Fiscal policy

FISCAL POLICY REVENUES EXPENDITURES DEFICITS

Fiscal Policy - fundamentals
Fiscal policy concerns the plans for taxation, borrowing and spending by the Government of a country.
A fiscal stance may be
Neutral
Expansionary
Contractionary
Collecting more taxes to finance more spending indicates a neutral stance
Spending more and financing it by borrowing and taxes would indicate a fiscal expansion
Collecting more taxes without increase in spending indicates fiscal contraction.

45 degree model C+I+G C+I+G+G1 Y 1 Y2 Government spending is an injection into the circular flow whereas taxes are withdrawals

ELEMENTS OF PUBLIC FINANCE
EXPENDITURE
ON GOODS AND SERVICES, HEALTH, EDUCATION, ROADS, INFRASTRUCTURE, DEFENCE.
INCOME = TAXES AND NON-TAX REVENUE
BORROWING = IF EXPENDITURE IS GREATER THAN REVENUES = PSBR

To raise revenues for the Government
To control externalities
To redistribute income and wealth
To protect industries from foreign competition
To provide a stabilizing effect on National Income e.g. taxes can dampen upswings of a trade cycle by reducing inflationary pressures.
Functions of Taxation

QUALITIES OF A GOOD TAX
According to ability to pay
Taxes should be comprehensive
Cost of collection should be small
Payment of tax should be according to how and when people receive and spend income
Tax evasion should be difficult.
Taxes should be equitable

Direct vs Indirect taxes
Advantages of Direct Taxes:
Direct taxes are”fair and equitable”
They act as built in or automatic stabilizers
Less inflationary than indirect taxes

Can be proportional, progressive or regressive
Disdavantages of Direct Taxes
Encourages migration
Reduce the initiative to train skilled workers
Encourages tax avoidance
Disincentives
Direct taxes

Progressive Taxes
Advantages
According to ability to pay
Enables redistribution of wealth
Progressive taxes counter-balance indirect taxes which are by nature regressive
Disadvantages
Not required in affluent societies
Reduces initiative to earn extra income and profits
Encourages tax evasion
Could encourage migration

Advantages of Indirect Taxes:
Can be painlessly extracted
Can discourage externalities
More flexible
Less administrative burden

Disadvantages of indirect taxes
Inflationary effect
Indirect taxes are regressive
Evasion is possible through black marketing

Government Finances
Revenue
Gross tax revenue
Corporate Profit tax, Income tax, Excise duty, Import Duty
Other taxes and duties
Devolvement to State and Union Territories
Net Tax revenue = (1) minus (2)
Non Tax revenue
Net revenue receipts = (3) plus (4)
Non Debt capital receipts
Recovery of loans
Privatisation
Borrowing and other liabilities
Total Receipts = 1+6+7

Government Finances - II
Expenditure
Revenue Expenditure
Interest, Subsidy, Defence, Admin
Plan Expenditure
Capital Expenditure
Planned Expenditure
Loans
Defence
Others
Planned expenditure on Rev and Capital Account
Non Plan expenditure on Rev and Capital Account
Total Expenditure = 3 + 4

Budget Deficit
Revenue Deficit = Rev Exp – Rev Receipts
Capital Deficit = Capital Exp – Capital Receipts
Budgetary Deficit = Total Revenue – Total Expenditure
Gross Fiscal Deficit = Total Expenditure – Total Receipts excluding Borrowings (this implies the overall borrowing requirement of the Govt.
Primary Deficit = Gross Fiscal Deficit - Interest

Government Balance Sheet
Liabilities of Central Government
Public Debt = Internal Debt + External Debt
Internal Debt
Market Loans, Treasury Bills, Bonds, Govt Securities
Small Savings
Provident Funds
Reserve Funds
Assets of Central Govt
Capital Outlay
Loans and Advances to States, Union Territories, Foreign Govts, PSUs, Govt Depts (Rail, P&T, Education, Other Govt employees)

Public Debt
Debt Instruments
Marketable Debt
Treasury Bills – Short term
Govt Securities – Long term
Non-marketable Debt
National Saving Schemes
Non-marketable loans

Measurement of Public Debt
Public Sector Borrowing Requirement (PSBR) is the annual excess of spending over income
Servicing the Debt involves redistribution of funds through taxes and borrowing with interest

Real Vs Nominal Deficit
Real Deficit is arrived at by reducing inflation adjusted Public Debt from Nominal Deficit
Real Budget Deficit = Nominal Budget Deficit – Public Debt x Inflation
Example : Where Public Debt is 4000Bln and Budget Deficit is 250Bln, Inflation rate is 5% then Real Budget Deficit = 250 – 4000x0.05 = 50

Cyclical deficit and Structural deficit
Cyclical Deficit is part of the deficit that results from the economy being a low level economic activity
Structural Deficit is that portion of the deficit that would exist even if the economy was operating at it’s full potential and hence it is not directly attributable to the business cycle and policy makers are directly responsible for it
To break the deficit into two parts we need a measure of potential output e.g. actual deficit = 100 but economy below potential if level of economic activity increases to the potential tax revenues will rise by 30 and transfers would fall by 10 hence structural deficit = 100 -10-30 = 60

Monetized Deficit
Amount of the deficit that is financed by borrowings from the RBI, this increases the money supply in the economy by an equivalent amount.

Effectiveness of Fiscal Policy
Taxes act as automatic stabilizers – help to reduce upward and downward movement of national income but they also act as a drag on expansion (fiscal drag) by reducing the size of the multiplier
Dis-incentive to work and invest
Crowding Out controversy – private investment falls due to high interest rates when Govt deficit is financed by accessing the public markets i.e. savings in the economy
Time lag between recognition and recovery
Lag between recognition and action
Lag between action and implementation
Lag between implementation and effect

Fiscal policy

by Kinnar Majithia

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