FISCAL POLICY

&
Economic
Consequence Of Debt

T.J. Joseph
 Fiscal Policy
Fiscal Policy
• ‘fisc’ means state treasury
• ‘fiscal policy’ refers to the use of state treasury or
government finances to achieve the macroeconomic goals
• Fiscal policy is also called budgetary policy
• The tax and expenditure policies together constitutes
fiscal policy of the government
– Budget / spending plan
Fiscal Policy and Economic Stabilization
• Stabilization policies are policies by the government to
maintain full employment and reasonably stable price
level

Fiscal Policy and Economic Stabilization – Theories

behind

Keynesian Theory: Y = AD = C + I + G + X - M
– Great Depression of 1930s: low AD
 Fiscal Policy
Keynesian Argument
 Under Economic Depression-
 Fiscal Policy
Keynesian Argument
• Govt. interference by:-
– Increasing spending or
Income rises
– Cutting taxes or
– Increasing transfer payments

Criticism:
• A deficit for government and the ill-effects of deficit
Answer:
“deepening of economic decline is worse than a deficit”
AD=C+I+G+(X-M) Potential GDP

AD’
E’
 AD

E
G

Potential GDP

45o
4000 5000 Output, Income
Recessionary GDP gap
 AD-AS framework
Price level
AS

P1
•
P0 •
AD1

AD0

Y0 Y1 Real GDP
 Fiscal Policy (Keynesian Argument)
 Under Excess Demand -
– Large govt. spending & tax cut, along with strong
consumer spending causes inflation
– Therefore, Govt. should either reduce spending or
raise taxes
Criticism:
 Is it politically viable?
 Fiscal Policy (Keynesian Argument)
 Under External Shocks (like Oil price rise)
– Creates a dilemma
– A situation of both high unemployment and high
inflation – called ‘stagflation’ – Keynesian argument
does not work
– Deficit seems to be a permanent part of fiscal scene
– Reducing deficit – the goal of fiscal policy
 Kinds of Fiscal Policy
How does Fiscal Policy work?

• There are two elements to the working of fiscal

policy:

i) Non-discretionary Fiscal Policy

(Also called Automatic Stabilization Fiscal Policy)

ii) Discretionary Fiscal Policy

(Also called Compensatory Fiscal Policy)
 Automatic Stabilization Policy
• Means automatic adjustment in the net taxes in response
to rise and fall in GNP (economic growth)
• When the economy begins to contract (GNP declines), tax
revenue falls and government’s transfer payments increase
automatically
• When the economy expands (GNP rises), tax revenue
increases and government transfers fall automatically
• In this kind of fiscal policy, the government adopts a tax
system and an expenditure program linked to GNP and
unemployment
• Also called non-discretionary fiscal policies
 Discretionary Fiscal Policy
• Economies do not work as expected under automatic fiscal
policy regime
• Such regime are more suitable for mature and developed
economies
• Discretionary fiscal policy is the most common form
• Ad hoc changes are made in the government expenditure
and taxation at the discretion of the government
• Discretionary changes are taken (in taxation, govt.
expenditure and public debt) to achieve certain specific
objectives
For example, changes in tax rates or tax base or tax system
to reduce inflationary pressure
 Compensatory Fiscal Policy
• Compensatory Fiscal Policy is a form of Discretionary Fiscal
Policy
• A deliberate budgetary action by the govt. to compensate for
the deficiency in or excess of AD
• Usually in the form of surplus budgeting or deficit budgeting
• During depression, taxes are reduced and govt. spending
goes up (deficit budgeting)
• Surplus budgeting is adopted during the period of high
inflation rate that caused by excessive demand
• Govt. keeps its expenditure lower than its revenue,
introducing higher rate of taxation
 Budget
• Two sides of the budget:

