.

Budgeting and Fiscal Policy—

 Tax,
 expenditure,
 budgetary deficits,
 pension and fiscal reforms,
 Public debt management and reforms,\
 Fiscal Responsibility and Budget Management (FRBM) Act,
 Black money and Parallel economy in India—definition, estimates, genesis, consequences
and remedies.

 Black money and Parallel economy in India—definition, estimates, genesis,

consequences and remedies.

A parallel economy may also be termed as ‘informal economy’, ‘black money economy’,
‘unaccounted economy’, ‘illegal economy’, ‘subterranean economy’, or ‘unsanctioned
economy’.

A parallel economy in its broadest sense may consist of:

 illegal economy, such as money laundering, smuggling, etc;
 legal but unreported economy including tax evasion;
 unregulated economy, ie economic activities outside regulations.

Causes of Emergence of a Parallel Economy

A parallel economy can come into existence due to various reasons:
 High tax rates implemented by the government which results in a higher tendency of tax evasion
among tax payers.
 Prevalence of rigid controls, permits, quotas and licenses.
 Complicated tax paying procedures and policies.
 The belief that taxpayers’ money is not being properly utilized by govt. as faith on govt. is
insufficient.
 High inflation that places tax payers in high tax paying brackets.
 Involvement of govt. agencies & officials in illegal activities.
 Insufficient laws & their application to counter corruption.
 Weak enforcement of tax laws in reverence of income tax, sales tax, excise duty, stamp duty which
leads to enormous unrestricted evasion of taxes & piling up of black money.
 The tendency of big trading houses of supporting political parties with the support of black money,
to enslave the political leadership for originating unwarranted profit by manipulating policy decisions.

Measurement of Parallel Economy

Policy makers and analysts can use direct and indirect methods to measure the size and volume of
a parallel economy.
Direct measures include tax audits and analysis of sample data to assess the size of undeclared
taxable income.
The indirect measures include the use of
 National Accounting Statistics to measure national and per capita incomes
 Labour Force Statistics in organized and unorganized sector
 Monetary Transactions of larger denominations
 Cash demand instead of credit instrument
 Physical Consumption Inputs, such as electricity consumption by production units

The World Bank research group’s work done in 2010 — Shadow Economies All Over the World: New
Estimates for 162 Countries from 1999 to 2007, by Friedrich Schneider, Andreas Buehn and Claudio
E Montenegro — is regarded to be one of the most reliable report on the illegal economy through the
globe. It estimated India’s shadow economy in 2006 to be 25.1 per cent of GDP, against 22.9 per cent
in 1999. This is estimated at around 30% currently

Harmful Effects of Parallel Economy

The presence of a parallel economy affects the economy in a number of ways:
 There is a misdirection of precious national resources. A share of black money is reserved in a form
that provides nothing/little to productive activities. A major portion of
the earned black money is misspent on pretentious consumption of goods and services.
 Reduction in government revenues and the quantity of public services
 There is a worsening of income distribution, thereby undermining the fabric of the society as
genuine tax payers earn much less than those earning black money.
 The presence of a big-sized unreported section of the economy is a big hindrance in making a
correct analysis & formulation of right policies for it. It becomes difficult to monitor the development in
the economy with precision.
 Availability of black money has eroded the social values of the society. The undeclared income is
‘earned’ by unlawful ways and is expended in unwanted & vulgar fashion.
 Black money leads to transfer of funds from a country to foreign countries via clandestine channels.
Such transfers are done by violations of exchange regulations by the device of under – invoicing of
exports & over-invoicing of imports.
 Black money needs for its protection, proliferation & growth of a service organization consists of
musclemen, touts & brokers to fight the powers of law & order & instead, there are income tax
advisers, or CAs in the pay of black money workers. Also, there are contact men, also known as
liaison officers who negotiate helps from top bureaucracy & political bosses via bribes of black money.
This has developed a new black money trend in the business world.
 Black money has corrupted our political system in a most malicious way. At several stages, MLAs,
MPs, Ministers, party functionaries openly & shamelessly go on gathering funds.

Govts. can perform to restraint the shadow

economy in the following ways:
 Changes in the tax rates can help in stabilizing the economic decisions of economic entities that are
prone to be encouraged by the parallel economy.
 There is a need to have more stringent implementation of tax laws, tax audits, and heavier
penalties for tax evasion to limit the size of the parallel economy.
 By introducing reforms to make the economy more competitive and liberalize regulations, firms get
an incentive to move from the parallel economy into the official one.
 Legalizing of certain shadowy economic activities like liberalizing the labour market can help to
integrate such activities in the official economy.
 Instead of introducing more regulations policy makers should focus on strict enforcement of limited
regulations and create an awareness about the significance of laws in the economy.
 Ordinance to declare black money a national asset with powers to seize as well as confiscate, be it
at home or overseas.
 Disclosing the identity of those with loot stashed abroad.
 Life sentence or capital punishment for those found guilty
 Joining global efforts to combat drug and terror funding
 Enacting legislation so as to make property transactions transparent
 State funding of elections, right from national to state, municipal and panchayat
 Creating Public Awareness and Public Support
 Enhancing the Accountability of Auditors
 Protection to Whistleblowers and Witnesses
 Need to Join International Efforts and Use International Platforms
 Need to Fine-tune Relevant Laws and Regulations
  Strengthening of Social Values

Government Regulations and Agencies to control parallel economy

The government has authorized its prevailing institutions & build new mechanisms & institutions
to excavate black money.
 The slow reduction in direct tax rates has helped improve compliance.
 Central Board of Direct Taxes, a legal authority operative across India underneath the Central
Board of Revenue Act of 1963 has Investigation Wings, spread all across India, which are
commanded by the Director General of Income Tax (Investigation) to find and stop black money.
 The Director General of Income Tax (International Taxation) is responsible for resolving
 taxation problems that rises from cross-border transactions & transfer pricing.
 Financial Intelligence Unit has been functioning as an investigative entity for receiving, processing,
analyzing, and publicizing information concerning to the financial transactions.
 Central Board of Excise and Customs and Directorate of Revenue Intelligence a zenith intelligence
organization is accountable for noticing cases of evasion of central excise & service tax.
 Central Economic Intelligence Bureau is accountable for coordination, intelligence sharing, &
investigations at national as well as regional levels between several law enforcement agencies to
avoid financial crimes, creation & parking of black money & illegal transfers.
 India has hinged with global efforts to handle illegal flows & also signed information
 exchange treaties with various countries.
 India also has Double Tax Avoidance Agreements with 82 nations, comprising all widespread tax
haven nations.
 The Government has also introduced measures to contain the growth of black income in the country,
such as, Deposit in the National Housing Bank, NRI foreign exchange remittance scheme, issuing
National Development Bonds in US dollars, controlling the election expenses incurred by the
candidates, conducting searches, seizures, raids and other steps to plug loopholes in the tax
administration.
 Formation of Special Investigation Team (SIT) by SC during the UPA government tenure while
considering a case filed by former Law Minister Shri. Ram Jetmalani.
 The government passed The Undisclosed Foreign Income and Assets (Imposition of Tax) Bill, 2015
 RBI initiated the process of taking back the currency notes issued before 2005 to reduce the level of
counterfeit notes and also to curb the menace of black money to a greater extent.
 The government is mulling for a dual strategy in the form of framing policies to bring back the illicit
money stashed abroad and also making domestic laws stringent to locate and identify the black
money in India.
 Tax reforms in the form of tax deduction at source (TDS) , increasing tax base than merely increasing
tax rates, voluntary disclosure schemes etc.
 Government and RBI are promoting the cashless economy. The government has either slashed
taxes or surcharge on online / card transactions to make transfers accountable and try to bring the
money into the normal banking system.
 Government has scrapped Rs.500 and Rs.1000 notes and changed the cash withdrawal limits from
banks and ATMs.
 India joined FATF ( Financial action Task forece) in 2005 to combat against financing terrorism
through the black money route. We also framed AML / PML laws in 2003 for combating money
laundering activities in our country.
 Prevention of Corruption Act and Binami Transactions Act were other such steps in the right
direction.
 Under pressure from India and other countries Switzerland and other tax havens have agreed in
principle to share the details of accounts to the public authorities on a case to case basis.
 Making PAN number mandatory for real estate and bullion purchases.
 The government is in a process of renegotiating DTAAs with countries which we have already signed.
 Limitation of benefits clause needs to be invoked in appropriate areas where it deemed necessary.

