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FISCAL POLICY

FISCAL POLICY

Fiscal policy is the means by which a government adjusts its expenditure and revenue to influence a nation’s economy. While exercising fiscal policy, the government keeps primarily the following factors in mind:

  • Welfare of people
  • Financial condition of government
  • Inflation level in the economy

HIGH EXPENDITURE AND LOW REVENUE COLLECTION

  • When the government incurs high expenditure on the welfare of people (i.e. higher salaries and pensions, etc.) and reduces revenue collection (i.e. lower taxes), it has the following effects:
  • People’s standard of living improves.
  • Financial condition of the government deteriorates.
  • Higher expenditure and reduced revenue collection increase money supply and may lead to inflation.

LOW EXPENDITURE AND HIGH REVENUE COLLECTION

  • When the government incurs less expenditure on the welfare of people (i.e. lower salaries and pensions, etc.) and increases revenue collection (i.e. higher taxes), it has the following effects:
    • The standard of living of people does not improve.
    • The financial condition of the government improves.
    • Less expenditure and high revenue collection reduce money supply and, therefore, may lead to a fall in prices.

EXERCISING FISCAL POLICY

  • While exercising fiscal policy, the government strives to strike a right balance between the aforesaid three factors. The right balance changes with circumstances as explained below.

When Economic Growth Needs to be Increased

  • Let us say that an economy has slowed down, unemployment levels have increased, consumer spending has reduced, and businesses are not making substantial profits.
  • In such a scenario, the government increases its expenditure and reduces its revenue, which leads to more funds with people and, consequently, rise in demand, investment, employment, and output. However, any such increase in expenditure and decrease in revenue collection would also depend on the financial condition of the government.
  • Pumping money into the economy by decreasing taxation and increasing government spending is known as “pump priming”. Thus, when the economy is slow, the RBI increases the money supply by exercising monetary policy and the government increases expenditure and reduces tax collection. This is called stimulus package.
  • In other words, a stimulus package is a package of economic measures put together by the government to stimulate a floundering economy. The objective of a stimulus package is to reinvigorate the economy and prevent or reverse a recession by boosting employment and spending.

When the Economy Needs to be Curbed

  • When inflation is too strong, the economy may need a slowdown. In such a situation, the 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 decreases the money in circulation.
    • Of course, the possible negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels.

WHOM DOES THE FISCAL POLICY AFFECT?

  • The effects of any fiscal policy are not the same for everyone. However, broadly the effects of shift in fiscal policy can be stated as follows:
  • When the government decides to increase the taxation, the most affected classes are middle and rich classes. On the other hand, when the government decides to reduce the taxation, the most benefited classes are also middle and rich classes. This is because the rich and middle classes are the taxpayers, whereas the poor do not pay or pay very less tax.
  • When the government decides to increase its spending, the benefits are reaped by all classes. However, the poor are the highest beneficiaries because most of the government spending is targeted towards the welfare of the poor sections of our society. Similarly, when the government reduces its spending, the poor are the most affected class.

MEASURES OF GOVERNMENT DEFICIT

  • When the government exercises fiscal policy, it incurs deficit (shortfall in funds). The expenditure of the government is usually higher than the revenue collection. The government prefers to run in deficit because deficit enables it to undertake more welfare of the people.
  • There are various measures of government deficit from different perspectives, which enhance analysis of the nature and cause of deficit.

Revenue Deficit 

  • Revenue deficit is the difference between revenue expenditure and revenue receipts. Revenue expenditure – Revenue receipts = Revenue deficit
  • Revenue deficit indicates that the government’s revenue expenditure exceeds the government’s revenue receipts. On the other hand, revenue surplus indicates that the government’s revenue receipts exceed the government’s revenue expenditure. Revenue deficit for the year ending on 31 March 2016 was 2.5% of GDP and on 31 March 2017 was 2.1% of GDP.