Receipts and Expenditure

• Receipts include all tax and non-tax receipts, capital
receipts, and borrowings
• Expenditures include revenue and capital
expenditures (also classified as Plan and Non-plan
expenditures)
Government Receipts
 Government Receipts
• Taxes are the major source of revenue for the govt.
• Major categories of taxes: personal income tax; corporate tax;
customs duties; union excise duties, VAT, services tax
• Non-tax revenues includes interest and dividend received from
its various investments, especially from the public sector
undertakings, fees, etc.
• Also includes revenue from lotteries and user charges

Revenue Receipts = Taxes + Non-tax Revenues

Capital receipts = recovery of loans + public sector
disinvestments
Total Receipts = Revenue Receipts + Capital Receipts
 Taxation
Which is the best base for taxation, income or
consumption?
• Direct taxes use income base, indirect taxes use
consumption base
Government Expenditure
 Government Expenditure
Government expenditures are classified into three different ways
A) Revenue and Capital Expenditure
B) Plan and Non-Plan Expenditure, representing new and existing
works under India’s Five Year Plans
• Both plan and non-plan expenditure will have elements of
revenue and capital expenditures
C) By departments, i.e., development and non-development
expenditure under various departments of the government
• Components of both revenue and capital expenditure will find
place in these development and non-development
expenditures
 Budget at a Glance 2010-11 (In Rs. crores)

