Economy - FISCAL POLICY

Economy - FISCAL POLICY

Public Finance (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 a complimentary 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.
• Fiscal policy deals with the taxation borrowing and expenditure decisions of the government.
• Fiscal policy is an important constituent of the overall economic framework of a country and is therefore intimately linked with its general economic policy strategy.

Objectives of Fiscal Policy

• In a system of indicative planning, reliance on fiscal policy as an instrument of development is considerable.
• The Planning Commission had stated in the Seventh Five Year Plan that “Though with it the government creates and sustains the public economy consisting of the provision of public services and public investment; at the same time it is an instrument for reallocation of resources according to national priorities, redistribution, promotion of private savings and investments, and the maintenance of stability”.
• Thus, fiscal policy primarily aims at economic growth with price stability. Among other goals of fiscal policies are: capital formation, resource allocation and redistribution for mitigating inequality. It is notable that fiscal policy in a developed country is preoccupied with the problems of business cycle-boom and depression.
• But in a developing economy, tackling business cycle becomes secondary because the prime objective of such economies is capital formation through increased savings and investments in order to achieve high level of economic growth. Further, given scarcity of capital and other resources in a developing economy, it is imperative to allocate resources to various sectors of the economy and heads of development judiciously and in line with development priorities. Fiscal policy helps to achieve these goals.

Types of Fiscal Policy

Expansionary fiscal policy

• It is defined as an increase in government expenditures and/or a decrease in taxes that causes the government’s budget deficit to increase or its budget surplus to decrease. A government can adopt Expansionary fiscal policy on the following basis:
  • Government needs to borrow from domestic or foreign sources.           
  • Print an equivalent amount of money.
  • Draws upon its foreign exchange reserves

Drawbacks of this policy 

• The flipside of printing is it leads to inflation.
• If the government borrows too much from abroad it leads to a debt crisis.
• If it draws down on its foreign exchange reserves, a balance of payments crisis may arise.

Contractionary fiscal policy 

• It is defined as a decrease in government expenditures and/or an increase in taxes that causes the government’s budget deficit to decrease or its budget surplus to increase.

Neutral Fiscal Policy

• It is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

Instruments of Fiscal Policy

• Fiscal policy is carried out by the legislative and/or the executive branches of government. The two main instruments of fiscal policy are:
  • Government expenditure
  • Taxes
• The effect of government expenditures, taxation, and debt on the aggregate economy is of immense importance. The government collects taxes in order to finance expenditures on a number of public goods and services.

Government Expenditure

Public Expenditure 

• It is also known as Government expenditure which can be classified under the following heads:

1. Capital Expenditure

• These are those government expenditures which result in the creation of physical or financial assets or reduction in financial liabilities. These include:
  • expenditure on the acquisition of land, building, machinery, equipment, investment in shares, and       
  • Loans and advances by the central government to State and Union Territory governments, PSUs and other parties.

2. Revenue Expenditure

• These are that expenditure incurred for purposes of day to day expenses rather than the creation of physical or financial assets of the central government. It relates to:
  • Expenses incurred for the normal functioning of the government departments and various services;
  • Interest payments on debt incurred by the government; and  
  • Grants given to state governments and other parties.
• Both Capital and Revenue expenditure are also categorized as plan and non-plan in the budget documents.
• Plan expenditure-relates to Expenditure on Central Plans (the Five-Year Plans) and Central Assistance for State and Union Territory plans.
• Non-plan expenditure-covers a vast range of general, economic and social services of the government. The main items of non-plan expenditure are:
  • Interest payments
  • Defence services
  • Subsidies
  • Salaries
  • Pensions
• Interest payments on market loans, external loans and from various reserve funds constitute the single largest component of non-plan revenue expenditure. Defence expenditure, is committed expenditure in the sense that given the national security concerns, there exists little scope for drastic reduction. Subsidies are an important policy instrument which aim at increasing welfare.

