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Public Finance
✓ Government intervention to direct the functioning of the economy is based on the belief that
the objective of the economic system and the role of government is to improve the wellbeing of
individuals and households.
✓ An economic system should exist to answer the basic questions such as what, how and for whom
to produce and how much resources should be set apart to ensure growth of productive
capacity.
✓ Role of the Government in an economic system
Adam smith’s view
➢ Adam smith is often described as the bold advocate of free markets and minimal
governmental activity. Smith believed that government’s roles in society should be limited
but well defined. According to him, the government should focus on resource allocation.
The government should contribute towards the national defence, establishing a system of
justice and establishment and maintenance of high beneficial public institutions and
works.
✓ Richard Musgrave’s View
➢ Richard Musgrave in ‘The Theory of Public Finance’ (1959) introduced the three-branch
taxonomy of the role of government in a market economy - resource allocation, income
redistribution and macroeconomic stabilization.
➢ The allocation and distribution functions are primarily microeconomic functions, while
stabilization is a macroeconomic function.
✓ The Allocation Function
➢ Resource allocation refers to the way in which the available resources or factors of
production are allocated among the various uses to which they might be put.
➢ It is the most important function of an economic system.
➢ Market failures which hinder the efficient allocation of resources occur mainly due to
imperfect competition, presence of monopoly power, collectively consumed public goods,
externalities, factor immobility, imperfect information, and inequalities in the distribution
of income and wealth.
➢ According to Musgrave, the state is the instrument by which the needs and concerns of the
citizens are fulfilled. Therefore, public finance is connected with economic mechanisms
that should ideally lead to effective and optimal allocation of limited resour ces.
✓ Actions taken by government to do allocation of resources properly
➢ A variety of allocation instruments are available by which governments can influence
resource allocation in the economy such as, direct production of economic goods,
provision of incentives and disincentives such as taxes and subsidies, legislation steps
(ban on plastic goods), competition and merger policies to prevent anti -
competition practices, regulatory policies (licensing, controls, minimum wages)
etc.
✓ The Re-distribution f unc tion
➢ The distributive function of budget is related to the basic question of for whom should
an economy produce goods and services and aims at redistribution of income so as to
ensure equity and fairness to promote the wellbeing of all sections of people and is
achieved through progressive taxation policy, enhancing public expenditure especially
for providing benefits to low income group people, preferential treatment of target
populations (unemployment benefits, employment reservations, minimum wages,
minimum support prices, monetary aid , aids in kind, regulation of manufacture and sale

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of certain products to ensure the health and well-being of consumers, special schemes for
backward regions and for the vulnerable sections of society.
➢ Redistribution policies are likely to have efficiency costs or deadweight losses and
therefore redistribution measures should be accomplished with minimal efficiency cost by
carefully balancing equity and efficiency objectives.
✓ The Stabilization Function
➢ A market economy does not automatically generate full employment and price stability
and therefore the governments should pursue deliberate stabilization policies.
➢ Stabilization function is one of the key functions of fiscal policy and aims at eliminating
macroeconomic fluctuations arising from suboptimal allocation.
➢ The stabilization function is concerned with the performance of the aggregate economy
in terms of labour employment and capital utilization, overall output and income, general
price levels, economic growth and balance of international payments.
➢ Government’s stabilization intervention may be through monetary policy as well as fiscal
policy. Monetary policy works through controlling the size of money supply and interest
rate in the economy, while fiscal policy aims at changing aggregate demand by suitable
changes in government spending and taxes.
✓ Centre and state Finance
➢ Fiscal federalism, a term introduced by Richard Musgrave deals with the division of
governmental functions and financial relations among the different levels of government.
➢ Musgrave argued that the central government should be responsible for the economic
stabilization and income redistribution, but the allocation of resources should be the
responsibility of state and local governments.
➢ Article 246 of the Constitution demarcates the powers of the union and the state by
classifying their powers into 3 lists, namely union list (on which the union parliament alone
can legislate), state list (on which the state legislative assemblies alone can legislate) and
the concurrent list on which both the parliament and the legislative assemblies can
legislate. In the event of conflicting legislation in concurrent list, the law passed by the
centre prevails.
➢ The union government can levy taxes such as tax on income, other than agricultural
income, customs and export duties, excise duties on certain goods, corporation tax,tax
on capital value of assets, excluding agricultural land, terminal taxes, security transaction
tax, Central GST, Union Excise Duty, taxes other than stamp duties etc.
➢ The state governments can levy taxes on agricultural income, lands and buildings,mineral
rights, electricity, vehicles, tolls, professions, as well as collect land revenue and impose
excise duties on certain items.
➢ Articles 268 to 281 of the constitution contain specific provisions in respect of distribution
of finances among states.
➢ Article 280, provides for an institutional mechanism, namely the Finance Commission,
to facilitate such transfers. It is responsible for evaluating the state of finances of the union
and state governments, recommending the sharing of taxes between them and laying
down the principles determining the distribution of these taxes among States,
determining the quantum of grants-in-aid to states which are in need of such assistance,
making recommendations to the president on measures needed to augment the
consolidated fund of a state to supplement the resources of the panchayats and
municipalities in the state on the basis of the recommendations made by the finance
commission of the state.

