AMRITA SCHOOL OF BUSINESS,BENGALOORU

FISCAL POLICY OF
INDIA
A REPORT
RAGHAVENDRA.K
12/18/2009
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Contents
Contents...................................................................................................................... 2
Introduction.............................................................................................................. 3
Overview of Fiscal Policy.......................................................................................3
Objectives of Fiscal Policy in Developing Countries..............................................4
ROLE OF FISCAL POLICY........................................................................................5
INSTRUMENTS OF FISCAL POLICY.............................................................................6
I. BUDGET:-........................................................................................................... 6
Revenue Deficit and Fiscal Responsibility and Budget Management Act (FRBMA)...7
II.TAXATION........................................................................................................... 7
III.PUBLIC EXPENDITURE........................................................................................9
IV. GOVERNMENT BORROWING:..........................................................................11
V.DEFICIT FINANCING..........................................................................................13
NEED FOR DEFICIT FINANCING:..............................................................................14
FISCAL POLICY STRATEGY STATEMENT..................................................................14
A. FISCAL POLICY OVERVIEW...............................................................................14
B. FISCAL POLICY FOR 2009-10...........................................................................16
Tax Policy ........................................................................................................... 17
Central Excise........................................................................................................ 18
Customs................................................................................................................. 18
Direct Taxes........................................................................................................... 19
Objective................................................................................................................ 20
Contingent and other Liabilities.............................................................................21
Government Borrowings, Lending and Investments...............................................22
Initiatives in Public Expenditure Management.......................................................24
Fiscal Policy Can Be Divided In Two Types.............................................................25
I) DISCRETIONARY FISCAL POLICY FOR STABILISATION.......................................26
Fiscal Policy to cure recession:............................................................................26
Fiscal Policy to Control inflation: ........................................................................29
NON_DISCRETIONARY FISCAL POLICY: AUTOMATIC STABILIZERS..........................30
EFFECTIVENESS OF FISCAL POLICY........................................................................32
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Limitations of fiscal policy......................................................................................37

References......................................................................................................... 38

Introduction

The most important instrument of government intervention in the country is

that of Fiscal or Budgetary policy. Fiscal policy refers to the taxation,
expenditure and borrowing by the government. The economists now hold the
government intervention through Fiscal policy is essential in the matter of
overcoming recession or inflation as well as of promoting and accelerating
economic growth, which monetary policy will not hold alone. There is no
doubt that the government budgetary or fiscal policy must be sound, keeping
in view the needs and requirements of a developing economy.

In short we can say that, it is a part of government policy, which is concerned

with raising revenue through taxation and other means and deciding on the
level and pattern of expenditure.

The main problem faced by the capitalist economies instability prevailing in

them. This instability is reflected in the periodic occurrence of trade cycles,
which are a general phenomenon in the free market capitalist economies.
During a recession or depression fiscal policy should help in increasing
demand.

Overview of Fiscal Policy

Economic Reforms have yielded credible gains in the external and

monetary sector. Since the early 1990s, Inflation has climbed down from a
peak of 17 per cent in August 1991 to about 5 per cent now. The economy
has grown at an average of over 6 per cent p.a. In a major structural change
in the economy, the share of the services sector continues to grow steadily.
Tax reforms during this period have laid the foundation of a robust,
expanding tax base. Out of our total external debt of nearly US $ 112 billion,
only about 5 per cent is short-term debt. Gradual and cautious liberalization
of the capital account has sought to control short-term capital inflows and
keep the maturity profile, end-use etc. within prudential norms. These are
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very impressive achievements. Stability has been achieved in the external

sector and the central bank can now conduct autonomous monetary policy.
However, continued fiscal deficits are restraining the economy from realizing
its full potential to grow and in providing quality infrastructure, both physical
and social, that can meet the growing needs of a resurgent economy.

Objectives of Fiscal Policy in Developing Countries

In developing countries, taxation, the government expenditure and borrowing

have to play a very important role in accelerating economic development. Fiscal
policy is a powerful instrument in the hands of the government by means of which it
can achieve the objectives of development. There are several peculiar
characteristics of a developing country, which necessitate the adoption of a specific
fiscal policy, which ensures a rapid economic growth. There are vast and diverse
resources human and material, which are lying underutilized. Such countries have
weak infrastructure, i.e. they lack adequate means of transport and
communications, road ports, highway, irrigation and power and technical know-how.
Their population increasing at an explosive rate, which necessitates rapid economic
development to, meet the requirements of the rapidly- growing population.

In order to overcome these handicaps, a suitable fiscal and taxation policy is called.

The principal objectives of fiscal policy in a developing economy are

 To mobilize resources for economic growth, especially for the public sector.
 To promote economic growth in the private sector by providing incentives to
save an invest.
 To restrain inflationary forces in the economic in order to ensure price
stability.
 To ensure equitable distribution of income and wealth so that fruits of
economic growth are fairly distributed.
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ROLE OF FISCAL POLICY

In recent weeks, a number of signs have appeared suggesting that the recovery
of the U.S. economy from the recent recession is on a bumpy path. During the
second quarter of 2002, real GDP grew at an anemic annual rate of barely over 1%,
well below market expectations. Unemployment, after rising throughout 2001, has
leveled off but has yet to show signs of declining. Adding some gloom to the general
outlook, the stock market continued to drop through most of July and has remained
volatile. This sluggish economic performance comes despite substantial stimulus
from both monetary and fiscal policy. Since January 2001, the Federal Reserve has
reduced its benchmark policy interest rate, the federal funds rate, from 6.52% in
September 2000 to a current level of 1.75%. Fiscal policy also has become more
expansionary. The federal government budget has swung from a surplus of $236
billion in 2000 (2.5% of GDP) to a projected 2002 deficit of $157 billion (1.5% of
GDP) as the government has increased expenditures and reduced taxes. This active
use of fiscal policy during a recession is somewhat unusual. During the last U.S.
recession, in 1990, then President George H.W. Bush resisted attempts to use fiscal
policy to stimulate the economy. In fact, his Council of Economic Advisers, in their
February 1992 report, argued that increases in fiscal expenditures or reductions in
taxes might hamper the economy’s recovery. In contrast, during the current
recession, both Congress and the President have supported increases in
expenditures and tax cuts as ways to stimulate economic growth, culminating in the
passage of the Economic Recovery Act in March 2002.The current recession and the
1990–1991 recession offer contrasting examples of the use of fiscal policy, and they
also highlight some elements of the longstanding debate in economics over whether
fiscal policy can play a useful role in combating business cycle downturns. This
Economic Letter discusses some of the issues involved in using fiscal policy to help
stabilize short-run fluctuations in the economy.

In developing economies, the government has to play a very active role in

promoting economic development and fiscal policy is the instrument that the state
must see. Hence the great importance of public finance in underdeveloped countries
desirous of rapid economic development. In a democratic society, there is an
inherent dislike for direct control regulation by the state. The entrepreneur would
not like to be ordered about to produce this or that, how much to produce or where
to produce. Fiscal incentives in the form of tax concessions, rebates or subside are,
therefore, preferable. Similarly, the consumers would not like to be told directly to
curtail their consumptions or to consume this and not to consume that. Taxation of
articles whose consumptions is to be discouraged is therefore preferable. Hence, a
democratic state must rely on indirect methods of control and regulation and this is
doing through fiscal and monetary policies. Thus in democratic countries, fiscal
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policy is a powerful and least undesirable weapon on which the states can rely for
promoting economic development.

INSTRUMENTS OF FISCAL POLICY

I. BUDGET:-
Keeping budget in balance, in surplus or deficit, is in itself a fiscal instrument.
When the government keeps its total expenditure equal to its revenue, as a matter
of policy, it means it has adopted a balanced budget policy. When the government
spends more than its expected revenue, as a matter of policy, it is pursuing a
deficit-budget policy. And when the government follows a policy of keeping its
expenditure substantially below its current revenue, it is following a surplus budget
policy.

Provisions of FRBMA

The 2004-05 budget is claimed to have adequate provisions to achieve fiscal

correction mandated in the Fiscal Responsibility and Budget Management Act 2003
(FRBM) through enhancement of revenue and reduction of revenue expenditure.

