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Index

Ch Description Page

0.0 Summary 3
1.0 Introduction 4
2.0 Public Revenue 11
3.0 Public Expenditure 18
4.0 Deficits
5.0 Examples of Fiscal Policy 27
T.0 Appendix – Tables 29-30
S.0 Sources and Bibliography 31

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SUMMARY

Fiscal policy can be explained as a policy executed by the government to


produce desirable effect on national income, output and employment.
There are two type of fiscal policy they are as follows:
1. Contractionary.
2. Expansionary.
It helps the government by creating an environment for rapid economic
growth. It helps in stabilizing the prices. It minimizes the inequalities of
income & wealth.

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MEANING
The word FISCAL is derived from Greek word FISC meaning basket.
The word FISC was used to devote the income and expenditure
operations of the Government. Thus, fiscal policy can be explained as a
policy executed by the Government to produce desirable effects on
national income, output and employment. Thus, broadly speaking,
PUBLIC EXPENDITURE+PUBLIC REVENUE constitute the tools of fiscal
policy which are at the disposal of the Government to pursue its micro
and macro economic goals, through taxation and expenditure policies.
FISCAL POLICIES
Micro Economic level Macro economic level
1. Equitable distribution of wealth and 1. Money supply.
expenditure and income.
2. Providing equitable access to social 2. Overall price level inflation.
services.
3. Meeting fundamental needs of 3. Rate of interest
people cost conditions so as to
discourage some utilities and
encourage others.
4. Enhancing the efficiency of 4. influencing relative prices and
production and competitiveness of employment and growth rate of
domestically produced output. economy.

Fiscal policy thus has performed impact on business competitiveness and


conditions.

Definitions of fiscal policy

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1) Fiscal policy is concerned with the manner in which his elements
of public finance may collectively be geared to forward the aim of
economic policy which is given by Prof. Ursula Hicks. Thus Prof.
Hicks, The objective of the fiscal policy is to achieve the aim of
economic policy or in other words, the macro-economic goals which
like the monetary policy remains the same, i.e. economic growth,
full employment and stability.

2) “The setting of taxes and public expenditures to help dampen the


swings of business cycle and contribute to the maintenance of a
growing , high employment economy ,free from high or volatile
inflation .” which is given by Prof. Paul Samuleson and Prof.
William Nordhaus .

According to them, fiscal policy serves 2 major functions:


A) It sets national priorities, allocates national output among private

and public consumption and investment.


B) It provides incentives to increase or decrease output in the

particular sectors of the economy.

Objectives of fiscal policies

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As said, fiscal policy has both macro and micro economic objectives.
A) In developed countries the focus is
1) On maintaining full employment
2) Stabilizing growth

B) In developing countries, fiscal policy is used to create an environment


for rapid economic growth.
The various objectives of fiscal policy are as follows:
1) Mobilization and efficient allocation of resources: Developing
countries are characterized by low level of income and
investment leading to vicious circle of poverty. Fiscal Policies
aims at breaking this circle by mobilizing and generating
resources, and investing the limited resources in efficient ways.
2) Minimization of inequalities of income and wealth.
Fiscal tools are used with the objective of bringing about redistribution of
income in favor of the poor by taxing the rich and spending the so raised
revenue on various social welfare activities .Distributions of income
affects consumption and saving, and also has political and social impact.
3) Increasing employment opportunities :
Level of employment influences aggregate output in the economy,
general standard of the populace, overall social and political stability
.Fiscal Policies in developing countries thus , strives at increasing the
employment level by promoting the growth of those industries that have
high employment generation potential . In developed countries
maintaining full employment is an important objective of F.P.

4) Increasing output and accelerating economic growth.

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5) Economic Stability: Fiscal policy is often employed especially in
developed countries, to moderate the business fluctuations leading to
business cycle. During the upswing the taxes can be used to curb the
rising demand for goods and services, whereas these can be lowered in
the recessionary phase to boost up the level of demand.
6) Price stability: Economic stability is largely dependent on overall
price stability. Stable Price level creates a conducive environment for
production, output and employment. F.P. aims at reducing the price
fluctuations and maintaining stable price level by containing
inflationary and deflationary tendencies in the economy.

TYPES OF FISCAL POLICY

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1) Contractionary:

F.P. is addressed as tight or contractionary when fiscal balance is in


surplus compare to the previous i.e. periods revenue > spending.
E.g. Raising taxes and lowering government spending are the forms of
the contractionary policy.
In terms of national income identity
Y =(Y-T)+I+G+X-M.