Government Revenue

Government revenue is classified into:

1. Revenue Receipts

• These are those receipts of the government which are non-redeemable, that is, they cannot be reclaimed from the government.
• They are further divided into tax and non-tax revenues

2. Tax Revenue

• Tax Revenues consist of the proceeds of taxes and other duties levied by the central government. Tax revenues are an important component of revenue receipts and comprise of following taxes:
  • Income tax: Taxes on individual salaries and income.
  • Corporate tax: Taxes on firms and corporations.
  • Excise duties: Duties levied on goods produced within the country.
  • Customs duties: Duties imposed on goods imported into and exported out of India.
  • Service tax: Tax levied by the government on service providers on certain service transactions.
  • Wealth tax: Charged on the net wealth of the assesse. It is a tax on the benefits derived from ownership of property.
  • Gift tax: Tax on the transfer of property by one individual to another while receiving nothing, or less than full value, in return.
• The tax applies whether the donor intends the transfer to be a gift or not. Taxes like wealth tax, gift tax and estate duty (now abolished) have never been of much significance in terms of revenue yield and have thus been referred to as paper taxes.
• The advantage of the tax is that it raises money for governments.
• Critics argue that the tax will result in fewer financial transactions being made, resulting in job losses in financial centres. Others warn that the tax will mean pension funds and savers get less returns, as banks will simply pass the cost of the tax onto their customers.

3. Non Tax Revenue

• Non-tax revenue mainly consists of:
  • Interest receipts on account of loans by the central government;
  • Dividends and profits on investments made by the government;
  • Fees and other receipts for services rendered by the government; and
  • Cash grants-in-aid from foreign countries and international organisations

4. Capital Receipts

• All those receipts of the government which create liability or reduce financial assets are termed as capital receipts.
• The main items of capital receipts are:
  • Loans raised by the government from the public which are called market borrowings,
  • Borrowings by the government from the Reserve Bank of India (RBI) and Commercial Banks and other Financial Institutions through the sale of treasury bills,
  • Loans received from foreign governments and international organisations,
  • Recoveries of loans granted by the central government,
  • Small savings (Post-Office Savings Accounts, National Savings Certificates, etc), 
  • Provident funds, and   
  • Net receipts obtained from the sale of shares in Public Sector Undertakings

The functions that operate through the revenue expenditure measures of the government are: Allocation Function - Expenditure on “Public Goods”:             

• Certain goods, referred to as public goods (such as national defence, roads, government administration), as distinct from private goods (like clothes, cars, food items), cannot be provided through the market mechanism, i.e. by transactions between individual consumers and producers and must be provided by the government. This is the allocation function. Note: Public goods are  financed through the budget.

Distribution Function:  

• Government, through its tax and expenditure policy, attempts to bring about a distribution of income that is considered ‘fair’ by society.
• The government affects the personal disposable income of households by making transfer payments and collecting taxes and, therefore, can alter the income distribution. This is the distribution function.

Stabilization function:  

• The economy tends to be subject to substantial fluctuations and may suffer from prolonged periods of unemployment or inflation. There may be times when extra government expenditure is needed to raise aggregate demand.  
• There may be times when expenditures exceed the available output under conditions of high employment and thus may cause inflation.
• In such situations, restrictive conditions are needed to reduce demand. These constitute the stabilization requirements of the domestic economy.

Government Budgeting

Budget

• Budget is an Annual Financial Statement of yearly estimated receipts and expenditures of the government in respect of every financial year.
• It acts as instruments of control and act as a benchmark to evaluate the progress of various departments.
• Budgeting is the process of estimating the availability of resources and then allocating them to various activities according to a pre-determined priority.

Types of Budgeting

1. Performance Budgeting

• A Performance Budget gives an indication of how the funds spent are expected to give outputs and ultimately the outcomes.
• A performance budget reflects the goal/objectives of the organization and spells out its performance targets.
• These targets are sought to be achieved through a strategy. Unit costs are associated with the strategy and allocations are accordingly made for achievement of the objectives.
• However, performance budgeting has a limitation – it is not easy to arrive at standard unit costs especially in social programmes, which require a multi-pronged approach.

2. Zero-Based Budgeting (ZBB)

• The concept of ZBB was introduced in the 1970s. As the name suggests, in the process every budgeting cycle starts from scratch.
• Unlike the earlier systems, where only incremental changes were made in the allocation, under zero- based budgeting every activity is evaluated each time a budget is made and only if it is established that the activity is necessary, funds are allocated to it.
• Under the ZBB, a close and critical examination is made of the existing government programmes, projects and other activities to ensure that funds are made available to high priority items by eliminating outdated programmes and reducing funds to the low priority items.
• The basic purpose of ZBB is phasing out of programmes/activities, which do not have relevance anymore. ZBB is done to overhaul the functioning of the government departments and PSUs so that productivity can be increased and wastage can be minimized. Scarce government resources can be deployed efficiently. Therefore, ZBB is followed for rationalization of expenditure.
• Governmental programmes and projects are appraised every year as if they are new and funding for the existing items is not continued merely because a part of the project cost has already been incurred.