The main provisions of the FRBM Act in its original form were:

 Revenue deficit as a ratio of GDP should be brought down by 0.5 per cent
every year and eliminated by 2007-08;
 The fiscal deficit as a ratio of GDP should be reduced by 0.3 per cent every year and
brought down to 3 per cent by 2007-08;
 The total liabilities of the Union Government should not rise by more than 9 per cent a
year;
 The Union Government shall not give guarantee to loans raised by PSUs and State
governments for more than 0.5 per cent of GDP in the aggregate;

Further, the Union Government should place three documents along with the budget,
namely, the Macroeconomic Framework Statement, the Medium Term Fiscal Policy
Statement and the Fiscal Policy Strategy Statement. In addition, the Finance Minister will
have to make a statement at the end of the second quarter on the trend of fiscal indicators and
corrective measures if they deviate from the budget estimates beyond the extent stipulated in
the FRBM.
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Revenue Deficit and Fiscal Responsibility and Budget

Management Act (FRBMA)

Revenue deficit is the difference between the revenue expenditure and the revenue receipts
(the recurring income for the government). When a country runs a revenue deficit it means that
the government is unable to meet its running expenses from its recurring income.

The FRBMA was notified on July 2, 2004 and came into force on July 5, 2004. This Act
requires the reduction of fiscal deficit and elimination of revenue deficit by March 31, 2009. The
idea seems to be that deficit, if any, should be used to finance capital expenditure that leads to
asset formation and not on revenue expenditure, the benefits of which do not go beyond that
particular year.

For the year 2005-06, Finance Minister P Chidambaram has chosen to overlook the
requirements of FRBMA. The fiscal deficit for the year has been budgeted at 4.5 per cent of the
estimated GDP, this will be 0.1 per cent less than the required reduction. The revenue deficit
target for the year 2005-06, if FRBMA requirements were followed, it had to be at 1.8 per cent of
the GDP. But it has been budgeted at 2.7 per cent of the GDP.

Given the strong growth experienced by the Indian economy better progress could have been
made on this front. One reason for ignoring FRBMA for this year is the fact that the government
has increased grants to the states in line with the recommendations of the Twelfth Finance
Commission.

The government might miss its revenue deficit target of 2.7 per cent of the GDP in the
coming year on account of a likely undershooting of tax revenue collections, as highly optimistic
assumptions of tax revenue growth have been made. This would lead to the budgeted fiscal
deficit also shooting up.

II.TAXATION

A tax is a non quid pro quo payment by the people to the government. By this definition,
taxation means non quid pro quo transfer of private income to public coffers by means of taxes.

Taxation takes many forms in the developed countries including taxation of personal and
corporate income, so-called value added taxation and the collection of royalties or taxes on
specific sets of goods. Government may want to smooth out the nation's income in order to
minimize the pejorative effects of the business cycle or they may want to take steps designed to
increase the national income. They may also want to take steps intended to achieve specific social
objectives deemed to be appropriate by the political or legal process.
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Sound tax system, with moderate rates and a broad base, is an integral part of
the prudent fiscal policy. The expansion in the tax base is sought to be achieved
through expansion in the scope of taxes, specifically service tax, removal of
exemptions and improvement in tax administration. With a decline in non-tax
revenue receipts as a proportion of overall revenue receipts, the burden of fiscal
corrections is expected to be mainly on tax revenues. However, the measures to
increase the tax-GDP ratio must be harmonized with the overall growth objective.
The strategy seeks to increase tax compliance, improve the efficiency of tax
administration and with intense focus on recovery of arrears of tax revenues and
prevent further build-up of such arrears.

Agricultural taxation: This economic surplus mainly goes to rich farmers, landlords,
intermediaries in the absence of suitable taxation on agriculture. It has potential surplus & to
achieve maximum utilization of land through devising a system of land taxation which would
penalize poor use of good land.

Tax Reforms

In August 1991, the Government of India constituted a Tax Reforms Committee

(TRC) to recommend a comprehensive reform of both direct & indirect tax laws.

Following measures were taken to increase collection of income tax:

1. Historically, rates of income tax in India have been quite high, almost punitive.
E.g. In 1973-94, the maximum marginal rate of individual income tax was as high as
97.7%. This proved to be counter productive. The income tax slabs were reduced &
the rates themselves have been scaled down.

1. Prior to assessment year 93-94, taxation of partnership differed according to

whether the firm was registered or not under the I.T. Act, which was
drastically modified through Finance Act, 92.
2. Tax rates for domestic companies have been reduced from 40% to 30%. The
tax rate on foreign companies has also been reduced from 55% to 40%.
3. The basic exemption limits for individuals & HUF have been reduced.
4. Dematerialization of TDS certificates will be made effective from 1.4.2008.
5. Scheme for submission of returns through Tax Return Preparers has been
introduced.
6. Special tax benefits have been allowed to power sector, SEZs & shipping
industries.
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Indirect Tax Reforms:

1. Reducing peak rate of custom duties.

2. Rectifying anomalies like inverted duty structure.
3. Rationalising excise duties with a movement towards a median CENVAT
4. Introduction of state – level VAT for achieving a non-cascading, self-enforcing
& harmonized commodity taxation regime.
5. Introducing innovative financing mechanism like creation of a special purpose
vehicle for infrastructure projects.
6. Widening of service tax base and increase in compliance continues to show
high buoyancy in service tax revenue collection during 2006-07 also.

Fiscal policy also changes the burden of future taxes. When the government runs an
expansionary fiscal policy, it adds to its stock of debt. Because the government will have to pay
interest on this debt (or repay it) in future years, expansionary fiscal policy today imposes an
additional burden on future taxpayers. Just as taxes can be used to redistribute income between
different classes, the government can run surpluses or deficits in order to redistribute income
between different generations.

Some economists have argued that this effect of fiscal policy on future taxes will lead
consumers to change their saving. Recognizing that a tax cut today means higher taxes in the
future, the argument goes; people will simply save the value of the tax cut they receive now in
order to pay those future taxes. The extreme of this argument, known as Ricardian Equivalence,
holds that tax cuts will have no effect on national saving, since changes in private saving will
offset changes in government saving. But if consumers decide to spend some of the extra
disposable income they receive from a tax cut (because they are myopic about future tax
payments, for example), then Ricardian Equivalence will not hold; a tax cut will lower national
saving and raise aggregate demand. The experience of the eighties, when private saving fell
rather than rose in response to tax cuts, is evidence against Ricardian Equivalence.

III.PUBLIC EXPENDITURE

Does increased government expenditure necessarily lead to a greater

fiscal deficit?

Not necessarily. Suppose the government spends more on an electricity project

for which the contract is given to a PSU like BHEL. Then the money that the
government spends comes back to it in the form of BHEL's earnings. Similarly,
suppose that the government spends on food-for-work programmes, and then a
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significant part of the expenditure allocation would consist of food grain from the
Public Distribution System which would account for part of the wages of workers
employed in such schemes. This in turn means that the losses of the Food
Corporation of India (which also includes the cost of holding stocks) would go down
and hence the money would find its way back to the government. In both cases, the
increased expenditure has further multiplier effects because of the subsequent
spending of those whose incomes go up because of the initial expenditure. The
overall rise in economic activity in turn means that the government’s tax revenues
also increase. Therefore there is no increase in the fiscal deficit in such cases.

Is it a Good Idea to Reduce Fiscal Deficits through Disinvestment?

No. The PSUs that the government has been disinvesting in are the profit making
ones. Thus, while the government earns a lump-sum amount in one year, it loses the
profits that the PSU would have contributed to the exchequer in the future.
Therefore, it is not a good idea even if the objective is to reduce the fiscal deficit.
The expenditure of the government can be classified into plan expenditure and
non-plan expenditure. Plan expenditure is an expenditure that the government plans
to incur on a scheme to be implemented in a given year. For example, in the year
2003-04 (as per the revised estimates for that year), the government had allocated
Rs 2588.62 crore (Rs 25.886 billion) for construction of national highways.

Non-plan expenditure is defined as expenditure committed by the expenditure.

Interest payments, pensions, salaries, subsidies and maintenance expenditure are
all non-plan expenditure. Non-plan expenditure is generally an outcome of plan
expenditure. For example, the national highways the government constructed in the
year 2003-04 and before need to be maintained. All the expenses going towards this
is treated as non-plan expenditure. Expenditure on both plan and non-plan front can
be categorised into capital and revenue expenditure. Capital expenditure includes
that expenditure which leads to creation of assets whereas revenue expenditure
does not involve asset creation and is recurring in nature.

The construction of the national highways in the year 2004-05 would involve expenditure on
aggregate, bitumen or cement (depending upon the nature of the road) and certain machinery.
This expenditure would be classified as capital expenditure. The labour charges would be
classified as revenue expenditure. Once the plan expenditure is over the maintenance of the road
would start. The expenditure on this would be non-plan and can be further categorized into non-
plan capital expenditure and non-plan revenue expenditure.

