NCERT Textbook - Government Budget and the Economy Commerce Notes | EduRev

Economy and Indian Economy (Prelims) by Shahid Ali

Created by: Lakshya Ias

UPSC : NCERT Textbook - Government Budget and the Economy Commerce Notes | EduRev

 Page 1


Chapter 5
The Governmen The Governmen The Governmen The Governmen The Government t t t t : : : : :
F F F F Functions and Scope unctions and Scope unctions and Scope unctions and Scope unctions and Scope
In a mixed economy, apart from the private sector, there is the
government which plays a very important role. In this chapter,
we shall not deal with the myriad ways in which it influences
economic life but limit ourselves to three distinct functions that
operate through the revenue and expenditure measures of the
government budget.
First, 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.
Second, through its tax and expenditure policy, the
government 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.
Third, the economy tends to be subject to substantial
fluctuations and may suffer from prolonged periods of
unemployment or inflation. The overall level of employment and
prices in the economy depends upon the level of aggregate demand
which is a function of the spending decisions of millions of private
economic agents apart from the government. These decisions, in
turn, depend on many factors such as income and credit
availability. In any period, the level of expenditures may not be
sufficient for full utilisation of labour and other resources of the
economy. Since wages and prices are generally rigid downwards
(they do not fall below a level), employment cannot be restored
automatically. Hence, policy measures are needed to raise
aggregate demand. On the other hand, 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 stabilisation requirements of the domestic economy.
To understand the need for governmental provision of public
goods, we must consider what distinguishes them from private
goods. There are two major differences. One, the benefits of public
goods are not limited to one particular consumer, as in the case
of private goods, but become available to all. For instance, if a
Page 2


Chapter 5
The Governmen The Governmen The Governmen The Governmen The Government t t t t : : : : :
F F F F Functions and Scope unctions and Scope unctions and Scope unctions and Scope unctions and Scope
In a mixed economy, apart from the private sector, there is the
government which plays a very important role. In this chapter,
we shall not deal with the myriad ways in which it influences
economic life but limit ourselves to three distinct functions that
operate through the revenue and expenditure measures of the
government budget.
First, 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.
Second, through its tax and expenditure policy, the
government 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.
Third, the economy tends to be subject to substantial
fluctuations and may suffer from prolonged periods of
unemployment or inflation. The overall level of employment and
prices in the economy depends upon the level of aggregate demand
which is a function of the spending decisions of millions of private
economic agents apart from the government. These decisions, in
turn, depend on many factors such as income and credit
availability. In any period, the level of expenditures may not be
sufficient for full utilisation of labour and other resources of the
economy. Since wages and prices are generally rigid downwards
(they do not fall below a level), employment cannot be restored
automatically. Hence, policy measures are needed to raise
aggregate demand. On the other hand, 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 stabilisation requirements of the domestic economy.
To understand the need for governmental provision of public
goods, we must consider what distinguishes them from private
goods. There are two major differences. One, the benefits of public
goods are not limited to one particular consumer, as in the case
of private goods, but become available to all. For instance, if a
person consumes a chocolate or wears a shirt, these will not be available to
other individuals. This person’s consumption stands in a rival relationship to
the consumption of others. However, if we consider a public park or measures
to reduce air pollution, the benefits will be available to all. The consumption of
such products by several individuals is not ‘rivalrous’ in the sense that a person
can enjoy the benefits without reducing their availablity to others. Two, in
case of private goods anyone who does not pay for the good can be excluded
from enjoying its benefits. If you do not buy a ticket, you are excluded from
watching a film at a local theatre. However, in case of public goods, there is no
feasible way of excluding anyone from enjoying the benefits of the good (they
are non-excludable). Since non-paying users usually cannot be excluded, it
becomes difficult or impossible to collect fees for the public good. This is what
is called the ‘free-rider’ problem. Consumers will not voluntarily pay for what
they can get for free and for which there is no exclusive title to the property
being enjoyed. The link between the producer and the consumer is broken
and the government must step in to provide for such goods. Public provision,
however, is not the same as public production. Public provision means that
they are financed through the budget and made available free of any direct
payment. These goods may be produced directly under government
management or by the private sector.