It is not impossible to curb, control, and finally prevent the generation of black money in future as
well as repatriation of black money, if a comprehensive mix of clear-cut strategies is followed
with patience & perseverance by the central & state governments & placed into practice by all
their agencies in a coordinated manner.
The Fiscal Responsibility and Budget Management (FRBM) Act, 2003
The Fiscal Responsibility and Budget Management Bill (FRBM Bill) was introduced in India by the
then Finance Minister of India, Mr.Yashwant Sinha in December 2000. The provisions provided in the
initial versions of the bill were too drastic. After much discussions, a watered-down version of the bill
was passed in 2003 to become the FRBM Act. The FRBM Rules came into force from July 5, 2004.
What is the FRBM Act all about?
FRBM Act is all about maintaining a balance between Government revenue and government
expenditure.
The intention of the Fiscal Responsibility and Budget Management Act was to bring –
 fiscal discipline.
 efficient management of expenditure, revenue and debt.
 macroeconomic stability.
 better coordination between fiscal and monetary policy.
 transparency in the fiscal operation of the Government.
 achieving a balanced budget.
Objectives of the FRBM Act
The main objectives of the act were:
1. to introduce transparent fiscal management systems in the country.
2. to introduce a more equitable and manageable distribution of the country’s debts over the
years.
3. to aim for fiscal stability for India in the long run
Additionally, the act was expected to give the necessary flexibility to Reserve Bank of India (RBI) for
managing inflation in India.
Provisions of the Fiscal Responsibility and Budget Management Act
The FRBM rules mandate four fiscal indicators to be projected in the medium-term fiscal policy
statement. These are:
1. revenue deficit as a percentage of GDP
2. fiscal deficit as a percentage of GDP.
3. tax revenue as a percentage of GDP.
4. total outstanding liabilities as a percentage of GDP.
The FRBM Act set targets for fiscal deficit and revenue deficit.
The FRBM act also provided for certain documents to be tabled in the Parliament of India, along with
Budget, annually with regards to the country’s fiscal policy. This included the Medium-term Fiscal
Policy Statement, Fiscal Policy Strategy Statement, Macro-economic Framework Statement, and
Medium-term Expenditure Framework Statement.  For details check the details of the budget
documents.
Initial FRBM Targets (to be met by 2008-09)
1. Revenue Deficit Target – revenue deficit should be completely eliminated by March 31,
2009. The minimum annual reduction target was 0.5% of GDP.
2. Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2009. The
minimum annual reduction target was 0.3% of GDP.
3. Contingent Liabilities – The Central Government shall not give incremental guarantees
aggregating an amount exceeding 0.5 per cent of GDP in any financial year beginning 2004-
05.
4. Additional Liabilities –  Additional liabilities (including external debt at current exchange
rate) should be reduced to 9% of the GDP by 2004-05. The minimum annual reduction target in
each subsequent year to be 1% of GDP.
5. RBI purchase of government bonds – to cease from 1 April 2006. This indicates the
government not to borrow directly from the RBI.
Did the government meet the FRBM targets by March 2009?
No. Implementing the act, the government had managed to cut the fiscal deficit to 2.7% of GDP and
revenue deficit to 1.1% of GDP in 2007–08. However, the targets were not met.
The global financial crisis (2007-08) led the government to infuse resources in the economy as the
fiscal stimulus in 2008. Therefore, fiscal targets had to be postponed temporarily in view of the global
crisis.
Amendments in the FRBM Act
In 2012 and 2015, notable amendments were made, resulting in relaxation of target realisation year.
A new concept called Effective Revenue Deficit (E.R.D) was also introduced.
The requirement of ‘Medium Term Expenditure Framework Statement’ was also added via
amendment in FRBMA.
FRBM Targets after Amendment to FRBM Act in 2012 (to be achieved by 2015)
1. Revenue Deficit Target – revenue deficit should be completely eliminated by March 31, 2015.
The minimum annual reduction target was 0.5% of GDP.
2. Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2015. The
minimum annual reduction target was 0.3% of GDP.
FRBM Targets after Amendment to FRBM Act in 2015 (to be achieved by 2018)
1. Revenue Deficit Target – revenue deficit should be completely eliminated by March 31, 2018.
The minimum annual reduction target was 0.5% of GDP.
2. Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2018. The
minimum annual reduction target was 0.3% of GDP.
FRBM Review Committee headed by NK Singh: Recommendations
The government believed the targets were too rigid.
In May 2016, the government set up a committee under NK Singh to review the FRBM Act. The
committee recommended that the government should target a fiscal deficit of 3 per cent of the GDP
in years up to March 31, 2020, cut it to 2.8 per cent in 2020-21 and to 2.5 per cent by 2023.
The Committee suggested using debt as the primary target for fiscal policy. This ratio was 70% in
2017.
These are the targets set by NK Singh:
1. Debt to GDP ratio: The review committee advocated for a Debt to GDP ratio of 60% to be
targeted with a 40% limit for the centre and 20% limit for the states.
2. Revenue Deficit Target – revenue deficit should be reduced to 0.8% of GDP by March 31,
2023. The minimum annual reduction target was 0.5% of GDP.
3. Fiscal Deficit Target – fiscal deficit should be reduced to 2.5% of GDP by March 31,
2023. The minimum annual reduction target was 0.3% of GDP.
Latest FRBM Targets
The latest provisions of the FRBM act requires the government to limit the fiscal deficit to 3% of the
GDP by March 31, 2021, and the debt of the central government to 40% of the GDP by 2024-25,
among others.
The Act provides room for deviation from the annual fiscal deficit target under certain conditions.
Escape Clause in the FRBM Act
Escape clause refers to the situation under which the central government can flexibly follow fiscal
deficit target during special circumstances. This terminology was innovated by the NK Singh
Committee on FRBM.
In Budget 2017, Finance Minister Arun Jaitley deferred the fiscal deficit target of 3% of the GDP and
chose a target of 3.2%, citing the NK Singh committee report.
However, the Comptroller and Auditor General of India (CAG) pulled up the government for deferring
the targets which it said should have been done through amending the Act.
In 2018, the FRBM Act was further amended. Specific details were updated in sub-section (2) of
Section 4. The clause allows the govt to relax the fiscal deficit target for up to 50 basis points
or 0.5 per cent. Under FRBM, if the escape clause is triggered to allow for a breach of fiscal deficit
target, the RBI is then allowed to participate directly in the primary auction of government bonds, thus
formalising deficit financing.
The Escape Clauses can be invoked:
 by the Government after formal consultations and advice of the Fiscal Council.
 with a clear commitment to return to the original fiscal target in the coming fiscal year.
In 2020, Finance Minister, Nirmala Sitharaman used the escape clause provided under the FRBM Act
to allow the relaxation of the target. Finance Minister revised the fiscal deficit for FY20 to 3.8 per cent
and pegged the target for FY21 to 3.5 per cent.
Note: The Act exempts the government from following the FRBM guidelines in case of war or
calamity.
What is the current status of Fiscal Deficit and Revenue Deficit?
  Fiscal Deficit (FD)- The Fiscal deficit as per the Indian Budget 2020-21 was estimated 3.5
% of GDP.
 Revenue Deficit (RD)- The Revenue Deficit as per the Indian Budget 2020-21 was
estimated 2.7 % of GDP.
 Effective Revenue Deficit (ERD)- The effective revenue deficit as per the Indian Budget 2020-
21 was estimated 1.8 % of GDP.
 Tax to GDP ratio: 10.8
 Debt to GDP ratio (Central Government): 50.1
What if there is no Fiscal Discipline?
If there is no fiscal discipline, the government (executive) may spend as it wishes.
A country is just like a house; if the expenditure is too much and if there is no revenue to balance the
high expenditure, the country will eventually fall into a debt trap, which may finally result in its
collapse.