The government wants to invest in infrastructure, power, primary education, health and water
supply to put India on the fast track to growth. But it simply doesn't have the money to implement
its strategy. The deficit is essentially servicing current consumption and not financing capital
11

investment, which should be the case. The current situation leads to a very interesting conclusion.
We all know that deficit financing involves the government financing its excess expenditure over
revenue through borrowing. Conventional wisdom tells us that money that is borrowed needs to
be invested in areas where the return generated is greater than interest to be paid on the debt (i.e.
the return generated should be greater than the cost of capital). But the government cannot always
work with the profit motive in mind. The government is not earning enough to pay back the
interest on its debt. So what is it doing? It is taking in more debt to repay its earlier debt and the
interest that is to be paid on the existing debt. Not a healthy sign one must say.

Government is keen that the funds reach the ultimate beneficiaries as speedily
as possible rather than remaining in the pipeline with the long chain of
intermediaries, including State Governments. While the House approves the
expenditures for specified objectives, there is avoidable delay in meeting those
objectives. The Government has tightened the fiscal discipline in this regard. The
Ministries have been advised to keep a close watch on the position of unspent
balances available with the State Governments and implementing agencies, and
insist upon furnishing of utilization certificates for funds released earlier, wherever
due under the Rules, before releasing more funds.

In a bid to improve transparency and accountability, Ministries/Departments are

expected to release a summary of their monthly receipts and expenditure to general
public (through their website, etc.) and in particular, disclose scheme – wise funds
released to different States.

IV. GOVERNMENT BORROWING:

Government borrowing is another fiscal Method by which savings of the

community may be mobilized for economic development. In developing economies,
the government resort to borrowing in order to finances schemes of economic
development. Government or what is also called public borrowing becomes
necessary because taxation alone cannot provide sufficient funds for economic
development. Besides, too heavy taxation has an adverse effect on private saving
and investment.

Government borrowing takes 2 forms: (a) market loans and

(b) small savings.
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In case of market borrowing the government sells to the public, negotiable

government securities of varying terms and duration and treasury bills for financing
capital project long-term government bounds are floated in the capital market. This
form of public borrowing is more important for mobilizing resources for
development. The treasury bills, which represent short-term, borrowing, are
intended to meet only the current government expenditure. New bonds may be
issued for meeting old maturing bonds. The small saving represented public
borrowing which are not negotiable and are bought and sold in the capital market.
For mobilizing small savings, various types of saving certificates are issued, e.g.,
National Savings certificates, national Developments certificates, Rural development
Bonds, Postal certificates and Postal Accounts, Compulsory Deposits, etc. A
widespread campaign is necessary to attract small saving.
Borrowing is the quickest Mode of raising funds:

Tax finance is not so expeditious because passing of tax laws, assessment of

taxes based on those laws and their collections involves considerable delay.
Besides, public debt does not involve any burden if it is devoted productive works.
The subscribers to Government loans are able to find remunerative investment
whereas the government can pay the principal and interest out of the income
yielded by investment finance from loans. Thus public borrowing is not only
necessary but also desirable.

There is another advantage in Government Borrowing. Government borrowing is

anti-inflationary. The underdeveloped countries are victims of inflation since they
have to resort to deficit financing for finding funds for economic development. Since
deficit financing is inflationary, public borrowing is preferable to deficit financing.
Public borrowing mops up the surplus purchasing power with the people. If thus
checks consumption and so a rise in prices. At the same time idle balances are
absorbed in productive activity.

Borrowing is resorted to meet the uncovered gap between total expenditure and
total non-debt receipts of the Central Government. Central Government policy
towards borrowing to finance its fiscal deficit places greater reliance on domestic
market borrowings over external debt. Thus, the Government finances major part of
its deficit through resources raised at market determined interest rates. Central
Government is taking several steps to moderate the carrying cost of debt and clean-
up its debt/liability portfolio. Debt restructuring measures along with the policy of
fiscal rectitude as prescribed under FRBMA is expected to moderate the overall
public debt burden.

Public borrowing generates additional productive capacity; the funds raised by

public borrowing can be utilized for building up economic infrastructure for economy
through schemes for the development of irrigation, transport, power and
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communication. They can help also in building up of the agricultural and industrial
base of the economy. Therefore public borrowing plays a very important role in
accelerating economic development of underdeveloped economies. Public debt
promotes saving and investment, the two most crucial determinants of economic
growth.

Some of the obstacles:

The success of borrowing policy in developing countries, like there are no

organized money and capital markets and in those where such markets exist, they
constitute a very a small proportion of total money market of the country.

Moreover the resources of the organized money market may be too inadequate
to fulfill the needs both of the private and public sectors. In the financial market the
competition for funds between the government and private sector will raise rate of
interest and this will have a highly distinctive effect on the expansion of investment
in the private sector. In India the rates of interest on loans of government have been
raised quite substantially. Since banks and others prefer to invest in government
securities because they are safe (i.e., risk less). This has reduced the fund for
private investment.

It is necessary that financial institution be developed and extended into rural

areas of the economy in order to inculcate the habit of thrift in he population and to
mobilize for productive purposes the amount of savings originating in this sector.
Besides, for the mobilization of savings it will be necessary to check and regulate
the diversion of savings into unproductive investment such as real estate, gold and
jewelry and inventory accumulation.

Suitable techniques of borrowing must also be devised. Bonds issued by

government should be adjusted to the preferences of the general public; bonds of
large denomination and long maturity may be offered to the institutional investors.

V.DEFICIT FINANCING
Deficit financing refers to “created money”, i.e., creation of additions
purchasing power in the form of currency notes. According to the Indian planning
commission, deficit financing is equal to the net increase in the purchasing power of
the economy arising out of the operations of the government. Deficit financing is
said to have been practiced whenever government expenditure exceeds the
government receipts from the public, etc. such an excess of expenditure is financed
by borrowing from the Central Bank.

When Government borrows from central bank which is a note-issuing

authority, the Central bank simply issues more notes and gives them to the
Government against Government securities. Thus in the last analysis deficit
financing means the creation of new currency. It may be noted that in India Net
Bank Credit from RBI by the central Government is called Deficit Financing. In fact
14

when central government borrows from RBI and the latter issues new currency it is
called monetization of government debt. It is the monetization of debt that lead to
the expansion in money supply due to Government’s fiscal deficit that was earlier
called deficit financing. However, in the modern terminology it is now called
monetization of fiscal deficit.

NEED FOR DEFICIT FINANCING:

The developing countries keen to promote rapid economic growth, the
resources required for development far exceeds the amount which can be raised by
normal means of resource mobilization, viz., taxation, borrowing, surpluses from
public enterprises, etc. the uncovered gap is made up by deficit financing. Rapid
economic development can be achieved only by setting up the rats of investment.
But wherefrom are the developing countries to raise the additional resources? In the
absence of sufficient foreign aid forthcoming from friendly countries and
international organizations, the additional funds must come from domestic
resources. For this purpose voluntary savings must be stepped up. These savings
are then mopped up through national small savings schemes to add to resources
available to the government.

FISCAL POLICY STRATEGY STATEMENT

A. FISCAL POLICY OVERVIEW
1. The Interim Budget 2009-10 was presented in the background of the
uncertainties prevailing in the world economy which was hit by three unprecedented
crises in the same financial year. The details of the extraordinary economic
15

circumstances have been enumerated in the Fiscal Policy Strategy Statement and
Macro-Economic Framework Statement presented along with the Interim Budget
2009-10. The prevailing situation now as well as during the presentation of the
Interim Budget is in sharp contrast to the conditions at the time of presentation of
the Union Budget 2008-09 in February 2008 when the Indian economy was riding on
a high and impressive growth trajectory registering about 9 per cent of average
growth during 2004-08. This performance coupled with significant improvement in
fiscal indicators during the regime of the Fiscal Responsibility and Budget
Management (FRBM) Act, 2003 inspired confidence in the medium to long term
prospects of the economy. The process of fiscal consolidation during these years
resulted in improvement in fiscal deficit from 5.9 per cent of GDP in 2002-03 to 2.7
per cent of GDP in 2007-08. During the same period, revenue deficit declined from
4.4 per cent to 1.1 per cent of GDP. The gradual reduction in fiscal deficit coupled
with higher rate of growth of GDP helped the total liabilities (net of MSS) to GDP
ratio of the Central Government improve from 69.1 per cent in 2002-03 to 56.5 per
cent in 2007-08.