The chapter proceeds as follows. In section 5.1, we present the components
of the government budget to bring out the sources of government revenue and
the avenues of government spending. In section 5.2, we discuss the issue of
government deficit, when expenditures exceed revenue collection. Section 5.3
deals with fiscal policy and the multiplier process within the income expenditure
approach described earlier. Government borrowing to cover deficits leads to debt
accumulation – what the government owes. The chapter concludes with an
analysis of the debt issue.
5.1 COMPONENTS OF THE GOVERNMENT BUDGET
There is a constitutional requirement in India (Article 112) to present before the
Parliament a statement of estimated receipts and expenditures of the government
in respect of every financial year which runs from 1 April to 31 March. This
‘Annual Financial Statement’ constitutes the main budget document. Further,
the budget must distinguish expenditure on the revenue account from other
expenditures. Therefore, the budget comprises of the (a) Revenue Budget and
the (b) Capital Budget (Refer Chart 1).
5.1.1 The Revenue Account
The Revenue Budget shows the current receipts of the government and the
expenditure that can be met from these receipts.
Revenue Receipts: Revenue receipts are divided into tax and non-tax revenues.
Tax revenues consist of the proceeds of taxes and other duties levied by the
central government. Tax revenues, an important component of revenue receipts,
comprise of direct taxes – which fall directly on individuals (personal income
tax) and firms (corporation tax), and indirect taxes like excise taxes (duties
levied on goods produced within the country), customs duties (taxes imposed
on goods imported into and exported out of India) and service tax. Excise
taxes are the single largest revenue earner contributing 35.7 per cent of total
tax revenue in 2003-04. Other direct taxes like wealth tax, gift tax and estate
61 61 61 61 61
The Government:
Function and Scope
Page 3


Chapter 5
The Governmen The Governmen The Governmen The Governmen The Government t t t t : : : : :
F F F F Functions and Scope unctions and Scope unctions and Scope unctions and Scope unctions and Scope
In a mixed economy, apart from the private sector, there is the
government which plays a very important role. In this chapter,
we shall not deal with the myriad ways in which it influences
economic life but limit ourselves to three distinct functions that
operate through the revenue and expenditure measures of the
government budget.
First, 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.
Second, through its tax and expenditure policy, the
government 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.
Third, the economy tends to be subject to substantial
fluctuations and may suffer from prolonged periods of
unemployment or inflation. The overall level of employment and
prices in the economy depends upon the level of aggregate demand
which is a function of the spending decisions of millions of private
economic agents apart from the government. These decisions, in
turn, depend on many factors such as income and credit
availability. In any period, the level of expenditures may not be
sufficient for full utilisation of labour and other resources of the
economy. Since wages and prices are generally rigid downwards
(they do not fall below a level), employment cannot be restored
automatically. Hence, policy measures are needed to raise
aggregate demand. On the other hand, 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 stabilisation requirements of the domestic economy.
To understand the need for governmental provision of public
goods, we must consider what distinguishes them from private
goods. There are two major differences. One, the benefits of public
goods are not limited to one particular consumer, as in the case
of private goods, but become available to all. For instance, if a
person consumes a chocolate or wears a shirt, these will not be available to
other individuals. This person’s consumption stands in a rival relationship to
the consumption of others. However, if we consider a public park or measures
to reduce air pollution, the benefits will be available to all. The consumption of
such products by several individuals is not ‘rivalrous’ in the sense that a person
can enjoy the benefits without reducing their availablity to others. Two, in
case of private goods anyone who does not pay for the good can be excluded
from enjoying its benefits. If you do not buy a ticket, you are excluded from
watching a film at a local theatre. However, in case of public goods, there is no
feasible way of excluding anyone from enjoying the benefits of the good (they
are non-excludable). Since non-paying users usually cannot be excluded, it
becomes difficult or impossible to collect fees for the public good. This is what
is called the ‘free-rider’ problem. Consumers will not voluntarily pay for what
they can get for free and for which there is no exclusive title to the property
being enjoyed. The link between the producer and the consumer is broken
and the government must step in to provide for such goods. Public provision,
however, is not the same as public production. Public provision means that
they are financed through the budget and made available free of any direct
payment. These goods may be produced directly under government
management or by the private sector.
