ECONOMICS II [MACROECONOMICS] CHAPTER-14 MODERN ECONOMICS: FISCAL POLICY, BUDGET DEFICITS AND THE GOVERNMENT DEBT Session Objectives

Instruments of fiscal policy Requirements of a good tax structure Tax Rate Structure ICOR Fiscal policy and stabilization Concepts of Deficits

Fiscal Instruments Fiscal policy refers to policies pertaining to taxes and government expenditure including transfer payments. Thus, the two important tools of fiscal policy are (a) (b) Taxes: Tax reduction is expansionary as taxpayers are left with higher disposable income, while an increase in tax is contractionary. Expenditure: Raising public expenditure is expansionary as it increases aggregate demand.

Unlike monetary policy, fiscal policy directly affects the aggregate demand and the level of economic activity in the country. Note that the monetary policy influences the aggregate demand through changes in interest rates. Principles of Taxation There are two approaches to fix tax. They are

a.
b.

Benefit principle: According to this approach, taxes are imposed based on the proportion of the benefit they receive from various public services. Ability to pay principle: This advocates people with equal capacity to pay the same, and people with greater capacity to pay more.

Both the approaches have their own shortcomings. Requirements of a Good Tax Structure Revenue yield should be adequate Distribution of tax burden should be equitable

Taxes should be chosen so as to minimize interference with economic decisions in otherwise efficient burden. Tax structure should facilitate the use of fiscal policy for stabilization and growth objectives. Tax system should permit fair and non-arbitrary administration Administration and compliance costs should be as low as it is compatible with other objectives.

Tax Rate Structure Tax Rate Structure consists of three types viz.

a. b. c.

Progressive tax: implies that higher the level of income greater will be the volume of tax burden, represented as a percentage of the total income. Regressive tax: (just opposite of progressive tax.) Proportional tax: The tax imposed is of a particular percent of income irrespective of his income slab. Tax Rates (Progressive) 10% 20% 30% Tax Rates (Proportional) 20% 20% 20% Tax Rates (Regressive) 30% 20% 10%

Income slabs (per annum) 50,000 to 60,000 60,000 to 1,50,000 1,50,000 above ICOR

ICOR = Change in Capital/ Change in output It indicates how much Capital is needed to produce an extra unit of output. It shows the productivity of Capital: The lower the ICOR the more productive the Capital is

Fiscal Policy and Stabilization Stabilization polices are undertaken by the government to maintain full employment and a reasonably stable price level. Thus, when the economy faces recession, the government would increase its spending and cut the tax rate to raise the aggregate demand so as to reduce unemployment level in the economy. When, on the other hand, the economy suffers from high inflationary pressures, the government can engage in contractionary fiscal policies i.e. reducing government spending or increasing taxes. a. b. Expansionary policies: Lower tax rate and higher government spending Contractionary policies: Higher tax rate and lower government spending

Budget The annual budget is a financial plan. It gives estimates of how the government proposes to spend that year and how that expenditure is to be financed. The following is the pro forma of budget at a glance of the Government of India BUDGET AT A GLANCE RECEIPTS 1. Revenue Receipts a. Tax Revenue b. Non-tax Revenue 2. Capital Receipts a. Recoveries of Loans b. Other Receipts (of which disinvestment proceeds committed for redemption of public debt) c. Borrowings and other Liabilities 3. Total Receipts EXPENDITURE (Approach: 1) 1. Non-plan Expenditure a. On Revenue Account (incl. interest payments) b. On Capital Account 2. Plan Expenditure a. On Revenue Account b. On Capital Account Total Expenditure EXPENDITURE (Approach: 2) 1. Revenue Expenditure a. Non-plan Expenditure b. Plan Expenditure 2. Capital Expenditure a. Non-plan Expenditure b. Plan Expenditure Total Expenditure

Concepts of Deficits a. b. c. d. Revenue Deficit: Revenue expenditure Revenue receipts Fiscal Deficit: Borrowings and liabilities Primary Deficit: Fiscal deficit Interest payments Monetized Deficit: Monetized deficit is the increase in net RBI credit to the Central Government, comprising the net increase in the holdings of Treasury bills of the RBI and its contribution to the market borrowings of the government. It indicates the amount of fiscal deficit that is monetized.

Summary: Fiscal policy refers to policies pertaining to taxes and government expenditure including transfer payments. Thus, the two important tools of fiscal policy are 1. Taxes: Tax reduction is expansionary as taxpayers are left with higher disposable income, while an increase in tax is contractionary. 2. Expenditure: Raising public expenditure is expansionary as it increases aggregate demand.

There are two approaches to fix tax. They are Benefit principle: According to this approach, taxes are imposed based on the proportion of the benefit they receive from various public services. Ability to pay principle: This advocates people with equal capacity to pay the same, and people with greater capacity to pay more. Both the approaches have their own shortcomings.

Stabilization polices are undertaken by the government to maintain full employment and a reasonably stable price level. Thus, when the economy faces recession, the government would increase its spending and cut the tax rate to raise the aggregate demand so as to reduce unemployment level in the economy. When, on the other hand, the economy suffers from high inflationary pressures, the government can engage in contractionary fiscal policies i.e. reducing government spending or increasing taxes. Automatic stabilizers are features of the government budget that automatically adjust net taxes to stabilize aggregate demand as the economy expands or contracts.