T=TAX I=INVESTMENT Y= OUTPUT


G=GOVT. E=EXPORTS
EXPENDITURE
C=CONSUMPTION M=INPORTS

It can be seen that increase in Tax (t) or govt. (g) given all other variables
(i.e. C, I, E, M) as fixed, reduces the aggregate demand, puts down
pressure on output (Y) and employment.
Eventually overall price level falls. Thus contracting fiscal policy
reduces the output, employment and inflation rate in the economy by
increasing taxes and reducing govt. expenditure. In a booming economy ,
when the economy is experiencing high growth rate of output as well as
high rate of inflation ,to stabilize the contractionary policy .

2) Expansionary:
When the extent of surplus fiscal balance is decreasing compared to
previous period ie.spending > revenue. Lowering taxes and raising govt
spending are forms of expansionary fiscal policy. Such policies increase
the aggregate demand and boosts up he output, income and employment
level and consequently raises the overall price level and inflation rate in

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the economy. Such policies are pursued by govt when the economy is
experience recession represented by negative growth rate of output,
deflation and high level of unemployment in the economy.

TAX REVENUE / PUBLIC REVENUE


A tax is a levy imposed by the government on the economic agents .It is a
duty of tax payer to pay it. Taxes are withdrawn from the private sector

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without leaving the government with a liability to the payee. Also the
contribution, received from the tax payer may not be incurred for their
benefit alone. Tax is expressed in percentage term which is referred as
tax rate .Tax rate can be marginal or average or it can be expressed as AD
VALOREM or specific. Total tax revenue collection is an outcome of tax
rate and tax base where tax base can be output, sales, value added,
personal, or corporate income.
TAX RATE
MARGINAL TAX RATE = DELTA [TAX OBLIGATION]/DELTA
[TAXABLE INCOME]
Average or effective tax rate, on the other hand, refers to total tax liability
as a percentage of total revenue.
AVERAGE TAX RATE= TAXABLE OBLIGATION /TAXABLE
INCOME

TYPES OF TAXES
♣ DIRECT TAX

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A direct tax is one that is paid by the people or organization by whom
they are imposed. The incident of these types of taxes cannot be shifted to
another party.
TYPES OF DIRECT TAXES
• Capital gains tax:
It is the tax levied on the profit released upon the sale of capital asset.
• Corporate tax:
It refers to a direct tax levied by the government on the profits declared
by the companies or associations.
• Inheritance tax:
It is the tax on the amount of inheritance received by a person .It is also
known as estate or death tax.
• Personal income tax:
Tax on the income is levied on the income of households, corporations or
other legal entities. It often tax the total income of the individual with
some permissible deductions , where as corporate income taxes the net
income , that is the difference between gross receipts , expenses and write
offs.
• Poll tax:
It is also known as per capita tax or capitation tax. It is easy to compute ,
involves less administrative costs, economically efficient as people are
fixed in supply It is levied as a set amount per individual . However they
are strongly regressive as a poorer section of the society ends up paying a
higher proportion of their income than richer .Moreover, the supply of the
people may not be fixed; poll tax may discourage couples to have more
children reducing the population over a period of time.

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• Property tax:
It is a tax imposed on the values of the property , generally real estate
such as land and buildings , owned by a person.
• Retirement tax:
It is used in many countries for funding social secutity system ment for
providing income to retired workers .These differ from comprehensive
economic taxes as they are levied only on specific sources of income
generally wages and salaties.These are sometimes known as payroll
taxes. In certain countries , each worker, irrespective of income pays at
the same rate upto a specified cap .Income above the cap is not taxed
making the regressive in impact. Moreover these taxes often exclude
investment earnings and other forms of income usually forming a major
component of income of higher income group escalating the regressive
impact of the tax.
• Wealth tax:
It is levied on the wealth of individuals and companies that has potential
to yield income in some form.

♣ INDIRECT TAXES
Indirect taxes are often collected from someone other than the person
presumably responsible for paying the taxes. Thus the incidence of tax
can be on a party other than the party which bears the impact of it. They
are mostly regressive in nature , thus , economists favour higher and
rising proportion of direct taxes in total yax revenue collection. This
implies that as the GDP increases the ratio of direct to indirect taxes

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should keep on increasing to retain the equity element in the system as
well in increasing the total tax revenue collection for the government.

