21 Fiscal Policy

Deven Mahajan

1.  Learning Outcome:

After completing this module the students will be able to:

Understand the concept of Fiscal Policy in India Describe the objectives of Fiscal Policy in India .Learn the basics of Fiscal Policy in India Interpret the terminology related to Fiscal Policy in India

2.  Introduction

The government policy related to public debt, public expenditure and taxation is called Fiscal Policy. Fiscal Policy is the aggregate demand curve shift due to tax uses, government transfers or goods and services purchases by government. As per Keynes in the thirties through fiscal measures the government can influence business activities. Fiscal Policy or Budgetary Policy is the most important instruments through which government intervenes in the economy. This is an important tool to combat recession, inflation and to accelerate the economic growth. There are alterations in taxation and spending policies of the government through the legislation.

2.1 Expansionary Fiscal Policy is the Fiscal Policy when aggregate demand is increased by the government through tax cuts to increase disposable income of consumers and it is used in the time of recession.

2.2 Contractionary Fiscal Policy is the Fiscal Policy when there are efforts of the government to decrease aggregate demand by decrease of disposable income of consumers and taxes are increased to combat inflation.

3. Definition of Fiscal Policy

Some definitions of fiscal policy are as follows:

3.1 As per G. K. Shaw “we define fiscal policy to include any design to change the price level, composition or timing of government expenditure or to vary the burden, structure of frequency of the tax payment”.

3.2 Otto Eskstein defined fiscal policy as “changes in taxes and expenditure which aim at short run goals of full employment price level and stability”.

3.3 Harvey and Johnson defined fiscal policy as “changes in government expenditure and taxation designed to influence the pattern and level of activity”.

4.    Objectives of Fiscal Policy

The governments all over the world formulate the fiscal policy to attain objectives of welfare state establishment, foreign trade promotion, full employment achievement, promotion of investments which are socially desirable, to achieve rapid economic development and income inequality reduction.

4.1         Growth preference of economy

Mainly two types of growth performance increased by fiscal policy. Firstly through resource mobilization growth is influenced, secondly resource allocation efficiency improved and it influences growth. For resource mobilization tax efforts are well done in India. Although government has to show some will as agricultural income is outside the purview of tax. If entire black money converted into white then India’s growth will be boosted and more jobs will be created for educated youth. Generation of non tax revenue, current government expenditure restriction and public sector enterprises surplus raising are other important aspects of resource mobilization. In India special incentives are provided to encourage investment in specific areas like housing for savings through fiscal policy. Inability to prevent growth black money in India is failure of fiscal policy. Due to tax evasion government has suffered heavy losses and black money quantified as a result. There is savings lower down due to black money generation as consumption is on luxury services.

4.2 Fiscal policy and allocation efficiency

Through allocation of resources fiscal policy influences growth performance. Tax policy is most important determinant of efficiency. At central government level customs and excise duties and at state level sales tax or VAT play an important role. Through restrictive controls by customs duties, protection is provided to a number of industries in recent years. Although as per recommendations of Challiah committee, import duties lowered down and unwarranted protection to industries is withdrawn.

4.3 Fiscal Policy to Mobilize Resources

Budget is the complete picture of the government for the year related to estimated expenditures and receipts. It includes the previous two years budget figures. Actually in a budget, figures of three years are included i.e following year budget estimates, current year revised and budget figures, proceeding year actual figures. For instance 2015-16 budget estimates includes: Year 2013-14 actuals, 2014-15 revised, budget figures and 2015-16 budget estimates.

4.4 Social Justice to the People

In a developing country to accelerate economic development taxation system, expenditure of Government and borrowings play a vital role. There are vast human and material resources in an economy which are underutilized. Such types of countries are lacking in communication and transportation system, roads connectivity, irrigation and power etc.which means they have a weak infrastructure. Hence for economic growth resources need mobilization, especially in the public sector. There should be incentives to save and invest so as to promote economic growth through private sector. To ensure price stability inflation pressure controlled and there must be fair distribution of income and wealth in the economy. Main objectives of fiscal policy in India are to ensure social justice to the people and to improve growth preference of economy.

5. Techniques of Fiscal Policy

Public taxation, public expenditure, deficit financing and public debt and are means and techniques of fiscal policy.