The chapter proceeds as follows. In section 5.1, we present the components
of the government budget to bring out the sources of government revenue and
the avenues of government spending. In section 5.2, we discuss the issue of
government deficit, when expenditures exceed revenue collection. Section 5.3
deals with fiscal policy and the multiplier process within the income expenditure
approach described earlier. Government borrowing to cover deficits leads to debt
accumulation – what the government owes. The chapter concludes with an
analysis of the debt issue.
5.1 COMPONENTS OF THE GOVERNMENT BUDGET
There is a constitutional requirement in India (Article 112) to present before the
Parliament a statement of estimated receipts and expenditures of the government
in respect of every financial year which runs from 1 April to 31 March. This
‘Annual Financial Statement’ constitutes the main budget document. Further,
the budget must distinguish expenditure on the revenue account from other
expenditures. Therefore, the budget comprises of the (a) Revenue Budget and
the (b) Capital Budget (Refer Chart 1).
5.1.1 The Revenue Account
The Revenue Budget shows the current receipts of the government and the
expenditure that can be met from these receipts.
Revenue Receipts: Revenue receipts are divided into tax and non-tax revenues.
Tax revenues consist of the proceeds of taxes and other duties levied by the
central government. Tax revenues, an important component of revenue receipts,
comprise of direct taxes – which fall directly on individuals (personal income
tax) and firms (corporation tax), and indirect taxes like excise taxes (duties
levied on goods produced within the country), customs duties (taxes imposed
on goods imported into and exported out of India) and service tax. Excise
taxes are the single largest revenue earner contributing 35.7 per cent of total
tax revenue in 2003-04. Other direct taxes like wealth tax, gift tax and estate
61 61 61 61 61
The Government:
Function and Scope
62 62 62 62 62
Introductory Macroeconomics
duty (now abolished) have never been of much significance in terms of revenue
yield and have thus been referred to as ‘paper taxes’. Two new
taxes – the fringe benefits tax (on those benefits enjoyed collectively by the
employees) and on cash withdrawals from banks over a certain threshold in a
day – were introduced in the budget for 2005-06. The share of direct taxes in
gross tax revenue has increased from 19.1 per cent in 1990-91 to 41.3 per cent
in 2003-04. There has been a reduction in the share of indirect tax revenue,
falling from 78.4 per cent in 1990-91 to 57.9 per cent in 2003-04.
The redistribution objective is sought to be achieved through progressive
income taxation, in which higher the income, higher is the tax rate. Firms are
taxed on a proportional basis, where the tax rate is a particular proportion of
profits. With respect to excise taxes, necessities of life are exempted or taxed at
low rates, comforts and semi-luxuries are moderately taxed, and luxuries,
tobacco and petroleum products are taxed heavily.
Non-tax revenue of the central government mainly consists of interest
receipts (on account of loans by the central government which constitutes the
single largest item of non-tax revenue), dividends and profits on investments
made by the government, fees and other receipts for services rendered by the
government. Cash grants-in-aid from foreign countries and international
organisations are also included.
The estimates of revenue receipts take into account the effects of tax proposals
made in the Finance Bill
1
.