TYPES OF INDIRECT TAXES


 Countervailing duties:
They are imposed on imports to raise the price of the imported
commodities in the domestic market , with the intention of discouraging
unfair trading practices such as dumping by other countries and
protecting the domestic manufacturers.
 Custom duties and tariffs:
These are taxes on import or export of commodities. Though mainly a
source of revenue, import duties quite often are used by the governments
to protect the domestic industries or goods produced within the domestic
boundaries.
 Excise duties:
Excise duty is tax imposed on the production of goods within the country
at the manufacturing stage . Excise is based on the quantity not the value
of product purchased. It is a tool for government revenue collection.
Though most often these duties are levied by the consumption is believed
to have adverse impact on public health or environment.
 Sales tax:
Sales tax is imposed at the stage commodity is sold to its final consumer.
Flat rate or specific rate of sales tax tends to be regressive as people with
lower income end up spending larger proportion of their income on goods
and services. To minimize the regressive impact, quite often, essential

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commodities are exempted from sales tax and luxury items are taxed
heavily.
 Stamp duty:
It is levied on the purchase of shares and securities, the issue of bearer
instruments and transfer of land, currency transactions or certain such
transactions. These duties reduce the liquidity of the instruments and thus
most often levied for discouraging speculative purchases of assets .stamp
duty on currency transactions is known as tobin tax.
 Value added tax:
This tax applies the equivalent of excise or sales tax to every operation
that creates value. It is assessed at each stage of production and covers
both producers and traders . Vat minimizes the cascading impact of taxes
on prices and market distortions resulting from the excise duty.

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EFFECTS OF TAXATION
EFFECT ON PRODUCTION
Effect of taxation on production depends on its impact on ability and
willingness to work, save and invest and diversion of economic resources
between different uses and localities. Taxation also reduces disposable
income and affects adversely the persons ability to work and his
efficiency. When imposed on the poorer people the reduction in their
income generally lowers both the present efficiency of adults and the
future efficiency of children. This argument applies to direct taxes on
small incomes and indirect taxes on necessities. Taxation is also
presumed to have adverse effects on willingness to work , save and
invest. However the impact may also work in reverse direction. With less
taxes people will find themselves with more disposable income and may
take life more easily and would be less inclined to work than when taxes
would be higher. Higher income may lead to higher saving but at the
same time there may be higher spending. Investment is as also expected
to be higher. Thus, though taxation may be an incentive to work more, it
is incentive to work more disincentive to both save and invest.
Depending on the elasticity of demand for income the different taxes
taxes affect the desire to work and save differently. Highly elastic
demand for income makes taxes disincentive to the desire for work and
save.
EFFECTS ON DISTRIBUTION

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Taxation also alter income redistribution. From an economic point of
views an ideal distribution is the one which causes a given amount of
production to yield the maximum economic welfare. A regressive tax and
even the proportional tax system tend to increase the inequality of
incomes. On the other hand, a more sharply progressive tax system tends
to reduce inequality. Sharper the progression in the tax system stronger is
the reduction in inequalities of income. Thus, consideration of
distribution supports most sharply progressive tax system. This also
implies that taxation should be according to ability to pay. However,
consideration of production may make sharply progressive tax system
undesirable.
EFFECT ON INFLATION
Direct and indirect taxes affect prices and, hence, inflation differently.
Direct tax is supposed to be non-inflantory as increase in the direct tax
reduces the demand for goods and services and thus leads to reduction in
prices. On the other hand, impact of indirect taxes taxes on prices
depends on the elasticity of demand for and supply of goods and services.
Indirect taxes affect the after tax price of the commodity. A large part of
the incidence of the tax falls on the producer if the taxed goods have a
high elasticity of demand and low elasticity of supply. This reduces the
profit of the producers and, thus, checks inflation. However, for those
taxed goods which have a low elasticity of demand and high elasticity of
supply, the incidence of tax gets shifted on to the buyers leading to higher
prices and higher wages. To the extent wages rise, the cost of production
of goods which are not taxed even increases. This leads to increase in
overall price level induced by the increase in the cost of production.
Tom minimize the impact of indirect taxes in inflation, a judicious choice

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has to be made for the commodities to be taxed and also the rate of the
tax. Luxuries can be taxed where necessities can be left out of the tax net.