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➢ The Finance Commission considers issues related to vertical equity (deciding about the
share of all states in the revenue collected by centre) and horizontal equity (allocation
among states their share of central revenue).
➢ The Fifteenth Finance Commission (constituted on 27 November 2017) recommended the
share of states in the central taxes (vertical devolution) for the 2021-26 to be 41%,
which is less than 42% share recommended by the 14 th Finance commission for 2015-20.
➢ The criteria for distribution of central taxes among states for 2021 -26 are income distance
i.e the distance of a state’s income from the state with the highest income, area,
population (2011), demographic performance (to reward efforts made by states in
controlling their population), forest and ecology and tax and fiscal efforts.
➢ The GST was introduced in India on 1 July 2017. It has subsumed the majority of indirect
taxes and made India’s indirect tax regime unitary in nature.
➢ States levy and collect state GST (SGST) and the union levies and collects the central
GST (CGST). An integrated GST (IGST) is applied on inter-state movement of goods and
services and on imports and exports.
➢ For providing compensation to states, a cess is levied on luxury goods and demerit goods
and the proceeds are credited to the compensation fund. GST compensation was
extended beyond five years to enable states to tide over the pandemic induced economic
slowdown.
➢ The state governments are entrusted with the responsibility of facilitating agriculture
and industry, providing social sector services such as health and education, police
protection, state roads and infrastructure.
➢ The local self- governments such as municipalities and panchayats are entrusted with the
responsibility of providing public utility services such as water supply and sanitation,
local roads, electricity etc. For items that fall in the concurrent list, both central and state
governments are responsible for providing services.
➢ Borrowings by the government of India and borrowing by states are defined under Article
-292 and 293 of constitution of India. The centre may borrow within the limits fixed by
parliament by law upon the security of the consolidated fund of India or give gu arantees
within such limits.
➢ The state governments may borrow within the territory of India upon the security of the
consolidated fund of the state within such limits.
➢ The centre may give loans to states within limits fixed under Article-292 and also can give
guarantee for it.
✓ Meaning of Market Failure
➢ Market failure is a situation in which the free market leads to misallocation of society's
scarce resources in the sense that there is either overproduction or underproduction
of particular goods and services leading to a less than optimal outcome.
✓ Types of Market Failure
➢ There are two types of market failure: complete market failure or “missing markets"
(the market does not supply the products at all despite of that the products are required
by the people) and partial market failure (the market produces wrong quantity of the
product)
✓ Reasons behind Market Failure
➢ There are four major reasons for market failure: market power, externalities, public goods,
and incomplete information.
✓ Market Power
➢ Market power or monopoly power is the ability of the firm to raise the market price over
and above the marginal cost of the product.