Government Budget
Revenue
Budget
Capital
Budget
Revenue
Receipts
Capital
Expenditure
Capital
Receipts
Capital
Expenditure
Non-tax
Revenue
Tax
Revenue
Plan Revenue
Expenditure
Non-plan Revenue
Expenditure
Non-plan Capital
Expenditure
Plan Capital
Expenditure
Chart 1: The Components of the Government Budget
1
A Finance Bill, presented along with the Annual Financial Statement, provides details of the
imposition, abolition, remission, alteration or regulation of taxes proposed in the Budget.
Revenue Expenditure: Broadly speaking, revenue expenditure consists of all
those expenditures of the government which do not result in creation of physical
or financial assets. It relates to those 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 (even though some of the grants may be meant for creation of assets).
Page 4


Chapter 5
The Governmen The Governmen The Governmen The Governmen The Government t t t t : : : : :
F F F F Functions and Scope unctions and Scope unctions and Scope unctions and Scope unctions and Scope
In a mixed economy, apart from the private sector, there is the
government which plays a very important role. In this chapter,
we shall not deal with the myriad ways in which it influences
economic life but limit ourselves to three distinct functions that
operate through the revenue and expenditure measures of the
government budget.
First, 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.
Second, through its tax and expenditure policy, the
government 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.
Third, the economy tends to be subject to substantial
fluctuations and may suffer from prolonged periods of
unemployment or inflation. The overall level of employment and
prices in the economy depends upon the level of aggregate demand
which is a function of the spending decisions of millions of private
economic agents apart from the government. These decisions, in
turn, depend on many factors such as income and credit
availability. In any period, the level of expenditures may not be
sufficient for full utilisation of labour and other resources of the
economy. Since wages and prices are generally rigid downwards
(they do not fall below a level), employment cannot be restored
automatically. Hence, policy measures are needed to raise
aggregate demand. On the other hand, 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 stabilisation requirements of the domestic economy.
To understand the need for governmental provision of public
goods, we must consider what distinguishes them from private
goods. There are two major differences. One, the benefits of public
goods are not limited to one particular consumer, as in the case
of private goods, but become available to all. For instance, if a
person consumes a chocolate or wears a shirt, these will not be available to
other individuals. This person’s consumption stands in a rival relationship to
the consumption of others. However, if we consider a public park or measures
to reduce air pollution, the benefits will be available to all. The consumption of
such products by several individuals is not ‘rivalrous’ in the sense that a person
can enjoy the benefits without reducing their availablity to others. Two, in
case of private goods anyone who does not pay for the good can be excluded
from enjoying its benefits. If you do not buy a ticket, you are excluded from
watching a film at a local theatre. However, in case of public goods, there is no
feasible way of excluding anyone from enjoying the benefits of the good (they
are non-excludable). Since non-paying users usually cannot be excluded, it
becomes difficult or impossible to collect fees for the public good. This is what
is called the ‘free-rider’ problem. Consumers will not voluntarily pay for what
they can get for free and for which there is no exclusive title to the property
being enjoyed. The link between the producer and the consumer is broken
and the government must step in to provide for such goods. Public provision,
however, is not the same as public production. Public provision means that
they are financed through the budget and made available free of any direct
payment. These goods may be produced directly under government
management or by the private sector.
The chapter proceeds as follows. In section 5.1, we present the components
of the government budget to bring out the sources of government revenue and
the avenues of government spending. In section 5.2, we discuss the issue of
government deficit, when expenditures exceed revenue collection. Section 5.3
deals with fiscal policy and the multiplier process within the income expenditure
approach described earlier. Government borrowing to cover deficits leads to debt
accumulation – what the government owes. The chapter concludes with an
analysis of the debt issue.
5.1 COMPONENTS OF THE GOVERNMENT BUDGET
There is a constitutional requirement in India (Article 112) to present before the
Parliament a statement of estimated receipts and expenditures of the government
in respect of every financial year which runs from 1 April to 31 March. This
‘Annual Financial Statement’ constitutes the main budget document. Further,
the budget must distinguish expenditure on the revenue account from other
expenditures. Therefore, the budget comprises of the (a) Revenue Budget and
the (b) Capital Budget (Refer Chart 1).
