Fiscal Policy: Economics | IBPS PO Prelims & Mains Preparation - Bank Exams PDF Download

Introduction

Fiscal policy is the guiding force that helps the government decide how much money it should spend to support the economic activity, and how much revenue it must earn from the system, to keep the wheels of the economy running smoothly.
For example: During an economic downturn, the government may decide to open up its coffers to spend more on building projects, welfare schemes, providing business incentives, etc. The aim is to help make more of productive money available to the people, free up some cash with the people so that they can spend it elsewhere, and encourage businesses to make investments. At the same time, the government may also decide to tax businesses and people a little less, thereby earning lesser revenue itself.

Objectives of Fiscal Policy

• Economic growth: Fiscal policy helps maintain the economy’s growth rate so that certain economic goals can be achieved.
• Price stability: It controls the price level of the country so that when inflation is too high, prices can be regulated.
• Full employment: It aims to achieve full employment, or near full employment, as a tool to recover from low economic activity.

Importance of Fiscal Policy 

• In a country like India, fiscal policy plays a key role in elevating the rate of capital formation both in the public and private sectors.
• Through taxation, the fiscal policy helps mobilise a considerable amount of resources for financing its numerous projects.
• Fiscal policy also helps in providing stimulus to elevate the savings rate.
• The fiscal policy gives adequate incentives to the private sector to expand its activities.
• Fiscal policy aims to minimise the imbalance in the dispersal of income and wealth.

Components of Fiscal Policy

1. Capital Account: A capital account is an account that includes capital receipts and payments. It basically includes assets as well as liabilities of the government.

(a) Capital Expenditure: Capital expenditure is the expenditures made by the government to create physical or financial assets.

Capital expenditure either create an asset or causes a reduction in liabilities of the government.

(b) Capital Receipts: Capital receipts are those which create a liability on the government or reduce the assets.

Revenue Expenditure is divided into:

• Plan Expenditure which is made for central government plans (Five-year plans), and other State and Union Territory plans.
• Non-Plan Expenditure which are general expenditures such as salaries, pensions, interest payments.

(b) Revenue Receipts: Revenue receipts are the current income to the government and they cannot be taken back from the government.

The Revenue receipts are divided into Tax and Non-Tax Revenue: 

• Tax Revenue is the main component of revenue receipts. It includes taxes and duties made by the government.

Tax Revenue mainly includes:

- Direct taxes (personal income tax, corporation tax) fall directly on a person.
- Indirect taxes include (excise duties and customs duties) which are on goods produced in the country or goods that are exported and imported.

• Non Tax Revenue includes interest on loans of the government, dividends and profits on investment and foreign aid.

Deficits and their Types

What Is a Deficit?
A deficit is an amount by which a resource, especially money, falls short of what is required. A deficit occurs when expenses exceed revenues, imports exceed exports, or liabilities exceed assets.
In a deficit, the total of negative amounts is greater than the total of positive amounts. In other words, the outflow of money exceeds the inflow of funds. A deficit can occur when a government, company, or individual spends more than is received in a given period, usually a year.

(i) Current account deficit is when a country imports more goods and services than it exports.

Current Account = Trade gap + Net current transfers + Net income abroad Trade gap = Exports – Imports

(ii) A fiscal deficit occurs when a government's total expenditures exceed the revenue that it generates, excluding money from borrowings.

Fiscal Deficit = Total expenditure of the government (capital and revenue expenditure) – Total income of the government (Revenue receipts + recovery of loans + other receipts)

(iii) Primary deficit is the fiscal deficit of the current year minus interest payments on previous borrowings.
Primary Deficit = Fiscal Deficit (Total expenditure – Total income of the government) – Interest payments (of previous borrowings)

(iv) Revenue deficit relates only to the government: It describes the shortfall of total revenue receipts compared to total revenue expenditures.

Revenue Deficit: Total revenue receipts – Total revenue expenditure.

(v) Effective Revenue Deficit is the difference between revenue deficit and grants for the creation of capital assets.