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➢ Excessive market power causes the single producer or small number of producers to
produce and sell less output than what would be produced in a p e r f e c t l y
competitive marketand charge higher prices.
✓ Externalities
➢ Externalities also referred to as ‘spill over effects’, ‘neighbourhood effects’, ‘third -party
effects’, or ‘side-effects’, occur when the actions of either consumers or producers result
in costs or benefits on others that do not reflect as part of the market price.
➢ Externalities can be positive or negative. Negative externalities occur when the action
of one party imposes costs on a third party who is not part of the transaction. Positive
externalities occur when the action of one party confers benefits on a third party.
➢ The four possible types of externalities are: negative externality initiated in production
which imposes an external cost on others, positive production externality initiated in
production that confers external benefits on others, negative consumption externalities
initiated in consumption which produce external costs on others and positive
consumption externality initiated in consumption that confers external benefits on others.
Each of the above may be received by another in consumption or in production.
➢ Private cost is the cost faced by the producer or consumer directly involved in a
transaction and includes direct cost of labour, materials, energy and other indirect
overheads and does not incorporate externalities.
➢ Social cost is the entire cost which the society bears. Social Cost =Private Cost +External
Cost.
➢ The firm or the consumer as the case may be, however, has no incentive to account for the
external costs that it imposes on others.
➢ When firms do not have to worry about negative externalities associated with their
production, the result is excess production and unnecessary social costs.
✓ Public Goods
➢ Paul A. Samuelson is the first economist to develop the theory of public goods in his path-
breaking paper – ‘The Pure Theory of Public expenditure’ in 1954.
➢ Public good (also referred to as a collective consumption good or a social good) are those
which are indivisible (the total amount consumed is the same for each individual), non -
rival (the consumption of the good by one individual does not reduce the quantity or
quality of the good for others), non-excludable (no one can be deprived of the
consumption) and enjoyed in common by all individuals.
➢ Public goods are generally more vulnerable to issues such as externalities, inadequate
property rights, free rider problems. The absence of excludability and the tendency of
people to act in their own interest will lead to problems of free riding. There is no incentive
to pay for the good also. Private producers will not produce public goods properly as they
cannot charge a positive price for it.
➢ Private goods are ‘rivalrous’ and ‘ excludable’ and less likely to have the free rider
problem.
✓ Incomplete Information
➢ Complete information is an essential element of competitive market.
➢ Asymmetric information occurs when there is an imbalance in information between the
buyer and the seller i.e. when the buyer knows more than the seller or the seller knows
more than the buyer. This can distort choices
➢ Adverse selection is a situation in which asymmetric information about quality eliminates
high-quality goods from a market. Buyers expect hidden problems in items offered for sale,
leading to lower prices and the good quality items being kept off the market.

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➢ Moral hazard is opportunism characterized by an informed person’s taking advantage

of a less-informed person through an unobserved action.
➢ Asymmetric information, adverse selection and moral hazard affect the ability of markets
to efficiently allocate resources and therefore, lead to market failure because the party
with better information has a competitive advantage.
✓ Government Intervention to correct market failure
✓ Government intervention to correct market power
➢ Because of the social costs imposed by monopoly, governments intervene by establishing
rules and regulations designed to promote competition and prohibit actions that are
likely to restrain competition, other measures include market liberalisation by introducing
competition in monopolistic sectors, controls on mergers and acquisitions, price capping
and price regulation, profit regulation, patronage to consumer associations, tough
investigations into cartelisation and unfair trade practices, restrictions on monopsony
power of the firms, reduction in import controls and nationalisation.
✓ Government interventions to correct externalities
➢ Government initiatives towards combating market failures due to negative externalities
are either direct controls or market-based policies.
➢ Direct controls or command solutions prohibit specific activities that explicitly create
negative externalities or require that the negative externality be limited to a certain level.
for instance- limiting emissions, licensing, production quotas, ban of smoking in many
public places, stringent rules for tobacco advertising etc
➢ Government may pass laws to alleviate the effects of negative externalities or fix emissions
standard which is a legal limit on how much pollutant a firm can emit. It may charge
emission fee which is levied on each unit of a firm’s emissions.
➢ The market-based approaches– environmental taxes and cap-and-trade – operate through
price mechanism to create an incentive for change.
➢ The key is to internalizing an externality (both external costs and benefits) is to ensure
that those who create the externalities include them while making decisions.
➢ One method of ensuring internalization of negative externalities is imposing pollution
taxes. (Pigouvian taxes). By ‘making the polluter pay’, pollution taxes seek to internalize
external costs into the price of a product or activity.
➢ Pollution taxes are difficult to determine and administer due to difficulty to discover
the right level of taxation, problems associated with inelastic nature of demand for the
good and the problem of possible capital flight.
➢ Tradable emission permits are marketable licenses to emit limited quantities of pollutants
and can be bought and sold by polluters. The high polluters have to buy more permits
and the low polluters receive extra revenue from selling their surplus permits.
➢ The system is administratively cheap and simple, allows flexibility and reward efficiency
and provides strong incentives for innovation.
➢ Subsidy is a market-based policy and involves the government paying part of the cost to
the firms in order to promote the production of goods having positive externalities.
✓ Government intervention in the case of merit goods
➢ Merit goods such as education, health care etc. are socially desirable and have substantial
positive externalities. Left to the market, merit goods are likely to be under- produced and
under- consumed so that social welfare will not be maximized.
➢ The possible government responses to under-provision of merit goods are regulation (the
way education is imparted is regulated by government), legislation (use of helmets),
subsidies, direct government provision (educational services through government
schools) and a combination of government provision and market provision.

