Fiscal policy refers to the expenditure a government undertakes to provide goods and services and to the way in which the government finances these expenditures. Fiscal policy of a country is concerned with government’s expenditure and revenue. Fiscal policy decides on the size and pattern of flow of expenditure from the government to the economy and vice versa. Thus it is important to realize that changes in fiscal policy affect both aggregate demand and aggregate supply.
Objectives of fiscal policy in India
The major objectives of fiscal policy are as follows
- Resource mobilization and their efficient allocation
- To reduce income inequalities through progressive taxation
- To control inflation
- To facilitate balance regional development
- Employment generation
- Capital formation and growth in national income
- To allocate resources for social and developmental objectives
- To reduce Balance of Payment deficits
Tools of fiscal policy
The three tools related to fiscal policy are:
- Public expenditure
- Government borrowings
- Income of the government
1. Public Expenditure
Public expenditure is incurred in the form of purchases of goods and services, transfer payments and lending. The public expenditure incurred by the government is divided under two heads i.e. Plan Expenditure and Non Plan expenditure.
The Five year plans in the country assign the resources for the Plan expenditure. The plan expenditure is developmental in nature. Plan expenditure refers to the expenditure incurred by the Central Government on Programs/Projects, which are recommended by the Planning Commission.
Non Plan Expenditure
According to the ministry of finance non-Plan expenditure is a generic term, which is used to cover all expenditure of Government not included in the Plan expenditure. It includes both developmental and non-developmental expenditure. Part of the expenditure is obligatory in nature e.g. interest payments, pensionary charges and statutory transfers to States. A part of the expenditure is an essential obligation of a State, e.g. Defense and internal security. Expenditure on maintaining the assets created in previous Plans is also treated as Non-plan expenditure.
2. Government’s Income
The revenue earned by government can be categorized under two heads i.e. tax and non-tax revenue. The, other chief elements which are included in the concept of public receipts but excluded from that of public revenue, are receipts from public borrowings and from the sale of public assets.
A tax is a compulsory charge imposed by a legitimate public authority. A tax is a compulsory contribution imposed by a public authority, irrespective of the exact amount of service rendered to the tax payer in return, and not imposed as a penalty for any legal offence. The taxes could be classified on various aspects like:
- Direct and Indirect Tax: Direct taxes are those taxes which are non-transferable and have to be borne by the persons/entities on which they are imposed. The examples of direct tax are Income Tax, Corporation Tax, Capital Gains Tax, Estate Duty, Gift Tax, and Wealth Tax. On the other hand indirect taxes are those which could be borne partially or fully by the persons/entities other than on which they are imposed. The examples of indirect tax are sales tax, VAT etc
- Progressive Tax and Regressive Tax: Progressive tax in that tax in which tax rate is directly proportional to the income levels. The income tax in India is progressive in nature. The purpose of progressive tax is to bridge the gap of income inequalities in the society. The regressive tax is opposite to that of progressive where tax rate is inversely proportional to the income levels.
- Ad valorem and specific duty: Ad valorem refers to the kind of taxation which is levied as per the value of a commodity. However specific duty is charged as per some attribute of the commodity for instance length etc.
Non Tax Revenue
The non-tax revenues of the Union Government include
(A) Administrative receipts: This refers to the interest payment on loans received by the Central government on the loans given to the states.
(B) Net contribution of
- Public sector undertaking
- Posts and Telegraphs
- Currency and mint
(C) Other revenues which include revenue from forests, opium, irrigation, electricity and dividends due from commercial and other undertakings.
(D) Fees are another important source of revenue for the government. The government provides certain services and charges certain fees for them. For example, fees are charged for issuing of passports, driving licenses, etc.
(E) Fines or penalties
3. Public Debt
A welfareist state wants to provide a great deal of goods and services to its people. To provide these goods and services the government requires mobilization resources. While not having the immediate revenue to fund that expenditure through tax and non tax revenue sources, the government can turn to the capital markets to borrow the necessary money. Borrowings could be from the Reserve Bank of India (RBI), from the public by floating bonds, financial institutions, banks and even foreign institutions. Borrowing from capital market is done primarily by issuing securities, either Treasury Bills or Treasury Bonds.
The fiscal deficit is the difference between the government's total expenditure and its total receipts (excluding borrowing). When the government fails to match its expenses with what it earns and thus has to resort to deficit financing. Fiscal deficit is a measure of borrowings by the government in a financial year.
Fiscal deficit- The two sides of the coin
According to economist like Keynes the increase in public expenditure will act as a stimulus for the growth. Thus economist like Keynes have advocated small fiscal deficit. According to Keynes rise in public expenditure would create demand which would result into the growth.
Logically, there are two ways in which the fiscal deficit can be reduced — by raising revenues or by reducing expenditure. Given the character of our State and the constraints of a liberalized economy, the government has not increased revenues. The main impact of the policy of reduced fiscal deficits has therefore been on the government's expenditure. This has had a number of effects. First, government investment in sectors such as agriculture has been cut. Secondly, expenditure on social sectors like education, health and poverty alleviation has been reduced leading to greater hardship for the unprivileged sections in the society.
