Prelims Capsule

Prelims Capsule: Public Finance / Fiscal Policy

In the previous posts, we did basics of Macroeconomics, National Accounting through GDP, Alternative measures to GDP, this week we will do the Fiscal Policy and its tools and all the related terminology. We can expect to get 2-3 questions from this chapter.

What is a Fiscal policy?

A Fiscal policy is used by the governments with tools like the use of taxation and public spending in order to control the total demand for goods and services in the economy.

Governments have control of the rate of taxes people pay and the amount of public spending and can use these policies to influence the amount of demand in the economy and to control the business cycle.

  • In India Fiscal Policy is mostly announced along with the Budget. For example in this year’s budget, in order to boost consumption among the salaried class, the tax rebate of Rs. 12500 is given to all.
  • Last year’s levy of Swacch Bharat Cess and Krishi Kalyan cess also forms a part of the Fiscal policy.
  • Another way of altering aggregate demand is by increasing the government spending itself. Increasing the allocation to the MNREGA helps in increasing the rural demand, or if the govt. chooses to spend less elsewhere to control the demand.

These were the examples of Fiscal policy dealing with the quantity of public finance; it also deals with spending money in the qualitative terms. For example, how the revenue is generated matters over how much revenue is generated. To explain further, if the revenue from indirect taxes is more than progressive direct taxes then such a method is regressive because tax burden falls even on the poor. A Fiscal policy tries to minimise this difference as well.

Fiscal Policy could also be used to rationalise the spending that is controlling wasteful subsidies and giving out onlywell-targetedd ones. DBT policy or Austerity measures taken by Modi Government are an apt example for Qualitative use of fiscal policy

There are three types of fiscal policy.

  1. Expansionary fiscal policy
  • When governments reduce taxes and increase public spending in order to increase demand in the economy. Reducing taxation (like recent budget measure of reducing income tax to 5% for people with 2 -5 Lac income) causes people to have more disposable income.
  • Increasing public spending means the government spend more money in the economy on things such as infrastructure.(This year PM Gramin Sadak Yojana has got allocation of 19000 Crores of allocation)
  • Both of these factors will increase the level of demand in the economy and will result in an increase in Gross Domestic Product. Expansionary fiscal policy is often used when an economy is slowing or in recession where the level of demand is low. This year’s budget was Expansionary because we saw reduction in income taxes and corporate taxes for MSMEs also increase in the public spending for infrastructure and agriculture in the backdrop of slowing consumption due to Demonetization.
  • Expansionary Fiscal Policy causes the general increases in prices i.e., inflation.

 Contractionary fiscal policy

  • When governments increase taxation and cut back on public spending in order to reduce demand in the economy.
  • The Contractionary fiscal policy has the reverse effects of expansionary policy and therefore results in a reduction in the total demand for goods and services in the economy.
  • Contractionary fiscal policy is used by governments when an economy is in a boom i.e. growing rapidly with high rates of inflation.
  • Increasing taxation and reducing public spending will reduce the total demand in the economy and should result in lower rates of inflation.
  1. Neutral fiscal policy
  • It is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
Key terms:

·         Aggregate demand – This refers to the total of all the demand in an economy. The equation for aggregate demand is: Consumption (C) + Government Spending (G) + Investment (I) + (Exports (X) – Imports (M)).

·         Business cycle – This is when economic activity fluctuates between its target growth rates. The four stages of the economic cycle are known as: upswing, boom, downturn, recession.

·         Public spending – This is the spending by governments on goods and services in the economy.

·         Taxation – This is the money collected by governments from people’s earnings, wealth or spending.


Article 112 of the Indian Constitution requires distinction between expenditure on revenue account from other expenditure. Therefore Budget in India differentiates between Capital Receipts and Revenue ReceiptsCapital Expenditure and Revenue Expenditure.

There was also additional distinction which was introduced by the way of Planning Commission called Plan expenditure and Non Plan expenditure, which has been abolished from this Budget.


Components of Fiscal Policy

Public Revenue:

The income of the government through all sources is called public income or public revenue. The budget of the Government of India classifies into “revenue” and “capital.”

  1. Revenue Receipts

Revenue Receipts is again classified into two types, tax revenue and non-tax revenue.

Tax Revenue:

  • A fund raised through the various taxes is referred to as tax revenue.
  • Taxes are compulsory contributions imposed by the government on its citizens to meet its general expenses incurred for the common good, without any corresponding benefits to the tax payer.