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➢ The government take steps to compel individuals to consume the merit goods (Right to
Education,2009) and also making the merit goods available free of cost to individuals (free
corona vaccines) attracts the individuals to consume that goods.
✓ Government intervention in the case of demerit goods
➢ Steps taken by government to limit demerit goods include complete ban of the good,
legislations, persuasion through negative advertising campaigns, strict regulations for
limiting access of the good, especially by vulnerable groups, levying higher tax rates or
fixing minimum prices below which the demerit goods can’t be exchanged.
✓ Government intervention in case of public goods
➢ In the case of non-excludable pure public goods where entry fees cannot be charged, direct
provision by governments through the use of general government tax revenues is the
only option.
➢ A very commonly followed method in the case of excludable public good is to grant licenses
to private firms to build a facility and then the government regulates the level of the entry
fee chargeable from the public.
➢ Due to strategic and security reasons, certain goods are produced and consumed as public
goods and services despite the fact that they can be produced or consumed as private
goods.
➢ Price controls may take the form of either a price floor (a minimum price, buyers are
required to pay) or a price ceiling (a maximum price, sellers are allowed to charge for
a good or service).
➢ When prices of certain essential commodities rise excessively, government may resort
to controls in the form of price ceilings (also called maximum price) for making a resource
or commodity available to all at reasonable prices.
➢ With the objective of ensuring stability in prices and distribution, governments often
intervene in grain markets through building and maintenance of buffer stocks.
✓ Government intervention for correcting information failure
➢ Mandatory to do accurate labelling, content disclosures by producers, public
dissemination of information to improve knowledge, regulation of advertising and setting
the advertisement standards to make advertisements more responsive, informative and
persuasive.
✓ Government intervention for equitable distribution
➢ Progressive taxation policy, targeted budgetary allocations, unemployment compensation,
transfer payments, subsidies, social security schemes, job reservations, land reforms,
gender sensitive budgeting.
✓ Government Budget
➢ A Government budget is a statement of the entire revenues and expenditures that the
government expects to receive and plans to spend during the following year. The estimated
government's receipts and expenditure in the budget is called Budgeted estimates.
✓ The Process of Budget Making
➢ The budget is prepared by the Ministry of Finance in consultation with NITI Aayog and
other relevant Ministries. It must be presented and approved by both houses of parliament
before the beginning of the fiscal year. The process of making budgets is called budgeting.
Article 112 of the Constitution - “President shall cause to be laid before both the houses of
parliament - Annual financial Statement”
✓ Budgetary procedures are:-
➢ Preparation of the Budget
➢ Presentation and enactment of the budget
➢ Execution of Budget

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✓ The Budget process mainly consist of two types of activities:

