Chapter Notes

Government Budget－Meaning and its Components

In India, there is a constitutional requirement under Article 112 for the government to present a statement of its estimated income (receipts) and spending (expenditures) to the Parliament for each financial year, which runs from 1 April to 31 March. This document is officially called the 'Annual Financial Statement', but we commonly know it as the government budget.

The budget isn't just about one year; its decisions have long-lasting effects. Because of this, the budget is divided into two main parts:

• Revenue Account (or Revenue Budget): This deals with income and expenses that relate only to the current financial year, like day-to-day government functioning.
• Capital Account (or Capital Budget): This deals with the government's assets (like buildings, machinery) and liabilities (like loans), which have a long-term impact.

To fully understand these components, we first need to look at what the government is trying to achieve with its budget.

Objectives of Government Budget

The government uses its budget as a tool to improve the welfare of its people. It intervenes in the economy in three main ways, known as the functions of the government budget.

Allocation Function of Government Budget

Some goods and services, called public goods, cannot be efficiently provided by the private market. The government must step in to provide them.

• Examples: National defence, roads, and government administration.

Public goods are different from private goods (like clothes, cars, or food) in two key ways:

1. Non-rivalrous: One person's use of a public good doesn't reduce its availability for others. Many people can enjoy a public park at the same time without diminishing its value for anyone else. In contrast, if you eat a chocolate, no one else can eat that same chocolate.
2. Non-excludable: It is practically impossible to stop someone from using a public good, even if they don't pay for it. For instance, you can't exclude a person from the benefits of national defence or cleaner air.

This non-excludability leads to the problem of 'free-riders'—people who use a good or service without paying for it. Since private companies can't force everyone to pay, they have no incentive to provide public goods. This is why the government must provide them, using funds from the budget.

Redistribution Function of Government Budget

The total income of a country is divided between the private sector (households and firms) and the government. The government can influence how much income households get to keep (personal disposable income) by:

• Collecting taxes.
• Making transfer payments (like pensions or subsidies).

Through these tools, the government can change the distribution of income in society to make it more 'fair'. For example, by taxing higher incomes at a greater rate and providing support to lower-income households, the government redistributes wealth.

Stabilisation Function of Government Budget

An economy naturally goes through ups and downs (fluctuations in income and employment). These are often caused by changes in aggregate demand (the total spending in the economy).

• If demand is too low: Resources like labour are not fully used, leading to unemployment. The government can intervene to increase aggregate demand, for example, by increasing its own spending.
• If demand is too high: When the economy is already at high employment, excess demand can lead to inflation (a general rise in prices). The government may need to take steps to reduce demand.

This role of the government in managing aggregate demand to correct economic fluctuations is called the stabilisation function.

Classification of Receipts

Government receipts are the ways the government gets its money. They are classified into two main categories.

Revenue Receipts

Revenue receipts are those that do not create any liability or reduce the government's assets. In simple terms, this is money the government receives that it doesn't have to pay back. They are non-redeemable.

Revenue receipts are divided into:

• Tax Revenues: This is the main source of income.
  • Direct Taxes: Taxes levied on the income of individuals (personal income tax) and profits of firms (corporation tax). These are often progressive, meaning higher incomes are taxed at higher rates to achieve the redistribution objective.
  • Indirect Taxes: Taxes levied on goods and services, such as excise taxes (on goods produced within the country) and customs duties (on imported/exported goods). The Goods and Services Tax (GST) is now the main comprehensive indirect tax in India.
• Non-Tax Revenues: This is income from sources other than taxes.
  • Interest receipts on loans given by the government.
  • Dividends and profits from investments in Public Sector Undertakings (PSUs).
  • Fees for services rendered by the government (e.g., passport fees).
  • Grants-in-aid from foreign countries and international organisations.

Capital Receipts

Capital receipts are government receipts that either create a liability or reduce a financial asset.

• Creating a liability: When the government takes loans, it creates a liability because these loans must be repaid with interest in the future.
• Reducing an asset: When the government sells its assets, like shares in a PSU (PSU disinvestment), it reduces its financial assets. This means it will no longer earn income from that asset in the future.