2. In tune with the philosophy of equitable growth, the process of fiscal

consolidation was taken forward without constricting the much-required social
sector and infrastructure related expenditure. This improvement in the state of
public finances was achieved through higher revenue buoyancy, driven by efficient
tax administration and improved compliance which is evident from increase in the
gross tax to GDP ratio from 8.8 per cent in 2002-03 to 12.6 per cent in 2007-08.

3. However to mitigate the adverse effects of petroleum price rise, rise in prices
of other commodities and the huge crisis in the global financial system during 2008-
09, the Government had to explore suitable fiscal as well as monetary policy
options. During the first half of the financial year 2008-09, the focus of the monetary
as well as fiscal policy was more on containing inflation, which had reached 12.9 per
cent in August, 2008. Series of fiscal measures both on tax revenue and expenditure
side were undertaken with the objective of easing supply side constraints. These
measures were supplemented by monetary initiatives through policy rate changes
by the Reserve Bank of India which together with the fiscal measures contributed to
the softening of domestic prices. Headline inflation fell below 5 per cent in January
2009 and is now placed at (-) 1.3 per cent in June, 2009. However, the fiscal
measures undertaken through tax concessions and increased expenditure on food,
fertiliser and petroleum subsidies along with increased salary bills for implementing
the Sixth Central Pay Commission recommendations significantly impacted the
deficit position of the Government.

4. The global financial crisis in the second half of the financial year shifted the
focus of fiscal policy to providing growth stimulus. The moderation in growth of the
economy and the impact of the fiscal measures taken to stimulate growth has been
reflected in lower gross tax revenue receipts at Rs.6,09,705 crore as per the
provisional accounts of 2008-09 against B.E.2008-09 of Rs.6,87,715 crore. Additional
16

budgetary resources provided as part of stimulus package including increase in plan

outlay from Rs.2,43,386 crore in B.E. 2008-09 to Rs.2,82,957 crore in R.E.2008-09
and various committed liabilities of Government including rising subsidy
requirements, implementation of Sixth Central Pay Commission recommendations
and Debt Waiver and Debt Relief Scheme for Farmers contributed to increase the
fiscal deficit to 6.2 per cent of GDP in 2008-09 (provisional accounts) as compared to
2.5 per cent of GDP in B.E.2008-09.

5. The Country is still facing a difficult economic situation, the cause of which is
not emanating from within its boundaries. However, left unattended, the impact of
this crisis is going to affect us in medium to long term. The Government had two
policy options before it. In view of falling buoyancy in tax receipts, the Government
could have taken a decision to cut expenditure and thereby live within the
mandated deficit for the year as per the FRBM Rules. This could have resulted in an
adverse impact on the growth of the economy in the absence of investments,
thereby putting at risk the revival of the economy in the prevailing situation. The
second option was to increase public expenditure, even with lower revenue receipts,
and stimulate economy by creating demand and maintain the growth trajectory. The
Government preferred the second option of undertaking fiscal measures to increase
public expenditure in order to boost demand and increase investment in
infrastructure sector. The above decision of the Government was guided on the
principles of insulating the vulnerable sections of society and sectors of economy
from the impact of economic downturn and at the same time ensure revival of the
economy with higher growth. These measures are expected to spur growth and
restore revenue buoyancy in medium term and provide the required fiscal space to
revert to the path of fiscal consolidation.

B. FISCAL POLICY FOR 2009-10

6. The General Budget 2009-2010 is being presented in the backdrop of signs of
moderation in the rate of decline in global economy. However, it is still early to
predict complete revival as the recovery may remain sluggish with further risks
towards the downslide. In the given scenario, the Government has to continue with
the policy of increased public expenditure to boost demand and create
infrastructure. The impact of three fiscal stimuli have started showing results. The
growth rate of 6.7 per cent in GDP makes India the second fastest growing economy
in the World during 2008-09. The measures taken by Government to counter the
effects of the global meltdown on the Indian economy have resulted in short fall in
revenues and substantial increases in government expenditures, leading to a
temporary deviation from the fiscal consolidation path mandated under the FRBM
Act for 2008-09 and 2009-2010. The revenue deficit and fiscal deficit in B.E. 2009-
2010 are, as a result, higher than the targets set under the FRBM Act and Rules. The
grounds due to which this temporary deviation has taken place, are detailed in the
Fiscal Policy Overview above and also in the Macro-economic Framework Statement
being presented in the Parliament. The fiscal policy for the year 2009-2010 will
continue to be guided by the objectives of keeping the economy on the higher
17

growth trajectory amidst global slowdown by creating demand through increased

public expenditure in identified sectors. However, the medium term objective will be
to revert to the path of fiscal consolidation with emphasis on structural fiscal
reforms and prudent fiscal management at the earliest, with improvement in the
economic situation.

Tax Policy

Indirect taxes
7. In recent years, tax policy has been guided by the need to increase the tax-
GDP ratio and achieve fiscal consolidation. In these years, the tax-GDP ratio
improved significantly from 9.2 per cent in 2003-04 to 12.6 per cent in 2007-08. This
has been achieved through rationalisation of the tax structure (moderate levels and
a few rates), widening of the tax base, and reduction in compliance costs through
improvement in tax administration. The extensive adoption of information
technology solutions and re-engineering of business processes has also fostered a
less intrusive tax system and encouraged voluntary compliance. These measures
have resulted in increased buoyancy in tax revenues till 2007-08 and helped in fiscal
consolidation. However, the process of consolidation slowed down in 2008-09,
especially in the case of indirect taxes, as a result of certain policy interventions
necessitated by the need to sustain the growth momentum in the wake of some
unforeseen developments in the global and domestic economy.

8. The first half of 2008-09 saw a sharp surge in the international prices of crude
petroleum and other commodities (food items, edible oils, metals etc.) leading to
severe inflationary pressures on the economy. The inflationary pressures were
contained through a slew of fiscal measures, including reduction of import duties
and imposition of export duties on a host of items.

9. The onset of the global financial crisis in September, 2009 led to a reversal of
trends with de-growth in export markets and domestic slowdown. A dip in industrial
and manufacturing growth and the prognosis of an impending crisis prompted the
Government to announce three fiscal stimulus packages in quick succession- on 7th
December, 2008, the 2nd January, 2009 and 24th February, 2009

10. Owing to the policy interventions for inflation management and subsequently for
providing a stimulus to growth, Government had to forego substantial revenues from
excise and customs duties. Consequently, despite the buoyancy of direct tax
revenues and service tax collections, the fiscal consolidation process received a
setback. On the positive side, however, the results of these proactive measures
have begun to show- with some sections of manufacturing and services exhibiting
preliminary signs of recovery. It is expected that this will reflect in recovery in
growth of tax receipts in the later part of 2009-10 and enable a return to the path of
fiscal consolidation by moving closer to FRBM targets.
18

11.Thus, as a policy direction, while continuing on the path of simplifying and

rationalizing the tax structure and improving the tax-GDP ratio, it has been
considered necessary to continue (and also enhance in some cases) fiscal support to
certain labour intensive and employment oriented sectors, which continue to be
beleaguered owing to falling demand in domestic and export markets.

12. It is also proposed to integrate the tax on goods (cenvat) and the tax on
services, and finally move to a common Goods and Service Tax (GST). In as much as
the policy so far has sought to achieve convergence of rates, this would facilitate the
introduction of GST by 1st April, 2010, as already announced by the Government.
This shift to GST is expected to significantly improve buoyancy from indirect taxes,
owing to the opportunity it provides for further convergence and moderation of rates
and a substantial expansion in the base which would extend beyond manufacturing
all the way to retail.

Central Excise

To provide continued fillip to the manufacturing sector and accelerate its recovery,
the reduction in ad valorem excise duty rates to 8%, effected in two phases as part
of the fiscal stimulus packages announced on 7.12.2008 and 24.2.2009, is being
continued. To mitigate the problem of credit accumulation (which arose in some
cases as a result of the cenvat cuts implemented as part of the recent fiscal
stimulus packages, owing to deeper cuts on finished goods as compared to their raw
materials), excise duty rate has been increased from 4% to 8% in the following
cases:-

♦ Manmade filament yarn and fibre (polyester, nylon, acrylic and viscose)

♦ Textile intermediates (DMT, PTA, acrylonitrile and polyester chips)

♦ Natural fibres and yarns such as silk, wool, coconut etc on optional basis

♦ Spun yarn, woven man made or blended fabrics, and industrial fabrics on
optional basis

In order to converge towards a mean cenvat rate, excise duty rate has been
increased from 4% to 8% on certain finished goods and consumer goods To provide
some relief to automobile manufacturers, who are careworn owing to falling demand
in domestic and export markets, the specific excise duty component on large cars
and utility vehicles of engine capacity 2000 cc and above has been reduced from
Rs.20,000 to Rs.15,000.