Conclusion
The FRBM Act seeks to achieve long-term macroeconomic stability, while generating budget
surpluses, prudential debt management, limiting borrowings to cut down deficits and debt, greater
transparency, removal of fiscal impediments and providing a medium-term framework for budgetary
implementation.
As seen in the above analysis, different governments have failed to achieve the FRBM targets set to
be achieved in 2008 even by 2020.
Though the Act aims to achieve deficit reductions prima facie, an important objective is to achieve
inter-generational equity in fiscal management. This is because when there are high borrowings
today, it should be repaid by the future generation. But the benefit from high expenditure and debt
today goes to the present generation.
Achieving FRBM targets thus ensures inter-generation equity by reducing the debt burden of the
future generation.

PUBLIC EXPENDITURE
· Spending incurred by public authorities to fulfill the collective social wants of the people
is termed as public expenditure.
· As economies experience tremendous growth in public expenditure, it is essential to formulate
judicious public expenditure policies so as to attain the objectives of income generation and its
equitable distribution, employment, and sustainable growth.

Significance of Public Expenditure

Being a component of GDP, public expenditure has an instantaneous impact on it. Ceteris paribus, a
rise in public expenditure increases GDP by the same amount. Moreover, an increase in income will
be tailed by a rise in consumption since income is an important factor of consumption. However the
extent to which this will happen depends on the person preference. Firm has two option it can either
increase production or prices in response to increase in aggregate demand. One possible case of fall in
aggregate demand could be , if consumers interpret the increase in public expenditure as a fall in their
disposable. At the microeconomic level, public expenditure when directed to provision of consumer
goods acts to substitute individual's expenditure, as with the case of free medicines. But when directed
to provision of social activities like education, public expenditure may prompt further consumption
expenditure like purchase of books and uniforms. At the macro level, public expenditure is considered
to crowd-out private investment, possibly through arise in interest rate. This behavior in a floating
exchange rate regime can trigger currency appreciation, thereby displacing exports as well.
Considering business cycles, during recessions, as tax revenue declines, in response of it
government can reduce public expenditure & freezing employment & wages in the public sector.
Others decide to spend more to stimulate the economy. The former risk the worsening of GDP
dynamics &prompting a vicious cycle, which can be broken only by international trade dynamics,
financial inflows or other variables. The second would provoke a deep public deficit, waiting for
GDP rebound and, possibly, introduction of new taxes.
A major part of public expenditure, which is misused in rent-seeking behaviours, corruption, and
purposeless purchases, by its very nature, can alter the rules of the game in markets, firms, and
income distribution, as it distorts the functioning of an economy.

Under this public expenditures are classified into:

· Plan Expenditures that comprise of all the expenditures of the government which arenincluded in the
central plan. The expenditures related to new projects &programmesnbecome Plan Expenditures
during the period of a five year plan.
· Non-Plan Expenditures are dedicated expenditures on accomplished schemes of earliern plans and
the interest on borrowings.
Plan and Non-Plan Expenditures are further sub-divided into Revenue Expenditures & Capital
Expenditures.
• Revenue Expenditures: Relate to the day to day running expenses of the government and consists of
interest payments, defence revenue expenditure, subsidies (food, fertilizers and
export promotion and others), debt relief to farmers, postal deficit, police, pensions, other general
services (organs of state, tax collection, external affairs) etc.
• Capital Expenditures: Those expenditures that lead to a creation of financial or physical assets or
reduction in recurring financial liabilities. They include capital outlays and loans to
states and union territories for financing plan projects, loans to foreign

Another classification is based on economic growth:

• Development Expenditure :Embraces all items of expenditures that directly promote economic
development & social welfare. It includes spending on both economic & social services.
• NonDevelopment Expenditure : contain expenditures relating to the general services provided by the
Govt. such as safeguarding law and order, defence of the country and the
looking after the administrative departments of the government.

It is very important for government to spend on social & economic for accomplishing the basic
needs of people in developing countries. However the proportion of the centre’s expenditures on
social services is low. On an average about 85% of the spending in social services in India is
undertaken by the state governments given the division of duties between the centre and the states
in India. It is the responsibility of the states, rather than the centre, to provide social services that
matter more for human development. Further, states are responsible for most of the infrastructure
facilities (except telecommunications, civil aviation, railways and major ports) and law and order.
Such an increase has mainly been accredited to a rise in revenue expenditures at the cost of
capital expenditures. Post reforms the government had to resort to suppressing capital
expenditures to bring down the deficits, as it was unable to reduce its revenue expenditures. This
has raised concerns about the future growth prospects of the Indian economy.

Principles of Public Expenditure

Canon of Growth: Public expenditure should encourage economic production and diminish the
inequality and poverty.
Canon of Social Welfare: Social benefit to the whole society should be the intention of public
expenditure.
Canon of Prior Permission: Public expenditure should be incurred only after getting prior
sanction from a competent authority to ensure optimum utilisation and avoiding misappropriation.
Canon of Economy: Government money should be spent in a way to ensure minimum wastage to
get maximum benefits.
Canon of Elasticity: Public expenditure should be fairly elastic to reflect its utilisation based on
situational requirements. In case of inflation it may be decreased and in case of deflation it may
be increased, without disturbance.
Canon of Equitable Distribution: Public expenditure should encourage equitable distribution of
income and wealth in an economy. By creating employment opportunities and reducing
interregional imbalances the government can ensured balanced growth.
Canon of Balanced Budget: The government must work towards ensuring that its public
expenditures are matched by its revenues to avoid deficits and debt burdens.

