Chapter 5 - Government Budget and the Economy

GOVERNMENT BUDGET — MEANING AND ITS COMPONENTS

Article 112 of the Indian Constitution requires the government to present an "Annual Financial Statement" to the Parliament before each financial year (April 1 to March 31). It serves as the primary budget document, containing estimated receipts and expenditures for the upcoming year.
The government maintains two separate accounts—the revenue account and the capital account—to manage finances efficiently.
The Budget is a comprehensive economic plan that outlines the government's priorities for the year ahead. The budget also serves as a tool for managing the economy and promoting long-term growth.
The budget is a reflection of the country's economic life and plays a crucial role in shaping its future trajectory.
The Medium-Term Fiscal Policy Statement (MTFPS), Fiscal Policy Strategy Statement (FPSS), and Macroeconomic Framework Statement (MFS) are three important policy statements that complement the annual budget and provide a comprehensive framework for fiscal management in India.

Objectives of Government Budget

Allocation Function of Government Budget

Public goods are goods or services that are non-excludable and non-rivalrous, meaning once produced, it's hard to exclude others from using them and one person's use doesn't reduce availability for others. E.g., National Defense.
On the other hand, Private goods, such as food items or clothing, are characterized by rivalrous consumption, meaning that one person's consumption directly reduces the availability of the good for others. For instance, if you eat an apple, it is no longer available for someone else to consume.
This creates a challenge known as the 'free-rider problem,' where individuals can benefit from public goods without contributing to their production
Recognizing this difference is crucial for understanding how governments intervene in the economy to ensure essential services are accessible to everyone.

Redistribution Function of Government Budget

The government sector plays a significant role in influencing the personal disposable income of households through its transfer payments and taxation policies. These policies, collectively known as the redistribution function, aim to achieve a more equitable distribution of income and address economic disparities within society.
The redistribution objective of the tax system is achieved through a combination of progressive income taxation, proportional corporation tax, and differentiated excise taxes.

Stabilisation Function of Government Budget

The government plays a crucial role in stabilizing the economy and preventing or mitigating economic fluctuations, such as recessions. One of the key mechanisms for achieving this stability is managing aggregate demand, which is the total demand for goods and services in an economy.
In certain circumstances, when aggregate demand surpasses the economy's capacity, it can result in inflationary pressures. In such cases, government intervention becomes necessary to mitigate demand and manage inflation.

Classification of Receipts

Revenue receipts, categorized into tax and non-tax revenues, don't create liabilities for the government. Non-tax revenue of the central government consists of various sources other than taxes. These sources play a crucial role in supplementing the government's overall revenue and financing its various expenditures.
Capital receipts are those receipts of the government that either create liabilities or reduce the asset value of the government. Capital receipts are typically classified into two categories: debt-creating and non-debt-creating.

Classification of Expenditure

1. Revenue Expenditure

Revenue expenditure refers to the expenses incurred by the government for the normal functioning of its departments and various services, interest payments on debt, and grants given to state governments and other parties. It does not include expenditures that directly lead to the creation of physical or financial assets.
The classification of total expenditure into plan and non-plan expenditure is a historical practice in India's budget documents. This distinction has been used since the First Five-Year Plan in 1951 to differentiate between expenditures aimed at promoting long-term economic development (plan expenditure) and those related to the ongoing functioning of the government (non-plan expenditure).
The government's non-plan revenue expenditure is primarily used to cover the day-to-day operational costs of the government. Interest payments on debt are a significant component of non-plan revenue expenditure. The government is taking steps to control the growth of non-plan revenue expenditure.
The government's defense expenditure, a non-plan expenditure, is a major concern for some economists. Further, the government provides subsidies to various sectors in order to support them and make them more competitive. The amount of non-plan revenue expenditure has been increasing in recent years.

2. Capital Expenditure

Capital expenditure refers to the expenses incurred by the government that result in the creation of physical or financial assets or the reduction of financial liabilities. It is typically distinguished from revenue expenditure, which covers the day-to-day operational costs of the government.

BALANCED, SURPLUS AND DEFICIT BUDGET

A balanced budget occurs when the government's revenue is equal to its expenditure. This means that the government is not borrowing money or accumulating debt to finance its operations.
Balanced budgets are generally considered to be fiscally responsible, as they indicate that the government is living within its means.
A surplus budget occurs when the government's revenue exceeds its expenditure. This means that the government has more money than it needs to operate, and it can use the surplus to pay down debt, invest in infrastructure, or provide tax breaks. Surplus budgets are generally seen as a sign of a healthy economy.
A deficit budget occurs when the government's expenditure exceeds its revenue. This means that the government is borrowing money or accumulating debt to finance its operations. Deficit budgets are often used to stimulate the economy during times of recession, or to fund large-scale projects such as infrastructure development.