Customs
19

In the wake of global slowdown, to provide a level playing field to domestically

produced goods against imports, the peak rate of customs duty on non-agricultural
goods has been retained at 10%. Customs duty concessions have been provided on
specified inputs and capital goods for exporters in sectors such as leather, textiles,
and synthetic footwear. To promote indigenous manufacture of LCD televisions,
customs duty has been reduced on ‘panels’, which is a primary cost-contributing
component for LCD TVs. To provide a level playing field to domestic manufacturers
of set top boxes, customs duty exemption has been withdrawn, and 5% duty
imposed. To mobilize some revenues, the specific rates of Customs duty on gold and
silver have been increased.

Direct Taxes

13. During the FRBM period there has been a structural change in the composition of
Centre’s tax revenue. While the Centre’s tax-GDP ratio has increased by 2.3
percentage points to 11.5 per cent in 2008-09 from 9.2 per cent in 2003-04, the
direct tax-GDP ratio has increased by 2.6 percentage points to 6.4 per cent in 2008-
09 from 3.8 per cent in 2003-04. Further, the share of direct taxes in Centre’s tax
revenues has also increased to 55.5 per cent in 2008-09 from 41.4 per cent in 2003-
04. This structural change has been brought about by a multi-pronged strategy
comprising of the following elements :-

(i) Minimizing distortions within the tax structure by expanding the tax base and
reducing the tax rates to moderate levels;

(ii) Improving the efficiency and effectiveness of the tax administration so as to

substantially increase deterrence level to encourage voluntary compliance; and

(iii)Providing quality taxpayer services by re-engineering business processes in the

Income-tax Department through extensive use of modern technology, viz., e-filing of
returns, e-payment of taxes, establishing a Centralized Processing Centre, issue of
refunds through ECS and refund bankers, computer aided selection of cases for
scrutiny and an effective taxpayer information system.
20

14. The medium term strategy for direct taxes is to consolidate the achievements of
the past and accelerate this process of change. The policy proposals in the Union
Budget 2009-10, are intended to achieve this

Objective

15. The important policy initiatives are:-

(i) Partly neutralizing the erosion in the tax base on account of various tax incentives
by increasing the Minimum Alternate Tax (MAT) rate to 15 per cent from the existing
level of 10 per cent. Also expanding the MAT base by plugging leakages on account
of innovative accounting practices;

(ii) Further rationalization of the Personal Income Tax (PIT) rate structure by
enhancing the threshold exemption limits and removing the surcharge on PIT;

(iii)Introducing a new package of presumptive taxation to encourage voluntary

compliance by small businesses;

(iv)Reducing the distortionary impact of profit-linked tax incentives by introducing

investment-linked tax incentives for specified new businesses by allowing full
expensing for capital expenditure;

(v)Rationalization of various tax incentives to ensure better targeting and also

preventing any misuse;

(vi)Removing uncertainty in tax liability of foreign Investors by providing for a fast-

track alternate dispute resolution mechanism;
21

(vii)Streamlining the provisions relating to tax deduction at source for improving

compliance and efficiency;

(viii)Rationalizing the tax treatment of the New Pension System (NPS) for enabling
the establishment of a much needed social security system in India;

(ix)Enabling the tax administration to communicate with the taxpayers by making

use of latest information technology tools;

(x)Enhancing levels of transparency in the functioning of the tax administration by

introducing the system of allotting and quoting a unique computer based Document
Identification Number (DIN) in respect of all correspondence sent from or received
by the Income-tax Department. This will help in proper record management and in
tracking taxpayer grievances.

Contingent and other Liabilities

16. The FRBM Act mandates the Central Government to specify the annual target for
assuming contingent liabilities in the form of guarantees. Accordingly the FRBM
Rules prescribe a cap of 0.5 per cent of GDP in any financial year on the quantum of
guarantees that the Central Government can assume in the particular financial year.
The Central Government extends guarantees primarily on loans from
multilateral/bilateral agencies, bond issues and other loans raised by various Public
Sector Undertakings/Public Sector Financial Institutions. The stock of contingent
liabilities in the form of guarantees given by the government has reduced from
Rs.1,07,957 crore at the beginning of the FRBM Act regime in 2004-05 to
Rs.1,04,872 crore at the end of 2007-08. As a percentage of GDP, it has reduced
from 3.4 per cent in 2004-05 to 2.7 per cent in year 2006-07 and further to 2.2 per
cent for the year 2007-08. The disclosure statement on outstanding Guarantees as
prescribed in the FRBM Rules, 2004 is appended in the Receipts Budget as Annex 3
(iii).

17. Assumption of contingent liability in the form of guarantee by the sovereign

helps to leverage private sector participation in areas of national priorities. In the
current situation, wherein a large number of infrastructure projects are being
cleared for implementation under the Public Private Partnership (PPP) mode,
difficulties are being faced in reaching financial closure due to the current
uncertainties in the global financial market. Within the given fiscal constraints and
22

with a view to supporting financing of above mentioned PPP projects, the India
Infrastructure Financing Company Limited (IIFCL) has been authorized to raise
Rs.10,000 crore through Government guaranteed tax free bonds in the previous
financial year 2008-09. Further, IIFCL have been authorised to raise additional
Rs.30,000 crore on the same basis as per requirement during 2009-10. The capital
so raised will be used by IIFCL to refinance bank lending of longer maturity to
eligible infrastructure projects. This initiative of the government is expected to
result in leveraging of bank financing to PPP programmes of about Rs. one lakh
crore. The likely assumption of contingent liability in the form of guarantee for
2008-09, including the above mentioned Rs.10,000 crore for IIFCL, will amount to
Rs.36,606 crore which will be 0.69 per cent of GDP during 2008-09, higher than the
target of 0.5 per cent of GDP set under the FRBM Rules. This deviation has been
necessitated in the larger interest of re-invigorating the economy in the background
of the current economic scenario, to stimulate demand and increase investment in
infrastructure sector projects. In the medium term while this may not have a
potential budgetary impact, the additional demand thus created will help restore the
economy to its higher growth path and contribute to higher revenue buoyancy which
has shown a slump in the current financial year due to moderation in the growth in
economy.

Government Borrowings, Lending and Investments

18. The Government policy towards borrowings to finance its deficit continues to
remain anchored on the following principles, namely (i) greater reliance on domestic
borrowings over external debt, (ii) preference for market borrowings over
instruments carrying administered interest rates, (iii) elongation of the maturity
profile and consolidation of the debt portfolio and (iv) development of a deep and
wide market for Government securities to improve liquidity in secondary market.

19. In order to provide fiscal stimulus to counter the situation created by the effects
of the global financial crisis, the borrowing calendar of the government had to be
revised during 2008-09. The gross and net market borrowings (including dated
securities and 364- day Treasury Bills) of the Central Government during 2008-09
amounted to Rs.3,18,550 crore and Rs.2,42,316 crore respectively as against Rs.
1,88,205 crore and Rs. 1,09,504 crore during 2007-08. The weighted average
maturity of dated securities issued during 2008-09 was 13.8 years as compared to
14.9 years during 2007-08. The Central Government is continuing with the policy of
elongating maturity profile of dated securities as well as building up a sound yield
curve. The Government has been issuing securities with maximum 30–year
23

maturity. The weighted average yield of dated securities issued during 2008-09 was
7.69 per cent and was lower than 8.12 per cent during 2007-08.

20. In consultation with RBI, after the presentation of the Interim Budget 2009-10,
the Government has announced a market borrowing programme of Rs.3,98,552
crore (gross) and Rs.3,08,647 crore (net) for 2009-10. Of this, Rs.2,07,364 crore
(net) is scheduled to be raised during the first half of the current financial year. The
borrowing calendar will undergo revision to take care of changes arising on account
of the General Budget presented now. The gross and net market borrowings
(including dated securities and 364- day Treasury Bills) of the Central Government
during 2009-10 (up to June 30 ,2009) amounted to Rs.1,96,000 crore and
Rs.1,53,361 crore respectively as against Rs. 65,550 crore and Rs. 33,144 crore
during 2008-09 for the same period. The weighted average maturity of dated
securities issued during 2009-10 (up to June 30, 2009) was 11.88 years which was
15.74 years during 2008-09 for the same period. The weighted average yield of
dated securities issued during 2009-10 (up to June 30, 2009) was 6.93 per cent
which was lower than 8.42 per cent during 2008-09 for the same period.