➢ Administrative Process:-Preparation of budget and accompanying documents in
consultation with various stakeholders.
➢ Legislative process:- Budget is passed by the parliament after discussions.
➢ Union Budget is presented on 1st February (or any other suitable date as decided by the
government). The process of Budget preparation Commences in August -September of the
previous year.
➢ The process of Budget making is set off with the Budget Division of the Ministry of Finance
issuing the budget circular containing detailed instructions and formats for preparing the
estimates of all ministries, states, union territories and autonomous bod ies.
➢ The detailed estimates of receipts & expenditures are prepared by the ministries and
departments according to their assessment of requirements for the subsequent year.
➢ A series of pre-budget consultations are done by the Union finance Minister with the
finance ministers and chief ministers of states, various stakeholders & interest groups to
elicit their Suggestions on the proposed budget. The budget is presented in the parliament
in such form as the finance ministry may decide after considering the suggestions (If any)
of the Estimates Committee. The Finance Minister makes a detailed budget Speech at the
time of presenting the budget before the Lok Sabha. It is a policy document which present
details of the proposals for the new financial year regarding taxation, borrowings &
expenditure plans of the government.
✓ The Budget Speech is divided into 2 parts:-
➢ Part A gives an outline of the prevailing macro-economic situation of the country and
budget estimates for the next financial year.
➢ Part B gives details about the progress, the government has made on various
developmental measures, the direction of future policies and government's tax proposals
for the upcoming financial year including variations in the current taxation.
✓ The Annual financial statement shows the receipts & expenditure of the government in 3
separate parts under which the government accounts are maintained:
✓ Consolidated fund of India
➢ It is the primary account where all revenues (taxes & non-tax receipts) are collected and
all expenditures are incurred from this fund. Money can be used only if approved by the
legislative body.
✓ Contingency fund of India
➢ It enables the government to meet unforeseen expenditure and does not require prior
legislative approval.
✓ Public Account
➢ Under provisions of Article 266(1) of the Constitution of India, Public account is used to all
the fund flows where government is acting as a banker.
✓ List of Budget documents.
The list of budget documents presented to the parliament, besides the budget speech
a) Annual financial statement (AFS)
b) Demands for Grants (DG)
c) finance Bill
d) Statements mandated under FRBM Act
i) Macro-economic framework Statement.
ii) Medium-Term fiscal policy cum fiscal Policy Strategy Statement1
➢ Nine other documents which are in the nature of explanatory statements Supporting the
mandated documents are also presented.

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➢ The expenditure of certain categories like emoluments & allowances of the president of
India and emoluments of judges of Supreme Courts and other high -ranking personnel are
charged on the consolidated fund of India & are not subject to vote of parliament a nd are
also indicated separately in the budget.
➢ The Budget is discussed in two stages in the Lok Sabha.
➢ General discussion on the budget as a whole and the house is adjourned for a fixed period.
➢ During the period, the demand for grants of various ministries or departments are
considered by the Concerned Standing Committees and once the reports are presented by
these committees within stipulated time, the house proceeds to discussion & conducts
ministry-wise voting on demand for grants. The Lok Sabha has the power to concur or to
refuse any demand for grant.
➢ The Budget is presented in the Rajya Sabha soon after the finance minister has completed
her budget speech in the Lok Sabha.
➢ The Rajya Sabha does not vote on the demands for grants and there is only general
discussion on the budget.
➢ After the discussion and voting, the government introduces the appropriation bill. The
Appropriation Bill is intended to give authority to government to incur expenditure from
and out of consolidated fund of India.
➢ The financial Bill is introduced in Lok Sabha immediately after presentation of general
budget. It is all about the government's taxation proposals. It is accompanied by a
memorandum explaining the provisions of the bill & their effect on the finances of t he
country.
➢ The Parliament has to pass the finance Bill within 75 days of its introduction.
➢ On the last days allotted for discussion on the demand for grants, the speaker puts all the
outstanding demands for grants to the vote of the house. This process is known as
Guillotine. It is a device for bringing the debate on financial proposals to an en d within
stipulated time.
➢ After the finance bill has been passed by Lok Sabha, it is transmitted to the Rajya Sabha for
its recommendations. The Rajya Sabha has to return it within a Period of 14 days, with or
without recommendations. The recommendations may be accepted or rejected by the Lok
Sabha.
➢ From 2017-18, the date of presentation of the Budget is 1st February.
➢ The Railway budget is merged into the general Budget.