Measures of Government Deficit

Budget deficit: It occurs when government spends more than it earns in revenue, leading to borrowing or debt accumulation. For example, if a government spends Rs 100 billion but only collects Rs 90 billion in taxes and other revenue, it incurs a budget deficit of Rs 10 billion.
Revenue deficit: It represents the shortfall in revenue income compared to revenue expenditure. It shows if the government's current spending exceeds its income, indicating reliance on savings from other sectors. For example, if a government's revenue expenditure is Rs 120 billion, but its revenue receipts are only $100 billion, the revenue deficit is $20 billion.
- A persistent revenue deficit can build up debt and interest liabilities, straining finances and necessitating expenditure cuts. A large revenue deficit compared to fiscal deficit suggests heavy borrowing for consumption rather than investment.

Revenue deficit = Revenue expenditure – Revenue receipts

Gross fiscal deficit: Total expenditure minus total receipts, including both revenue and capital receipts. For example, if a government's total expenditure is Rs150 billion, and its total receipts (including revenue and capital) are Rs 120 billion, the gross fiscal deficit is Rs 30 billion.

Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts)

Non-debt creating capital receipts: Receipts that do not lead to an increase in government debt. Non-debt creating capital receipts are sources like recovery of loans or sale of PSUs that don't increase debt. It includes proceeds from the sale of government assets like public sector undertakings (PSUs) or recovery of loans given by the government.
Net borrowing at home: Government borrowing from domestic sources excluding borrowings from the Reserve Bank of India (RBI). For example, when the government issues bonds to the public or borrows from commercial banks through instruments like Statutory Liquidity Ratio (SLR).
Primary deficit: Fiscal deficit minus interest payments on accumulated debt. Primary deficit excludes interest payments, providing a clearer picture of current fiscal imbalances. For example, if a government's fiscal deficit is Rs 40 billion and its interest payments on debt are Rs 10 billion, the primary deficit is Rs 30 billion.

Gross primary deficit = Gross fiscal deficit – Net interest liabilities

Fiscal Policy

Keynesian Theory: John Maynard Keynes argued governments should use fiscal policy (spending and taxes) to stabilize the economy, not just rely on market forces.
Fiscal Policy Tools: Governments can create a surplus (tax more, spend less), deficit (spend more, tax less), or balanced budget to influence economic activity.
Government Spending (G): Increases aggregate demand, stimulating the economy.
Taxes and Transfers: Taxes reduce disposable income (YD) and potentially consumption. Transfers (welfare progarmmes by the government) have the opposite effect.
Lump-Sum Taxes vs. Constant Transfers: Lump-sum taxes (fixed amount) affect consumption less than constant taxes that rise with income. Constant transfers (e.g., welfare) improve income distribution and potentially boost consumption.
Changes in Government Expenditure: Increased government spending (G) can boost the economy (aggregate demand) but needs responsible management to avoid high deficits. Fiscal policy decisions should prioritize responsible and sustainable growth.

Changes in Taxes

Cutting taxes can greatly affect how much people spend and how the economy performs. Think of the tax multiplier like this: if taxes go up, people tend to spend less, which means less economic activity.
Compared to government spending, tax changes have a smaller direct impact on the economy because they affect how much money people have to spend.
Moreover, both tax and government spending changes play big roles in how our economy grows or slows down.
When it comes to balancing the budget, if the government spends more but also collects more taxes, it can sometimes balance out, not greatly impacting the economy.
This is because increased government spending is balanced by reduced disposable income from taxes, resulting in no net change in demand. It means when the government spends more, but we also pay more taxes, it usually balances out, so overall demand stays the same.
Tax cuts influence the multiplier process by making people to spend more because they have extra money. It also leads to more savings. Tax cuts raise disposable income, stimulating consumption and economic growth.
Proportional taxes, based on income percentage, affect consumption and multiplier effect, making fiscal policies less effective in boosting growth. Proportional income tax adjusts with the economy by taking more during good times (healtheir economy with increases income) to cool things down, and less during bad times (recession) to help boost spending, keeping the economy stable.
Fiscal policies are important for keeping the economy stable and making sure businesses invest enough. When investment goes down, the government can spend more to keep the economy steady.
Both government and private businesses help balance the economy, making sure it stays on track.
Built-in stabilizers are inherent features of the economy that automatically counteract economic fluctuations without the need for explicit policy decisions.

Built-in stabilizers examples:

Fiscal Policy: Progressive taxes (higher rates for higher incomes) automatically reduce disposable income during booms (acting as a brake). During recessions, they provide some cushion as the tax burden falls with lower income.
Transfer Payments: These payments (unemployment benefits, welfare) rise during recessions (helping consumption), and fall during booms (reducing inflationary pressures).

Note: Increased government spending on goods and services has a larger impact on aggregate demand compared to increasing transfer payments (as some transfers are saved).