21. During the year 2009-10, the financing of fiscal deficit is estimated to be done
without taking recourse to short-term borrowings through Treasury Bills or cash or
cash draw down. However to take care of temporary mismatch between receipts
and expenditure, the Government will have to take recourse to ways and means
advances from RBI. In the last quarter of 2009-10, depending on the prevailing
liquidity with the Government suitable adjustment in the size and composition of the
borrowing programme may be required.

22. The outstanding balance under Market Stabilization Scheme (MSS) on 1st April,
2008 was Rs.1,70,554 crore. Notwithstanding fresh issuance of Rs.43,500 crore
during 2008-09, the outstanding balance under the MSS declined to Rs.88,773 crore
mainly reflecting the change in policy, unwinding of MSS through buy-back of
Rs.47,544 crores and de-sequestering of Rs.12,000 crore. This was part of the
Government decision to de-sequester Rs.45,000 crore from MSS for using it in
financing increased fiscal deficit during 2008-09 and 2009-10. As only Rs.12,000
crore was de-sequestered during 2008-09, of the balance Rs.33,000 crore the
option of de-sequestering MSS to the tune of Rs. 28,000 crore was opted (up to June
30, 2009) during 2009-10 to augment the liquidity with the Central Government.
The outstanding amount in MSS as on June 24, 2009 is Rs. 23,273 crore consisting of
Rs.18,773 crore of dated securities and Rs.4,500 crore of T-bills.

23. In order to have prudent management of debt and greater focus on carrying cost
as well as meeting secondary market liquidity, the government has set up a Middle
Office which in due course will merge with the proposed Debt Management Office.

24. Central Government has stopped playing the role of financial intermediary for
State Governments for domestic market borrowings. The trends in the current year
24

show that this transition has been very smooth resulting in reduction in cost for the
State Governments, while at the same time bringing in a sense of market discipline.

25. The Government has set up the National Investment Fund (NIF) to which the
disinvestment proceeds from Central PSUs are being transferred. This fund is being
managed by professional fund managers. The receipts in the Fund are not reckoned
as resources for the purpose of financing the fiscal deficit. However, the income
from investments under NIF is used to finance social infrastructure and provide
capital to viable public sector enterprises without depleting the corpus of NIF.

Initiatives in Public Expenditure Management

26. The focus has shifted from financial outlays to outcomes for ensuring that the
budgetary provisions are not merely spent within the financial year but have
resulted in intended outcomes. As part of process reform, all new expenditure
proposals will have to report on how the proposal under consideration will enhance
the goals of equity or inclusion, innovation and public accountability. The
government has outlined in the President’s address to the joint session of Parliament
in June 2009 that an area of major focus would be reform of governance for effective
delivery of public services. Following initiatives are being taken by the Government
to achieve the above mentioned objective:

Establishing mechanisms for performance monitoring and performance evaluation

in government on a regular basis;

Strengthening public accountability of flagship programmes by the creation of an

Independent Evaluation Office at an arm’s distance from the government which will
concurrently evaluate the impact of these programmes and place it in public
domain;

Putting up a public data policy to place all information covering non-strategic areas
in the public domain which will help citizens to challenge the data and engage
directly in governance reform.

27. Initiatives have also been taken to evenly pace the plan expenditure during the
year and also to avoid rush of expenditure at the year-end which results in poor
quality of outcomes. The practice of restricting the expenditure in the month of
March to 15 per cent of budget allocation within the fourth quarter ceiling of 33 per
cent is being enforced. The quarterly exchequer control based cash and expenditure
management system which inter alia involves preparing a Monthly Expenditure Plan
25

(MEP) continues to be followed in select Demands for Grants. The emphasis is on

right pacing plan expenditure by ensuring adequate resources for execution of
budgeted schemes. At the same time, steps have also been taken in the form of
austerity instructions to reduce expenditure in non-priority areas without
compromising on operational efficiency. This has resulted in availability of adequate
resources from realised receipts for priority schemes.

28. Delays in receipts of utilization certificate are broadly indicative of poor

implementation strategy, diversion of funds or delay in utilization of funds for
intended purposes. Monitoring of utilization certificates and unspent balances with
the implementing authorities is reviewed at the highest level in the Ministry of
Finance. Necessary control mechanisms have been put in place with the help of the
office of the Controller General of Accounts (CGA) to avoid parking of funds and to
track expenditure.

29. A central monitoring, evaluation and accounting system for the 1258 centrally
sponsored schemes and central sector schemes of the Government has been
instituted under the Central Plan Schemes Monitoring System. All sanctions issued
by the Central Ministries under these schemes are now identified with a unique
sanction ID that enables the tracking of release as per their accounting and budget
heads across the different implementing agencies. This central system is hosted on
the e-lekha portal of the CGA.

30. The application software COMPACT has been extended to all civil ministries of
the Government and expenditure data is being uploaded on a daily basis by the Pay
and Accounts Offices on e-lekha. This is a significant step towards faster and
accurate compilation of the accounts for the Government of India and will lead to
the development of a core accounting solution. The monthly and annual Finance and
Appropriation Accounts are regularly updated on the CGA website:
www.cgaindia.gov.in.

http://indiabudget.nic

Fiscal Policy Can Be Divided In Two Types

26

I) DISCRETIONARY FISCAL POLICY FOR STABILISATION

Fiscal policy is an important instrument to stabilise the economy, that is, to

overcome recession and control inflation in the economy. By discretionary policy we
mean deliberate change in the Government expenditure and taxes to influence the
level of national output and prices. Fiscal policy generally aims at managing
aggregate demand for goods and services. To cure recession expansionary fiscal
policy and to control inflation contractionary fiscal policy is adopted.

Fiscal Policy to cure recession:

27

The recession occurs when aggregate demand decreases due to fall in private
investment. Private investment may fall when businessmen become highly
pessimistic about making profits in future, resulting in decline in marginal efficiency
of investment. A fall in private investment expenditure, aggregate demand curve
shifts down creating a deflationary or recessionary gap.

There 2 fiscal methods to get the economy out of recession.

 Increase in Government Expenditure.

 Reduction of taxes.
i) Increase in Government Expenditure to Cure Recession:
This is the important tool to cure depression. Government may increases
expenditure by starting public works, such as buildings roads, dams, ports
telecommunication links, irrigation works electrification of new areas etc.
Government buys various types of goods and materials and employs workers. The
effect of this increase in expenditure is both direct and indirect. The direct effect is
the increase in incomes of those who sell materials and supply labour for these
projects. The output of these public works also goes up together with the increase in
incomes, and for those who get more income they spend further on consumer goods
depending on their marginal propensity to consumer. This creates the multiplier. As
during the period of recession there exists excess capacity in the consumer good
industries, the increase in demand for them bring about expansion in their output
which further generates employment and incomes for the unemployed workers and
so the new income are spent and serpent further and the process of multiplier goes
on working till it exhausts itself.

How large should be the increase in expenditure so that equilibrium is established at

full employment or potential level of output. This depends on magnitude of GNP gap
caused by deflationary gap on the one hand and the size of multiplier depends on
the marginal propensity to consume. The impact of increase in government
expenditure in a recessionary condition is illustrated in the following figure. Suppose
to begin with economy is operating at full-employment or potential level of output Y F
with aggregate demand curve C+I2+G2 intersecting 45o line at point E2 .Now due to
some adverse happening (say due to the crash in the stock market), investor’s
expectations of making profits form investment projects become dim causing a
decline in investment. With the decline in investment, say equal to E2B, aggregate
demand curve will shift down to new position C+I1+G1 that will bring the economy to
the new equilibrium position at point E1 and thereby determine Y1 level of output or
income. The fall in output will create involuntary unemployment of labour and also
excess capacity (i.e. idle capacity stock) will come to exist in the economy. Thus
emergence of deflationary gap equal to E2B and the reverse working of the
multiplier has brought about conditions of recession if the government increases its
expenditure by E1H, the aggregate demand curve will shift upward to original
28

position C+I2+G2 and as a result the equilibrium level of income will increase to the
full employment or potential level of output Yf and in this way the economy would be
lifted out of depression.
E

P 45o

E
E2 C+I2+G2
N
H C+I1+G1
D

I
Deflationary
Gap
T E1
Y= G 1
U Potential
R
450 output 1-MPC

E
Y1 YF

NATIONAL INCOME

Reduction in Taxes to Overcome Recession:

The reduction in taxes increases the disposable income of the society and
causes the increase in consumption spending by the people. If tax reduction of
Rs.200 crores is made by the Finance Minister, it will lead to Rs.1520 crores in
consumption, assuming marginal propensity t6o consume is 0.75 or ¾. Thus
reduction in taxes will cause an upward shift in the consumption function. It is worth
nothing that reduction in taxes has only an indirect effect on expansion and output
through causing a rise in consumption function. Like the increase in government
expenditure, the increase in the consumption achieved through reduction in tax will
have a multiple effect on increasing income, output and employment.