Effective Revenue Deficit: Revenue deficit - Grant for creation of capital assets.

Fiscal Responsibility and Budget Management Act (FRBMA), 2003

The objective of this FRBM Act is to impose fiscal discipline on the government.

It means fiscal policy should be conducted in a disciplined manner or in a responsible manner i.e. government deficits or borrowings should be kept within reasonable limits and the government should plan its expenditure in accordance with its revenues so that the borrowing should be within limits.

Targets under this FRBM Act

• The FRBM rule specifies reduction of fiscal deficit to 3% of the GDP by 2008-09 with an annual reduction target of 0.3% of GDP per year by the Central government.
• Similarly, the revenue deficit has to be reduced by 0.5% of the GDP per year with complete elimination to be achieved by 2008-09.

Methods to Control Fiscal Deficit

• Printing Fresh Currency by RBI (May Cause Inflation)
• Market Borrowing (May Cause Crowding Out of Private Investment)

Better Approach Is That Resources Should Be Raised from Taxes, User Charges, Disinvestment Etc.
Expenditure Control Should Not Involve Cost Cuts on Important Social Schemes Like Mgnrega Etc.

• GST
• Selective Disinvestment (Air India)
• Broadening of Tax Base
• Tax Buoyancy Etc

NK Singh Committee Recommendations (From Review Committee).

The FRBM Review Committee headed by former Revenue Secretary, NK Singh was appointed by the government to review the implementation of FRBM.

Major Recommendations of the N.K. Singh Committee

The key recommendations of the committee are summarised below:

Debt to GDP ratio

• The NK Singh Committee suggested making debt the main focus of fiscal policy.
• They proposed targeting a Debt to GDP ratio of 60%, with a 40% limit for the central government and a 20% limit for state governments.
• Many countries with fiscal rules in place also aim for a Debt-to-GDP ratio of 60%.
• The goal is to reach the targeted debt to GDP ratio by 2023.
• To achieve this goal, the committee recommended setting yearly targets to gradually decrease fiscal and revenue deficits until 2023.
• Debt signifies the total government liabilities, while fiscal deficit represents new borrowings for the year and revenue deficit indicates the portion used to cover expenses.

Fiscal Council

• The NK Singh Committee recommended establishing an independent fiscal Council with a chairperson and two members chosen by the central government.
• To ensure autonomy, it suggested a fixed 4-year term for both the chairperson and members.
• Individuals in these roles must not hold positions in the Central or State Government during their appointment.

Role of the Fiscal Council

• The Council's task would involve creating financial forecasts for multiple years.
• It would suggest alterations to the financial plan.
• Enhancing the quality of fiscal information is another goal.
• If necessary, the Council would advise the government on straying from the fiscal target.
• If there is non-compliance with the bill, the Council would recommend corrective actions to the government.

Debt Trajectory for the Individual States

• The committee suggested that the 15th finance commission should be tasked with proposing the financial path for each State.
• This decision should be based on how well each State has managed its finances and public well-being.

Deviations

• The NK Singh Committee emphasized that the government must adhere to targets under the FRBM act, except in specific circumstances like national calamities, national security concerns, or other exceptional situations as designated by the government.
• It was recommended by the committee that the reasons permitting the government to deviate from the set targets should be explicitly outlined, and the government should not have the authority to specify additional circumstances.

Fiscal Deficit as the operating target

• The group supported using fiscal deficit as the main target to decrease the government debt.
• To consolidate finances, the central government needs to reduce the fiscal deficit from 3.5% in 2017 to 2.5% by 2023.
• An analysis conducted for the central government indicates that aiming for this deficit will aid in achieving the 40% public debt target by 2023.

Revenue Deficit Target

• The committee suggested that the national government should gradually reduce the revenue shortfall by 0.25% of the Gross Domestic Product (GDP) each year.
• The goal is to achieve 0.8% by 2023 from the current level of 2.3% in 2017.

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