3. Programme Budgeting

• It aimed at a system in which expenditure would be planned and controlled by the objective. The basic building block of this system is the classification of expenditure into programmes, which meant objective oriented classification so that programmes with common objectives are considered together.

4. Programme and Performance Budgeting System (PPBS)

• PPBS went much beyond the core elements of programme budgeting and was much more than the budgeting system. It aimed at an integrated expenditure management system, in which systematic policy and expenditure planning would be developed and closely integrated with the budget. Thus, it was too ambitious in scope.
• Many governments today use the “programme budgeting” label for their performance budgeting system. As pointed out by Marc Robertson, the contemporary influence of the basic programme budgeting idea is much wider than the continuing use of the label. It is defined in terms of its core elements as mentioned above. Programme budgeting is an element of many contemporary budgeting systems which aim at linking funding and results. Neither was adequate preparation time given nor was a stage-by-stage approach adopted. Therefore, the Introduction of PPBS in the federal government in USA was not successful, although the concept of performance budgeting and programme budgeting endured.

5. Outcome Budget

• Outcome Budget was first introduced in India in 2005-06 by stating “the people of the country are concerned with outcomes, not just outlays”.
• In 2007-08 onwards the previous Performance Budget was merged with Outcome Budget.
• It is practiced by most of the ministeries while preparing their budget details and submitting it to the Ministry of Finance for the preparation of annual budget towards the end of February.
• It is a performance measurement tool that helps in better service delivery; decision-making; evaluating programme performance and results; communicating programme goals; and improving programme effectiveness.
• It measures the development outcomes of all government programmes.
• It, however, will not necessarily include information of targets already achieved.
• This method of monitoring flow of funds, implementation of schemes and the actual results of the usage of the money is followed by many countries.

6. Gender Budgeting

• Gender Buget was also introduced along with Outcome Budget in India in 2005-06.
• Gender budgeting is an exercise to translate the stated gender commitments of the government into budgetary commitments, involving special initiatives for empowering women and examination of the utilization of resources allocated for women and the impact of public expenditure and policies of the government on women.
• The 2019-20 Budget aims to design a roadmap for woman empowerment and their increased participation in the Indian economy through gender budgeting.

7. Balanced Budgeting

• It is that budget in which Government receipts are equal to Government expenditure.

Merits of the Balanced Budget

• The Government does not indulge in wasteful expenditure.
• Interference in economic functioning of the system is totally avoided by the government generally.
• Financial stability is ensured with balanced budget.
• However, balanced budget is not an achievement of the government when economy is in a state of depression for at that time, government is expected to increase its expenditure with a view to increasing aggregate demand.

Demerits of a Balanced Budget

• It does not offer any solution to the problem of unemployment during depression.
• It is not helpful to the growth and development programmes of the less developed countries.

8. Unbalanced Budgeting

• It is that budget in which receipts and expenditure of the government are not equal.
• It includes two cases: Surplus Budget and Deficit Budget arise.
• In Surplus Budget, Government receipts are greater than Government expenditures. While in the case of Deficit Budget, Government expenditures are greater than Government receipts.

Merits of a Deficit Budget

• It helps in addressing the problem of unemployment during depressions.
• It is conducive for growth and development in less developed countries.
• It works towards social welfare of the people.

Demerits of Deficit Budget

• It shows wasteful expenditure by the government.
• It shows less revenue realization in comparison with the expenditure.
• It increases debt burden of the government

Measures used to record government deficit and their implications for the economy are as follows:

Revenue Deficit

• Revenue deficit refers to the excess of government’s revenue expenditure over revenue receipts (Revenue deficit = Revenue expenditure - Revenue receipts).
• The revenue deficit includes only such transactions that affect the current income and expenditure of the government. When the government incurs a revenue deficit, it implies that the government is dissaving and is using up the savings of the other sectors of the economy to finance a part of its consumption expenditure.
• This situation means that the government will have to borrow not only to finance its investment but also its consumption requirements. This will lead to a build-up of stock of debt and interest liabilities and force the government, eventually, to cut expenditure. Since a major part of revenue expenditure is committed expenditure, it cannot be reduced.
• Often the government reduces productive capital expenditure or welfare expenditure. This would mean lower growth and adverse welfare implications.
• Effective revenue deficit: Revenue deficit - those grants given to states which are used for creation of capital assets.