5.1 Public Taxation Policy

The taxes are levied by state and central governments both. There are two types of taxes i.e. direct and indirect. The direct taxes are imposed on corporate and individuals and are major part of revenue of the government. On capital goods, transfer of income, wealth property direct taxes are imposed whereas excise duty, service tax, customs duty, Value Added Taxes (VAT)form part of indirect taxes. The purpose of taxes is not only collection of revenue but it also brings down income and wealth inequalities, prevents wealth concentration and diverts capital to desirable sectors.

5.2 Public Expenditure Policy

The expenditure of the government may be capital or revenue in nature. Developmental and non developmental expenditure is another classification of government expenditure. There may be state or central level expenditure. The expenditure on social and community services, economic services is developmental expenditure. Whereas non developmental expenditure is expenditure on defence, interest payments and pensions etc Non plan expenditure is rising in the last few years which include expenditure on defence, payment of interest, general services and subsidies which form large part of non plan expenditure. Over the years due to public debt growth and other liabilities central government tax burden is bound to increase. Due to growing tensions with Pakistan and China defence expenditure is increasing. Subsidies are given by central government on food, fertilizers which become important part of expenditure. The expenditure on collection of tax, police pensions etc. rising every year due to wage hikes. The central government also grants assistance to state governments and union territories for natural calamities.

Although central government has main objective of economic development for establishment of welfare state. Still defence expenditure has grown over the years. For development and other needs interest payments has become bigger item of expenditure due to borrowings from markets, financial institutions and banks for developmental purposes. Although interest payments which are part of debt services is under non plan expenditure. This has good contribution to economic development of country.

5.3 Deficit financing Policy: When government for public sector plan in a developing economy fails to mobilize resources from external and internal domestic sources, the deficit financing becomes a necessity. Alternatively government can slash demand for investible funds by cutting size of plan, although it may affect growth. Hence a choice has to be made between inflationary price and lower growth rate in a developing economy. Obviously lower growth rate bigger evil as compared to price rise.

5.3.1 Deficit Financing: There was a gap in overall budget up to mid 1980’s between expenditure and receipts together in capital and revenue accounts. Deficit financing in India is used to fill this gap and borrowings availed from Reserve Bank of India against issue of treasury bills and accumulated cash balances used. Government transfers its securities to Reserve Bank of India when borrowings made from RBI then securities transferred to bank and more notes issued, circulated on behalf of government.

5.3.2 Deficit financing consequences: In a developed economy during depression phase deficit financing play an important role. General public and banks don’t undertake investment risk and level of expenditure comes down and idle cash balance is preferred .Due to deficiency in aggregate demand there is lack in incentive to produce, although capital equipment and machinery is available. Level of effective demand may increase through deficit financing by government which pumps additional purchasing power in the economy. The unused capital equipment and machinery will come into operation to meet the demand. Accordingly production level will increase if in relation to aggregate spending level production level increased there will be no generation of inflationary tendencies. There are different conditions in underdeveloped countries, because capital equipment is built up there as it does not exist already. As a result of deficit financing there is increase in purchasing power of people as new money created, but simultaneously goods production is not increased. There is a time lag between consumer goods availability and generation of extra purchasing power. Food consumption level is low due to poverty of masses. Hence on increase in income first priority is to spend more on consumption of food. In short time food supply can’t be increased. Although by adopting new agriculture techniques and implementation of land reforms supply can be increased in the long run. Hence price rise will be there as demand for food items will be high as compared to supply. Food price rise is a signal for other items price rise in a developing economy. The inflationary impact may be restricted if additional created money supply is matched with increased amount of consumption goods and deficit financing resources used for consumption goods production. Although in a developing economy main task is not to increase consumption goods output but is capital equipment building, build up thermal and hydraulic power plants, railway tracks and communication facilities etc.Hence deficit financing extra money generation is spent on these projects. In near future consumer goods increase will be less and it would raise inflation level.