Capital receipts can be debt creating (like borrowings) or non-debt creating (like the recovery of loans or proceeds from disinvestment).

Classification of Expenditure

Government expenditure is what the government spends its money on. It is also classified into two categories.

Revenue Expenditure

Revenue Expenditure is spending that does not create any physical or financial assets for the government. It is incurred for the normal functioning of government departments and services.

• Examples: Salaries and pensions for government employees, interest payments on government debt, subsidies (on food, fertilisers, etc.), defence services, and grants given to state governments.

Capital Expenditure

Capital Expenditure is spending that either creates physical or financial assets or reduces financial liabilities. This type of spending is an investment in the country's future.

• Examples: Expenditure on building roads, bridges, machinery, and equipment; investment in shares; and loans given by the central government to state governments or PSUs.

Balanced, Surplus and Deficit Budget

The relationship between the government's total receipts and total expenditure determines the state of the budget.

• Balanced Budget: When government expenditure is exactly equal to its revenue.
• Surplus Budget: When the government collects more revenue than it spends (tax collection > expenditure).
• Deficit Budget: When government expenditure exceeds its revenue. This is the most common situation for most governments.

Measures of Government Deficit

When a government runs a deficit, it means it is spending more than it is earning. There are different ways to measure this deficit, and each one tells us something different about the government's financial health.

Revenue Deficit

The Revenue Deficit is the excess of the government's revenue expenditure over its revenue receipts. Revenue Deficit = Revenue Expenditure – Revenue Receipts

• What it implies: A revenue deficit means the government's regular income is not enough to cover its regular, day-to-day expenses. This indicates that the government is dissaving, meaning it is using up the savings of other sectors of the economy to finance its own consumption expenditure. To cover this gap, the government has to borrow, which increases its debt and future interest payment liabilities. This can force the government to cut productive capital or welfare spending in the future.

Fiscal Deficit

The Fiscal Deficit is 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)

• What it implies: The fiscal deficit shows the total borrowing requirement of the government from all sources (the public, the RBI, and abroad). It is a key indicator of the financial health of the public sector.

Primary Deficit

The government's borrowing requirement (fiscal deficit) includes interest payments on debt accumulated from previous years. To see the extent of borrowing needed to finance spending in the current year (excluding past interest obligations), we calculate the Primary Deficit. Gross Primary Deficit = Gross Fiscal Deficit – Net Interest Liabilities

• What it implies: The primary deficit focuses on present fiscal imbalances. It shows the borrowing requirement of the government for its current year's expenditure, over and above its current year's revenue, after excluding interest payments.

Fiscal Policy

Fiscal policy refers to the government's use of expenditure and taxation to influence and stabilise the economy. As economist John Maynard Keynes suggested, the government can use these tools to manage the level of output and employment.

Changes in Government Expenditure

• When the government increases its purchases of goods and services (G), it directly increases aggregate demand.
• This initial increase in spending leads to a larger increase in national income through the multiplier effect.
• The government spending multiplier is calculated as: 1 / (1 - c), where 'c' is the marginal propensity to consume (MPC).

Changes in Taxes

• When the government cuts taxes (T), it increases households' disposable income, which in turn increases consumption and aggregate demand.
• The effect of a tax change also works through a multiplier, but its impact is indirect. The initial change in spending is only a fraction (c) of the tax change.
• The tax multiplier is calculated as: -c / (1 - c). It is negative because a tax increase reduces income, and a tax cut increases it.

The Balanced Budget Multiplier

What happens if the government increases its spending and finances it with an equal increase in taxes?

• The balanced budget multiplier is equal to 1.
• This means that if government spending and taxes both increase by the same amount (e.g., ₹100), the national income will also increase by that same amount (₹100). The positive effect of the spending increase is stronger than the negative effect of the tax increase.

Proportional Taxes and Automatic Stabilisers

In reality, taxes are not usually a fixed lump sum. A more realistic assumption is a proportional tax, where the government collects a constant fraction (t) of income.

