Fiscal and Monetary policy

Dr Anil Pande
Fiscal policy : an introduction

 Fiscal policy deals with taxation and

expenditurre of governmant
 Monetory policy deals with money supply
and rate of interest
 FP steers the broader aspects of economy
 Modern economy, governemtn deals with the
FP and Central Bank deals with monetory
policy
 Fiscal policy comprises of several parts as:
– Tax policy
– Expenditure policy
– Investment and disinvestment strategies
– Debt or surplus management
 Fiscal policy influences monetory policy
 Surplus- when government receives more
than spend
 Deficit: when government spends more than
it receives
– To meet additional expenses government has to
borrow, print notes or draw upon foreign
investment
– Excessive printing may lead to inflation
– If govt borrows leads to excessive debt
– If govt draws on foreign reserves affect on
balance of payment
 – Excessive domestic borrowing leads to high interest rates
– Combination of all above may occur in economy
 Developing economy running on large deficit is
unwise
 Also running on large surplus at cost of long term
growth is unwise
 Fisher and easterly, 1990- source

 Challenge for developing economy is to manage

infrastructure and social needs and managing govt
finances
India’s fiscal policy architecture

 Indian constitution provides a framework for

country's fiscal policy
 India, federal form of government with taxing powers
and spending responsibilities divided
 Third tier of government at local level
 Central government assigns revenue to states
 For guidance on fiscal matters, constitution provides
for formation of FINANCE COMMISSION EVERY 5
YEARS
 Constitution provides for govt to place before
a legislature a statement of its proposed
taxing and spending provisions for legislative
debate and approval
 This document is called as budget
 Central and states have separate budgets
 Issues in central govt:
– National defense, shipping, national highways, airways,
railways, post and telegraphs, trade and banking, foreign
policy , etc
 State:
– Law and order, agriculture, fisheries, water supply,
irrigation, public health
 State and central list
– Forests, economic and social planning, trade unions,
education price control, electricity, industrial dispute
 Taxes levied by central government:
– Tax on income ( except agri)
– Exise on goods produced (other than alcohol)
– Custom duties and interstate sale of goods
 Taxes by state:
– Agri income
– Land and building
– Sale of goods
– Excise on alcohol
Liberalization, growth, fiscal
consolidation (1991-tilldate)

 Balance of payment crisis results into path of

economic liberalisation
– Economy opened up for foreign investment and
trade
– Private sector encouraged for participation
– Quotas and licenses were dismantled
– Tax reform committee suggested reformation in
direct and indirect taxes
 Focus was to reduce trade tax revenue and increase
domestic consumption tax share
 Excise converted to VAT to enhance direct tax revenue
 Some recommendations by Tax Reform
Committee:
– Reducing the rate of major taxes
– Minimizing exemptions and deductions
– Simplifying laws and procedures
– Improving tax administration
– Source Rao & Rao, 2006
 Effects of tax reforms:
– Personal income tax brackets reduced
– Wealth tax gift tax removed
– Personal income tax rates reduced
– Exemption limit increased
– 2% education cess charged
– Corporate tax rate reduced 35% ??
 MAT-minimum alternative tax
 Transaction tax
 Fringe benefit tax
What is Fiscal Policy ?

 Public Revenue
 Public Debt
 Public Expenditure
What is Revenue Deficit?

 RD = Revenue Expenditure – Revenue Receipts

 Revenue Receipts -
1. Income Tax
2. Corporate tax
3. Wealth Tax
4. Service Tax
5. Custom/Import Duties
6. Excise Duties
7. CENVAT
Revenue Expenditure

 Plan Expenditure
1. Interest payments
2. Defence Revenue Expenditure
3. Subsidies
4. Postal Deficit
5. Pension
6. W/O of loans to States
7. Expenditure on social, general and economic services etc.

