FISCAL POLICY

REVENUES
EXPENDITURES
DEFICITS
Fiscal Policy - fundamentals
 Fiscal policy concerns the plans for taxation, borrowing and
spending by the Government of a country.
 A fiscal stance may be
– Neutral
– Expansionary
– Contractionary
 Collecting more taxes to finance more spending indicates a
neutral stance
 Spending more and financing it by borrowing and taxes would
indicate a fiscal expansion
 Collecting more taxes without increase in spending indicates
fiscal contraction.
45 degree model

C+I+G+G1

C+I+G

Government
spending is an
injection into the
circular flow whereas
taxes are
withdrawals

Y1 Y2
ELEMENTS OF PUBLIC FINANCE
 EXPENDITURE
– ON GOODS AND SERVICES, HEALTH, EDUCATION,
ROADS, INFRASTRUCTURE, DEFENCE.
 INCOME = TAXES AND NON-TAX REVENUE
 BORROWING = IF EXPENDITURE IS GREATER THAN
REVENUES = PSBR
Functions of Taxation

 To raise revenues for the Government

 To control externalities
 To redistribute income and wealth
 To protect industries from foreign competition
 To provide a stabilizing effect on National Income e.g.
taxes can dampen upswings of a trade cycle by reducing
inflationary pressures.
QUALITIES OF A GOOD TAX
 According to ability to pay
 Taxes should be comprehensive
 Cost of collection should be small
 Payment of tax should be according to how
and when people receive and spend income
 Tax evasion should be difficult.
 Taxes should be equitable
Direct vs Indirect taxes

 Advantages of Direct Taxes:

1. Direct taxes are”fair and equitable”

2. They act as built in or automatic stabilizers
3. Less inflationary than indirect taxes
Direct taxes

 Can be proportional, progressive or regressive

 Disdavantages of Direct Taxes
1. Encourages migration
2. Reduce the initiative to train skilled workers
3. Encourages tax avoidance
4. Disincentives
Progressive Taxes
 Advantages
– According to ability to
pay
– Enables redistribution of
wealth
– Progressive taxes
counter-balance indirect
taxes which are by
nature regressive
 Disadvantages
– Not required in affluent
societies
– Reduces initiative to
earn extra income and
profits
– Encourages tax evasion
– Could encourage
migration
Advantages of Indirect Taxes:

1. Can be painlessly extracted

2. Can discourage externalities
3. More flexible
4. Less administrative burden
Disadvantages of indirect taxes

1. Inflationary effect
2. Indirect taxes are regressive
3. Evasion is possible through black marketing
 Government Finances

 Revenue
1. Gross tax revenue
 Corporate Profit tax, Income tax, Excise duty, Import Duty
 Other taxes and duties
2. Devolvement to State and Union Territories
3. Net Tax revenue = (1) minus (2)
4. Non Tax revenue
5. Net revenue receipts = (3) plus (4)
6. Non Debt capital receipts
 Recovery of loans
 Privatisation
7. Borrowing and other liabilities
8. Total Receipts = 1+6+7
 Government Finances - II

 Expenditure
1. Revenue Expenditure
 Interest, Subsidy, Defence, Admin
 Plan Expenditure
2. Capital Expenditure
 Planned Expenditure
 Loans
 Defence
 Others
3. Planned expenditure on Rev and Capital Account
4. Non Plan expenditure on Rev and Capital Account
5. Total Expenditure = 3 + 4
Budget Deficit

 Revenue Deficit = Rev Exp – Rev Receipts

 Capital Deficit = Capital Exp – Capital Receipts
 Budgetary Deficit = Total Revenue – Total
Expenditure
 Gross Fiscal Deficit = Total Expenditure – Total
Receipts excluding Borrowings (this implies the
overall borrowing requirement of the Govt.
 Primary Deficit = Gross Fiscal Deficit - Interest
Government Balance Sheet
o Liabilities of Central Government
1. Public Debt = Internal Debt + External Debt
 Internal Debt
 Market Loans, Treasury Bills, Bonds, Govt Securities
2. Small Savings
3. Provident Funds
4. Reserve Funds
o Assets of Central Govt
o Capital Outlay
o Loans and Advances to States, Union Territories, Foreign
Govts, PSUs, Govt Depts (Rail, P&T, Education, Other Govt
employees)
Public Debt

 Debt Instruments
– Marketable Debt
 Treasury Bills – Short term
 Govt Securities – Long term
– Non-marketable Debt
 National Saving Schemes
 Non-marketable loans
Measurement of Public Debt

 Public Sector Borrowing Requirement

(PSBR) is the annual excess of spending
over income
 Servicing the Debt involves redistribution of
funds through taxes and borrowing with
interest
Real Vs Nominal Deficit

 Real Deficit is arrived at by reducing inflation

adjusted Public Debt from Nominal Deficit
 Real Budget Deficit = Nominal Budget Deficit
– Public Debt x Inflation
 Example : Where Public Debt is 4000Bln and
Budget Deficit is 250Bln, Inflation rate is 5%
then Real Budget Deficit = 250 – 4000x0.05
= 50
Cyclical deficit and Structural
deficit
 Cyclical Deficit is part of the deficit that results from the
economy being a low level economic activity
 Structural Deficit is that portion of the deficit that would exist
even if the economy was operating at it’s full potential and
hence it is not directly attributable to the business cycle and
policy makers are directly responsible for it
 To break the deficit into two parts we need a measure of
potential output e.g. actual deficit = 100 but economy below
potential if level of economic activity increases to the potential
tax revenues will rise by 30 and transfers would fall by 10
hence structural deficit = 100 -10-30 = 60
Monetized Deficit

 Amount of the deficit that is financed by

borrowings from the RBI, this increases the
money supply in the economy by an
equivalent amount.
Effectiveness of Fiscal Policy
 Taxes act as automatic stabilizers – help to reduce upward and
downward movement of national income but they also act as a
drag on expansion (fiscal drag) by reducing the size of the
multiplier
 Dis-incentive to work and invest
 Crowding Out controversy – private investment falls due to high
interest rates when Govt deficit is financed by accessing the
public markets i.e. savings in the economy
 Time lag between recognition and recovery
– Lag between recognition and action
– Lag between action and implementation
– Lag between implementation and effect