Factors Responsible for Increase in Public Expenditure

Provision of Welfare Activities
The government plays the role of a provider of basic necessities and social welfare benefits to the
weaker and dependent population of the country. To ensure the basic necessities like food,
shelter, clothing, health and education are provided to the masses, the government needs to
engage in schemes like mid-day meals, cheap housing and medical facilities, installation and
maintenance of basic public goods like transportation and power.
Increase in Administrative Expenditure
To maintain economic stability, peace, security and democracy the government needs to spend
money. However the prevalence of a defective financial and civil administration trapped in
corruption, and redtapism, puts pressure on the public expenditure for providing ever growing
law and order mechanisms.
Increasing Population Pressure
Most developing countries are in the second stage of demographic transition where birth rate is
still very high. To provide the basic necessities of life to the increasing population, the
government has to spend huge amounts of money.
Development of Backward Areas
To meet its objective of reduction in interregional disparities, the government needs to develop its
neglected areas. There is need for upliftment of the backward regions investment climate,
building of social overheads, and enhancing the productive capacity of the people.
Inflationary Pressures
In the developing countries as the rate of inflation is very high so the cost of provision of public
services is also increasing. This adds a burden on the government as its revenue generation
capacity is low.
Increasing Defence Expenditure
Though expenditure on defence is considered to be a regrettable necessity, to prepare the country
for war or for its prevention, modernization of defense equipment becomes essential. This factor
has grown over the years due to animosity among nations and terrorist activities.
Dynamic Global Economic Environment
Global environmental factors, like, import and export restrictions, international political changes,
and growing need to integrate with rest of the world has been influential in increasing the role of
government. To attract foreign direct investment under its objective of globalization, the
government has to increase its public expenditure in provision of infrastructure facilities of world
standards.

Effects of Public Expenditure

Effect on Production
In an economy if the private investment expenditure is not enough in generating national income
at its optimal level, the government needs to fill up the gap between actual and full employment
levels, by investing in public works programme. Public expenditure acts as an operative instrument to
stimulate investment in industries. The government may start public sector enterprises or provide
benefits like subsidies, tax benefits to existing industries. It can also encourages new investment in
variant sectors. Moreover, the government can also promote inter regional development by providing
various incentives to those who make investment in rural and backward regions. Policy initiatives in
public works programmes encourages an economy's productive capacity by creating employment
opportunities. Expenditures incurred on education and health accelerate productivity & thereby the
incomes of the people. The increase in incomes encourages saving, which in turn have a positive
effect on the economy's ability to work, save and invest. With increasing domestic savings resulting in
investment and capital formation the rate of economic growth and development rises. However there
is a possibility that the increase in government's social security expenditures like unemployment
allowances, old age pension, insurance benefits, medical benefits may cause uncomplimentary results.
Such benefits as they are not linked with efforts or contribution, may hamper the people's attitude
towards work, as their dependence on the government increases.
Effect on Consumption
As public expenditure improves the capacity of poor to consume as it allows for reallocation of
income in errands of poor. A rise in public expenditure promotes consumption or rise in
aggregate demand and thereby other economic undertakings. The government expenditure on
welfare programmes like free education, housing, and health care improves standard of living of
the poor people. It also enhances their capacity to consume & save.
Effect on Distribution
With public expenditure, the government aims at maximising social benefit and minimization of
income inequality. Through income and sale tax on luxuries, government collects excess income
from the rich. Funds are mobilized& directed towards welfare agendas to assist the poor and
weaker section via taxations. Expenditure on social security benefits & subsidies to poor are
intended at raising their real income & purchasing power. By increasing public expenditure on
education, communication, and health a positive impact can be generated on productivity capacity
of the weaker sections of society, thereby increasing their incomes.
Effect on Level of Income and Employment
According to Keynes, during periods of depression, governments can remove widespread
unemployment and the slowdown in growth rates by encouraging public works. Using the
multiplier effect he explained the link between the increase in public expenditure, income and
employment. As the people employed in public works get income there is an increase in
aggregate demand, which triggers the increase in production activity. This results in creation of
employment opportunities, more income, more aggregate demand, propelling the economy
towards economic growth. Moreover with increase in production capacity, economic instability
that is caused by inflation can be resolved
Effect on Economic Growth
In its planning estimates the govt.assigns funds for the growth of various sectors like agriculture,
industry, transport, communications, education, energy, health, exports, imports, with a view to
accomplishremarkable growth meet its planning goals. By engaging directly or indirectly in
various sectors, the government expenditure is helpful in maintaining balanced economic growth.

Suggestions for Reducing Public Expenditure

With a focus on transparency in fiscal operations, the government needs to introduce financial
and operational reforms to eradicate the structural bottlenecks & rise in the growth rate.
There is a need to reduce revenue expenditures & rise in the growth rate of capital expenditures.
To attain fiscal consolidation, there should be better targeting of social expenditures. While
adequate requirements should be made for essential social sectors such as education, caution
should be taken to avoid non priority expenditures. For adequate distribution of essential goods
the PDS should be fortified. Emphasis should be laid on reducing subsides especially to the
energy sectors as these are quite high and increase the burden of budget deficits.
By improving the efficiency and management of public sector enterprises and administrative
departments, revenues can be generated which can then be reinvested in development of other
sectors. Provisions should be made to reduce overstaffing and sickness in various departments
and industries. The optimum utilisation of funds and resources can be ensured by appointing
special monitoring committees.

The first major trend in public expenditures which we observe in India is the growing revenue
expenditures of the government from Rs.14,410 crores in 1980-81 to Rs. 10,40,723 crores in
2010-11 which is an 80 fold increase.

 Capital expenditures during the same period increased about 20 times, from Rs. 8,358 crores
in 1980-81 to Rs. 1,56,605 crores in 2010-11

 The composition of total expenditures was skewed in favour of revenue expenditures and the
ratio of revenue expenditures in total expenditures increased from 63 percent in 1980-81 to about
70 percent in 1990-91 and further to 85 percent in 2000-01 and then to about 87 percent in 2010-
11. Capital expenditures as a percentage of total expenditures reduced accordingly from 36.7
percent to 30 percent to 14.6 percent to 13 percent.

 Revenue expenditures as a percentage of GDP, increased from 9.6 percent in 1980-81 to 12.5
percent in 1990-91. With the increasing public debt, the interest payments grew from 1.7 percent
of the GDP in 1980-81 to 3.6 percent in 1990-91. Defence expenditures during this period stayed
above 2 percent of GDP throughout. Subsidies increased from 1.3 percent in 1980-81 to about 2
percent in 1990-91. Out of the capital expenditures, loans and advances and capital outlay
declined, resulting in a fall in capital expenditures to GDP ratio from 5.5 to 5.4 percent during
this period.

 In the nineties, as a percentage of GDP, capital expenditures fell from 5.4 percent in 1990-91
to 2.2 percent in 2000-01. Revenue expenditures, on the other hand showed an increase from 12.5
percent in 1990-91 to 12.8 percent in 2000-01, mainly because of the increase in interest
expenditures. Defence expenditures and subsidies both showed a decline during this decade. The
fall in capital expenditures could be attributed to fall in loans and advances from 3.3 percent in
1990-91 to about 1 percent in 2000-01 and fall in capital outlays from 2 percent to 1.1 percent
during the same period.