Difference between Capital and Revenue Items of Expenditure and Income

  • Before we explain the difference between capital and revenue items of expenditure and income, we must know that transactions can be divided into two types according to the period of time.
  • Long-term period: Long-term period means the time period of more than 1 year. Transactions having long-term implications are capital transactions. For instance, a building purchased by the government will be used over many years. Thus, the transaction to purchase the building is a long-term transaction.
  • Short-term period: Short-term period means less than or equal to 1 year. Transactions having short-term implications are revenue transactions. For instance, salary paid by the government to its employees is only for rendering services in the current year. Therefore, the implications of paying salary are limited to the present financial year.
  • Thus, on the basis of time period, transactions can be classified into two types: revenue and capital. Further, both revenue and capital transactions can be in nature of receipts or expenditure.

Capital expenditures

  • These expenditures have implications of more than 1 year. Examples include buildings purchased by the government.

Revenue expenditures

  • Expenditures having implications of less than or equal to 1 year are called revenue expenditure. The benefit that the government gets is for short period of time. Examples include salary paid by the government, etc.

Capital Receipts

  • These receipts have implications of more than 1 year. Examples include loans from the public. If the government takes loan, it is required to repay the loan along with interest.

Revenue Receipts

  • These receipts have implications of less than or equal to 1 year. Examples are tax collected by the government. The government is not liable for anything in the future for the tax collected in the current year.

Fiscal Deficit

  • Fiscal deficit refers to the excess of total expenditure over total receipts (excluding borrowings) during a given financial year.

Fiscal deficit = Total expenditure – Total receipts, excluding borrowings

  • Fiscal deficit includes not just revenue expenditure and receipts but also capital expenditure and receipts, except borrowings. Fiscal deficit for the year ending on 31 March 2017 was 3.5% of GDP (3.9% for the year ending 31 March 2016).
  • The extent of fiscal deficit is an indication of how far the government is spending beyond its means. In other words, fiscal deficit indicates the level of borrowings of the government.

Primary Deficit

  • Primary deficit is one of the parts of fiscal deficit. While fiscal deficit is the difference between total revenue and expenditure, primary deficit can be arrived by deducting interest payment from fiscal deficit. Interest payment is the payment that a government makes on its borrowings.

Primary deficit = Fiscal deficit – Interest payments

  • Interest payments are excluded from the calculation of primary deficit because interest payments are made on account of borrowings made in the past. Thus, primary deficit specifies the net impact of present transactions (and excludes the impact of transactions undertaken in the past).
  • Note: Like there are fiscal, revenue, and primary deficits of the central government, in the same manner each state has separate figures for fiscal, revenue, and primary deficits.

Effective Revenue Deficit

  • Earlier, the central government used to classify the grants given to state governments as revenue expenditure. However, some part of the central government grants is used by state governments for the purpose of capital expenditure (such as purchase of various assets). Thus, in the budget of 2012-13, the Ministry of Finance has coined the term effective revenue deficit.

Effective revenue deficit = Revenue deficit – Central grants used by States for capital transactions

  • For example, under the MGNREGA programme, some capital assets such as roads, ponds, etc. are created. Thus, the grants for such expenditure will not strictly fall in the revenue expenditure.

DEFICIT FINANCING  | FISCAL POLICY 

  • 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 is a necessary evil in a welfare state as it allows the state to undertake activities that, otherwise, would be beyond its financial capacity.

Consequences of Deficit Financing

  • Inflation: Deficit financing may lead to inflation. Due to deficit financing, money supply increases without increase in aggregate supply.
  • Adverse effect on savings: It is not possible for the people to maintain the previous level of savings during period of rising prices.
  • Rise in inequality: Price rise creates inequality in income distribution, which makes the rich richer and the poor poorer. The fixed wage earners are badly affected, and their standard of living deteriorates.
  • Balance of payment problems: A high price level as compared to other countries makes the exports more expensive in the global market and imports cheaper in the domestic economy.

Should Deficit Financing be Resorted to?