5.4 Public debt of India: Government also raises debt like institutions and individuals. Public debt may be in the form of internal debt and external debt .These debts which are meant for public use are also called government debt. Like other governments Indian Government has been borrowing with certain conditions and limits. The debt raised may be internal or may be external. Loans raised from foreign governments and bodies are external debt whereas internal debt is in the form of treasury bills, special securities issued to Reserve Bank of India and market borrowings. During British times the borrowings were for war purposes. But during post independence period in India borrowings are made for economic development. In the initial stages borrowings were for financing of developmental schemes. Later government was forced to borrow for current revenue expenditure. In addition to public debt Government of India raises funds from general public through provident fund and small saving schemes etc.

5.4.1 State’s Public Debt Crisis: In the last few years state governments are unable to undertake certain necessary expenditure on social activities due to heavy public debt and large interest payments. State governments are forced to pay high rates of interest and unable to maintain infrastructure, public health, sanitation, education and other services. State government’s expenditure on salaries and pensions increasing which is highly responsible for state’s public debt. When state governments raise funds from international bodies like World Bank, Asian Development Bank (ADB) they are charged higher interest rates as compared to central government. State’s power to borrow from commercial banks, financial institutions and markets are also curtailed by central government. Hence growing debt burden of central and state governments is a serious concern. There is a suggestion that central government should raise loans by itself and disburse them to states as per their requirements .As loans and funds to central government are available at low rates.

6. Centre Government’s Revenue and Expenditure

6.1 Central Government Expenditure: Revenue expenditure of central government has been increasing tremendously .Central government revenue expenditure before 1987-88 was classified into three types : (1)Civil expenditure, in which economic services ,social and community services, grants-in-aids for developmental purposes to the union territories and states were included.(2)Central government defence expenditure is related to armed forces and retired armed persons pensions

(3)Central government other expenditures which are related to taxes and duties collection ,pension and retirement benefits, interest payments and other grants to states etc.A new classification was given to central government budget from 1987-88.As per this classification public expenditure is of two types i.e. non plan and plan expenditure.

6.1.1 Non Plan Expenditure: Non plan expenditure is divided into revenue expenditure and capital expenditure. The revenue expenditure financing is done by revenue receipts i.e. tax and non tax revenue.

6.1.1.1 Revenue expenditure: Revenue expenditure includes the following: a) Revenue expenditure on defence services, subsidies for food, fertilizers etc., other subsidies like debt relief to farmers, pensions, police, and general services for tax collection, external affairs and interest payments etc.(b)Agriculture,transport,communication,power,science and technology etc. are included in economic services.(c)Social services i.e. health and education etc.(d)Grants to foreign governments, states and union territories. Items like public enterprises loans, foreign government loans, capital expenditure on defence and loans to union territories and state governments.

6.1.1.2 Capital Expenditure: Capital expenditure includes defence capital expenditure, general services capital expenditure, social and community development capital expenditure, capital expenditure on economic development, for the financing of plan project loans to union territories and loans to foreign governments.

6.1.2 Plan Expenditure: Planned expenditure is another important expenditure of central government and composes of: (a) Central plan on irrigation and flood control, industry, energy, agriculture, rural development, science and technology, environment and social services etc. (b) Assistance for plans of central government to union territories and states.

6.2 Central Government’s Revenue Receipts

Like other countries the central government revenue in India is rising. Per capita income, national income and government revenue sources growth are the reasons for this trend. Tax receipts are increased in combined. Although central government revenue is rising fast as compared to state government revenue due to the reason that taxes imposed by central government i.e. excise duties, corporation tax, custom duties and excise duties are productive highly and even are elastic in nature. Central government’s personal income tax at one moment of time was most important single tax of the government followed by custom duties. In the present era corporation tax is most important source of revenue which is followed by central excise duties, personal income tax and custom duties.

6.2.2 Central government’s Capital receipts

Central government’s capital receipts include non market borrowings i.e. gross borrowings less repayments, state governments ,union territories and public sector enterprises loans net recoveries, net small saving collections and other capital receipts which includes special deposits and provident funds.

6.3 Central Government Expenditure Trends

Public expenditure trends in India are changing after independence because of planning and welfare state objectives of the government. Before independence public expenditure was comparatively small .Due to world war public expenditure increased. There was a rapid increase in public expenditure of the government after post war period due to introduction of planning provision for welfare services. Defence and civil administration of the country were the motives of British Government before independence. Hence these services comprises of large part of expenditure of central and state governments at that time. After independence developmental expenditure has increased due to economic growth objective and due to security reasons defence expenditure is also rising. Democratic institutions working like parliament, defence commitments, administration expansion, international commitments of government, nation building activities like health and education has increased revenue expenditure of central government.Non developmental expenditure comprises of large part of total expenditure which includes administrative expenses, debt services and defence services which keeps non developmental expenditure to be high.