 Revenue expenditures increased to 13.5 percent in 2010-11 from 12.8 percent in 2000-01 and
capital expenditures, on the other hand, declined from 2.2 percent in 2000-01 to 2 percent in
2010-11. Out of the revenue expenditures, defence expenditures and interest payments as a
percentage of GDP, have shown a
decline, whereas, subsidies have increased from 1.2 percent in 2000-01 to 2.2 percent in 2010-11.
Out of the capital expenditures, loans and advances have shown a decline whereas; capital outlays
have shown an increase from 1.1 percent in 2000-01 to 1.7 percent in 2010-11.

PUBLIC DEBT
It is a significant source of revenue for government. If revenue collected from taxes & other
sources is not sufficient to cover government expenditure govt may depend on borrowing. Local,
state and central governments borrow money to compensate for big projects, like new buildings,
schools or for financing public expenditure etc. Such borrowings turn out to be essential in times
of financial crises & tragedies like war, droughts, etc. Public debt can be upraised internally or
externally. Internal debt denotes to public debt floated within the country, while external debt
denotes to loans floated outside the country. Public debt may be categorized as:

# Productive and Unproductive Debt

Productive debt: Public debt is said to be productive when it is upraised for fruitful objectives such
as railways, irrigation projects, power generations, & is used to enhance the productive capacity of the
economy . As productive loans are self-liquidating, they must be refunded within the lifespan of
property. Such loans do not lead to any net burden on the public.
Unproductive debt: Unproductive debts are the one which are raised to meet expenses
on war, famine relief, social services and these doesn’t increase the productive capacity of economy.
As unproductive debts are not self-liquidating, interest & principal sum may have to be funded from
other sources of revenue, usually from taxation. So, such debts are a burden on the society.
Unproductive expenditures are not always considered as bad because they may lead to welfare of the
society. But loans for unproductive activities are a net burden on the society as they are generally
repaid by imposing additional taxes.

# Voluntary and Compulsory Debt

Voluntary debt: These loans are provided by members of public on voluntary basis. Most of the
loans obtained by government are voluntary in nature. Voluntary debt may be acquired in type of
market loans, bonds, etc. Govt makes a declaration in the media to attain such loans. The rate of
interest is normally higher, in order to persuade people to offer loans to government.
Compulsory debt: A compulsory debt is like a compulsory deposit scheme where public is asked to
contribute as a compulsion during some special circumstances like war or crisis. The rate of interest
on such loans may be low.

# Short-Term, Medium-Term & Long-Term Debt

Short-Term debt: Short term debt like Treasury Bills of 91 days and 182 days, mature within
duration of 3 to 9 months, and are made to cover temporary scarcities of funds. Interest rates are
usually less on such loans.
Medium-Term debt: Government may borrow funds for medium term requirements like
development and non-development activities. The period of this debt is normally above 1 year & up to
5 years. One of the main types of this debt is market loans.
Long-Term debt: It has a maturity period of 10 years or more and generally rate of interest is high.
These loans are upraised for developmental programmes & to encounter other long term requirements
of public authorities.

# Redeemable and Irredeemable Debt

Redeemable debt: The debt which government promises to pay off at some future date is
called redeemable debt. Maximum debt is redeemable in nature and there is a definite maturity period
of the debt. Govt has to arrange a sum to repay the principal and the interest on the maturity date.
Irredeemable debt: These debt has no due date. Here, govt may pay interest timely, but
repayment date of principal sum is not fixed. These are also named as perpetual debt. # Funded and
#Unfunded Debt
Funded debt: Funded debt is repayable after a long period of time, such as 30 years or more. It has
a compulsion to pay fixed amount of interest conditional to an option to govt to repay the principal.
Govt may repay it even before the due date if market conditions are positive. It is commenced for
meeting more permanent requirements, say building up economic and industrial infrastructure. Govt
commonly forms a separate fund to repay this debt.
Unfunded debt: These are incurred to meet temporary needs of governments. The debts period is
reasonably short like a year and rate of interest is very low. It has a compulsion that it is to be paid on
due date with interest.

# Internal and External Debt

The government borrows funds from internal and external sources.
Internal debt: It denotes to the funds borrowed by govt from several internal sources within the
country, like individuals, banks, business firms, and others. Several instruments of internal debt
comprise market loans, bonds, treasury bills, ways & means advances, etc. Internal debt is repayable
only in domestic currency. It implies a reallocation of income & wealth inside the country & so it has
no direct money burden.
External debt: These are borrowed from foreign countries or international institutions, and are
repayable in foreign currencies. It help to initiate several developmental programmes in developing &
underdeveloped countries. These advances are generally voluntary. An external loan initially includes
a transmission of resources from foreign countries to the domestic country, but when interest &
principal sum are refunded a transfer of resources happens in the reverse direction.

Public Debt in India

These have been rising at an alarming rate, during current years. Funding of economic development is
a complex issue because of the under-developed nature of the economy & institutional credit
shortages. So, govt needs to play a vital part in encouraging the rate of capital formation and
promoting economic development of the economy. Govt bonds or securities of various kinds are the
instrument of public debt. These securities are drawn as a contract among government and lenders. By
issuing securities government there is a rise in public loan and experiences a liability to repay the
principal and interest amount as per contract. In India, govt issues treasury bills, post office savings
certificates, NSC’s as instruments public borrowings.
A. Internal Debt
Its components are:
Market Loan: These have a maturity period of 12 months or more at the time of issue and is interest
bearing. The govt issues these loans almost every single year. They are raised in the open market by
sale of securities or otherwise.
Bonds: The Govt borrows funds by way of issue of bonds. The govt acquires funds through the
issue of bonds like National Rural Development Bonds, Central Investment Bonds. These are issued
at different maturity periods, which may vary from 3 years to 10 years period. They offer medium-
term to long-term funds to the government.
Treasury Bills: The main source of short-term funds for the govt is acquired by issue of these bills.
Presently, govt issues 91 day & 364 day treasury bills. These are acquired by commercial banks and
others.
Special Floating and Other Loans: These represent India's input to share capital of international
financial institutions such as IMF, World Bank, International Development Agency. These are non-
negotiable & non-interest bearing securities. GOI is accountable to pay the sum at the call of these
institutions. So, it is a short-term debt on GOI.
Special securities issued by RBI: Govt acquires temporary advances for a period of maximum 12
months from RBI and issues special securities, which are non-negotiable and non-interest bearing.
These securities offer short term funds to the government.
Ways and Mean Advances (WMA): GOI acquires WMA from RBI to encounter its short term
expenditure. These debts are temporary in nature & are generally repaid within 3 months.
Securities against small savings: Since 1999-2000, as per the new accounting system, NSS have
been transformed into Central Government securities. As a consequence there has been a huge rise in
internal debt & corresponding decline in small savings.
B. External Debt
It refers to liabilities of govt, public sector, private sector & financial institutions to rest of the
world. These can be mainly classified in two groups:
1. Long term debt
Multilateral borrowings
Bilateral borrowings
Loans from IMF, World Bank, etc.
2. Short term debt
It includes government debt and non-government debt. Govt debt is owed by government
authorities, both Central & State Govts, while non-Government debt is payable by private parties
in India.
C. Other Internal Liabilities
The govt liabilities are not included under public debt but the govt is accountable to refund these
liabilities.
Small Savings: As money incomes have increased in economy, small savings have also increased.
In recent times the govt has started a no. of small savings instruments like 9% Relief Bonds, Kisan
Vikas Patras, Indira Vikas Patras, etc.
Provident Funds: It can be distributed into 2 groups:
o Employee Provident Fund for employees
o Public Provident Fund for general public
Other accounts: It comprises of Postal Insurance and Life Annuity Fund, Borrowings against
Compulsory Deposits, Income Tax Annuity Deposit, Special Deposit of Non-Government Provident
Fund and Outstanding Amount.
Reserve Funds and Deposits: Reserve Funds and Deposits can be divided into two categories:
o Interest bearing
o Non-interest bearing which includes depreciation and reserve funds of Railways, Department of
Post, Telecommunication, Deposits of Local Funds, Departmental and Judicial Deposits, Civil
Deposits, etc.

