Public Finance and Fiscal Policy

Public Finance

How the Government raises resources to meet its ever-rising expenditure

The income and expenditure of the public authorities and their adjustments among them

Fiscal policy
The effects of budget on the economy

Classical Economic View

Keep the expenditure to the minimum Impose minimum taxes The budget should be balanced

Public borrowings should resorted to only under exceptional conditions, e.g. war, natural calamities etc.

Functional Finance

Balanced budgets are no longer considered sacrosanct

Public Finance should play an active role

It is an instrument of economic regulation, it can be used for maintaining stability through management of aggregate demand

Objectives of Fiscal policy

Sustained Economic Growth Economic Stability High level of Employment Social Justice and Equity

Horizontal and vertical equity Socially optimum pattern of distribution Reducing unemployment Controlling inflationary pressure

Basic Fiscal Concepts

Public Expenditure

Types of Public Expenditure

Trends in Public Expenditure Effects of Public Expenditure

Public Revenue -- Types

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Principles
Effects

Basic Fiscal Concepts

Public Borrowings

Internal Debt External Debt - Revenue Deficit - Budget Deficit - Fiscal Deficit - Primary Deficit

Deficit

Types of Public Expenditure

Revenue and Capital Expenditure Transfer Payments and expenditure on goods and services Developmental and Non-developmental Expenditure

Trends in Public Expenditure

Wagners Law of Increasing State Activity

As the economy develops over time, the functions of the government increase

Wiseman- Peacock Hypothesis

- government expenditure increases in jerks and step-like manner

Factors responsible for growth of Public Expenditure in India

Defence Expenditure Population growth Urbanisation Welfare Activities of the Government Maintaining Economic Stability Huge Investments in developmental activities Mounting Debt Service Charges Increasing Food and Fertilizer subsidies Huge expenditure on Employment generating antipoverty schemes

Effects of Public Expenditure

On Production

Expenditure on investment projects and capital formation will expand the productive capacity and generate long term growth Expenditure on Research and development ensures advancement of technology and would improve the productivity

Effects of Public Expenditure

On Production

Expenditure on Education and Public Health helps in building Human Capital and enhances productivity At times of recession or depression, increase in Public Expenditure leads to manifolds increase in income and employment through the process of multiplier

Effects of Public Expenditure

On Allocation of Resources

Government Expenditure can influence the pattern or composition of output It leads to reallocation of resources between industries and regions It leads to socially desirable allocation resources

Effects of Public Expenditure

On Distribution Through Public Expenditure, the Government redistributes income in favour of the poor

Social Security measures Subsidies (food, fertilizer, kerosene, small scale industries, cottage industries) Social Infrastructure Government Employment Guaranty / assistance schemes Free education for girls

Public Revenue

Tax

A tax is a compulsory payment levied by the Government. It does not have any direct quid pro quo

Non-tax Revenue

Fees, penalties etc

Charged for a specific purpose

There is a direct quid pro quo

Types of Taxes

Direct and Indirect Taxes

Specific and Ad-Valorem Taxes Progressive, Proportional and Regressive Taxes

Direct and Indirect Taxes

The burden of the direct tax cannot be shifted to others, the person who pays it has to bear it
Income tax, Wealth tax, Capital gains tax

Those who pay indirect taxes can pass the burden, wholly or partly, to others

Excise Duty, Sales tax

Merits of Direct Taxes

They are progressive in nature The tax structure can be closely linked to Ability to pay

It is an important instrument of reducing inequalities of income and wealth

They serve as an automatic stabilizers as their revenue elasticity is quite high

Merits of Indirect Taxes

Convenient to pay Large revenue potential for the Government It is an important instrument for influencing the pattern of production and investment

Demerits of Indirect Taxes

They are regressive
They are inflationary

Cascading effect

They may lead to inefficient resource allocation

Specific and Ad-Valorem Taxes

A Specific tax is a tax per unit of a commodity, whatever may be its price
It is based on the volume of operation

An Ad-Valorem tax is levied on the basis of the value of a commodity

It is expressed as a percentage of price

Sales tax

Toll tax

Progressive, Proportional and Regressive Taxes

Progressive Tax

The rate of tax increases as the tax base (income, wealth etc) increases

Greater the tax base, higher is the tax rate

Income tax in India

Proportional tax

The tax rate is constant irrespective of the magnitude of the tax base A rate is fixed, and is applicable to all

Regressive tax

The rate of tax decreases as the tax base increases

The burden of the tax is more on the poor than on the rich

Principles/ Canons of Taxation

Adam Smith The wealth of Nations

Canon of Equality

Canon of Certainty
Canon of Convenience

Canon of Economy

Union Budget
1. Total Expenditure
1.1 Revenue Expenditure
1.1.1 Plan 1.1.2 Non-plan *1.1.2.1 Interest Payments

2. Total Receipts
2.1 Revenue Receipts
2.1.1 Tax 2.1.2 Non-tax

1.2 Capital Expenditure

1.2.1 Plan 1.2.2 Non-plan

2.2 Capital Receipts

2.2.1 Recovery of Loans 2.2.2 PSU Disinvestment 2.2.3 Borrowings

Revenue Deficit

Revenue Expenditure () Revenue Receipts Revenue Receipts include Tax and Non-tax receipts Revenue Expenditure includes

Interest payments on public debt Defence expenditure Subsidies on food, exports etc. Civil Administration

Revenue surplus would imply

Prudent resource management by the Government Government savings are being used for financing developmental activities

Revenue deficit would imply

Government is dis-saving Capital funds are being used for consumption expenditure The Government has to borrow in order to meet the day to day expenditure.

Budget Deficit

Total Government Expenditure (-) Total Government Receipts It is financed by borrowing from the RBI against the Government securities and treasury bills Issuing of new currency against government securities is known as Deficit Financing or Monetising of deficit.

Fiscal Deficit

Total Government Expenditure (-) Total Government Receipts(excluding borrowings) Budget Deficit (+) borrowings In India we have had huge Fiscal deficits Attempts have been made to reduce fiscal deficits by curtailing capital expenditure; which has adversely affected economic growth

Primary Deficit

Fiscal Deficit (-) Interest Payments It is lower than the fiscal deficit Indicator of the fiscal management in the current year

Fiscal Policy

Discretionary

Non-discretionary
Automatic Stabilisers

To cure Recession

To control Inflation

Measures to cure Recession

Increase in Government Expenditure

by starting public works such as building roads, dams, ports, telecommunication links, irrigation works The Govt will buy material and employ people This will directly and indirectly increase incomes, output and effective demand in the economy
Government Expenditure Multiplier= G / (1 - MPC)

Measures to cure Recession

Reduction of Taxes

Increase in disposable income Increase in consumption expenditure

Tax Multiplier = T * MPC (1- MPC)

Measures to control Inflation

Reducing Government Expenditure Increasing Taxes

Non-discretionary Fiscal Policy

Automatic Stabilisers

Personal Income Taxes Corporate Income Taxes Transfer Payments: Unemployment Compensation, Welfare Benefits

What do these number tell us?

(In crore of Rupees) 2004-2005 Budget Estimates DEBT SERVICING 1. Repayment of debt** 2. Total Interest Payments 3. Total debt servicing (1+2) 4. Revenue Receipts 5. Percentage of 2 to 4 198380 129500 327880 309322 41.9% 2004-2005 Revised Estimates 224075 125905 349980 300904 41.8% 2005-2006 Budget Estimates 247984 133945 381929 351200 38.1%