5.1.1 The Revenue Account
The Revenue Budget shows the current receipts of the government and the
expenditure that can be met from these receipts.
Revenue Receipts: Revenue receipts are divided into tax and non-tax revenues.
Tax revenues consist of the proceeds of taxes and other duties levied by the
central government. Tax revenues, an important component of revenue receipts,
comprise of direct taxes – which fall directly on individuals (personal income
tax) and firms (corporation tax), and indirect taxes like excise taxes (duties
levied on goods produced within the country), customs duties (taxes imposed
on goods imported into and exported out of India) and service tax. Excise
taxes are the single largest revenue earner contributing 35.7 per cent of total
tax revenue in 2003-04. Other direct taxes like wealth tax, gift tax and estate
61 61 61 61 61
The Government:
Function and Scope
62 62 62 62 62
Introductory Macroeconomics
duty (now abolished) have never been of much significance in terms of revenue
yield and have thus been referred to as ‘paper taxes’. Two new
taxes – the fringe benefits tax (on those benefits enjoyed collectively by the
employees) and on cash withdrawals from banks over a certain threshold in a
day – were introduced in the budget for 2005-06. The share of direct taxes in
gross tax revenue has increased from 19.1 per cent in 1990-91 to 41.3 per cent
in 2003-04. There has been a reduction in the share of indirect tax revenue,
falling from 78.4 per cent in 1990-91 to 57.9 per cent in 2003-04.
The redistribution objective is sought to be achieved through progressive
income taxation, in which higher the income, higher is the tax rate. Firms are
taxed on a proportional basis, where the tax rate is a particular proportion of
profits. With respect to excise taxes, necessities of life are exempted or taxed at
low rates, comforts and semi-luxuries are moderately taxed, and luxuries,
tobacco and petroleum products are taxed heavily.
Non-tax revenue of the central government mainly consists of interest
receipts (on account of loans by the central government which constitutes the
single largest item of non-tax revenue), dividends and profits on investments
made by the government, fees and other receipts for services rendered by the
government. Cash grants-in-aid from foreign countries and international
organisations are also included.
The estimates of revenue receipts take into account the effects of tax proposals
made in the Finance Bill
1
.
Government Budget
Revenue
Budget
Capital
Budget
Revenue
Receipts
Capital
Expenditure
Capital
Receipts
Capital
Expenditure
Non-tax
Revenue
Tax
Revenue
Plan Revenue
Expenditure
Non-plan Revenue
Expenditure
Non-plan Capital
Expenditure
Plan Capital
Expenditure
Chart 1: The Components of the Government Budget
1
A Finance Bill, presented along with the Annual Financial Statement, provides details of the
imposition, abolition, remission, alteration or regulation of taxes proposed in the Budget.
Revenue Expenditure: Broadly speaking, revenue expenditure consists of all
those expenditures of the government which do not result in creation of physical
or financial assets. It relates to those 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 (even though some of the grants may be meant for creation of assets).
63 63 63 63 63
The Government:
Functions and Scope
Budget documents classify total revenue expenditure into plan and
non-plan expenditure. Plan revenue expenditure relates to central Plans
(the Five-Year Plans) and central assistance for State and Union Territory Plans.
Non-plan expenditure, the more important component of revenue 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 and pensions.
Interest payments on market loans, external loans and from various reserve
funds constitute the single largest component of non-plan revenue
expenditure. They used up 41.5 per cent of revenue receipts in 2004-05.
Defence expenditure, the second largest component of non-plan 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. Apart from
providing implicit subsidies through under-pricing of public goods and
services like education and health, the government also extends subsidies
explicitly on items such as exports, interest on loans, food and fertilisers.