6.4 Revenue Account or Revenue Budget In India budget is divided into two parts i.e. revenue account or revenue budget and capital account or capital budget. The taxation receipts, receipts from non tax sources and expenditures out of these sources are dealt in Revenue Budget of Central Government. The tax revenue comprises of income and expenditure taxes, property taxes, commodity and service taxes. Non tax revenue includes: current coinage and mint, dividends, receipts from interest and other non tax revenues. The revenue expenditure is related to economic services like trade, transportation, agriculture and industry; community and social services like medical, public health, education etc.; general services like judiciary, police and defence etc.

7.  State Government’s Revenue and Expenditure

7.   1 State Government’s Revenue Expenditure

States are required to maintain law and order situation and in addition have to involve in activities for nation building like public health, medicine, irrigation, agriculture and education etc. Welfare state building is main motive of state governments. Hence agriculture and industrial productivity is required to be increased and needs of poor people are kept in mind. Ultimately there is an increase in expenditure of the states.

7.1.1 Non Developmental Expenditure of States

This expenditure of the states is in the form of pensions and miscellaneous general services, administrative services, interest payments related to debt raised and fiscal services which comprises of collection of taxes and duties. Police, judiciary and jails are the matters related to internal security and is responsibility of state government. There may be problems in states due to communal distrabrances, industrial disputes etc. Hence special police forces are set up to deal with law and order issues. Non developmental expenditures like pensions is another state expenditure. For district administration funds are also utilized by state governments.

7.1.2 Developmental Expenditure of States

It may be an expenditure on social and community services which may be related to education, public health, family planning, natural calamities and social security etc.On front of economic services the expenditure of state may include irrigation, rural and community developmental projects,industries,minerals and agriculture etc.

7.2 State Governments and Current Revenue

So as to meet the revenue expenditure the revenue is collected by state governments in India. It may be in the form of state’s own taxes, contributions and grants-in-aid from central government and non tax revenue of the states. State’s tax revenue consists of two parts :(1) States taxes revenue which is composition of taxes on income, property tax, capital transaction taxes and taxes on services and commodities (2) central taxes share.Non tax revenue of states is in the form of receipts from interests, profits, services of general nature like state lotteries, social and economic services. State governments depend upon central government for their share of taxes. In addition state governments on the basis of recommendations of finance commission receive grants from central government. Grants are for centre plan schemes and state plan schemes consisting of grants of non plan nature, natural calamities grants and statutory grants.

7.3 Income from State’s Taxes

7.3.1 Professional tax and tax on agriculture income are revenue generation sources for state governments in form of taxes. These are the taxes levied and imposed by state governments.

7.3.2 Tax revenue generation of states is also from property and capital transactions. These may be in the form of land revenue which varies from state to state. Although due to failure of crops, production in some areas land revenue may be waived off. There is an inequitable distribution of land revenue as it falls heavily on small farmers as compared to bigger landlords.

7.3.3 On transfer of property registration fees and stamp duty occupy a major position and it is increasing day by day due to property dealings in large. Although to escape stamp duty the property transactions are undervalued .By some state government’s urban immovable property is also charged to tax.

7.3.4 On commodities and services, taxes of the state governments may be there. The commodity taxes may be in the form of excise duties of states, motor vehicles tax, environment tax, electricity duty and VAT etc.In case of state sales tax which is replaced by Value Added Tax (VAT) is important source of revenue. On sales and purchases of goods the state governments have been given power during interstate trade but these tax proceeds are retained and collected by states in which interstate goods movement commences. On alcoholic liquors, narcotics etc. excise duty is levied by state governments. These duties are charged when drugs are produced in state or from other state these enter into the jurisdiction of state. From one state to another state these duties vary. In some state there is prohibition of liquor and these states lose heavy revenue in the form of these duties. Additional excise duties are charged at special rates on sales of goods during interstate trade i.e. fabrics, tobacco, and sugar etc.During movement of goods in interstate trade taxes are collected and retained by state governments.

