ECONOMIC AND SOCIAL ISSUES (ESI)

CHAPTER
FISCAL POLICY

SUMMARY SHEET

FOR RBI GRADE B AND NABARD GRADE

A/B 2019

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1 What is fiscal Policy?
Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor
and influence a nation's economy. It is the sister strategy to monetary policy through which
a central bank influences a nation's money supply. These two policies are used in various
combinations to direct a country's economic goals.

2 Objectives of Fiscal Policy:

• To maintain and achieve full employment.
• To stabilize the price level.
• To stabilize the growth rate of the economy.
• To maintain equilibrium in the Balance of Payments.
• To promote the economic development of underdeveloped countries.

3 How does the fiscal policy work?

The fiscal policy is used by the government to effectively utilize the money.

The governments can influence macroeconomic productivity levels by increasing or decreasing tax
levels and public spending (Fiscal policy is based on the theories of British economist John Maynard
Keynes).

• This influence, in turn, curbs inflation, increases employment and maintains a healthy value
of money.
• The idea, however, is to find a balance between changing tax rates and public spending.

For example:
Case 1: High Expenditure and Low Revenue Collection

Stimulating a stagnant economy by increasing spending or lowering taxes runs the risk of causing
inflation to rise.

This is because an increase in the amount of money in the economy, followed by an increase in
consumer demand, can result in a decrease in the value of money - meaning that it would take more
money to buy something that has not changed in value.

Case 2: Low Expenditure and High Revenue Collection

On the other hand, when inflation is too strong, the economy may need a slowdown. In such a
situation, a government can use fiscal policy to increase taxes to suck money out of the economy.
Fiscal policy could also dictate a decrease in government spending and thereby decrease the money
in circulation.

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4 Types of Fiscal Policy:
There are three types of fiscal policy:
• Neutral
• Contractionary (restrictive)
• Expansionary

Neutral Fiscal Policy: This implies a balanced budget where (Government spending = Tax revenue).
It further means that government spending is fully funded by tax revenue and overall the budget
outcome has a neutral effect on the level of economic activity.

Contractionary (restrictive) Fiscal policy: This policy involves raising taxes or cutting government
spending, so that (Government spending < Tax revenue) it cuts up on the aggregate demand (thus,
economic growth) and to reduce the inflationary pressures in the economy.

Expansionary Fiscal Policy: It is generally used for giving stimulus to the economy i.e., to speed up
the rate of GDP growth or during a recession when growth in national income is not sufficient
enough to maintain the present standards of living. A tax cut and/or an increase in government
spending would be implemented to stimulate economic growth and lower unemployment rates.
This is not a sustainable policy, as it leads to budget deficits and thus, should be used with caution.

Budget deficit: When the government’s budget expenditure exceeds its budget revenue, it results
in budget deficit.

5 Tools of fiscal policy:

The tools of fiscal policy can be studied under two categories: Components of spending and
Components of earning.

5.1 Components of Spending:

✓ Maintenance (including staff salaries)
✓ Loan payments
✓ Subsidies
✓ Welfare schemes
✓ Wasteful expenses

5.2 Components of Earning:

✓ Tax
✓ Borrowing
✓ Proceeds from sale/lease of assets
✓ Profits from Public Sector Understandings (PSUs)

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6 Objectives of India's Fiscal Policy:

Fiscal policy of India always has two objectives, namely improving the growth performance of the
economy and ensuring social justice to the people.

The fiscal policy is designed to achieve certain objectives as follows:

✓ Development by effective Mobilization of Resources

✓ The financial resources can be mobilized by
a. Taxation: Through effective fiscal policies, the government aims to mobilize resources by way of
direct taxes as well as indirect taxes because most important source of resource mobilization in
India is taxation.

b. Public Savings: The resources can be mobilized through public savings by reducing government
expenditure and increasing surpluses of public sector enterprises.

c. Private Savings: Through effective fiscal measures such as tax benefits, the government can raise
resources from private sector and households. Resources can be mobilized through government
borrowings by ways of treasury bills, issuance of government bonds, etc., loans from domestic and
foreign parties and by deficit financing.

✓ Reduction in inequalities of Income and Wealth

✓ Price Stability and Control of Inflation
✓ Employment Generation
✓ Balanced Regional Development
✓ Reducing the Deficit in the Balance of Payment
✓ Increasing the National Income
✓ Development of Infrastructure
✓ Foreign Exchange Earnings

The fiscal policy is put forth as part of the Union Budget. In the section below, we shall have a
look at the various components of it.

7 Union (Central Budget of India):

7.1 Meaning of Union (Central) Budget of India:

• According to Constitution of India, there is three-tier system of government, namely: Central

(or Union) government, State government and Local government (like Municipal
Corporation, Municipal Committee, Zila Parishad, etc).
• Accordingly, these governments prepare their own respective budgets (called Union Budget,
State Budget and Municipal Budget) containing estimates of expected revenue and proposed
expenditure.