  • A certain measure of deficit financing is inevitable to step up the tempo of economic progress beyond what it would have been in the absence of deficit financing. As long as deficit financing does not lead to inflation, there is no objection to its use.

FISCAL RESPONSIBILITY AND BUDGET MANAGEMENT (FRBM) ACT, 2003

  • The FRBM Act 2003 was adopted to institutionalize the fiscal discipline at both the central and state levels. Originally, the FRBM Bill had given annual numerical targets as well. But in the process of making it a law, the annual targets were dissolved and the act simply said that the centre would take appropriate measures to eliminate revenue deficit by 31 March 2008. The act left the annual numerical targets, to be formulated by the central government in the form of FRBM rules.
  • The key provisions of the act as well as FRBM rules are as follows:
    • Every year, the government will bring down the revenue deficit by 0.5% and eliminate it by 2007-08.
    • Every year, the government will bring down the fiscal deficit by 0.3% and bring it down to 3% by 2007-08.
    • Total liabilities of the union government should not rise by more than 9% a year.
    • The union government would not give guarantee to loans raised by PSUs and state governments for more than 0.5% of the GDP in aggregate.
    • State governments were asked to formulate their own FRBM acts. Those states that have formulated their own FRBM acts have been given autonomy to borrow further without the permission of the central government. Other states can undertake further borrowing only with the permission of Central Government.
  • Impact of Global Financial Crisis on FRBM Act, 2003
    • Due to the 2008 global financial crisis, the deadlines for the implementation of the targets in the act were initially postponed and subsequently suspended in 2009. At times of global financial crisis, the central government incurred heavy expenditure and reduced tax collection in order to insulate Indian economy from global economic slowdown.
    • After overcoming the 2008 global financial crisis, the FBRM Act was readopted in 2012-13 but not in a strict sense.
  • Criticism of the FRBM Act
    • Measures to enforce compliance were the particularly weakest area of the act. It required the Finance Minister of India to conduct quarterly reviews of the receipts and expenditures of the government and place these reports before the Parliament. Deviations to targets set by the central government for fiscal policy had to be approved by the Parliament. No other measures for the failure of compliance have been specified.
    • Some criticized the act and its rules as it might require the government to cut back on the social expenditure necessary for the uplift of the poor population of India.

BUDGET   | FISCAL POLICY 

  • A budget is an estimation of the revenue and expenses over a specified future period of time. The government publishes annual budget for the coming financial year. In this budget, receipts that are expected to arise and expenses that are expected to be incurred are mentioned.
  • Financial year refers to a year as reckoned for taxing or accounting purposes. In India, financial year starts on 1 April and ends on 31 March.

Budget consists of three set of figures:

  • Actual data: Actual data are of the preceding year’s economic activity (expenditure and receipts). For instance, the budget presented on 1 February 2017 would contain actual figures for the financial year 2015-16.
  • Provisional estimates: Provisional estimates are the estimates of revenue and expenditure of the current year. These are called provisional estimates as the budget is presented on 1 February. Thus, the actual data are available of 9 months. Based on these actual figures, estimates are made for the remaining period of the year. For instance, the budget presented on 1 February 2017 would contain provisional estimates for the financial year 2016-17.
  • Budgetary estimates: Budgetary estimates are the estimates of revenue and expenditure of the coming year. For instance, the budget presented on 1 February 2017 would contain budgetary estimates for the financial year 2017-18.

Estimates are arrived at by one of the following three methods:

  • Advanced estimates: These estimates are made before the actual occurrence of economic activity.
  • Revised estimates: Revision in estimates (made earlier) based on changes in the economic scenario or actual occurrence of some economic activity.
  • Quick estimates: These estimates are based on sample survey. Information gathered from the sample is used to predict the overall economic activity.

Which Government Body  Makes National Income Estimates in India?

