Influencing the level of economic activity though
manipulation of government income and expenditure
Associated with Keynesian Demand Management
Influence Aggregate Demand –
Tax regime influences consumption (C) and investment (I)
Government Spending (G)
Influences key economic objectives
Acts as an ‘automatic stabiliser’
Also used to influence non-economic objectives and
provide framework for supply side policy e.g. education
and health, poverty reduction, welfare reform,
investment, regional policies, promotion of enterprise,
Sale of Government Services – e.g.
prescriptions, passports, etc.
Why do we need to pay taxes?
To raise revenue to finance spending on goods and service by
central & local government
The government when managing the level of AD output and
prices uses taxation. When demand is perceived as being too
strong the government can increase direct taxation, to reduce
the level of real disposable income and household spending.
A progressive system of taxation can be utilized to achieve great
equality in income & wealth between individuals and households
Taxes can correct for externalities and other forms of market
failure (such as monopoly)
Import taxes may control imports and therefore help the
country's international balance of payments and protect
industries from overseas competition.
Objectives for the tax system
Revenue yield should be adequate
To reduce inequalities in income
To keep the overall tax burden as low as possible
To reduce tax rates on income to sharpen incentives to work
and create wealth in the economy
To maintain a broad tax base - having a range of taxes helps
to keep each separate tax rate low
To shift the balance of taxation away from taxes on income
towards taxes on spending
To ensure taxes are applied equally and fairly to everyone
To use taxes to make markets work better (including the use
of environmental taxes to make both consumers and
producers aware of external costs)
Progressive Regressive and Proportional taxes
Generally, indirect taxes are seen as regressive; the proportion of
income paid in tax decreases as income rises.
Direct taxes are progressive because the proportion of income paid
in tax increases as income rises. With a progressive tax, the
marginal rate of tax exceeds the average rate of tax. As a result,
progressive taxes act to reduce inequalities in the distribution of
With a proportional tax, the proportion of income paid in tax remains
constant as income changes. In this situation, the marginal rate of
tax will be equal to the average rate of tax.
Any tax that does not vary with income is called a lump sum tax
The principles of taxation
The two central principles of taxation relate to the impact
of tax on efficiency (concerned with the allocation of
resources) and equity (concerned with the distribution of
Other principles relate to the cost of operation of the tax
system, to its flexibility and certainty.
The costs of operation are divided into two types administrative costs and compliance costs.
Direct and Indirect Taxes
Law and Order
Culture, Media and
Fiscal policy framework
Objectives of fiscal policy are implemented through two fiscal rules,
against which the performance of fiscal policy can be judged. The
fiscal rules are:
the golden rule: over the economic cycle, the Government will
borrow only to invest and not to fund current spending; and
the sustainable investment rule: public sector net debt as a
proportion of GDP will be held over the economic cycle at a stable
and prudent level.
If Assume an
rise in AD leads to
AD initial in real
an increase taxes’
Apart from G, C
shifts are also
and I to the
ceteris paribus,and a
affected directly or
fall to National at will
spending, it a cost
indirectly by the
of higher inflation
t rate of 5%
(U = 5%)
Fiscal Policy In Action
Real National Income
Supply Side Policy
Intention is to shift the aggregate supply curve
to the right, increasing the long term
productive capacity of the economy
Tend to be long-term policies
Arguments about how effective they are – e.g.
lowering taxes increases incentives, reducing
welfare dependency increases the urge
to find work
Supply Side Policy
to push can help
curve to the right
the economy to
capacity of the
economy from Yf
Real National Income
Supply Side Policies
Policies aim to influence productivity and
efficiency of the economy
Key feature – open up markets and deregulate to improve efficiency in the working of
markets and the allocation of resources
Main areas of policy:
Tax and Welfare Reform
Education and Training
Incentives and technology
What is the FRBM Act?
The FRBM Act was enacted by Parliament in
2003 to bring in fiscal discipline. It received the
President’s assent in August the same year.
The United Progressive Alliance (UPA)
government had notified the FRBM Rules in
How will it help in redeeming the fiscal
The FRBM Rules impose limits on fiscal and revenue
deficit. Hence, it will be the duty of the Union government
to stick to the deficit targets.
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% of the GDP.
The fiscal deficit is required to be reduced to 3% of the
GDP by 2008-09.It would mean reduction of fiscal deficit
by 0.3 % of GDP every year.
How are these targets monitored?
The Rules have mid-year targets for fiscal and revenue
deficits. The Rules required the government to restrict fiscal
and revenue deficit to 45% of budget estimates at the end of
September (first half of the financial year).
In case of a breach of either of the two limits, the FM will be
required to explain to Parliament the reasons for the breach,
the corrective steps, as well as the proposals for funding the
What is fiscal deficit?