Fiscal Deficit

• Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing.
• Gross fiscal deficit = Total expenditure - (Revenue receipts + Non-debt creating capital receipts)
• The fiscal deficit will have to be financed through borrowing. Thus, it indicates the total borrowing ! requirements of the government from all sources.
• From the financing side: Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from abroad
• Net borrowing at home includes that directly borrowed from the public through debt instruments (for example, the various small savings schemes) and indirectly from commercial banks through Statutory Liquidity Ratio (SLR).
• The gross fiscal defecit is a key variable in judging the financial health of the public sector and the stability of the economy. From the way gross fiscal defecit is measured it can be seen that revenue deficit is a part of fiscal deficit.
• Fiscal Deficit = Revenue Deficit + Capital Expenditure - non-debt creating capital receipts.
• A large share of revenue defecit in fiscal defecit indicated that a large part of borrowing is being used to meet its consumption expenditure needs rather than investment.

Primary Deficit

• Borrowing requirements of the government includes interest obligations on accumulated debt. The goal of measuring primary defecit is to focus on present fiscal imbalances.
• Primary deficit is used to obtain an estimate of borrowing on account of current expenditures exceeding revenues. It is simply the fiscal deficit minus the interest payments.
• Gross primary deficit = Gross fiscal deficit - Net interest liabilities
• Net interest liabilities consist of interest payments minus interest receipts by the government on net domestic lending.

Public Debt

• Budgetary deficits must be financed by either taxation or borrowing or printing money. Governments have mostly relied on borrowing, giving rise to what is called government debt. The concepts of deficits and debt are closely related. Deficits can be thought of as a flow which adds to the stock of debt. If the government continues to borrow year after year, it leads to the accumulation of debt and the government has to pay more and more by way of interest. These interest payments themselves contribute to the debt.
• By borrowing, the government transfers the burden of reduced consumption on future generations. This is because it borrows by issuing bonds to the people living at present but may decide to pay off the bonds some twenty years later by raising taxes.
• These may be levied on the young populations that have just entered the work force, whose disposable income will go down and hence consumption. Thus, national savings, it was argued, would fall. Also, government borrowing from the people reduces the savings available to the private sector. To the extent that this reduces capital formation and growth, debt acts as a ‘burden’ on future generations.

Fiscal Responsibility and Budget Management (FRBM) Act 

• Enacted in 2003, the FRBM Act requires the elimination of revenue deficit by 2008-09. This means that from 2008-09, the government will have to meet all its revenue expenditure from its revenue receipts. Any borrowing would then only be to meet capital expenditure - repayment of loans, lending and fresh investment.
• The Act also mandates a 3% limit on the fiscal deficit after 2008-09. This is a reasonable limit that allows significant-cant leverage to the government to build capacities in the economy without compromising fiscal stability.
• It is important to note that since the entire Budget is at current market prices the deficits are also calculated with reference to GDP at current market prices. The main features of the bill are as follows:
  • The Fiscal Responsibility and Budget Management (FRBM) Bill was introduced in December 2000 and enacted in August 2003. The rules are effective from July 5, 2004 and the government is now committed to implement the FRBM act. Following are the main features of the FRBM Act:
  • The Act stipulates the elimination of revenue deficit by March 31, 2008.
  • According to the Act, the revenue deficit is to be reduced by a minimum of 0.5% of GDP per annum and the fiscal deficit by 0.3%. The rolling targets of FRBM provide for a reduction in the revenue deficit to 1.5% in 2005-06 and to 1.1% in 2006-07 and eventually to zero in 2008.
  • The FRBM Act also caps the level of guarantees and prohibits government to borrow from the RBI after April 1, 2006.
  • The Act requires that on a quarterly basis, the Government would have to place before both the Houses of Parliament an assessment of trends of receipts and expenditure. The Government also has to annually present the macro-economic framework statement, medium term fiscal policy statement and fiscal policy strategy statement. The three statements would provide the macroeconomic background and assessment relating to the achievement of FRBM goals.
  • The medium term fiscal policy statement will contain a three-year rolling target for key fiscal parameters that underpin the Government’s fiscal correction trajectory.
  • Through the FRBM discipline, the Government is also committed to undertake an intra-year assessment of the achievement of its budgetary targets. During the Economy Crisis of 2008, the FBRM guidelines were not followed rigorously but now government is committed for reducing the deficits.