2007-08 2008-09 2009-10 2009-10 2010-11

Actuals Actuals@ (BE) (RE) (BE)
1. Revenue Receipts 541864 540259 614497 577294 682212
2. Tax Revenue (net to Centre) 439547 443319 474218 465103 534094
3. Non-tax Revenue 102317 96940 140279 112191 148118
4. Capital Receipts (5+6+7) 170807 343697 406341 444253 426537
5. Recoveries of Loans 5100 6139 4225 4254 5129
6. Other Receipts 38795 566 1120 25958 40000
7. Borrowings and other Liabilities 126912 336992 400996 414041 381408
8. Total Receipts (1+4) 712671 883956 1020838 1021547 1108749
9. Non-plan Expenditure 507589 608721 695689 706371 735657
10. On Revenue Account of which, 420861 559024 618834 641944 643599
11. Interest Payments 171030 192204 225511 219500 248664
12. On Capital Account 86728 49697 76855 64427 92508
13. Plan Expenditure 205082 275235 325149 315176 373092
14. On Revenue Account 173572 234774 278398 264411 315125
15. On Capital Account 31510 40461 46751 50765 57967
16. Total Expenditure (9+13) 712671 883956 1020838 1021547 1108749
17. Revenue Expenditure (10+14) 594433 793798 897232 906355 958724
18. Capital Expenditure (12+15) 118238 90158 123606 115192 150025
19. Revenue Deficit (17-1) 52569 253539 282735 329061 276512
-1.1 -4.5 -4.8 -5.3 -4
20. Fiscal Deficit {16-(1+5+6)} 126912 336992 400996 414041 381408
-2.7 -6 -6.8 -6.7 -5.5
21. Primary Deficit (20-11) -44118 144788 175485 194541 132744
-0.9 -2.6 -3 -3.2 -1.9
 Receipts (Revenue)
2008-2009 2008-2009 2009-2010
Budget Estimate Revised Estimates Budget Estimates
REVENUE RECEIPTS
1. Tax Revenue
Gross Tax Revenue 687715 627949 641079
Corporation tax 226361 222000 256725
Income tax 138314 122600 112850
Other taxes and Duties 325 400 425
Customs 118930 108000 98000
Union Excise Duties 137874 108359 106477
Service Tax 64460 65000 65000
Taxes of the Union Territories 1451 1590 1602
Less- NCCD transferred to the National 1800 1800 2500
Calamity Contingency Fund
Less States' Share 178765 160179 164361
Net Tax Revenue 507150 465970 474218
2. Non -Tax Revenue
Interest Receipts 19135 19036 19174
Dividend and Profits 43204 39736 49750
External Grants 1795 2748 2136
Other Non-Tax Revenue 30836 33934 68465
Receipts of Union Territories 815 749 754
Total Non-Tax Revenue 95785 96203 140279
Total Revenue Receipts 602935 562173 614497
 Receipts (Capital)
2008-2009 2008-2009 2009-2010
Budget Estimate Revised Estimates Budget Estimates
3. CAPITAL RECEIPTS
A. Non-debt Receipts
1. Recoveries of Loans &
4497 9698 4225
Advances
2. Miscellaneous Capital receipts 10165 2567 1120
Total 14662 12265 5345
B. Debt Receipts
3. Market Loans 100571 261972 397957
4. Short term borrowings 12429 57500 ...
5. External assistance (Net) 10989 9603 16047
6. Securities issued against
9873 1324 13256
Small Savings
7. State Provident Funds (Net) 4800 4800 5000
8. Other Receipts (Net) -12600 -38668 -31264
Total 126062 296531 400996
Total Capital Receipts (A+B) 140724 308796 406341
Total Receipts (1+2+3) 750884 900953 1020838
 Expenditure (Non-Plan)
2008-2009 2008-2009 2009-2010
Budget Estimates Revised Estimates Budget Estimates
1. NON-PLAN EXPENDITURE
A. Revenue Expenditure
1. Interest Payments and Prepayment Premium 190807 192694 225511
2. Defence 57593 73600 86879
3. Subsidies 71431 129243 111276
4. Grants to State and U.T. Governments 43294 38421 48570
5. Pensions 25086 32690 34980
6. Police 15562 20711 25390
7. Assistance to States from NCCF 1800 3265 2500
8. Economic Services (Agri., Indu., Infra. etc.) 17987 22055 23840
9. Other General Services (State Depts.) 11498 15898 18729
10. Social Services (Education, Health, etc) 10385 28126 33491
11. Postal Deficit 958 3825 5395
12. Expenditure of U.T. without Legislature 2269 3092 3162
13. Amount met from NCCF -1800 -3265 -2500
14. Grants to Foreign Governments 1482 1435 1611
Total Revenue Non-Plan Expenditure 448352 561790 618834
B. Capital Expenditure
1. Defence 48007 41000 54824
2. Other Non-plan Capital Outlay 10567 13694 21056
3. Loans to Public Enterprises 673 788 637
4. Loans to State and U.T. Governments 89 89 89
5. Loans to Foreign Governments 4 815 125
6. Others -194 -180 124
Total Capital Non-Plan Expenditure 59146 56206 76855
Total Non-Plan Expenditure 507498 617996 695689
 Expenditure (Planned)
2008-2009 2008-2009 2009-2010
Budget Estimates Revised Estimates Budget Estimates
2. PLAN EXPENDITURE
A. Revenue Expenditure
1. Central Plan 151417 171633 200290
2. Central Assistance for State & 58350 70023 78108
Union Territory Plans
Total-Revenue Plan Expenditure 209767 241656 278398
B. Capital Expenditure
1. Central Plan 28537 32495 39550
2. Central Assistance for State & 5082 8806 7201
Union Territory Plans
Total Capital Plan Expenditure 33619 41301 46751
Total - Plan Expenditure 243386 282957 325149
179954 204128 239840
Total Budget Support for Central Plan

Total Central Assistance 63432 78829 85309

for State & UT Plans
TOTAL EXPENDITURE* 750884 900953 1020838
 Government Deficit
• Government deficit (usually called fiscal deficit) arises
because total govt. expenditure exceeds govt.’s own receipts
• Fiscal deficit can be incurred either due to revenue deficit or
deficit on capital account
• This deficit is financed through borrowing, either from
domestic sources or from external sources
• Domestic sources include market borrowings (by floating
bonds, etc.) and other liabilities like PFs, etc.
• External sources can be bilateral or multilateral
Monetized Deficit: When the deficit is being financed from
borrowing from the Central Bank (RBI), it is called monetized
deficit
• So called because it results in an increase in money supply
• MD is a part of Fiscal Deficit

Government debt: When the fiscal deficit accumulated over the

years, it is the stock of the debt
• Called government debt or public debt or national debt

Primary Deficit = Fiscal Deficit – interest payments

• It is the difference between govt.’s current expenditure (total
expenditure – interest payments), minus govt.’s total receipts
 Fiscal Deficit
• Definition
– “The difference between the total expenditure of Government
and revenue receipts of government and capital receipts which
are not in the form of borrowing constitutes Gross Fiscal Deficit”
– http://indiabudget.nic.in
– Essentially, it is the difference between what the government
spends and what it earns.