EFFECTS OF PUBLIC EXPENDITURE

 Effect on production and growth :


1. Public expenditure affects the economy from both demand and supply
side.
2. The economies suffering from deficiency of aggregate demand,
higher public expenditure by increasing aggregate demand creates
conditions that are favorable for the market forces to increase the level of
production.
3. Economic stabilization and stimulation of investment activity public
expenditure helps in maintaining a stable rate of growth.
4. In the developing economies, constrained by limited skilled labor,
physical and social infrastructure , public expenditure can be used for
stimulating investment, creating physical, social and economic
infrastructure and developing basic and key industries.
5. Improvement in infrastructure, both social and physical, integrates the
different regions and sectors of the economy and stimulates the process
of economic growth.
 Effects on distribution :
1.Public expenditure can even be used for bringing equitable
distribution or income and wealth. Shift towards equitable distribution
can be achieved by the public expenditure on the schemes which are
expected to benefit the poorer section of the society.

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2. Government canintervene in the market for those goods which are in
short supply and which are essential for the society either stepping in to
the production of these or importing this commodities.

3. Expenditure on various employment generating schemes helps in


improving the employment level and bringing in more equitable income
distribution.
 Economic Stability :
1. The economies often experience wide fluctuation in income,
employment and prices.
2. In recession, there is deficiency of aggregate demand resulting

in idle capacity and growth of the economy below its potential.


Govt can flow anti- cycle measure to stabilize the economy.
3. Curbingthe public expenditure during the upturn of the
economy helps in restraining the inflation.
4.Public expenditure acts as effective device in stabilizing the economy
only in a well integrated economy where the effects of initial change in
the expenditure trickle down to the other sectors of the economy in the
desired manner and desired extent.
5. The impact of higher public expenditure even in downturn may be
inflationary.

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Some Basic Fiscal Concepts

1. Revenue Deficit = Revenue Expenditure – Revenue


Receipts

Revenue Deficits = (E1+E2) - (R1+R2+R3) =RE - RR.

It implies an increase in the liabilities of the government without


corresponding increase in its assets.
Continuously increasing share of revenue deficit in the fiscal deficit
adversely affects public investment and hence, has adverse impact on the
productive capacity of the economy in the long run.
On the other hand, falling revenue deficit, for a given level of fiscal
deficit implies that the borrowed funds are used for capital formation. It’s
a healthy trend as it enhances the productive capacity of the economy.
2. Fiscal Deficit = Total expenditure - (Revenue receipts + Recovery of
Loans + Receipts from the sale of assets)
i.e = (Revenue expenditure + capital expenditure) – (Revenue receipts +
own capital receipts + capital grants Recoveries + sale of public assets).
= (E1+E2+E3+E4) – (R1+R2+R3+R8+R9).
= (R5+R4+R7).
Thus fiscal deficit is the sum of the revenue account deficit and the
capital account deficit.

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 Fiscal deficit capturestheentire shortfall in govt’s fiscal operations
that is expected to be covered by undertaking all borrowing
operation (domestic and foreign) including issue of 91 days ad
hoc TBs to the RBI and running down on its cash balances
with the RBI.
 FD can be curtailed by reducing revenue deficit and / or capitl a/c
deficit.
 Corrections in FD brought about by reduction in revenue deficit
often leads to compression in capital expenditure adversely
affecting the productive capacity of the economy.
3.Capital account deficit / Deficit in capital A/C.
= Capital Expenditure-capital receipts(excluding net sale of treasury bills)
(E3+E4)-(R4+R8+R9)
It reflects that the earnings on capital A/C are not sufficient to meet the
investment requirements of the govt,and govt is borrowing to fund itsd
investment for creation ofn physical assets,social and economics
infrastructure
This type of deficit,since used for funding assets that add on to the
productive capacity and production efficiency,is not considerd to be of
great worry as far as it isn self-sustaining.
4 Traditional budget deficits
 Budget deficit = [Total expenditure- Total receipts] (excluding net
sale treasury bills).
 =(E1+E2+E3+E4) –(R1+R2+R3) + (R4+R5+R7+R8+R9).= R6

Fiscal deficit

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 Fiscal deficit= Total expenditure-(Revenue receipts + Recovery of
loans + Receipts from the sale of assets).
= (E1+E2+E3+E4) – (R1+R2+R3+R4+R8+R9)
= [R5+R6+R7]
It captures the entire shortfall in govt’s fiscal operations tht is expected to
be covered by undertaking all borrowing operations.
 Fiscal deficit can be curtailed by reducing revenue deficit.
 Corrections in fiscal deficits brought about by reduction in revenue
deficit often leads to compression in capital expenditure adversely
affecting the productive capacity of the economy.