Deficit Financing

• Excessive domestic borrowing by the government may lead to higher real interest rates and the domestic private sector being unable to access funds resulting in the crowding out of private investment. Sometimes a combination of these can occur.
• In any case, the impact of a large deficit on long run growth and economic well-being is negative.Therefore, it is not prudent for a government to run an unduly large deficit.
• However, in case of developing countries, where the need for infrastructure and social investments may be substantial, running surpluses at the cost of long-term growth might also not be wise.
• The challenge then for most developing country governments is to meet infrastructure and social needs while managing the government’s finances in a way that the deficit or the accumulating debt burden is not too great.
• Deficit Financing is a practice in which a government spends more money than it receives as revenue, the difference being made up by borrowing or minting new funds.
• Although budget deficits may occur for numerous reasons, the term usually refers to a conscious attempt to stimulate the economy by lowering tax rates or increasing government expenditures.

What is Fiscal Stimulus?

• Fiscal or Economic Stimulus are attempts by government to financially stimulate an economy.
• An economic stimulus is the use of monetary or fiscal policy changes to kick start a lagging or struggling economy.
• Example: Governments can adopt practices such as lowering interest rates, increasing government spending and quantitative easing, to name a few, to accomplish this.

 Effects of Fiscal Policy on Macro Economy

• Fiscal policy affects aggregate demand, the distribution of wealth, and the economy’s capacity to produce goods and services. In the short run, changes in spending or taxation can alter both the magnitude and the pattern of demand for goods and services. With time, this aggregate demand affects the allocation of resources and the productive capacity of an economy through its influence on the returns to factors of production, the development of human capital, the allocation of capital spending, and investment in technological innovations.
• Tax rates, through their effects on the net returns to labour, saving, and investment, also influence both the magnitude and the allocation of productive capacity. Fiscal policy also feeds into economic trends and influences monetary policy.

Effects of Fiscal Policy on Consumer Spending

• Lower taxes, everything else being constant, increase households’ disposable income, allowing consumers to increase their spending. The consequences of the cut - how much is spent or saved, and the response of economic activity - depend on the way households make their decisions and on prevailing macroeconomic conditions.
• Whether the tax cut is perceived to be temporary or permanent will influence how much consumers save. A temporary cut will alter households’ disposable income relatively little, and so might have little effect on consumption. If the cut is, instead, perceived to be permanent, then households will perceive a larger increase in their disposable income and so will likely increase their desired consumption by much more than they would if they thought the cut were temporary.
• There is a potential conflict between the use of fiscal policy to stimulate aggregate demand when the economy is operating below potential in the short run and the use of policy to promote longer-run goals for national saving and capital formation to improve future living standards. When there are underutilized economic resources, fiscal stimulus can increase investment. But when the economy is operating near potential, an increase in the public debt might eventually depress private investment, unless the fiscal stimulus is reversed as the economy approaches full employment and utilisation.
• This fiscal drag has the effect of reducing Aggregate Demand and becomes an example of deflationary fiscal policy. It could also be viewed as an automatic fiscal stabiliser because higher earnings growth will lead to higher tax and therefore moderate inflationary pressure in the economy.

Limitations of Fiscal Policy

• There are significant time lags
  • Recognition lag: time it takes government to recognize there is a problem
  • Decision lag: time required for government to determine most appropriate policy
  • Implementation lag: time it takes to figure out how to implement new directives
  • Impact lag: time it takes to be felt through multiplier effect
• There are difficulties in changing spending and taxation policies
  • It is far easier to increase spending and decrease taxes then to increase taxes and decrease spending
• There is a conflict between levels of government over appropriate policies
  • Federal, provincial and city governments may differ on what needs to be done.
  • Regional variations
• There is crowding out of private investment
  • Increases interest rates
  • Reduces amount of funding for private investment
• Deficits impose burden on future generations and Foreign-owned debt removes capital from economy