Tax Revenue can be based classified into Direct and Indirect Taxes which you all already know but there is another type of classification which is important to understand and they are: Regressive Taxes, Proportional Taxes and Progressive taxes.

  1. A regressive tax is calculated as a percentage of the item being purchased. Example: A VAT of 5% levied on an everyday product bought at the grocery store is a regressive tax. Everyone pays the same percentage, regardless of earnings, so people with low incomes are hit much harder than those with large incomes. As such most indirect taxes are regressive.
  2. Proportional taxes are a flat tax system in which taxpayers pay a set percentage, regardless of their income. An example is income tax of 10% that does not change as income rises or falls. Someone who earns Rs. 2 Lac a year pays 20,000 in taxes; someone who makes Rs. 2 Crores pays 20 Lac.
  3. The current income tax in India is a progressive tax system. Tax liability rises as income increases based on an increasing rate schedule. The wealthy bear a larger tax burden than the low or middle class. For example in India tax slabs are 5 Lac, 10 Lac, and above

Progressive taxes can help in reducing inequalities of income and wealth by lowering the high income group’s disposable income. By disposable income is meant the income left in the hands of the tax payer for disbursement after tax payment. Taxes imply a forced saving in a developing economy. Thus, taxes constitute an important source of development finance.

Non-Tax Revenue:

Public income received through the administration (Fees, Fines and Penalties), Profits from the PSUs, gifts and grants are the source of non-tax revenues of the government.

  1. Capital Receipts

Capital receipts are the receipts which either create a liability or cause a reduction in the assets of the government. They are non-recurring.

A receipt is a capital receipt if it satisfies any one of the two conditions:

  • The receipts must create a liability for the government. For example, External Commercial Borrowings are capital receipts as they lead to an increase in the liability of the government and a tax received is not a capital receipt as it does not result in creation of any liability.
  • The receipts must cause a decrease in the assets. Like Selling of shares of PSUs like Coal India, NTPC etc., is a capital receipt as it leads to reduction in assets of the government. Disinvestment earnings are all the Capital Receipts.

Sources of Capital Receipts

  1. Borrowings:
  • Borrowings are the funds raised by government to meet excess expenditure. Governments borrow funds from: Open Market (Public, Reserve Bank of India (RBI); Foreign governments (like loans from USA, England etc.), International institutions (like World Bank, International Monetary Fund).
  • Borrowings are capital receipts as they create a liability for the government.
  1. Recovery of Loans: Government grants various loans to state governments or union territories. Recovery of such loans is a capital receipt as it reduces the assets of the government.
  2. Other Receipts:
    • Disinvestment: Selling the shares of the PSUs held by the government to public or the institutional investors.
    • Small Savings: Money from the public in the form of Post Office deposits, Sukanya Samriddhi Yojana, Public Provident Fund (PPF), National Saving Certificates, Kisan Vikas Patras etc. They are capital receipts because they result in an increase in the liability of the government.

Public Expenditure

In democracy, public expenditure is an expression of people’s will, managed through political parties and institutions.

Public expenditure plays four main roles:
1. Increases the current demand;
2. It can be used for stabilization, business cycle inversion, and growth purposes;
3. It increases the public endowment of goods for everybody;
4. it gives rise to positive externalities to economy and society.

Different economists classify the public expenditure different way. The classification is used in India currently is Revenue and Capital Expenditure

Capital Expenditure is that expenditure which results in increasing of government asset (giving out loans) or reduces in some liability (paying back old loans).

Following are the key examples of capital expenditures.

  • Loans Given: The loans given by the Government to the states, PSUs and other governments come under Capital Expenditures because such loans are assets of the government.
  • Loan Repayments: The loans that were borrowed in past but are now returned back are included in the capital expenditures; because they result in reduction of liability.
  • Expenditures resulting in asset creation: The government’s spending money on infrastructure, machinery, land, roads, bridges etc. and purchase of arms and equipments, modernization of the army etc.

Revenue expenditure is expenditure which doesn’t create any asset and neither does it cause any reduction in any liability of the government. It is recurring in nature and is incurred on normal functioning of the government and the provisions for various services.

For example the salaries, pensions, interests, defence services, health services, grants to state, etc are all revenue expenditure.

Note: Union Grants to states are treated as revenue expenditure, even though some of the grants may be used for creation of assets while the loans to the States are Capital Expenditure because Grants are money you don’t have to repay and are usually based on your financial need while loans are money you borrow that you must pay back, usually with interest costs.

In the next post, we will go through different types of Deficits. How such deficits can be financed, provisions of FRBM Act, Role of Finance Commissions.

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