Trends in Public Debt

In 2013, govt debt to GDP was 67.72% of the India's GDP. It was around 73.97% from 1991 till 2013,
attaining an all-time high of 84.30% in 2003 & as low as 66.60% in 2012. Government debt to GDP
in India is reported by Ministry of Finance, GOI.
In 2011, India had 44th position in the world, having 55.9% of GDP as public debt. Japan had the
maximum public debt at 225.8% of GDP.
The chief reason for rise in internal public debt in India has been increasing necessity of funds for
financing various developmental programmes as both tax & non-tax revenues have been
insufficient to finance government expenditure.
The external public debt in India has increased significantly as it is instrumental in providing
funds to make import payments and solve balance of payment problems.

Burden of Public Debt

Internal & external debt, both carry a major debt burden on the economy.
Burden of Internal Public Debt
Internal debt trap: Interest payments on debt upsurge public expenditure & may cause fiscal deficit.
If internal public debt is not monitored & retained within limits, the country may face a position of
'Internal Debt Trap'.
Increasing burden on poor and weaker sections: Internal debt offers chances for rich & higher
middle class to receive higher rate of interests from the state on their lending. But the poor suffer due
to additional tax burden as government tends to levy taxes to repay public debt. If taxes are not
progressive then it is not the rich but the poor citizens who feel more of the tax burden.
Increasing burden of interest payment: When government resorts to public borrowing by issuing
bonds and debentures, its public borrowings become costlier. Such bonds and debentures carry a high
interest rate. The influence of such interest payments may develop manifold & still deteriorate in the
future if the government’s borrowings continue.
Unjustified transfer: Servicing of internal debt includes transfers of income from younger to the
older generations & from the active to the inactive enterprises. The govt levies taxes on enterprises &
incomes from productive efforts for the advantage of the idle, inactive, old & leisurely class of bond
holders. Therefore work & productive risk taking efforts are penalized for the benefit of accumulated
wealth. This enhances to the net real burden of debts.
Indirect real burden: Internal debt results in extra indirect real burden in an economy, as taxation
essential for servicing debt reduces the tax payer's ability to work & save, thereby affecting
production adversely. Govt might also economize social expenditure, thus decreasing economic
welfare of people. Taxation reduces personal efficiency & desire to work. The creditor class will also
not have any reason to work hard as the return on bonds may decline. Moreover any loss to
production will increase indirect burden of debt.

Burden of External Public Debt

External debt is beneficial in early stages as it raises resources availability to the country, but its
repayment and servicing entails a burden on the debtor country.
External debt trap: External debt entails a direct money burden, as it includes transfer of funds from
debtor country to foreign citizens. The degree of burden depends on interest rate, and loan amount. As
loans are required to be paid in foreign currency, funds are mainly shifted from export earnings or by
raising funds from foreign markets. Borrowing by additional loans puts an extra burden on the
country. The situation may worsen over time and debtor country may be caught in external debt trap.
Borrowing from foreign markets to repay the interest amount, would make it very hard to pay the
principal sum.
Direct real burden: Repayment of principal amount and interest burden forces the debtor countries
to suffer loss of economic welfare. Exports earnings of foreign exchange could be utilized to import
better goods & technology to increase economic welfare of debtor country citizens. But because of
external debt repayment, the citizens of debtor country are deprived of imported goods and services
till the loans & interest amount is repaid.
Decline in expenditure to public well-being programmes: When the govt spends a major share of its
resources towards the payment of foreign debt, it decreases govt expenditure to that level which
otherwise would have been paid for public welfare programmes.
Decline in value of nation's currency: Repayment of external debt involves an increase in demand
for currency of the creditor country. But this raises the exchange rate of the creditor country's
currency, and aggravates the problem of foreign exchange. If the creditor country is forced to import
more from the debtor country, it may hinder growth of domestic industries & cause unemployment.
Burden of unproductive foreign debt: If external debt funds are used for unproductive purposes
instead of productive purposes, it would create burden and sacrifice on present and future citizens of
debtor country.
Political exploitation: In current years, lending countries who dominate international organizations
like World Bank & IMF have been using their loan giving capacity to exploit borrowing countries,
both economically and politically.

Public Debt Management in India

Increase in public debt puts a load on citizens of the country, and adversely affects growth and
development of an economy. Effective management of public debt requires controlling volume of
borrowings, making productive use of borrowed funds for development, and repayment of public
debt.
Measures that can be adopted to reduce and repay public debt are:
Reduction in Primary Deficit: Corrective action for rising internal debt must be taken in 2 stages. In
the 1st stage, action must be focused toward slowing down pace of growth of debt ratio or decreasing it
to a rational level. In the 2nd by Govt, so that Govt's net borrowings are used only for fruitful
objectives.
Reduction of current expenditure: In order to reduce primary deficit, emphasis has to be placed on
reducing growth of current expenditure of Government, than on raising rate of growth of revenues.
According to R.J. Chelliah, changes in expenditure policy should include:
o Reduction in overall subsidies
o Reduction in capital assistance & subsidy to public enterprises
o Liquidation of public debt
o Reduction in the govt's consumption expenditure on its staff
o Reduction in government civilian employment
Raising effectiveness of borrowing program of Central Government: RBI has played a major role in
improving efficiency of borrowing programmes of Central Government and making it more market
oriented. The new system of ways and means advances to meet temporary mismatches of central
government finances has been introduced to replace the earlier system of ad hoc treasury bills. Before
issuing a loan, RBI now takes into account cash needs of government, liquidity conditions in the
market, and primary and secondary market yields.
Reforms in Debt Management of States: Numerous reforms in debt management policy have been
announced regarding sale of central govt securities, but sale of state government loans continues to be
outdated. There is no scope for better managed states to access funds at competitive rates of interest.
So, it is essential to bring flexibility in borrowing programs of state govts with help of RBI initiatives.
Foreign institutional investors and Public debt: Foreign Institutional Investors have been permitted
to invest in government debt, by investing in dated govt securities only.
Consolidated Sinking Fund (CSF): It has an objective of breaking the vicious cycle of increase in
repayment burden of public debt. Even State Governments should set up such a fund in view of
problem regarding repayment of loans.
Improving condition of debt market: RBI has taken numerous measures to expand & deepen debt
market in India, since 1997. The measures undertaken comprise uniform price auction of 91 days
treasury bills, repos in non-government debt instruments, capital index bonds sales, etc.
Appropriate Disinvestment Policy: Government should disinvest in non-strategic and non-sick
public sector units. Disinvestment enables govt to increase funds that can be used to repay a portion of
public debt.
4. UNDERSTANDING FISCAL IMBALANCE
It is a mismatch in revenue powers & expenditure responsibilities of a govt. The 2 types of fiscal
imbalances are: Vertical Fiscal Imbalance & Horizontal Fiscal Imbalance.
Vertical fiscal imbalance is a situation where revenues do not match expenditures for various levels
of govt. When fiscal imbalance is measured between 2 levels of govt (Centre & States) it is known as
vertical fiscal imbalance.
Horizontal imbalance is a situation where revenues do not match expenditures for various regions of
the country. When fiscal imbalance is measured between governments at same level it is known as
horizontal fiscal imbalance. Such an imbalance is also called regional disparity.
Horizontal fiscal imbalance needs equalization transfers, while vertical fiscal imbalance is a structural
issue that needs to be corrected by reassignment of revenue & expenditure responsibilities between 2
types of governments. Fiscal imbalance is a condition where future debt obligations of a govt are
different from its future income streams. To measure fiscal imbalance, difference between present
value of all future debt and present value of all income streams are calculated. Fiscal imbalance is also
known as fiscal crisis.
Indicators of Fiscal Imbalance
Fiscal imbalance can be measured by deficits such as:
Revenue Deficit is measured as revenue receipts (income) minus revenue expenditure.
Budgetary Deficit is measured as total expenditure minus total receipts. Both revenue and capital
expenditure and receipts should be considered.
Fiscal Deficit is measured as excess of total expenditure over revenue receipts and grants. Fiscal
deficit is equal to budget deficit plus government borrowings and other liabilities.
Primary Deficit is measured as fiscal deficit minus interest payments.
Formula for fiscal deficit as given by Sukhmoy Chokroborthy Committee is:
Fiscal deficit = Budgetary deficit + market borrowings (through Government securities or bonds)
+ other liabilities (like pension and future provident)