Fiscal Deficit = {Revenue Receipts + Capital Receipts

(Non-debt)} – Total Expenditure (Revenue + Capital
Expenditure)
 Fiscal Deficit
• Why fiscal deficit a concern?
– It’s a borrowing
• Borrowing for what? Where is it spend?
• For capital or revenue expenditure?
– A lower deficit reduces government borrowing, bring
down interest rates, more capital to finance expansion
– How to make capital expenditure without causing
inflation or increasing fiscal deficit?
– How to increase resources without increasing fiscal
deficit?
Implications of High Fiscal Deficit

1. Money supply growth: When debt is monetized, it

leads to increased high-powered money

With the introduction of Ways and Means Advances

(WMA), the component of debt monetized is limited,
therefore, no strong impact on money supply

2. Inflation: Unproductive govt. expenditures increases

AD but not the production or supply
Implications of High Fiscal Deficit
3. Crowding-out of Private Investment: Continued market
borrowing to meet fiscal deficit leads to high interest rates
This may crowd-out private sector investment, which is
more efficient than government investment. So, growth
suffers.
4. Crowding-out of Exports: High interest rate attract more
capital from abroad, appreciating domestic currency
against foreign currencies, crowding-out exports
5. Crowding-out Essential Public Expenditure on health,
education, and other social welfare
Large amount of money is spent for debt servicing
Implications of High Fiscal Deficit
Government spending may not always crowd-out private
Investment:
1. If private sector has large unutilised capacity, they may not
be investing and therefore, interest rate may not rise
(Soft interest rate prevailed in India during recession 2008-09)
2. The sensitivity of private investment to increase in
interest rate may be very low if their expectations about
future growth are very positive
(Happened during the initial years of eco. Liberalization)
3. Export competitiveness is more important and it depends
upon foreigner’s economic conditions
Complementarity Between Public and Private Investment –
The ‘Crowding-in’ Effect
• Mainly a Keynesian view
• Complementarity or ‘Crowding-in’ occurs because public
expenditure enhances the productivity of private
investment
E.g.: investment in infrastructure and public goods, increased
demand for private goods through demand for inputs and
ancillary services, etc.
• The overall relationship is not definitive
 Exercise
• Five economists are debating the impact of fiscal deficit
on the economy. This is what each has to say:
– Economist 1: Fiscal deficit is an excellent way of stimulating
the economy
– Economist 2: No, fiscal deficit crowds out private investment
– Economist 3: No, fiscal deficit crowds in private investment
– Economist 4: It is not a concern for India when we compare
the fiscal deficits of many other countries at present
– Economist 5: Whatever you say, fiscal deficit is matter of
concern in India
Assume each economist is correct in what he/she is
saying. Spell out the conditions that must hold true in the
economy for each argument to be correct.
 References
1. Chapters 11,‘Principles of Macroeconomics’, 8th edn. by
Michael Melvin and William Boyes.
2. Chapters 4, ‘Macroeconomic Policy Environment’ by
Shymal Roy
Videos
1. http://www.moneycontrol.com/video/economy/is-supply-c
runchonly-reason-for-food-inflation_513573.html
2. http://www.moneycontrol.com/video/economy/fiscal-
deficit-goal46-not-easy-to-meet-economists_527733.html
3. http://www.moneycontrol.com/video/economy/rbi-likely-
to-hike-repo-rate-to-675-cnbc-tv18-poll_529104.html
THANK YOU