government borrowing from the people reduces the savings available to the private sector – this reduces capital formation and growth, debt acts as a ‘burden’ on future generations.
When a government cuts taxes and runs a budget deficit, consumers respond to their after-tax income by spending more.
They may also increase savings now, which will fully offset the increased government dissaving so that national savings do not change. This view is called Ricardian equivalence. It is called ‘equivalence’ because it argues that taxation and borrowing are equivalent means of financing expenditure.
When the government increases spending by borrowing today, which will be repaid by taxes in the future, it will have the same impact on the economy as an increase in government expenditure that is financed by a tax increase today.
Deficits are inflationary because when government increases spending or cuts taxes, aggregate demand increases. Firms may not be able to produce higher quantities that are being demanded at the ongoing prices. Prices will, therefore, have to rise. However, if there are unutilized resources, output is held back by lack of demand.
A high fiscal deficit is accompanied by higher demand and greater output and, therefore, need not be inflationary.
There is a decrease in investment due to a reduction in the amount of savings available to the private sector. This is because if the government decides to borrow from private citizens by issuing bonds to finance its deficits, these bonds will compete with corporate bonds and other financial instruments for the available supply of funds.
The actual debt could be paid off by the growth in output.
The growth in debt will have to be judged by the growth of the economy as a whole.
Deficit Reduction:
Government deficit can be reduced by an increase in taxes or reduction in expenditure.
In India, the government has been trying to increase tax revenue with greater reliance on direct taxes (indirect taxes are regressive in nature – they impact all income groups equally).
However, the major thrust has been towards reduction in government expenditure. This could be achieved through making government activities more efficient through better planning of programmes and better administration.
Cutting back government programmes in vital areas like agriculture, education, health, poverty alleviation, etc. would adversely affect the economy.
Deficit increases in a recession and falls in a boom, even with no change in fiscal policy.
Side Note:
Fiscal Responsibility and Budget Management Act, 2003 (FRBMA)
Enactment of the FRBMA, in August 2003 – for fiscal reforms, binding the government through an institutional framework to pursue a prudent fiscal policy.
The central government must ensure inter-generational equity, long term macro-economic stability by achieving sufficient revenue surplus, removing fiscal obstacles to monetary policy and effective debt management by limiting deficits and borrowing.
The rules under the Act were notified with effect from July, 2004.
Main Features
1. Central government to take appropriate measures to reduce fiscal deficit to not more than 3 percent of GDP. This should be done to eliminate the revenue deficit by March 31, 2009. This has been reschuduled by one year to 2009-10, primarily on account of a shift in plan priorities in favour of revenue expenditure – intensive programmes and schemes and thereafter build up adequate revenue surplus.
2. The reduction in fiscal deficit by 0.3 per cent of GDP each year and the revenue deficit by 0.5 per cent. If this is not achieved through tax revenues, the necessary adjustment has to come from a reduction in expenditure.
3. The actual deficits may exceed the targets specified only on grounds of national security or natural calamity or such other exceptional grounds as the central government may specify.
4. The central government shall not borrow from the Reserve Bank of India except by way of advances to meet temporary excess of cash disbursements over cash receipts.
5. The Reserve Bank of India must not subscribe to the primary issues of central government securities from the year 2006-07.
6. Measures to be taken to ensure greater transparency in fiscal operations.
7. The central government to lay before both Houses of Parliament three statements –
Medium-term Fiscal Policy Statement
The Fiscal Policy Strategy Statement
The Macroeconomic Framework Statement along with the Annual Financial Statement.
8. Quarterly review of the trends in receipts and expenditure in relation to the budget be placed before both Houses of Parliament. The act applies to the central government.
However, 26 states have already enacted fiscal responsibility legislations which have made the rule based fiscal reform programme of the government more broad based. Although the government has emphasised that the FRBMA is an important institutional mechanism to ensure fiscal prudence and support macroeconomic balance there have been fears that welfare expenditure may get reduced to meet the targets mandated by the Act.
References:
NCERT Macro Economics: Government Budget and Economy