Sources of Revenue
✓ Sources of Revenue
The Department of Revenue of the Ministry of finance exercises control in respect of the revenue
matters related to direct and indirect union taxes.
✓ The Department of Revenue exercises control through two statutory boards: -
➢ The Central Board of Direct taxes (CBDT)
➢ The Central Board of Indirect taxes and Customs (CBIC)

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Government Receipts

Revenue Receipts Capital Receipts

Tax Revenue Non-Tax Revenue Debt Creating Non-Debt Creating

Government Receipts

Tax Revenue Non-Tax Revenue

✓ Corporation Taxes ✓ Interest Receipts

✓ Taxes on Income ✓ Profit & Dividends
✓ Wealth Tax ✓ Fees & Fines
✓ Custom Duties ✓ Escheat
✓ Excise Duties

Capital Receipts

Debt Creating Non-Debt Creating

✓ Borrowings ✓ Recoveries of Loans

✓ State Provident Fund ✓ Disinvestments

Public Expenditure Management

✓ Public Expenditure Management
It includes budget formulation, execution, monitoring & evaluation. Effective Public expenditure
Management Contributes to fiscal discipline, transparency & accountability in government
finances. The Department of Expenditure of the Ministry of finance is the nodal department for
overseeing the Public financial management system in the central government & matters
connected with state finances.
✓ In expenditure Budget, Central government expenditure is classified into 6 categories:-
✓ Centre's Expenditure: -
➢ Establishment Expenditure of the Centre
➢ Central sector schemes &

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➢ Other Central expenditures (CPSES, Autonomous Bodies)

✓ Centrally Sponsored Schemes and other transfers
➢ Centrally sponsored schemes
➢ Finance Commission transfers
➢ Other transfers to states
✓ Public Debt management
It is the process of setting up and implementing the strategy for managing public debt in order
to raise the required amount of funding at the desired risk and cost levels. Debt Management
Strategy is based on low cost of borrowings, risk mitigation and market development.
The institutions responsible for Public Debt Management:-
✓ RBI - domestic marketable debt (Treasury & Cash management Bills)
✓ Ministry of finance - external Debt
✓ Ministry of finance, Budget division & RBI-other liabilities such as small savings, deposits &
Reserve funds etc.
➢ Internal Debt Management Department (IDMD) of RBI has the responsibility of managing
the domestic debt of the central government and of 28 state governments and 2 union
territories.
➢ External Debt is managed by the Department of Economic Affairs in the Ministry of Finance
(MOF).
➢ The Fiscal Responsibility & Budget Management (FRBM) Act was passed in 2003 to
provide a legislative framework for reduction of deficit and the debt of the central
government.
✓ Objectives of the FRBM Act:-
➢ Inter-generational equity in fiscal management, long run macroeconomic stability, better
coordination between fiscal & monetary policy, transparency in fiscal operation of the
government.
The Public Debt Management Cell (PDMC) was created in 2016 under the department of
Economic Affairs to raise debt at the lowest cost ensuring that financial requirements are
met without disruption.
Types of Budgets

Types of Budgets

Balanced Budget Unbalanced Budget

(Estimated Govt. Receipts = (Estimated Govt. Receipts ≠
Estimated Govt. Exp) Estimated Govt. Exp)

Surplus Budget Deficit Budget

(Estimated Govt. Receipts > (Estimated Govt. Receipts <
Estimated Govt. Exp) Estimated Govt. Expe)

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Budget expenditure

Capital Expenditure Revenue Expenditure

Expenditure incurred by the Govt. Expenses which neither
government which either creates the assets nor reduces the
increases the assets or reduces liabilities of the govt.
the liabilities of the govt.

✓ Types of Deficit
➢ Deficit = Estimated Govt. Expenditure - Estimated Govt. Receipts.
➢ There are three types of deficit – Revenue deficit, fiscal deficit and primary deficit
➢ Revenue deficit = revenue expenditure – revenue receipts
➢ Fiscal deficit = borrowings
Or
➢ Fiscal deficit = total expenditure – total receipts (excluding borrowings)
➢ Primary deficit = fiscal deficit – interest payments
✓ Outcome Budget
The outcome budget is the progress card on what various ministries & departments have done
with the outlays in the previous annual budget.
✓ Fiscal policy is the policy used by the government involving the deliberate use of government
spending, taxation and borrowing to influence both the pattern of economic activity and level
of growth of aggregate demand, output and employment.
➢ According to classical economists, there was no need of fiscal policy (market mechanism
was self -regulating)
➢ The great depression in 1930 resulted in very low aggregate demand along with high levels
of unemployment aroused the need of fiscal policy as classical economists could not
provide the solution to that.
➢ In 1936, John Maynard Keynes advocate to increase in government spending to combat the
recessionary forces in the economy and to solve the problem of unemployment. (Book –
The General Theory of Employment, Interest, and Money)
✓ Objectives of Fiscal policy
➢ The objectives of fiscal policy may vary from country to country, but generally they are:
achievement and maintenance of full employment, maintenance of price stability,
acceleration of the rate of economic development and equitable distribution of income and
wealth.
➢ Since GDP = C + I + G + NX, governments can influence economic activity (GDP), by
controlling G directly and influencing C, I, and NX indirectly, through changes in taxes,
transfer payments and expenditure.
➢ The tools of fiscal policy are taxes, government expenditure, public debt and the budget.
✓ Types of Fiscal policy
➢ There are two types of fiscal policy – expansionary fiscal policy and contractionary fiscal
policy.
➢ Expansionary fiscal policy is designed to stimulate the economy during the
contractionary phase of a business cycle and is accomplished by increasing aggregate
expenditures and aggregate demand through an increase in all types of government
spending and/or a decrease in taxes.
➢ Contractionary fiscal policy is designed to restrain the levels of economic activity of
the economy during an inflationary phase by decreasing the aggregate expenditures and