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 • The basic structure of government budget is almost the same at all levels of government, but
items of expenditure and sources of revenue differ from budget to budget.
• Again, there is no clash with regard to sources of revenue because functions of Central, State
and local government have been clearly demarcated and laid down in the Indian
Constitution.
• Central Government is constitutionally (As per the Article 112 of the Constitution of India)
required to lay an “annual financial statement” before both the houses of Parliament. This
statement is conventionally called Government Budget.
• Accordingly, in India, every year Central (or Union) Budget for the coming financial year is
presented by the Union Finance Minister in the Lok Sabha.
• The Government Budget is passed by the legislature and approved by the President.

7.2 How is the Budget prepared in India?

Budget preparation in India is a calculative process between the Ministry of Finance and the
spending Ministries. The Budget Division of the Department of Economic Affairs in the Ministry of
Finance is the nodal body responsible for producing the budget.

It is a combination of:

a. Top down approach with the Ministry of Finance issuing guidelines or communicating
instructions to spending Ministries, and

b. A bottom-up approach, wherein the spending Ministries plan and present requests for budget
allocation.

The Budget documents presented to Parliament comprise, besides the Finance Minister's Budget
Speech, of the following:

• Annual Financial Statement (AFS)

• Demand for Grants (DG)
• Appropriation Bill
• Finance Bill
• Memorandum Explaining the Provisions in the Finance Bill
• Macro-economic framework for the relevant financial year
• Fiscal Policy Strategy Statement for the financial year
• Medium Term Fiscal Policy Statement
• Expenditure Profile
• Expenditure Budget
• Receipts Budget

Other Budget related documents are:

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 • Detailed Demand for Grants
• Economic Survey
• Status of implementation of provisions in Finance Minister's previous Budget speech

7.3 Components of Union Budget in India:

Note: Budget 2017-18 contains three major reforms: advancement of date of presentation of
Budget (usually it used to be presented on the last day of February but this year it was presented
on the 1st day of February), merger of railway budget with general budget, Plan and non-Plan
expenditure classification was done away with.

The main benefits of these reforms are listed in the following sections of the document.

Plan Expenditure and Non-plan expenditure:

Plan expenditure is associated with productive expenditure, which increases the productive
capacity of the economy.

Non-plan revenue expenditure is accounted for by interest payments, subsidies (mainly on food
and fertilizers), wage and salary payments to government employees, grants to States and Union
Territories governments, pensions, police, economic services in various sectors, other general
services such as tax collection, social services, and grants to foreign governments.

Let us study the components one by one in detail:

The budget is divided into two parts:

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(i) Revenue Budget and

(ii) Capital Budget.

The Revenue Budget comprises revenue receipts and expenditure met from these revenues. The
revenue receipts include both tax revenue (like income tax, Central GST etc) and non-tax revenue
(like interest receipts, profits). Capital Budget consists of capital receipts (like borrowing,
disinvestment) and long period capital expenditure (creation of assets, investment).

What are receipts?

Any accrual of money from any source is called a receipt.

What are revenue receipts?

Those receipts which neither create liability nor reduce assets are known as revenue receipts.

There are 2 types of Revenue Receipts:

1. Tax revenue receipts
2. Non Tax revenue receipts

Tax Revenue Receipts are the receipts of the Government of India from direct as well as indirect
taxes.

Examples: Income tax, Corporate Tax, GST (Indirect Tax), Custom duty.

Non-Tax Revenue Receipts are the receipts that the Government receives from the following
sources:

• Dividends/profits from PSU’s

• By providing services such as power, telecommunication, etc

• GRANTS received by the government

• INTEREST PAYMENTS received by the government on the money lent by it

• By issuing challans, imposing penalties, etc

What is revenue expenditure?

• It is a kind of expenditure that neither creates assets nor reduces a liability.

• It is that expenditure that generally does not result in the creation of productive assets.

• It is usually recurring in nature.

• Also called maintenance expenditure.

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 • Examples: salaries, pensions, money spent on various social services, subsidies, INTEREST
PAID BY government on loans, GRANTS given by GOI to states and other nations.

What is Revenue deficit?

• Total Revenue Receipts – Total Revenue Expenditure
• If this number comes out to be negative, it would be called Revenue Deficit.

What are capital receipts?

• All the non-revenue receipts of the GOI.

• These are those receipts which either create liability or reduce assets.

Examples:

• Loans (Internal + External)

• Money in PPF, Small saving schemes, etc

• The above two are debt creating capital receipts

• Proceeds from disinvestment

• Recovery of principal amount of loan

• The above two are non-debt creating capital receipts

What is capital expenditure?