  • Since 1955, the national income estimates have been prepared by the Central Statistical Organisation (CSO). The CSO is a governmental agency in India under the Ministry of Statistics and Programme Implementation.
  • The CSO is responsible for the coordination of statistical activities in the country and evolving and maintaining statistical standards. Its activities include national income accounting, economic censuses, human development statistics, gender statistics, energy statistics, etc.

How the Budget Is Made?

  • The budget is made through a consultative process involving the Ministry of Finance, NITI Aayog, and 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.
  • The Finance Ministry issues guidelines on spending by various ministries. On the basis of these guidelines, various ministries present their demands. In September, the Budget Division issues a circular to all union ministries, states, union territories, autonomous bodies, departments, and the defence forces for preparing the estimates for the next year.
  • After the ministries and departments send their demands, extensive consultations are held between the union ministries and the Department of Expenditure of the Finance Ministry vq,
  • At the same time, the Department of Economic Affairs and the Department of Revenue meet the various interest groups such as farmers, businesspersons, etc. to take their views.
  • After the pre-budget meetings, a final call on the tax proposals is taken by the Finance Minister. The proposals are discussed with the Prime Minister before the budget is finalized.

Economic Survey

  • The Finance Ministry of India presents the Economic Survey in the Parliament every year, just before the Union Budget . It is the ministry’s view on the annual economic development of the country.
  • Economic survey reviews the developments in the Indian economy over the previous 12 months, summarizes the performance on major development programmes, and highlights the policy initiatives of the government and the prospects of the economy in the short to medium term. This document is presented to both the houses of Parliament during the budget session.
  • The first draft of the economic survey is prepared by the Department of Economic Affairs in the Finance Ministry. Then this draft is cleared by the Chief Economic Advisor and Secretary of Economic Affairs. The final version is scrutinized by the Finance Secretary and Finance Minister. Most of the data are given by CSO.

Zero-base Budgeting

  • Zero-base budgeting (ZBB) is a method of budgeting in which all the expenses must be justified for each new period. ZBB starts from a “zero base”, and every expenditure by each ministry is analysed for its needs and costs.
  • ZBB was introduced in India under the Ministry of Science and Technology in 1983 on a pilot basis. However, ZBB could not be implemented on a larger scale because it involves a lot of paperwork, is time consuming, and is a costly exercise.

Zero-base Budgeting versus Traditional Budgeting

  • Traditional budgeting calls for incremental increases over previous budgets, such as a 5% increase in spending, as opposed to the justification of all the expenses required in ZBB.
  • Traditional budgeting analyses only new expenditures, while ZBB starts from zero and calls for a justification of old, recurring expenses in addition to new expenditures.

Performance Budgeting and Outcome Budgeting

  • The conventional budget indicates the resources allocated to various ministries but does not focus so much on the use of those resources to achieve results.
  • The modern budgeting aims at linking of funds to the results or ultimate objectives for which funds were given. There are also differences regarding the ultimate objective of the government programmes—whether “output” or “outcome” should be considered the basis to ensure government accountability. Outputs such as roads to rebuilt, number of vaccinations done, and area to be irrigated are more tangible and in the control of government officials. This type of budgeting that links expenditure with output is called performance budgeting.
  • Performance budgeting is not new in India. Since 1968, government departments have been preparing performance budgets, trying to link financial aspects to physical results. However, this remained a supplementary device without any perceptible impact on resource allocation.
  • Outcomes, on the other hand, are indicators showing the progress in achieving programme objectives, such as decline in diseases, improvement in agricultural production, and achievements in education. These are not directly under the control of the government officials on account of the effect of many factors. This type of budgeting that links expenditure with outcome is called outcome budgeting.
  • The government introduced “Outcome Budget” in 2005. Outcome budgets are separately placed by the departments in the later part of the budget session. Unfortunately, these outcome budgets escape the notice of the analysts, while they should have been vigorously debated in public forums. Outcome budgeting requires measurement of performance indicators, specification of standards, and a monitoring and evaluation system. Our budgeting system is not evolved enough to facilitate outcome budgeting.