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Primary deficit
 Primary deficit= gross fiscal deficit – Interest payments.
 =(Revenue expenditure+ capital expenditure)-(Revenue receipts +
capital grants + Recoveries + sale of public assets)-(interest
payments)
= (E1+E2+E3+E4)-(R1+R2+R3+R4+R8+R9)-(E1)
= (E2+E3+E4)-(R1+R2+R3+R4+R8+R9).
= R5+R6+R7-E1.
 IT OCCURS WHEN THE GOVT REVENUE IS NOT
SUFFICIENT TO MEET THE govt non-interest expenditure.

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Gross vs Net deficit
 A sizeable part of central govt borrowings is lent to other sectors –
state & local govts, public sector enterprises etc.
 When net domestic lending are deducted from the gross fiscal

deficit
& gross primary deficit the residual is called net fiscal deficit & net
primary deficit, respectively
 Net fiscal deficit = gross fiscal deficit -net loans & advances.
= gross fiscal deficit - loans & advances+ recoveries.
=R5+R6+R7+R8-E3.
 NET PRIMARY DEFICIT= gross primary deficit – net loans &

advances = gross primary deficit – loans & advances + recoveries.


R5+R6+R7+R8-E1-E3.

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Example of inflation in relation with the fiscal policies
That inflation for the week ended July 5 did not rise to the widely
expected 12% provides some consolation, albeit the numbers released by
the government on Thursday evening are provisional.
However, the slower week-on-week rise in the WPI to 11.91% (from
11.89% for the week ended June 28) coupled with the 0.1% decline in the
index for primary goods and 0.5% decline in food products does not
mean that inflationary pressures are abating.
Nor does it mean that the rate of price increases in the weeks and months
ahead would not be as ferocious as in the previous five weeks. Inflation
has been kept artificially low by ordering steel companies to hold prices
and avoiding complete pass-through of higher oil prices. But steel prices
are unlikely to remain at current levels.
Steel producers have announced plans to raise prices next month to offset
rising input costs. Besides, there is no saying how the crude oil prices,
which are dictated largely by the volatile geo-political situation rather
than by demand and supply levels, will move.
Prices of many other commodities also remain elevated. That apart, the
second-round effects of the fuel price increase could exert pressure on the
general index. Also, the monsoon, which was expected to cool food
prices, has been way below normal in many parts of the country

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including Maharashtra and Andhra Pradesh.
Although the restrictive monetary policy has started paying off, the full
impact of the measures taken by the RBI over the past couple of months
to compress demand may be seen only later this year. Until then, inflation
may continue to be in double digits.
Further tightening, aimed at reducing money supply in the economy, may
be required to bring down inflation to a more comfortable level. The
government too would need to take appropriate measures, including some
fiscal ones, and remain vigilant.
The flip side of such monetary tightening would be slower growth. Yet,
the government remains convinced that the economy would grow at least
8% this fiscal. But corporate earnings can come under pressure amid
rising input costs and that, in turn, could hurt tax collection and fiscal
consolidation

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Appendices

INSTRUMENTS OF FISCAL
POLICY

PUBLIC REVENUE PUBLIC EXPENDITURE

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PUBLIC
REVENUE

REVENUE CAPITAL
RECEIPTS RECEIPTS

PUBLIC SECTOR
TAX NON-TAX RECOVERY OF
DISINVESTMENT
REVENUE REVENUE PROCEEDS LOANS

GRANTS

ADMINISTRATIVE COMMERCIAL

DIRECT INDIRECT

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Revenue & capital receipts of the government
Receipts Notati Disbursement Notati
ons. ons.

A] revenue receipts RR A]Revenue expenditures


R1 1] interest expenditures RE
1] tax receipts 2] other expenditures E1
2] Non- tax receipts (2a+2b) E2
2a. interest receipts R2
2b. non- interest receipts
R3

B] Capital receipts CR B}Capital expenditures


1] Grants R4 1] domestic lending
2] borrowing (2a+2b) 2] other expenses
2a. Foreign R5
2b. domestic(2bi+2bii)
2bi. 91 days TBs &
drawing down of cash
balances with the
central bank. R6

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2bii. Other than (2bi) R7
3] Recovery of loans R8
4]Disinvestment receipts R9

Aggregate receipts RR+CR Aggregate expenditures RE+CE

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SOURCES & BIBLOGRAPHY
1] ECONOMIC ENVIRONMENT OF BUSINESS
-VEENA KESHAV PAILWAR.
2] ARTICLE FROM “TIMES OF INDIA” dated 19th july.
3] VIPUL PRAKASHAN.

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