Debt

Government budgetary deficits and debt are interconnected concepts that impact a nation's economy. While borrowing can finance essential expenditures, it may lead to reduced national savings, capital formation, and burden future generations.
Tax cuts and deficits can stimulate short-term consumption but may increase government debt long-term.
The Ricardian equivalence hypothesis, named after the 19th-century economist David Ricardo, proposes that government borrowing and taxation are equivalent methods of financing government expenditures.
- It suggests that consumers are forward-looking and understand that government borrowing today will lead to higher taxes in the future, causing them to adjust their consumption and savings behavior accordingly.
Deficits can potentially lead to inflation. This is because when the government increases spending or cuts taxes, aggregate demand (AD) increases. For example, if the government invests heavily in infrastructure, it creates jobs and raises incomes, leading to higher spending and potential price increases, contributing to inflation.
Increased aggregate demand (AD) can cause demand-pull inflation when the economy operates at full employment. While concerns about crowding out private investment exist, government deficits can positively impact the economy by boosting production and income. Investments in infrastructure can yield long-term benefits if returns are high.
The government aims to enhance revenue through direct taxes (more progressive than indirect taxes) and selling PSU shares, focusing on program efficiency and administration for deficit reduction.
Reforming welfare programs with options like cash transfers and targeted subsidies is suggested to alleviate poverty. Deficits are not always indicative of expansionary fiscal policy; their size depends on the economy's state. For instance, a recession can lower tax revenues, leading to larger deficits.

Fiscal Responsibility and Budget Management Act, 2003 (FRBMA)

The Fiscal Responsibility and Budget Management Act (FRBMA), enacted in 2003, marked a significant step towards fiscal reforms, establishing a framework to ensure a good fiscal policy. This is because the central government has a responsibility to ensure intergenerational equity and long-term macroeconomic stability by achieving a revenue surplus.
The government must also remove fiscal obstacles to monetary policy and ensure effective debt management by limiting deficits and borrowing.

Main Features:

The Fiscal Responsibility and Budget Management Act (FRBMA) mandates the central government to reduce its fiscal deficit to 3% of GDP by 2009 and achieve a revenue surplus thereafter.
The Act requires a gradual reduction of the fiscal deficit by 0.3% of GDP each year.
If the target is not achieved through tax revenues, necessary adjustments should be made by reducing expenditures.
The central government can only borrow from the Reserve Bank of India (RBI) for temporary cash shortfalls.
The RBI is prohibited from subscribing to primary issues of central government securities.
The FRBMA emphasizes transparency in fiscal operations.
The central government has to present three statements to both Houses of Parliament: Medium-Term Fiscal Policy Statement, Fiscal Policy Strategy Statement, and Macroeconomic Framework Statement.
A quarterly review of trends in receipts and expenditure should be placed before both Houses of Parliament.

The Fiscal Responsibility and Budget Management Act (FRBMA) applies to the central government, but 26 states have also enacted similar legislation, expanding the scope of the government's rule-based fiscal reform program.
The government views the FRBMA as a crucial institutional mechanism for maintaining fiscal discipline and supporting macroeconomic stability. However, concerns have been raised that the FRBMA's deficit reduction targets might lead to cuts in welfare spending.

FRBM Review Committee

Since the implementation of the Fiscal Responsibility and Budget Management Act (FRBMA) in 2003, India has achieved middle-income status. Despite global shifts away from fiscal rules, India continues to uphold the principles of FRBMA.
The FRBM Review Committee has been assigned the responsibility to modernize the framework to align with India's changing economic needs and foster future growth.

GST: One Nation, One Tax, One Market

The Goods and Services Tax (GST), implemented in 2017, is a single, nationwide indirect tax on goods and services in India. It is a destination-based consumption tax that allows businesses to claim input tax credit, streamlining the tax structure, and simplifying tax compliance.
By replacing multiple central and state taxes, GST has eliminated cascading of taxes and reduced overall tax burden, fostering a more unified and efficient tax system.
GST has subsumed a wide range of taxes levied by the Central and State governments, including:
1. Central Taxes: Central Excise Duty, Service Tax, Central Sales Tax, KKC and SBC Cess
2. State Taxes: VAT/Sales Tax, Entry Tax, Luxury Tax, Octroi, Entertainment Tax, Taxes on Advertisements, Taxes on Lottery/ Betting/ Gambling, State Cess on goods
3. Five petroleum products are currently not subject to GST but will be included in the future.
4. State governments will continue to levy VAT on alcoholic liquor for human consumption.
5. Tobacco and tobacco products will be subject to both GST and Central Excise Duty.
6. There are six standard GST rates: 0%, 3%, 5%, 12%, 18%, and 28%.
7. GST was made possible by the 101st Constitution Amendment Act of 2016, which amended Article 246A of the Constitution to give both the central and state governments the power to legislate on GST.
GST has standardized tax laws, procedures, and rates nationwide, streamlining compliance for businesses and eliminating interstate barriers, fostering competition and economic growth.
It reduces production costs, making Indian products and services more competitive globally, and is expected to boost economic growth by up to 2%.
With a single online portal, GST simplifies tax compliance, expands the tax base, increases transparency, and enhances ease of doing business in India.

Key Important Points

Public Goods	Goods or services that cannot be denied to anyone and whose use by one person does not affect the use by another
Automatic Stabilizer	Features of the tax and spending system that automatically counteract economic fluctuations
Discretionary Fiscal Policy	Policies that involve deliberate changes in government spending or taxation to influence economic activity
Ricardian Equivalence	The idea that government borrowing and taxation have the same impact on private spending