There is other side of the coin as well. If we incur fiscal deficits together with revenue deficits, it means we are using up borrowed resources for current consumption which may raise growth in the short term, but on the virtue of our future earnings.
The rise in public expenditure also results in the increase in money supply in the economy which can result into inflation. However the fiscal deficit is not the only cause of inflation. During the late 1990s the rate of inflation has fallen even when the fiscal deficit was as high as 5.5% of GDP. Likewise in the recent past (2008-10) the inflation was high irrespective of the fact that the fiscal deficit was under control.
Fiscal deficit results into increase in debt and interest obligations. As a result a large share of public resources goes for meeting debt obligations thereby leaving that much less for desirable expenditures such as physical infrastructure (e.g.: roads, power) and social infrastructure (e.g.: education, health).
Thus when the fiscal deficit is seen as an instrument to augment the growth the following crucial aspects are need to be addressed:
- There should be no revenue deficit
- Quality of fiscal deficit: It is very important to choose the sectors in which the borrowed money is utilized. It must be keep in mind that the fiscal deficit would result in growth only if the borrowed money is spent in the productive works like producing human capital, physical capital (infrastructure) etc. On the other hand fiscal deficit used in non productive purposes would be counterproductive.
- The time lag: There is always the time lag between the pumping of money in the economy (deficit financing) and the point at which it start showing the effects. The smaller is the time lag, better it id for the economy.
- Ideally, the yield on investment on borrowed funds must be higher than the cost of borrowing.
Fiscal Responsibility and Budget Management Act (FRBM)
The FRBM Act was enacted by Parliament in 2003 in order to institutionalize the fiscal discipline. The following were the major features of the act:
- This act imposes limits on fiscal and revenue deficit.
- As per the target, revenue deficit, which is revenue expenditure minus revenue receipts, have to be reduced to nil in five years beginning 2004-05.
- Each year, the government is required to reduce the revenue deficit by 0.5% and fiscal deficit by 0.3% of the GDP.
- The fiscal deficit is required to be reduced to 3% of the GDP by 2008-09.
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. As a result, the fiscal deficit doubled to that of the target i.e. 6% of GDP during 2008-09, the revenue deficit is nowhere near being eliminated as envisaged by the Act.
In 2011, given the process of ongoing recovery, Economic Advisory Council publicly advised to reconsider reinstating the provisions of the Act.
Proposed amendments in the FRBM Act
There is the demand to have a cushion in FRBM Act to make it flexible to meet the unforeseen contingencies. This demand has come as a result of the ongoing debt crisis in Europe and soaring oil prices due to the turmoil in Middle East.
The logic behind the demand is that the fixed and rigid targets as envisaged by FRBM Act are impossible to achieve in certain exceptional situations like recession etc. Therefore the government should have the flexibility of not binding to the rigid targets in the contingencies, however otherwise these targets should be a binding on the government.
Some terms related to Fiscal Policy
Components of Budget: There are two components of union Budget i.e. it comprises of the revenue budget and the capital budget.
- Revenue Budget: The revenue budget consists of revenue receipts of the government (revenues from tax and other sources), and its expenditure. It includes day to day expenditure and income of the government like interest on debt, challans etc
- Capital Budget: The capital budget is different from the revenue budget as its components are of a long-term nature. Capital receipts are government loans raised from the public, government borrowings from the Reserve Bank and treasury bills, loans received from foreign bodies and divestment of equity holding in public sector enterprises etc. Capital payments are capital expenditures on acquisition of assets like land, buildings, machinery, and equipment. Investments in shares.
Budgetary Deficit: Budgetary Deficit is the difference between all receipts and expenditure of the government, both revenue and capital.
Revenue Deficit: Revenue deficit refers to a condition when the revenue expenditure of the government is more than the revenue receipts.
Primary Deficit: It is the deficit which is derived after deducting the interest payments component from the total deficit of any budget. Mathematically, it is Fiscal deficit minus the interest payments.
Monetized Deficit: Monetized deficit is when the government prints money to pay down the deficit. As a result of this, the economy gets monetized or the money supply increases in the economy.
Twin Deficit: Twin deficits refer to a situation where an economy is running both a fiscal deficit and also a deficit on the current account of the balance of payments.
Laffer curve: Laffer curve is a theoretical representation of the relationship between government revenue raised by taxation and all possible rates of taxation.
Zero Based Budgeting: In traditional incremental budgeting, departmental managers justify only variances versus past years, based on the assumption that the "baseline" is automatically approved. Zero based budgeting is a method of budgeting in which all expenses must be justified for each new period. Zero-based budgeting starts from a “zero base” and every function within an organization are analyzed for its needs and costs every year.
Outcome Budget: It means a qualitative exercise under which qualitative impact of expenditure incurred on a certain project has to be assessed. For instance if through a scheme some amount of money is spent, the outcome budget would measure to what extent the scheme has produced the outcomes or the impact on the society.