Example: -There are some instances in history of capitalist world, especially USA
when taxes were reduced to stimulate the economic. In 1964,the President Kennedy
reduce personal and business tax by about $12 billion to give a boost to the
American economy when there was high unemployment and lower capacity
utilization in American economy. This tax cut was quiet successful in reducing
unemployment substantially at expanding national Income through full utilization of
excess capacity. Again, over the period 1981-84, President Reagan made a very
large tax reduction to get out of recession and to achieve expansion in National
29

Income to reduce unemployment. However, tax reduction by President Reagan play

a significant role for bringing about the recovery.

Fiscal Policy to Control inflation:

When due to large increases in consumption demand by the households or

investment expenditure by the entrepreneurs, or biggest budget deficit caused by
too large an increase in Government Expenditure, aggregate demand increases
beyond what the economy can potentially produce by fully employing its given
resources, it gives rise to the situation of excess demand which results in
inflationary pressures in the economy. This inflationary situation can also arise if too
large an increase in money supply in the economy occurs. In these circumstances
inflationary gap occurs which tend to bring about rise in prices. If to check the
emergence of successful steps exceeds demands or close the inflationary gap are
not taken, the economy will experience a period a period of inflation or rising prices.
For the last few decades, both the developed and developing countries of the world
have faced problems of demand-pull inflation. Both have faced an alternative way of
looking at inflation is to view it from the angles of business cycles. After recovery
from recession, when during upswing an economy finds itself in conditions of boom
and become overheated prices start rising rapidly. Under such circumstances anti
cyclical fiscal policy calls for reduction in aggregate demand. Thus fiscal policy
measures to control inflation are

1) Reducing Government expenditure and;

2) Increasing taxes.

If in the beginning the government is having balanced budget, then increasing

taxes while keeping government expenditure constant will yield budget surplus. The
creation of budget surplus will cause downward shift in aggregate demand curve
and will therefore help in easing pressure on prices. If there is a balanced budget to
begin with and the government reduces its expenditure, say on defense, subsidies
transfer payments, while keeping taxes constant, this will also create budget surplus
and result in removing excess demand in the economy.

i) Raising Taxes to Control Inflation:

As an alternative to reduction in Government expenditure, the taxes can be
increased to reduce aggregate demand .For these purpose especially personal direct
taxes such as income tax, wealth tax, corporate tax can be raised. The hike in taxes
reduces the disposable in the comes of the people and thereby force them to reduce
their consumption demand.
30

ii) Disposal of Budget Surplus:

The government either reduces its expenditure or raises taxes to lower
aggregate demand for goods and services. Reduction in expenditure or hike in
taxes results in decrease in budget deficits {if occurring before such step} or in the
emergency of the budge serapes if the government was having balances budget
prior to the adoption of anti-inflationary fiscal policy measures. Assume that anti-
inflationary fiscal policy results in budget surplus. Anti-inflationary impact of budget
surplus depends to a good extent on hoe the government disposes of this budget
surplus.

There are two ways in which budget surplus can be disposed of: -

1) Reducing Or Retiring Public Debt: The budget surplus created by Anti-

inflationary policy can be use by the government pay back the outstanding debt.
However, using budget surplus for retiring public debt will weaken its anti-
inflationary effect. In plying of the debt of held by the public the government will be
returning the money to the public which it has collected through taxes. Further, this
will also add to the money supply with public. General public will spend a part of the
money so received, which will raise consumption demand. Beside, retiring of public
debt will result in the expansion of money supply in the money market, which will
tend to lower the rate of interest. The lower rate of interest will stimulate
consumption and investment demand while anti-inflationary policy requires that
they should be reduced.
2) Impounding Public Debt: - To realize a large anti-inflationary effect of
budget surplus it is desirable to impound the surplus fund. The impounding surplus
fund means that they should be kept idle. Thus by impounding the budget surplus,
the government shall be withdrawing some income or purchasing power from the
income-expenditure stream and thus will not create any inflationary pressure to
offset the deflationary impact of the budget. To conclude, the impounding of the
budget surplus is the better method of disposing of budget surplus than of paying of
public debt.

NON_DISCRETIONARY FISCAL POLICY: AUTOMATIC STABILIZERS

There is an alternative to use of discretionary fiscal policy, which generally

involves the problem of, large in recognizing the problem of recession or inflation
31

and large of the taking appropriate action to tackle the problem. In this Non-
discretionary fiscal policy, the tax structure and expenditure are so designed that
taxes and government spending vary automatically inappropriate direction with the
changes in National Income. That is, these taxes and expenditure pattern without
any special deliberate action by the government and parliament automatically raise
aggregate demand in times of recession and reduce aggregate demand in times of
boom and inflation and there by help in insuring economic stability. These fiscal
measures are therefore called automatic stabilizers or built-in stabilizers. Since
these automatic stabilizers do not require any fresh deliberate policy action or
legislation by the government, they represent non-discretionary fiscal policy. Built-
in-stability of tax revenue and government expenditure of transfer payment of
subsidies is created because they vary with national income. These taxes and
expenditure automatically bring about appropriate change in aggregate demand
and reduce the impact to recession and inflation that might occur in an economy at
sometimes. This means that because of existence of this automatic or built-in-
stabilizers recession and inflation will be shorter and less intense than otherwise is
the case. Important automatic fiscal stabilises compensation, welfare benefits
corporate dividends.

 Below are some taxes and revenue from which varies directly
with the change in national income:

1) Personal Income Taxes: The tax rate structure is so designed that revenue
from these taxes directly varies with income. Moreover, personal income taxes have
progressive rates: The higher rates are changed are from the upper income
brackets. As a result, when national income increases during expansion and
inflation, increasing percentage op the people’s income is paid to the government.
Thus, through causing a decline in their disposable income this taxes automatically
reduce people’s consumption and therefore aggregate demand. This decline n
aggregate demand because of imposition of progressive personal income tax
tender’s to check inflation from becoming more severe. On the other hand, when
national income decline’s at times of recession, the tax revenue declines as well
which prevent aggregate demand from falling by same proportion as the decline in
income.

2) Corporate Income Taxes: Companies, or corporations as they are called

now, also pay a percentage of their profits as tax to the Government. Like personal
income taxes, corporate income tax rate is also generally higher at higher levels of
corporate profits. As recession and inflation affect corporate taxes greatly, they
have a powerful stabilizing effect on aggregate demand; the revenue from them
rises greatly during inflation and boom which tends to reduce aggregate demand,
32

and revenue from them falls greatly during recession which tends to offset the
decline in aggregate.

3) Transfer payments: Unemployment compensation and welfare benefits:

When there is recession and as a result unemployment increases, the Government
has to spend more on compensation for unemployment and other welfare
programmes such as food stamps, rent-subsidies to farmers. This hike in
Government expenditures tends to make recession short-lived and less intense. On
the other hand, when at times of boom and inflation national income increases and
therefore unemployment falls, the government curtails its programme of social
benefit, which result in lowering government expenditure. The smaller spending by
the government help to control inflation.

4) Corporate Dividend Policy: With economic fluctuation, corporate profits

also rise and fall. However, corporations do not so quickly increase or reduce
dividend in turn with fluctuation in profits and follow a fairly stable dividend policy.
This permit the individuals to spend more during recession and spend less then
would have the case if dividends were lowered in time of recession and raised in
condition of boom and inflation. Thus, fairly stable dividends tend to cushion
recession and curb inflation by sabilising consumption.