Gender Budgeting  | FISCAL POLICY 

  • Gender budget does not refer to a separate budget for women. Instead, the gender budget is an attempt to ensure that some part of the budget is definitely spent on women. As a result, separate women cells have been created in various ministries to ensure that a section of grants is allocated dedicatedly for women.

Performance Monitoring and Evaluation System

  • In 2009, a performance monitoring and evaluation system (PMES) was introduced for some ministries and departments. Under the PMES, each ministry/department is required to prepare a result framework document (RFD), which is being implemented for various ministries/departments in a phased manner. In 2013-14, 84 ministries/departments were covered under the RFD system.
  • Under the RFD system, long-term vision, mission, and annual targets for each ministry/department are given. The actual performance of a ministry/department is compared with the targets assigned. RFD leads to transparency, accountability, and responsibility of the ministries/departments for their respective areas of performance.

Budget Break up

  • In economic terms, budget is divided into two types: revenue budget and capital budget. The revenue budget consists of transactions that have implications up to 1 year. The capital budget consists of transactions that have implications of more than 1 year. Both revenue and capital budgets consist of receipts as well as expenditure. The 2017-18 budget size was ₹21.47 lakh crore.

Maior heads of expenditure of the central government (₹100 crore)

Note: Revenue expenditure + Capital expenditure = Total expenditure

Source: RBI

  • Revenue expenditure includes revenue defence expenditure, interest payments and subsidies. Capital expenditure includes loans and advances, capital outlay and capital defence expenditure.

Budget Reforms 

  • In Budget 2017-18, three major reforms have been undertaken:
    • Merger of railway budget into general budget (no separate railway budget)
    • A separate rail budget has its genesis in the recommendations of the Acworth Committee of 1920.
    • This was considered necessary because the railway’s revenues far outstripped the general revenue.
  • In budget 2017-18, the government decided to merge the rail budget and the general budget.
  • In 1947, when independence was achieved, railway revenues were still 6% more than the general revenue. By the 1970s, the size of rail revenues had shrunk and was about 30% of the general revenues. By 2015-16, it was down to 11.5%.
  • The decision reflects the decrease over time in the relative size of the rail budget compared to some of the other components in the general budget, such as defence and roads and highways.
  • Moreover, a separate railway budget kept the railway portfolio into the public limelight and thus the railway minister avoided raising fares, leading to losses for the railways.

Advancement in presentation of budget

  • The Finance Ministry presented the budget on 1 February 2017. The idea behind bringing forward the budget date, according to the government, is that the ministries and state governments can begin disbursing funds from the beginning of the financial year. Advancing the budget date will allow funds to be released to the states by April.
  • Earlier, the budget was used to be passed till the end of May and funds used to be assigned to the states by June. Thereafter, the development works are affected on account of rainy season. Thus, actual utilisation of funds for development purposes begin in September.

Elimination of distinction between plan and non-plan expenditure

  • Plan expenditure refers to the expenditure that is incurred as part of the five-year plan for development purposes. Non-plan expenditure refers to the expenditure that is not part of five-year plans and is incurred to meet revenue expenses of consumptive nature, for instance salaries, subsidies, interest payments, etc.
  • The distinction between plan and non-plan expenditure has been removed by the government because of the following reasons:
  • Plan expenditure tends to get priority especially when expenditure reduction has to be done to meet fiscal deficit target. Non-plan expenditure is reduced even if it is vital for economic development. For instance, allocation of funds for the maintenance of assets such as hospitals, schools, and irrigation dams, which have been already created, is also equally important.
    • The funds used for the creation of assets (such as hospitals) are treated as plan expenditure, and the funds used for the maintenance of assets (such as running hospitals) are treated as non-plan expenditure.
  • Outcome budgeting and performance budgeting are applicable only on plan expenditure. This means that estimation of outcome of expenditure incurred on running schools and hospitals is not within the purview of budgeting as it is a non-plan expenditure.

 

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