 Non Plan Expenditure

Budget of Central Government
Revenue Account (In crores)

Head 1950-51 1980-81 2001-02 2006-07

budget
Revenue 406 12,830 2,01,450 4,03,460
receipts
Revenue 347 14,540 3,01,610 4,88,190
Expenditure
surplus/ Deficit +59 -1,710 -1,00,160 -84,730
Revenue of Central Government
(In Crores)

Head 1950-51 1980-81 2001-02 2006-07

Budget

Tax 357 9,390 1,33,660 3,27,200

Revenue

Non -Tax 49 3,440 67,790 76,260

Revenue

Total 406 12,830 2,01,450 4,03,460

Central government-Tax Revenue
(In Crores)

Head 1950-51 2001-02 2006-07

Budget
Income Tax 140 32,000 77,410

Corporate Tax 40 36,610 1,33,010

Other Direct - 450 150

taxes
Excise Duties 70 68,530 1,19,000

Custom Duties 160 47,540 77,070

Service tax - 2,610 34,500

What is Capital Deficit?

 CD = Capital Expenditure – Capital Receipts

 Capital Expenditure
1. Non plan
 Defence
 Loans to PSU’s
 Loans to states
2. Plan Expenditure
Capital Receipts

 Borrowings of the Government

 Sale of Government stake in PSU’s
 Recovery of Loans
Capital Receipts/ Expenditure of
Central Government

1950-51 1980-81 2001-02 2006-07

budget

Capital 120 8,770 1,61,000 1,60,530

Receipts

Capital 182 9,630 60,840 75,800

Expenditure

Surplus / -62 - 860 + 1,00,160 + 84,730

Deficit
Budget Deficit, Fiscal Deficit, Primary
Deficit

 Budget Deficit = Total Expenditure – Total Receipts

 Fiscal Deficit = Total Expenditure – (Revenue

receipts + Recovery of Loans + Disinvestment
Funds) + Govt Borrowings

 Primary Deficit = Fiscal Deficit – Interest

obligations of the government

 Why Fiscal Deficit is bad?

Fiscal deficit and union budget

 FD is sum of the amount the central

government borrows and the overall budget
deficit in order to meet the excess
expenditure over receipts during a financial
year.
 It is budgetary deficit +the borrowings of the
government
Government revenue and expenditure
trends as reflected in Budget

 Revenue Deficit
 Capital Deficit
 Budget Deficit
 Fiscal Deficit
 Primary Deficit
Sources and Uses of Funds

 Source  Use
1. Corporation tax – 20% 1. Interest – 21%
2. Customs – 11% 2. Defence – 13%
3. Non tax Revenue – 11% 3. Other non plan expenditure –
4. Non-Debt Capital Receipts – 12%
2% 4. Subsidies – 7%
5. Income Tax -11% 5. Central plan -19%
6. Service & Other taxes – 5% 6. State & UT Plan assistance –
7. Excise – 18% 6%
8. Borrowings & other Liabilities 7. Non plan assistance to states –
– 22% 5%
8. States’ share of taxes – 17%
What is FRBM?

 Targets to be achieved by 2009

1. To bring down Fiscal Deficit to the level of

3% of GDP
2. To completely eliminate Revenue Deficit
Trends in Fiscal Policy

 Rationalisation of tax structure.

 Introduction of new taxes- Service tax and Securities
Transaction tax.
 Withdrawal of Estate duty and Gift Tax.
 Introduction of CENVAT and VAT.
 Control over Fiscal Deficit.
 Promotion of SEZ’s. with tax holiday.
 Discontinuing the practice of deficit financing done
by printing more currency notes.
Current account deficit
What is Monetary Policy?

 Tools of Monetary Policy

1. Cash Reserve Ratio
2. Statutory Liquidity Ratio
3. Bank Rate
4. Open Market Operation
5. Use of Liquidity Adjustment Facility via use
of Repo transactions
6. Directives of RBI
Trends in Monetary Policy

 Reduction in CRR.
 Reduction in SLR.
 More active use of open market operations.
 Use of Repo/ Reverse Repo transactions.
Use of Fiscal and Monetary policy

 Pumping up growth rate of economy

 Controlling Inflation/ Deflation/ Stagflation
 Controlling Asset Price Bubble
 Removal of inequality of income
 Removal of poverty and generation of
employment