The amount of subsidies as a per cent of GDP has been falling from 1.7 per
cent in 1990-91 to 1.66 per cent in 2002-03 to 1.45 per cent in 2004-05.
5.1.2 The Capital Account
The Capital Budget is an account of the assets as well as liabilities of the central
government, which takes into consideration changes in capital. It consists of
capital receipts and capital expenditure of the government. This shows the capital
requirements of the government and the pattern of their financing.
Capital Receipts: The main items of capital receipts are loans raised by the
government from the public which are called market borrowings, borrowing by
the government from the Reserve Bank and commercial banks and other financial
institutions through the sale of treasury bills, loans received from foreign
governments and international organisations, and recoveries of loans granted
by the central government. Other items include 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 (PSUs).
Capital Expenditure: This includes 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. Capital expenditure is also categorised as plan and non-plan in
the budget documents. Plan capital expenditure, like its revenue counterpart,
relates to central plan and central assistance for state and union territory plans.
Non-plan capital expenditure covers various general, social and economic services
provided by the government.
The budget is not merely a statement of receipts and expenditures.
Since Independence, with the launching of the Five-Year Plans, it has also become
a significant national policy statement. The budget, it has been argued, reflects
and shapes, and is, in turn, shaped by the country’s economic life. Along with
the budget, three policy statements are mandated by the Fiscal Responsibility
and Budget Management Act, 2003 (FRBMA). The Medium-term Fiscal Policy
Statement sets a three-year rolling target for specific fiscal indicators and
examines whether revenue expenditure can be financed through revenue receipts
on a sustainable basis and how productively capital receipts including market
Page 5


Chapter 5
The Governmen The Governmen The Governmen The Governmen The Government t t t t : : : : :
F F F F Functions and Scope unctions and Scope unctions and Scope unctions and Scope unctions and Scope
In a mixed economy, apart from the private sector, there is the
government which plays a very important role. In this chapter,
we shall not deal with the myriad ways in which it influences
economic life but limit ourselves to three distinct functions that
operate through the revenue and expenditure measures of the
government budget.
First, 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.
Second, through its tax and expenditure policy, the
government 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.
Third, the economy tends to be subject to substantial
fluctuations and may suffer from prolonged periods of
unemployment or inflation. The overall level of employment and
prices in the economy depends upon the level of aggregate demand
which is a function of the spending decisions of millions of private
economic agents apart from the government. These decisions, in
turn, depend on many factors such as income and credit
availability. In any period, the level of expenditures may not be
sufficient for full utilisation of labour and other resources of the
economy. Since wages and prices are generally rigid downwards
(they do not fall below a level), employment cannot be restored
automatically. Hence, policy measures are needed to raise
aggregate demand. On the other hand, 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 stabilisation requirements of the domestic economy.
To understand the need for governmental provision of public
goods, we must consider what distinguishes them from private
goods. There are two major differences. One, the benefits of public
goods are not limited to one particular consumer, as in the case
of private goods, but become available to all. For instance, if a
person consumes a chocolate or wears a shirt, these will not be available to
other individuals. This person’s consumption stands in a rival relationship to
the consumption of others. However, if we consider a public park or measures
to reduce air pollution, the benefits will be available to all. The consumption of
such products by several individuals is not ‘rivalrous’ in the sense that a person
can enjoy the benefits without reducing their availablity to others. Two, in
case of private goods anyone who does not pay for the good can be excluded
from enjoying its benefits. If you do not buy a ticket, you are excluded from
watching a film at a local theatre. However, in case of public goods, there is no
feasible way of excluding anyone from enjoying the benefits of the good (they
are non-excludable). Since non-paying users usually cannot be excluded, it
becomes difficult or impossible to collect fees for the public good. This is what
is called the ‘free-rider’ problem. Consumers will not voluntarily pay for what
they can get for free and for which there is no exclusive title to the property
being enjoyed. The link between the producer and the consumer is broken
and the government must step in to provide for such goods. Public provision,
however, is not the same as public production. Public provision means that
they are financed through the budget and made available free of any direct
payment. These goods may be produced directly under government
management or by the private sector.