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aggregate demand through a decrease in all types of government spending and/or an

increase in taxes.
➢ A recessionary gap, also known as a contractionary gap, is said to exist if the existing levels
of aggregate production is less than what would be produced with the full employment of
resources.
✓ Tools of Fiscal policy
✓ Government expenditure / public expenditure as a tool of fiscal policy
➢ During recession, the government expenditure is increased which in turn will generate the
income of the people in the economy, the purchasing power will increase and the aggregate
demand will be increased and vice versa in case of inflation.
➢ Forms of government expenditure – current expenditures, capital expenditures and
transfer payments.
✓ Taxes as a tool of fiscal policy
➢ Taxes determine the size of disposable income in the hands of general public which in turn
determines aggregate demand and possible inflationary and deflationary gaps.
➢ During recession and depression, the tax policy is framed to encourage private
consumption and investment. A general reduction in income taxes and lower corporate
taxes, will increase the personal disposable income, which will increase aggregate demand
and investments respectively and vice versa in case of inflation.
✓ Public debt as a tool of fiscal policy
➢ Public debt is basically the borrowings done by the government. It is of two types –
Internal debt (Borrowings from the people and organisations of the domestic country)
External debt (Borrowings from the people and organisations outside the domestic
country)
➢ Forms of public debt- market loans, small savings etc.
➢ Borrowing from the public through the sale of bonds and securities curtails the money
available for spending which in turn reduces the aggregate demand in the economy.
Repayment of debts increases the availability of money in the economy and increase
aggregate demand.
✓ Budget as a tool of fiscal policy
➢ Budget is widely used as a policy tool to stimulate or to contract aggregate demand as
required.
➢ Deficit budget is used in case of deflation and surplus budget in case inflation.
✓ Fiscal policy for long term growth
➢ Increasing public expenditure on the creation of infrastructure, providing public goods,
implementing well designed taxation policy that rewards innovations and
entrepreneurship which will encourage private sector to increase their investments,
providing subsidies on inputs to producers.
✓ Fiscal policy for reduction in inequalities of income and wealth
➢ Progressive taxation policy, differential indirect tax rates, executing poverty alleviation
programmes, provision of free medical and educational services, balanced regional
development.
✓ Limitations of Fiscal policy
➢ Fiscal policy suffers from limitations such as limitations in respect of choice of appropriate
policy, recognition lag, decision lag, implementation lag, impact lag, inappropriate timing,
difficulties of forecasting due to uncertainties, possible conflicts between different
objectives, possibility of generating disincentives, practical difficulty to reduce
government expenditures and the possibility of certain fiscal measures replacing private
spending.

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✓ Crowding Out
➢ An increase in the size of government spending during recessions will ‘crowd-out’ private
spending in an economy. In other words, when spending by government in an economy
replaces private spending, the latter is said to be crowded out.
➢ As a result of crowding out, the effectiveness of expansionary fiscal policy in stimulating
aggregate demand will be diminished to a great extent. This may also possibly reduce the
economy’s prospects of long-run economic growth.
➢ During deep recessions, crowding-out is less likely to happen as private sector investment
is already minimal and therefore there is only insignificant private spending to crowd
out.

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