Every government raises resources for funding its
expenditure. The major sources for funds are taxes and
Borrowings could be from the Reserve Bank of India
(RBI), from the public by floating bonds, financial
institutions, banks and even foreign institutions. These
borrowings constitute public debt and fiscal deficit is a
measure of borrowings by the government in a financial
In budgetary arithmetic, it is total expenditure minus the
sum of revenue receipts, recoveries of loans and other
receipts such as proceeds from disinvestment.
Indian Budget at a glance
Structural deficit is a government deficit that is independent of the
business cycle—it remains even when an economy is at its full
Structural deficit is created when a government is spending more
than a long-term average of tax revenue can bring in.
The component of the budget that depends on the ebbs and flows
of the business cycle is called cyclical deficit.
Economists generally maintain that structural deficit is much more
serious than cyclical deficit, as it implies unsustainable spending.
Investment is one justification for taking on structural deficit.
example of this is investment in infrastructure, such as roads and railways. While these projects
are expensive, they create jobs and can be used for many years.
The government budget deficit always goes
deep in the red during recessions..
Expenditures rise and receipts fall during a
Automatic stabilizers exacerbate the swing of
the deficit during a recession..
Do economies need a fiscal deficit?
Many economists, including Lord Keynes, had advocated the need for small
fiscal deficits to boost an economy, especially in times of crises. What it means
is that government should raise public investment by investing borrowed funds.
This exercise is also called pump-priming.
The basic purpose of the whole exercise is to accelerate the growth of
an economy by public intervention. Hence, there is nothing fundamentally wrong
with a fiscal deficit, provided the cost of intervention does not exceed the
For example, if the government borrows Rs 100 at 10%, it must earn more than
10% on investment of Rs 100. In that situation, fiscal deficit will not pose any
However, the government spends money on all kinds of projects, including
social sector schemes, where it is impossible to calculate the rate of return at
least in monetary terms. So, one will never know whether the borrowed funds
are being invested wisely.
WAYS & MEANS ADVANCES
These are temporary advances (overdrafts) extended by RBI to the
govt. Section 17(5) of RBI Act allows RBI to make WMA both to the
Central and State Govt.
Objective - to bridge the interval between expenditure and receipts.
They are not a sources of finance but are meant to provide support,
for purely temporary difficulties that arise on account of
mismatch/shortfall in revenue or other receipts for meeting the govt.
liabilities. They have to be periodically adjusted to enable use of
such financing for future mis- matches.
hen did it start ? On March 26, 1997, Govt. of India and RBI
signed an agreement putting the ad hoc T-bills system to end w.e.f
April 1, 1997.
WAYS & MEANS ADVANCES
Interest rate The interest rate on WMA is at or around bank rate (with
small adjustment for different kinds of WMA for State Govt.) and
overdrawing if any carries 2% higher interest.
Duration 10 consecutive working days for Central Govt. and 14 days for
Amount ceiling Limits on WMA are fixed at the beginning of a fiscal
year by RBI. For 2005-06, Central Govt. limit is Rs.10000 cr for AprSept and Rs.6000 cr for Oct-Mar.
Minimum balances The minimum balance required to be maintained by
Govt. on Fridays and at the close of the Govt.’s or RBI’s financial year
shouldn’t be less than Rs.100 cr and on any other working day not less
than Rs.10 cr. Further when 75% of WMA is utilized, the RBI may
consider fresh flotation of market loans depending on the market
Fiscal Deficit & Public Debt
The concepts of fiscal deficit and public debt
are closely linked. It has been observed that in
situations where fiscal deficit is high, amount
of public debt owed by governments is
proportionately high as well. This can have an
adverse impact on economic growth.
The Deficit and the Explosion of
Debt at the start of next year
= Debt at the start of this year
+ Purchases this year
+ Transfers this year
+ Interest on the debt this year
- Receipts this year
Fiscal Deficit & Public Debt
Government debt also known as public debt,
national debt is money owed by any level of
By contrast, annual government deficit refers
to the difference between government receipts
and spending in a single year.
Government debt can be categorized as internal debt, owed to lenders
within the country, external debt, owed to foreign lenders and other
Both internal and external debt is secured under ‘Consolidated Fund of
India’ and other liabilities under Public account.
Governments usually borrow by issuing securities and government bonds
Less creditworthy countries sometimes borrow directly from international
% of GDP
Short-term public debt is foreseen to last only
one or two years, so the turnover rate is fairly
Long-term public debt is designed to last more
than ten years, with some long term debt
lasting considerably longer than that.
Mid-term public debt lasts anywhere between
three and ten years.
Public Debt: India
The Ricardian equivalence proposition suggests consumers
internalise the government's budget constraint and thus the timing
of any tax change does not affect their change in spending.
Ricardian equivalence suggests that it does not matter whether a
government finances its spending with debt or a tax increase, the
effect on total level of demand in an economy being the same.
Governments can raise money either through taxes or by issuing
bonds. Since bonds are loans, they must eventually be repaid—
presumably by raising taxes in the future. The choice is therefore
"tax now or tax later."