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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



spending is an
injection into the
circular flow whereas
taxes are

Y1 Y2

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.

 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  Disadvantages
– According to ability to – Not required in affluent
pay societies
– Enables redistribution of – Reduces initiative to
wealth earn extra income and
– Progressive taxes profits
counter-balance indirect – Encourages tax evasion
taxes which are by – Could encourage
nature regressive 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 = 5+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
 Gross Fiscal Deficit = Total Expenditure – Total
Receipts excluding Borrowings (this implies the
overall borrowing requirement of the Govt.
 Primary Deficit = Gross Fiscal Deficit - Interest
 Effective Revenue deficit is a new term introduced
in the Union Budget 2011-12. While revenue deficit
is the difference between revenue receipts and
revenue expenditure, the present accounting system
includes all grants from the Union Government to the
state governments/Union territories/other bodies as
revenue expenditure, even if they are used to create
assets. Such assets created by the sub-national
governments/bodies are owned by them and not by
the Union Government. Nevertheless they do result
in the creation of durable assets.

 The Fiscal Responsibility and Budget Management Act,

2003 (FRBMA) is an Act of the Parliament of India to
institutionalise financial discipline, reduce India's fiscal deficit,
improve macroeconomic management and the overall
management of the public funds by moving towards a balanced
 The main purpose was to eliminate revenue deficit of the
country (building revenue surplus thereafter) and bring down
the fiscal deficit to a manageable 3% of the GDP by March
2008. However, due to the 2007 international financial crisis,
the deadlines for the implementation of the targets in the act
was initially postponed and subsequently suspended in 2009.
Targets and fiscal indicators

 Revenue deficit
– Date of elimination – 31 March 2009 (postponed from 31 March
– Minimum annual reduction – 0.5% of GDP
 Fiscal Deficit
– Ceiling – 3% of the GDP by 31 March 2008
– Minimum annual reduction – 0.3% of GDP
 Total Debt – 9% of the GDP (a target increased from the
original 6% requirement in 2004–05)
Fiscal Indicators

 Four fiscal indicators to be projected in the

medium term fiscal policy statement were
proposed. These are,
 Revenue deficit as a percentage of GDP,
 Fiscal deficit as a percentage of GDP,
 Tax revenue as percentage of GDP and
 Total outstanding liabilities as percentage of
 In 2011, given the process of ongoing
recovery, Economic Advisory Council publicly
advised the Government of India to
reconsider reinstating the provisions of the
FRBMA. N. K. Singh is currently the
Chairman of the review committee for Fiscal
Responsibility and Budget Management Act,
2003, under the Ministry of Finance (India),
Government of India.
NK Singh Committee

 The Committee advocated fiscal deficit as the

operating target to bring down public debt. For fiscal
consolidation, the centre should reduce its fiscal
deficit from the current 3.5% (2017) to 2.5% by 2023.
 The Committee also recommends that the central
government should reduce its revenue deficit
steadily by 0.25 percentage (of GDP) points each
year, to reach 0.8% by 2023, from a projected value
of 2.3% in 2017.
 The debt to GDP ratio should fall to 38.7% in 2023
from the current level of 49.4% in 2017-18
Ways and Means Advances:

 These are temporary advances (overdrafts)

extended by RBI to the govt.
Objective - to bridge the interval between
expenditure and receipts. They are not a sources of
finance but are meant to provide support, for purely
temporary difficulties that arise on account of
mismatch/shortfall in revenue or other receipts for
meeting the govt. liabilities. They have to be
periodically adjusted to enable use of such financing
for future mis-matches.

 When did it start ? On March 26, 1997,

Govt. of India and RBI signed an agreement
putting the ad hoc T-bills system to end w.e.f
April 1, 1997.
 It has been decided, in consultation with the
Government of India, that the limit for Ways
and Means Advances (WMA) for the first half
of the financial year 2017-18 (April 2017 -
September 2017) will be at ₹ 60,000 crore.
 The Reserve Bank may trigger fresh
floatation of market loans when the
Government of India utilises 75 per cent of
the WMA limit.
 The Reserve Bank retains the flexibility to
revise the limit at any time, in consultation
with the Government of India, taking into
consideration the prevailing circumstances.
 The interest rate on WMA/overdraft will be:
 WMA: Repo Rate
 Overdraft: Two percent above the Repo Rate
 The minimum balance required to be
maintained by the Government of India with
the Reserve Bank of India will not be less
than ₹ 100 crore on Fridays, on the date of
closure of Government of India's financial
year and on June 30, i.e., closure of the
annual accounts of the Reserve Bank of
India and not less than ₹ 10 crore on other
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
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
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

 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
 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