The chapter proceeds as follows. In section 5.1, we present the components
of the government budget to bring out the sources of government revenue and
the avenues of government spending. In section 5.2, we discuss the issue of
government deficit, when expenditures exceed revenue collection. Section 5.3
deals with fiscal policy and the multiplier process within the income expenditure
approach described earlier. Government borrowing to cover deficits leads to debt
accumulation – what the government owes. The chapter concludes with an
analysis of the debt issue.
5.1 COMPONENTS OF THE GOVERNMENT BUDGET
There is a constitutional requirement in India (Article 112) to present before the
Parliament a statement of estimated receipts and expenditures of the government
in respect of every financial year which runs from 1 April to 31 March. This
‘Annual Financial Statement’ constitutes the main budget document. Further,
the budget must distinguish expenditure on the revenue account from other
expenditures. Therefore, the budget comprises of the (a) Revenue Budget and
the (b) Capital Budget (Refer Chart 1).
5.1.1 The Revenue Account
The Revenue Budget shows the current receipts of the government and the
expenditure that can be met from these receipts.
Revenue Receipts: Revenue receipts are divided into tax and non-tax revenues.
Tax revenues consist of the proceeds of taxes and other duties levied by the
central government. Tax revenues, an important component of revenue receipts,
comprise of direct taxes – which fall directly on individuals (personal income
tax) and firms (corporation tax), and indirect taxes like excise taxes (duties
levied on goods produced within the country), customs duties (taxes imposed
on goods imported into and exported out of India) and service tax. Excise
taxes are the single largest revenue earner contributing 35.7 per cent of total
tax revenue in 2003-04. Other direct taxes like wealth tax, gift tax and estate
61 61 61 61 61
The Government:
Function and Scope
62 62 62 62 62
Introductory Macroeconomics
duty (now abolished) have never been of much significance in terms of revenue
yield and have thus been referred to as ‘paper taxes’. Two new
taxes – the fringe benefits tax (on those benefits enjoyed collectively by the
employees) and on cash withdrawals from banks over a certain threshold in a
day – were introduced in the budget for 2005-06. The share of direct taxes in
gross tax revenue has increased from 19.1 per cent in 1990-91 to 41.3 per cent
in 2003-04. There has been a reduction in the share of indirect tax revenue,
falling from 78.4 per cent in 1990-91 to 57.9 per cent in 2003-04.
The redistribution objective is sought to be achieved through progressive
income taxation, in which higher the income, higher is the tax rate. Firms are
taxed on a proportional basis, where the tax rate is a particular proportion of
profits. With respect to excise taxes, necessities of life are exempted or taxed at
low rates, comforts and semi-luxuries are moderately taxed, and luxuries,
tobacco and petroleum products are taxed heavily.
Non-tax revenue of the central government mainly consists of interest
receipts (on account of loans by the central government which constitutes the
single largest item of non-tax revenue), dividends and profits on investments
made by the government, fees and other receipts for services rendered by the
government. Cash grants-in-aid from foreign countries and international
organisations are also included.
The estimates of revenue receipts take into account the effects of tax proposals
made in the Finance Bill
1
.
Government Budget
Revenue
Budget
Capital
Budget
Revenue
Receipts
Capital
Expenditure
Capital
Receipts
Capital
Expenditure
Non-tax
Revenue
Tax
Revenue
Plan Revenue
Expenditure
Non-plan Revenue
Expenditure
Non-plan Capital
Expenditure
Plan Capital
Expenditure
Chart 1: The Components of the Government Budget
1
A Finance Bill, presented along with the Annual Financial Statement, provides details of the
imposition, abolition, remission, alteration or regulation of taxes proposed in the Budget.