• With proportional taxes, the multiplier becomes smaller: 1 / (1 - c(1 - t)).
• This is because when income rises, some of it is automatically taken away as taxes, which dampens the increase in consumption.
• This feature makes proportional taxes an automatic stabiliser. They help cushion the economy from shocks without any deliberate government action.
  • During a boom: As GDP rises, tax collections rise automatically, slowing down the growth in consumption and preventing the economy from overheating.
  • During a recession: As GDP falls, tax collections fall automatically, preventing disposable income and consumption from dropping too sharply.

Debt

When a government runs a budget deficit, it must be financed by borrowing, which leads to the accumulation of government debt.

• Deficit is a flow concept (the amount borrowed in a year).
• Debt is a stock concept (the total accumulated amount owed at a point in time). Continuous deficits add to the stock of debt.

Is Government Debt a Burden?

There are several perspectives on this issue:

• Burden on Future Generations: One view is that by borrowing today, the government is passing the burden of repayment onto future generations. They will have to pay higher taxes, which will reduce their consumption. Government borrowing can also reduce the savings available for the private sector, potentially lowering capital formation and future growth.
• Ricardian Equivalence: A counter-argument, known as Ricardian equivalence, suggests that consumers are forward-looking. They understand that government borrowing today means higher taxes in the future. In response, they will save more now to offset those future taxes. If this happens, national savings do not fall, and there is no burden on future generations.
• 'We Owe it to Ourselves': It is often argued that domestic debt is not a burden because it is a transfer of resources within the country from taxpayers to bondholders. However, debt owed to foreigners is a real burden, as it involves sending goods and services abroad to pay the interest.

Other Perspectives on Deficits and Debt

• Are deficits inflationary? Deficits can be inflationary if they increase aggregate demand when the economy's resources are already fully utilized. However, if there is unemployment and unused capacity, a deficit can lead to higher output without causing inflation.
• Crowding Out: A major concern is that government borrowing 'crowds out' private investment. By borrowing from the public, the government competes with private firms for the available supply of savings, potentially driving up interest rates and making it harder for firms to invest. However, if the deficit leads to higher income and savings, both the government and private industry can borrow more.

Fiscal Responsibility and Budget Management Act, 2003 (FRBMA)

To ensure fiscal discipline, India enacted the FRBMA in 2003. This law created an institutional framework to guide the government's fiscal policy.

Main Features:

1. It mandated the central government to reduce its fiscal deficit and eliminate the revenue deficit by a specific target date.
2. It set annual targets for deficit reduction (e.g., reduce fiscal deficit by 0.3% of GDP each year).
3. It prohibited the government from borrowing directly from the Reserve Bank of India (RBI) after a certain date, except under specific circumstances.
4. It required the government to be more transparent by presenting three key policy statements to Parliament along with the budget: the Medium-term Fiscal Policy Statement, the Fiscal Policy Strategy Statement, and the Macroeconomic Framework Statement.

The goal of the FRBMA is to ensure long-term macroeconomic stability and intergenerational equity by keeping deficits and government debt under control.

GST: One Nation, One Tax, One Market

The Goods and Service Tax (GST), implemented on 1 July 2017, was a major tax reform in India.

• What it is: GST is a single, comprehensive indirect tax on the supply of goods and services. It is a destination-based consumption tax.
• How it works: It replaces a large number of central and state taxes (like Excise Duty, Service Tax, VAT, Entry Tax). It is based on the principle of 'value-added taxation', where tax is levied at each stage of the supply chain, and producers can claim credit for the taxes they have already paid on their inputs (Input Tax Credit). This avoids the cascading of tax (tax on tax) that existed in the old system.
• Benefits:
  • Simplifies the tax structure with standardised laws and rates across the country.
  • Creates a common national market, facilitating the free movement of goods.
  • Aimed at reducing business costs and making Indian products more competitive.
  • Expected to increase GDP, expand the tax base, and improve transparency.

GST has several rate slabs, such as 0%, 5%, 12%, 18%, and 28%, applied to different goods and services.