7.4 State Governments Revenue Trends

After independence states were no so responsible in the financial receipts and expenditure matters.RBI converted payments to states in form of loans due to huge imbalances which were earlier created by state governments as they were highly dependent on centre for resources. With the passage of time there is an increase in state government’s revenue like central government. Funds requirements of states have increased due to population increase and responsibilities enhancements. Hence old taxes are raised with imposition of new taxes. Service tax and commodity tax is important tax revenue of state governments. Certain taxes are shared in between central and state governments although collected and imposed by central government.

8. Limitations of Fiscal Policy

Fiscal Policy has achieved a great success in developed countries but in developing countries a partial success has been achieved by fiscal policy .Fiscal policy in developing countries has certain limitations.

A successful fiscal policy cannot be implemented due to a narrow and rigid and defective tax structure in India. A well integrated taxation policy can be helpful for the growth.

There is inadequate information of statistics related to expenditure, income. employment and income etc. Hence it is difficult to formulate a realistic fiscal policy.

For proper implementation of fiscal policy general public cooperation is required. But people are not in a position to understand the importance of fiscal policy as majority of the people is illiterate.

Fiscal policy is not properly implemented as people adopt tax evasion and government is not in a position to collect proper funds for implementation of development programs.

Due to different political parties fiscal policy move in different direction and welfare of people is ignored as parties have their own agendas to complete.

In India fiscal policy has failed to reduce the inequality in distribution of income and wealth due to tax evasion by the people.

Fiscal policy in India has failed to control inflation as public expenditure on non developmental activities and deficit financing has raised demand pull inflation and due to indirect taxes cost pushinflation is promoted.

9. Summary

Planning commission in seventh plan mentioned that through fiscal policy government creates and sustains public economy consisting of provisions of public services and public investment, at some time it is an instrument for reallocation of resources according to national priorities, redistribution, promotion of private savings and investment, maintenance of stability. By means of fiscal policy social justice is ensured to the people and growth preference of economy is improved. Fiscal policy is an important instrument through which government promotes economic development. In the era of rapid economic development developing economies may suffer from capital deficiency. Hence capital formation needs more emphasis which requires more savings. Hence it may be concluded that since independence central government expenditure is affected by two factors i.e. make a pace of economic development in the country and keep the security concerns up to date. Although in the recent years general administration and subsidies constitutes a good part of central government expenditure.

Learn More

Few important sources to learn more about Fiscal Policy:

1. Ahuja,H.L. (2013),Modern Economics,17th ed.,New Delhi: S Chand and Co. Pvt. Ltd.
2. Ahuja,H.L. (2014),Macroeconomic Theory and Policy New Delhi: S Chand and Co. Pvt. Ltd.
3. Ashwathapa,K. (2011),Essentials of Business Environment,Text,Cases and Exercises , 11th ed.,Mumbai: Himalaya Publishing House.
4. Cherunilam Francis (2012),Business Environment,Text and Cases ,21st ed.,Mumbai: Himalaya Publishing House.
5. Datt, Gaurav, Ashwani Mahajan (2014), Datt and Sundharam Indian Economy, New Delhi: S Chand and Co. Pvt. Ltd.
6. Dwivedi,D.N. (2010), Macroeconomics Theory and Policy, 3rd ed., New Delhi: Tata McGraw Hill Education Pvt. Ltd..
7. Fernando,A,C., (2013),Business Environment, 3rd  ed.,New Delhi: Pearson.
8. Puri,V.K.,S.K. Misra (2013), Indian Economy, 31st ed., Mumbai: Himalaya Publishing House.
9. Saleem ,Shaikh. (2010),Business Environment ,2nd ed.,New Delhi: Pearson.
10. .jafarsayyid.blogspot.com/…/business-environment..
11. www.vpmthane.org/…/Module%20II,II…
12. www.csub.edu/…/2011/…/chap011.pdf
13. en.wikipedia.org/wiki/Fiscal_policy
14. www.investopedia.com/terms/f/fiscalpolicy.asp

Points to Ponder

1. Meaning of Fiscal Policy.
2. Objectives of Fiscal Policy.
3. Fiscal Policy related terminology