Causes of Fiscal Imbalance

The chief aspects responsible for fiscal imbalance in India are:
Increase in Subsidies: Main subsidies provided by Central Government like fertilizers, exports, food
items, have risen over the years forcing higher expenditure.
Excessive Govt borrowings and Interest burden: Government debt and interest payment both on
domestic loans & foreign loans, have improved significantly over the years.
Defence Expenditure: Govt has limited scope to decrease defence budget due to security problems
from across the Indian borders, and so defence expenditures have been gradually rising over the years.
Poor Performance of Public Sector: It is due to political interference, inefficiency & corruption,
yields low revenue by way of dividends.
Weak Revenue Mobilisation: Revenue receipts of Centre, consisting of tax revenue, net of state's
share & non-tax revenue, have increased at a slower rate than the growth in expenditure.
Tax Evasion: There is tendency of tax evasion and avoidance as Indian tax system has complex
procedures with numerous exemptions.
Other Causes: Unproductive expenditure by the government, weak resource mobilisation and low
capital formation, have put pressures on revenue generation.
Consequences of Fiscal Imbalance
Fiscal imbalances result in harmful consequences like ever increasing inflation, deficits in
balance of payment, and adverse effects on growth of the economy. Government should introduce
major fiscal correction policies to overcome fiscal crisis.
Debt Trap: With growing levels of borrowing for financing unproductive activities, which have zero
or low yields, interest payments rise at faster rate. As, unproductive expenditures rise, they force
revenue deficits to increase.
Decrease in Capital Expenditure and Social Welfare Activities: With increasing burden of debt
service payments, government capital expenditure in economic & social infrastructure suffers as
resource availability reduces.
High Interest Rates: Occurrence of high interest rates and high levels of public borrowings have an
adverse effect on rest of the economy.
Slow Economic Growth: Fiscal imbalance initially affects capital formation which later on slows
down economic growth.
Other Consequences: Fiscal imbalance may cause inflation in the economy and depress foreign
investment in the country.
Measures to Correct Fiscal Imbalance in India
Fiscal imbalance happens on account of excess of government expenditure over revenue. To
overcome deficit government has to resort to borrowings. But this aggravates situation of debt
servicing. Fiscal imbalance can be corrected by:
1. Reducing Government Expenditure
Reducing Interest Burden: Over the years, there has been considerable increase in government
borrowings. As a result, interest payment of government has increased considerably. There is a need
to reduce government borrowings so as to reduce interest burden and government expenditure.
Reducing Subsidies: Government has been providing huge amounts of subsidies on a number of
items like food, education, petroleum. To keep a check on government expenditure, there is need to
control government subsidies.
Reducing Government Overheads: The public sectors and government departments usually have
high overheads due to overstaffing, mismanagement, inefficiencies, and corruption. To reduce
Government expenditure, government departments should focus on reducing overheads.
Closure of Sick Units: Government needs to close down sick public sectors or disinvest in them.
Closing down non-viable sick units would enable saving of valuable resources
and disinvestment would generate additional revenue for government expenditure.
2. Raising Government Funds
Collection of user charges: Government should take appropriate steps to collect user charges from
consumers for provision of public utilities like water supply, electricity, irrigation, transportation. At
present user charges subsidies are given for certain services.
Improvement in performance of PSUs: Poor performance of PSUs results in government losing
revenues by way of dividends. So, government should make every effort to improve efficiency and
performance of public sector units (PSUs). Profits from PSUs would enable the government obtain
more funds for productive expenditure.
Proper Mobilization of Tax Resources: In India there is rampant tax evasion of both direct and
indirect taxes, due to high tax rates, complex filing systems, improper documentation, inefficiency
and corruption in tax administration. Government should make efforts to simplify tax procedures,
introduce e-tax filing and take stringent measures to reduce tax evasion.
Market oriented development: To stimulate demand and encourage growth, ample incentives should
be given through fiscal policy for encouraging investment in private sector. Areas of operation of
public sector enterprises need to be reduced, to control governments borrowing and its dependence
on household savings.

There is also a problem of Debt Trap as certain countries borrow heavily from external sources.
Quite often, these funds are utilised for non-development and unproductive purposes. Every so
often, countries which are highly indebted borrow funds to repay its earlier debts. These heavy
borrowings to repay earlier debts put already highly indebted countries in an external debt trap.
Counties affected by 2010 crisis are European nations such as Portugal, Italy, Spain and Ireland.
Also, Dubai debt crisis did have an effect on International community.
The paying off the external debt puts a liability on foreign exchange reserves of a nation.
International crisis, often lead to a contagion (spreading) effect. This means, if one country is
affected, the other countries are also affected. Internal debt is considered less burdensome as
compared to external debt.