EFFECTIVENESS OF FISCAL POLICY

The critics of Keynesians theory has pointed out that expansionary effect of
fiscal policy is not as larger as Keynesians economists suggest. In Keynesians theory
it is asserted that the Government increases its expenditure, without raising its
taxes or when it reduces taxes without changing expenditure it will have a large
expansionary effect of national income. In other words deficit budget would lead to
the large increase in aggregate demand and thereby help to expand national output
and income. However it has been pointed that the above analysis of the effect
expansionary fiscal policy of budget deficit ignores the effect of increase in
government expenditure or budget deficit on private investment. It has been argued
that the increase in government expenditure or creation of budget deficit adversely
affects private investment which offsets to a good extent the expansionary affects
of budget deficit. This adverse effect comes about as increase in Government
expenditure or reduction in taxes causes rate of interest to go up. There are two
ways in which rise in rate of interest is explained.
33

First, within the framework of Keynesian theory increase in government

expenditure leads to the rise in the national output which raises the transaction
demand for money. Given the supply of money in the economy, the increase in
transactions demand for money will cause the rate of interest to go up.

Secondly, in order to finance its budget deficit the government will borrow funds
from the market. This will raise the demand for the loanable funds which will bring
about rise in the rate of interest.

Whatever the mechanism the budget deficit or increase in Government

expenditure to achieve expansion in national income and output will cause the rate
of interest to go up. The rise in the rate of interest will discourage private
investment. As we know from the theory of investment, at a higher rate of interest,
private investment declines. Thus, increase in government expenditure or fiscal
policy of budget deficit crowds out private investment. This fall in private investment
as a result of the rise in rate of interest will be quiet substantial and will greatly
offset the expansionary effect of the increase in the government expenditure. On
the contrary, if investment demand is relatively inelastic, the rise in rate of interest
will lead to only a small decline in private investment and therefore crowding out
effect will be relatively small.

Differences in the Effectiveness of Monetary and Fiscal Policies

34

When the economy is in a recession (when business and consumer confidence is

very low and perhaps where deflationary pressures are taking hold) monetary policy
may be ineffective in increasing current national spending and income. The
problems experienced by the Japanese in trying to stimulate their economy through
a zero-interest rate policy might be mentioned here. In this case, fiscal policy might
be more effective in stimulating demand. Other economists disagree – they argue
that short term changes in monetary policy do impact quite quickly and strongly on
consumer and business behavior. Consider the way in which domestic demand in
both the United States and the UK has responded to the interest rate cuts
introduced in the wake of the terror attacks on the USA in the autumn of 2001

However, there may be factors which make fiscal policy ineffective aside from
the usual crowding out phenomena. Future-oriented consumption theories hold that
individuals undo government fiscal policy through changes in their own behavior –
for example, if government spending and borrowing rises, people may expect an
increase in the tax burden in future years, and therefore increase their current
savings in anticipation of this.

CHART SHOWING PRIMARY, REVENUE AND FISCAL DEFICIT FOR 10 YEARS

 TABLE 17
35
TRENDS IN FISCAL DEFICITS
Gross Revenu
Fiscal Fiscal e Revenue Primary Primary
Deficit
Year Deficit as Deficit Deficit as Deficit Deficit as
(Rs. % of (Rs.
crs) GDP crs) % of GDP (Rs. crs) % of GDP

1996-97 56242 4.1 32654 2.4 -3236 -0.2

1997-98 73204 4.8 46449 3.1 7567 0.5

1998-99 89560 5.1 66976 3.8 11678 0.7

1999-00 104717 5.3 67596 3.5 14468 0.7

2000-01 118816 5.6 85234 4.0 19502 0.9

2001-02 140955 6.2 100162 4.4 33495 1.5

2002-03 145072 5.9 107880 4.4 27268 1.1

2003-04 123272 4.5 98262 3.6 -816 0.0

2004-05 125202 4.0 78338 2.5 -1732 -0.1

2005-06 (RE) 146175 4.1 91821 2.6 16143 0.5

2006-07 (BE) 148686 3.8 84727 2.1 8863 0.2

2006-07
(Provisional up 108201 - 84483 - 20258 -
to November)
RE= Revised Estimates BE= Budget Estimates

Source: Ministry of Finance and Controller General of Accounts..

TABLE 18
DEBT POSITION OF THE CENTRE (INTERNAL
DEBT)
Amount Outstanding at the end of
March (Rs. crores)
2000 2001- 2002- 2003- 2004- 2005- 2006-
DEBT -01 02 03 04 05 06 07
(RE) (BE)
Internal 8036 91306 10206 11417 12759 135594 152203
debt (Total) 98 1 89 06 71 3 1
I) Market 4287 51651 61910 70796 75899
Loans 93 7 5 5 5 867368 984645
3749 39654 40158 43374 51697
II) Others 05 4 4 1 6 488575 537386
As % of
GDP 38.1 40.0 41.7 41.4 40.7 39.9 38.9

RE= Revised Estimates BE= Budget Estimates

36

The FRBM Rules envisage an annual reduction of at least 0.3 percentage points
in fiscal deficit and 0.5 percentage points in revenue deficit. In BE 2006-07,
Government had projected Revenue Deficit to be at 2.1 per cent of GDP i.e., 0.5
percentage points lower than the BE 2005-06. The Revenue Deficit estimates have
shown improvement at 2.0 per cent of GDP at RE 2006-07. Similarly, Fiscal Deficit,
which was budgeted to decline from 4.3 per cent of GDP in BE 2005-06 to 3.8 per
cent of GDP in BE 2006-07 has shown further improvement at 3.7 per cent of GDP in
RE 2006-07. This improvement has been possible due to high economic growth,
increased revenues and prudent expenditure management practices.

FISCAL INDICATORS – ROLLING TARGETS AS A PERCENTAGE OF GDP

 37

(AT CURRENT MARKET PRICES)

FISCAL DEFICIT AND INTERNAL DEBT

Limitations of fiscal policy

1. Formulation of an appropriate fiscal policy requires reliable forecasting of the

target variables, like GNP, consumption, investment and its determinants,
technological changes, and so on. But no one has yet discovered a foolproof
method of economic forecasting.’
2. The Overall effect of changes in the policy instruments, like, changes in
government spending and taxation is determined by the rate of dynamic
multiplier. Forecasting the multiplier is in itself an extremely difficult task and
a time consuming process. Therefore, by the time the full impact of one policy
change is realized, economic conditions change necessitating another change
in the fiscal policy.
3. A decision and execution lag in case of discretionary fiscal policy makes both
working and efficacy of fiscal policy shrouded with uncertainty.
4. Working and effectiveness of fiscal policy in underdeveloped countries is
severely limited by a) low levels of income, b) small proportion of population
in taxable income groups, c) existence of large non - monetized sector, d) all
pervasive corruption and inefficiency in administration, especially in tax
collection machinery.
5. Countries which are excessively dependent on fiscal policy for their economic
management, the governments are often forced to have recourse to internal
and external borrowings and deficit financing. Excessive borrowings take such
countries close to debt trap and deficit financing beyond the absorption
capacity of the economy accelerates the pace of inflation, which further
creates other control problems.

Revised Budget Targets for Targets for

Estimates Estimates
2008-09 2009-10
2006-07 2007-08

Revenue Deficit 2.0 1.5 0.0 0.0

Fiscal Deficit 3.7 3.3 3.0 3.0

Gross Tax Revenue 11.4 11.8 12.3 12.7

Total outstanding 64.4 61.4 58.6 56.0

liabilities

at the end of the year

38

References

• Agenor Pierre-Richard and Peter J. Montiel (1999) Development

Macroeconomics (2nd ed.), Princeton:Princeton University Press.
• Ahluwalia Montek S. (2002) Financial Sector Reform in India, paper presented
at conference on Financial Sector Reform Across Asia: Facts, Analyses,
Solutions, John F. Kennedy School of Government, HarvardUniversity,
December.
• Alesina, Alberto, and Roberto Perotti (1997). Fiscal adjustments in OECD
countries: Composition and
• macroeconomic effects. IMF Staff Papers, 44 (2): 210-248.
• Anand, Mukesh, Amaresh Bagchi and Tapas K. Sen (2001), Fiscal Discipline at
the State Level: Perverse
• Incentives and Paths to Reform, paper presented at conference, “India: Fiscal
Policies to Accelerate Economic Growth”, NIPFP, New Delhi, May.
• Athukorala, Prema-Chandra, and Kunal Sen (2002) Saving, Investment, and
Growth in India, New Delhi: Oxford University Press.