Economics Chapter 1.5 – Government Budget and The Economy

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Chapter 1.5 – Government Budget and The Economy

Economics Chapter 1.5 – Government Budget and The Economy

1. Introduction to Government in a Mixed Economy

  • The government plays a significant role in managing the economy alongside the private sector in a mixed economy.
  • Through the government budget, it regulates income distribution, manages public goods, stabilizes economic fluctuations, and provides essential services.
  • This chapter focuses on understanding the components of the government budget, types of deficits, fiscal policies, and public debt.

2. The Government Budget: Meaning and Components

2.1 Constitutional Requirement (Article 112)

  • India’s constitution mandates the government to present an Annual Financial Statement to the Parliament, which outlines the government’s estimated receipts and expenditures for each financial year (April 1 to March 31).

2.2 Objectives of the Government Budget

The government intervenes in the economy through several functions to ensure the welfare of the people:

  1. Allocation Function:
    • The government provides public goods that the private sector cannot efficiently supply due to their nature:
      • Non-rivalrous: One person’s consumption does not reduce the availability for others.
      • Non-excludable: It’s impossible to prevent non-payers from benefiting (e.g., national defense, roads).
    • Public provision refers to financing goods via the budget, while public production means the government directly produces these goods.
  2. Redistribution Function:
    • The government alters income distribution through taxes and transfers. For example, progressive income taxation reduces income inequality.
    • This function allows the government to achieve what society considers a fairer distribution of wealth.
  3. Stabilization Function:
    • The government adjusts aggregate demand to stabilize income and employment levels.
    • During periods of low demand, the government may increase its spending to prevent underutilization of resources.
    • Conversely, when demand exceeds supply, leading to inflation, the government may reduce spending or increase taxes to stabilize the economy.

3. Classification of Receipts

3.1 Revenue Receipts

  • These are non-redeemable receipts that do not result in claims on the government.
  • Divided into:
    1. Tax Revenues:
      • Direct Taxes: Levied on individuals and corporations (e.g., income tax, corporation tax).
      • Indirect Taxes: Levied on goods and services (e.g., excise, customs, and service taxes).
    2. Non-Tax Revenues:
      • Includes interest receipts from government loans, dividends, and profits from public enterprises.

3.2 Capital Receipts

  • These receipts either create liabilities or result in the sale of assets.
  • Examples:
    1. Loans: Borrowed money that creates a liability for repayment.
    2. Disinvestment: Selling shares in public enterprises reduces government assets.

4. Classification of Expenditure

4.1 Revenue Expenditure

  • This includes day-to-day expenses that do not create assets or reduce liabilities, such as salaries, interest payments, and subsidies.
  • Divided into:
    1. Plan Expenditure: Spending on central plans and state plans (Five-Year Plans).
    2. Non-Plan Expenditure: Spending on essential services such as defense, education, and interest payments.

4.2 Capital Expenditure

  • This expenditure results in the creation of assets or reduction of liabilities.
  • Examples:
    1. Investment in infrastructure like roads and buildings.
    2. Loans and advances provided by the government to states or other entities.

5. Types of Budgets

5.1 Balanced Budget

  • Occurs when the government’s total expenditure equals its receipts.

5.2 Surplus Budget

  • Happens when revenues exceed expenditures. This is less common and can reduce inflationary pressures.

5.3 Deficit Budget

  • The most common type, where expenditures exceed revenues. The government needs to finance the deficit through borrowing or other means.

6. Measures of Government Deficit

  1. Revenue Deficit:
    • The difference between revenue expenditure and revenue receipts.
    • Indicates how much the government needs to borrow to meet its regular consumption needs.
    • Formula:

Revenue Deficit = Revenue Expenditure − Revenue Receipts

  1. Fiscal Deficit:
    • Represents the total borrowing requirement of the government.
    • Formula:

Fiscal Deficit = Total Expenditure − (Revenue Receipts + Non-Debt Capital Receipts)

  1. Indicates how much the government needs to borrow to cover both its consumption and capital investments.
  2. Primary Deficit:
    • Focuses on the government’s fiscal imbalance excluding interest payments on previous borrowings.
    • Formula: Primary Deficit = Fiscal Deficit − Interest Payments

7. Fiscal Policy: Keynesian Perspective

  • Fiscal policy refers to government actions in adjusting its expenditures and revenues to influence the economy.
  • Keynes argued that government spending could stimulate demand during economic downturns and curb demand during periods of inflation.
  • The fiscal multiplier measures how changes in government spending or taxes affect overall income levels.
  1. Government Spending Multiplier:
    • An increase in government spending directly raises aggregate demand.
    • Formula: ΔY=1 / 1−c × ΔG
    • Where ccc is the marginal propensity to consume (MPC), and ΔG is the change in government spending.
  2. Tax Multiplier:
    • A reduction in taxes increases disposable income, leading to higher consumption.
    • Formula: ΔY= −c / 1−c × ΔT
    • This multiplier is negative, as tax cuts increase consumption but the effect is generally smaller than direct government spending increases.

8. Debt and Deficits

  • Public debt results from accumulated borrowing to cover past deficits.
  1. Is Public Debt a Burden?
    • If the government borrows domestically, the burden is mainly on future generations who must repay it through taxes.
    • If debt is owed to foreigners, it requires the transfer of goods and services abroad, which impacts national wealth.
  2. Ricardian Equivalence:
    • A theory suggesting that consumers are forward-looking. They anticipate that borrowing today will lead to higher taxes tomorrow, thus they increase savings to prepare for future tax burdens, making government borrowing equivalent to taxation.

9. Reducing Deficits

  • Governments can reduce deficits by:
    1. Increasing taxes.
    2. Cutting expenditure.
    3. Privatizing public enterprises (e.g., disinvestment in PSUs).
  • There is often debate over which areas of government spending to reduce. Cuts to critical services like education and healthcare can have long-term negative effects, while increased efficiency and better administration can help reduce unnecessary expenditures.

10. Fiscal Responsibility and Budget Management Act (FRBMA)

  • Enacted in 2003, the FRBMA aimed to reduce fiscal deficits and ensure macroeconomic stability.
  • Key objectives:
    1. Reduce fiscal deficit to 3% of GDP by a set deadline.
    2. Eliminate revenue deficit over time.
    3. Restrict the government’s ability to borrow from the central bank (RBI).

11. Goods and Services Tax (GST)

  • The GST, implemented on July 1, 2017, replaced multiple indirect taxes with a unified tax system.
  • It is a destination-based consumption tax, designed to reduce tax cascading (tax on tax) and make compliance easier.

GST applies to most goods and services in India, streamlining taxation across states and reducing the complexity of the tax structure.

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