Revenue Expenditure: Broadly speaking, revenue expenditure consists of all
those expenditures of the government which do not result in creation of physical
or financial assets. It relates to those 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 (even though some of the grants may be meant for creation of assets).
63 63 63 63 63
The Government:
Functions and Scope
Budget documents classify total revenue expenditure into plan and
non-plan expenditure. Plan revenue expenditure relates to central Plans
(the Five-Year Plans) and central assistance for State and Union Territory Plans.
Non-plan expenditure, the more important component of revenue 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 and pensions.
Interest payments on market loans, external loans and from various reserve
funds constitute the single largest component of non-plan revenue
expenditure. They used up 41.5 per cent of revenue receipts in 2004-05.
Defence expenditure, the second largest component of non-plan 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. Apart from
providing implicit subsidies through under-pricing of public goods and
services like education and health, the government also extends subsidies
explicitly on items such as exports, interest on loans, food and fertilisers.
The amount of subsidies as a per cent of GDP has been falling from 1.7 per
cent in 1990-91 to 1.66 per cent in 2002-03 to 1.45 per cent in 2004-05.
5.1.2 The Capital Account
The Capital Budget is an account of the assets as well as liabilities of the central
government, which takes into consideration changes in capital. It consists of
capital receipts and capital expenditure of the government. This shows the capital
requirements of the government and the pattern of their financing.
Capital Receipts: The main items of capital receipts are loans raised by the
government from the public which are called market borrowings, borrowing by
the government from the Reserve Bank and commercial banks and other financial
institutions through the sale of treasury bills, loans received from foreign
governments and international organisations, and recoveries of loans granted
by the central government. Other items include 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 (PSUs).
Capital Expenditure: This includes 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. Capital expenditure is also categorised as plan and non-plan in
the budget documents. Plan capital expenditure, like its revenue counterpart,
relates to central plan and central assistance for state and union territory plans.
Non-plan capital expenditure covers various general, social and economic services
provided by the government.
The budget is not merely a statement of receipts and expenditures.
Since Independence, with the launching of the Five-Year Plans, it has also become
a significant national policy statement. The budget, it has been argued, reflects
and shapes, and is, in turn, shaped by the country’s economic life. Along with
the budget, three policy statements are mandated by the Fiscal Responsibility
and Budget Management Act, 2003 (FRBMA). The Medium-term Fiscal Policy
Statement sets a three-year rolling target for specific fiscal indicators and
examines whether revenue expenditure can be financed through revenue receipts
on a sustainable basis and how productively capital receipts including market
64 64 64 64 64
Introductory Macroeconomics
borrowings are being utilised. The Fiscal Policy Strategy Statement sets the
priorities of the government in the fiscal area, examining current policies and
justifying any deviation in important fiscal measures. The Macroeconomic
Framework Statement assesses the prospects of the economy with respect to
the GDP growth rate, fiscal balance of the central government and external balance
2
.
5.1.3 Measures of Government Deficit
When a government spends more than it collects by way of revenue, it incurs a
budget deficit
3
. There are various measures that capture government deficit and
they have their own implications for the economy.
Revenue Deficit: The 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.
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)
Non-debt creating capital receipts are those receipts which are not borrowings
and, therefore, do not give rise to debt. Examples are recovery of loans and the
proceeds from the sale of PSUs. 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 fiscal deficit of the central government, after declining from
6.6 per cent of GDP in 1990-91 to 4.1 per cent in 1996-97 rose to 6.2 per cent
2
The 2005-06 Indian Budget introduced a statement highlighting the gender sensitivities of the
budgetary allocations. 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 utilisation of resources allocated for women and the impact of public expenditure
and policies of the government on women. The 2006-07 budget enlarged the earlier statement.
3
More formally, it refers to the excess of total expenditure (both revenue and capital) over total
receipts (both revenue and capital). From the 1997-98 budget, the practice of showing budget
deficit has been discontinued in India.
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