• It is a kind of expenditure that creates an asset or reduces a liability.

• It is usually not recurring in nature.

Examples:

• Capital expenditure on defence

• Loans given by GOI to states, etc

What is fiscal deficit?

• It is equal to (Total Revenue Receipts + Non debt Capital Receipts) – (Total Expenditure)
• If this value comes out to be negative, it would be a deficit.
• Total expenditure includes Revenue + Capital expenditure.
• It shows the amount of borrowing that the government will have to do.

Primary deficit is equal to Fiscal deficit – Interest liabilities.

Budget deficit is the excess of Total Expenditure over Total Receipts.

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Effective Revenue Deficit: Effective Revenue Deficit is the difference between revenue deficit and
grants for creation of capital assets. In other words, the Effective Revenue Deficit excludes those
revenue expenditures which were done in the form of grants for creation of capital assets.

8 What is Fiscal Consolidation?

Fiscal consolidation is a process where government’s fiscal health is getting improved and is
indicated by reduced fiscal deficit.

Fiscal consolidation in India:

• In India, fiscal consolidation or the fiscal roadmap for the centre is expressed in terms of the
budgetary targets (fiscal deficit and revenue deficit) to be realized in successive budgets.
• The Fiscal Responsibility and Budget Management (FRBM) Act gives the targets for fiscal
consolidation in India.

FRBM Act:

The Fiscal Responsibility and Budget Management Act or the FRBM Act, 2003 is an Act mandating
Central Government to ensure intergenerational equity in fiscal management and long term macro-
economic stability.

There are targets that are considered as ideal as per the FRBM Act:

According to FRBM, the government should eliminate revenue deficit and reduce fiscal deficit to 3%
(medium term) of the GDP.

9 What is Deficit Financing?

• Deficit refers to the difference between expenditure and receipts.

• In public finance, deficit financing is the practice in which a government spends more money
than it receives as revenue, and the difference is made up by borrowing or printing new
funds.
• Deficit financing can be called a necessary evil in a welfare state as it allows the state to
undertake activities that, otherwise, would be beyond its financial capacity.

9.1 Consequences of Deficit Financing:

✓ Inflation
✓ Decreased savings
✓ Inequality becomes wider
✓ Reforms in the process of Budgeting

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10 Significance of the reforms in the Budget 2017-18:

Budget for 2017-18 has removed the plan and non-plan distinction to present the budgetary
allocations in the form of constitutionally mandated and standard international norms of revenue
and capital expenditure.

• The earlier plan and non-plan distinction had resulted in a skewed pattern of expenditure
allocation. There was an excessive focus on plan expenditure.
• This also caused substantial distortion in the expenditure profile whereby important
manpower related or maintenance needs of assets, particularly in the areas of public delivery
of services were neglected.
• Expenditure commitments for any scheme/ programme of the Government were not
assessed holistically but in fragmented plan and non-plan parlance.
• As a result, it became difficult not only to assess the cost of delivery of services but also to
link the outlays with the deliverables and outcomes.
• It is expected that with the presentation of budget in the capital and revenue based
classifications, there will be efficient deployment of public resources. Policy formulation and
sectoral needs assessment will also become easier along with developing a performance-
oriented approach.
• A new consolidated Outcome Budget document is also being laid with the budget papers,
indicating scheme wise outputs and deliverables linked with the outlays along with the
anticipated medium-term outcomes.

Another major budgetary reform that has taken place in Budget 2017-18 relates to the merger of
the Railway budget with the General budget.

• The Committee constituted by Ministry of Railways under the chairmanship of Shri Bibek
Debroy, Member, NITI Aayog on restructuring of Ministry of Railways, had recommended
that the present system.

The advancement of the budget presentation by about a month to the 1st day of February in
place of the last day of the month is another budgetary reform which is expected to garner long
term benefits to fiscal performance of the Government through optimization of both expenditure
and revenue outcomes.

• Advancing the budget day would help ensure that implementation of the new schemes can
begin as soon as the financial year begins.
• It gives time to the departments and ministries to prepare for implementation and plan their
spending. This is consistent with best practices in other countries.

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11 Criticism of fiscal policy

• The government may have poor information about the state of the economy and struggle to
have the best information about what the economy needs.
• Time lags. To increase government spending will take time. It could take several months for a
government decision to filter through into the economy and actually affect Aggregate
Demand. By then it may be too late.
• Crowding out. Some economists argue that expansionary fiscal policy (higher government
spending) will not increase Aggregate Demand because the higher government spending will
crowd out the private sector. This is because the government has to borrow from the private
sector which will then have lower funds for private investment.
• Government spending is inefficient. Free market economists argue that higher government
spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult
to reduce spending in the future because interest groups put political pressure on
maintaining stimulus spending as permanent.
• Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to
higher bond yields, increasing the cost of debt repayments.

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