FISCAL REFORMS
One of the primary objectives of fiscal policy in the post-independence years was stimulating and
accelerating growth. In a newly emerging economy due to low income levels and financial
savings, the fiscal policy was given the responsibility of creating the capital base for
infrastructure building and stimulating growth. As India embarked on a planning process since
1950 which assigned a large role to the public sector, taxation was the main instrument used to
raise funds for planned development.
In 1970s the taxation and expenditure polices aimed at achieving the twin objectives of equity
and social justice. However a regime of high marginal tax rates did not yield the necessary
revenue to support the required public expenditure. The government action of administered
pricing also did not yield desired results.
So, by 1980s public finance was in a state of disarray. It seemed that the fiscal pattern was
destabilizing the relationship between the economy and budget, thereby resulting in persistently
increasing huge deficits. The decade of 1980s was considered as a decade of fiscal deterioration,
also raising the pertinent question of sustainability of fiscal stance of the Government.
The fiscal issues of 1980s also had an impact on the external sector resulting in the
macroeconomic crisis of 1991. The economy was facing a large size monetized deficit which was
exerting immense inflationary pressures. Also a persistent and burgeoning revenue deficit
increased debt burden and reduced the availability of resources for capital investment.
The structural adjustment programme and the consequent economic reforms gave a fresh
dimension to fiscal policy which focused not only on the various instruments and issues of debt,
but also on the overall fiscal sustainability in the long run. Although the first half of the 1990s
witnessed some fiscal correction, its retraction during the second half of the decade underlined
the need for a consistent and sustainable fiscal consolidation process
Phase I: 1947 to 1968
The fiscal policy in the post-independence era focused on the taxation policy to achieve various
economic objectives. To promote employment, tax incentives and tax holidays were granted to
new investment ventures; inequality was aimed to be reduced through progressive taxes on
income and wealth; emphasis was given to increasing import duties to reduce pressure on balance
of payments; and tax rebate in excise duties on consumption goods were introduced to stabilize
prices. As initially there was a narrow tax base, the tax policy had to rely mainly on indirect
taxes.
Phase II: 1969 to 1980
In the IInd phase, fiscal policy was used as a means to reduce income inequality, along with
promoting economic growth. The main instrument to achieve this objective was taxation. So the
Government raised the income tax rates by substantially high levels during the 1970s. Marginal
rate of taxation was moved up to 97 per cent and, together with the incidence of wealth tax,
crossed 100 per cent. Wealth tax, estate duty and gift tax were also imposed. Indirect taxes were
increased on goods considered luxuries or inessential. These initiatives were taken to meet the
government objective of alleviating poverty and bring about social justice.
Phase III: 1981 to 1990
At the beginning of the IIIrd phase the economic situation was characterized by low economic
growth, high inflation and deteriorating balance of payments as a result of a sharp increase in
price of crude oil imports. The Government sought to reduce its deficit through tax increases.
New tax savings instruments were introduced to enable financing of the large plan expenditure.
Tax concessions were also given to non-residents to encourage flow of foreign exchange
remittances to address the balance of payments problem. Customs duties were hiked to contain
growth in imports, augment revenue and protect the domestic industry. A modified system of
Value Added Tax (MODVAT) was introduced in 1986 in a phased manner to reduce the
distortionary effect of tax on production, and minimize tax cascading. Reforms in customs duty
focused on increased reliance on tariff system rather than on quantitative restrictions to regulate
imports in order to yield more revenue. This phase marked the first real effort towards a long-
term perspective for tax reform.
Phase IV: 1991 onwards
The focus of tax reforms before 1991 was on enhancing revenue productivity to finance large
developmental plans and promoting equity. The reforms since 1991were aimed ataugmenting
revenues. Efforts were made to resolve issues in the tax structure through restructuring,
simplification and rationalization of both direct and indirect taxes. These were based on Chelliah
Committee report recommendations. The key tax reforms included:
 lowering the maximum marginal rate on personal income tax
 widening of the tax base by way of a series of steps including introduction of presumptive
taxes
 adoption of a set of six economic criteria for identification of potential tax payers in urban
areas and taxation of services
 reducing the corporate tax rate on both domestic and foreign companies
 unification of tax rates on closely held as well as widely held domestic companies
 rationalization of capital gains tax and dividend tax
 progressive reduction in the peak rate of customs duty on nonagricultural products and
rationalization of excise duties

Adopting Long Term Fiscal Policy

The main objectives of adopting a long term fiscal policy were:
 Restoring fiscal equilibrium in the economy
 Reforming existing tax structure
 Promoting socially desirable activities
 Focusing on market oriented development

Various steps that were initiated by policy makers to achieve the objectives of LTFP included:
 Simplification of income tax and brining stability in tax regulations
 Identifying new areas of taxation to expand the tax base
 Bringing transparency in budget framing
 Introduction of MODVAT
 Merging several excise duties into a single basic duty for ease in functioning
 Reducing tariff in order to promote international competitiveness
 Abolition of surcharge on profits
 Improvement in tax administration and effective implementation

With proper application of LTFP the benefits achieved were:

 Tax revenue collection became better
 Non tax revenue also performed better though non plan expenditure was high
 Borrowings and budget deficit remained high

Contribution of public enterprises was below expectation

 Assistance to state and union territories remained high
Government also took initiatives to announce a series of austerity measures such as making
strategic investment in infrastructure and human resource, rationalizing major subsidies,
improving tax accumulation of debt, encouraging privileged exports, emphasizing on compliance
of rules and regulations, and curtailing plan and non-plan budgetary support to loss making public
enterprises.
Components of Fiscal Reforms
Revenue Reforms
The areas of fiscal reforms for raising more revenues should include:
Expansion of tax base
Imposition of user-charges on all public services
Imposition of taxes on services
Widespread and bold programme of disinvestment
Expansion of tax base:
In India, it is not feasible nor desirable to raise higher revenues through increase in tax
rates. It can only be attained by increasing the tax base, which means that more and more
activities must be considered under the tax net. With economic development, the share of
agriculture has gone down considerably, while that of industry and services sector has
gone up. Since agriculture has remained largely untaxed, there is no loss of tax revenue
on this account. But expansion of industry and services do offer a much greater potential
for enhancing tax revenues. As the growth in industrial sector is also comparatively slow,
and the service sector contributes more than 50% of GDP, so there is potential in bringing
a larger chunk the service sector under the tax net.
User Charges:
Most public sector activities are involved in providing public services like water, power,
irrigation, transport etc. which are supplied to people either free of cost or at a price lower
than the economic cost of providing these services. Also a substantial hidden subsidy is
involved in providing these services. Moreover as these services have been provided free of
cost for a long period, people’s perception is that the government is required to solely bear
their burden. Also as their quality is very poor so also people are not interested in paying
nominal charges for them. This vicious circle needs to be broken. So, user charges must be
imposed to ensure reasonable returns on public investment in supplying these services. A
major improvement also needs to be made in the quality of these services so that consumers
are interested in paying a user charge for them.
Sometimes to justifying the non application of any charges to share the economic cost by
the government, an equity argument is used. It is advocated that as poor people are in no
position to afford paying an appropriate prices for the public services, they will not get
any benefit. However, the ground reality is that public services are mainly availed by the
richer people who have the ability to pay. In the rural areas poor people do not have land
to avail free power for irrigation, or get subsidized seeds and fertilizers. So, imposition of
user charges will not adversely affect the welfare of the poor people and
will also enhance the fiscal position of the government.
Taxing Services:
A significant aspect of fiscal rejuvenation is that the government must tax services and
tap the service sector for larger resource mobilization. In India, agriculture which
contributes to a fifth of GDP is outside the scope of tax net. Industry that contributes to
over one-fourth of GDP, is heavily taxed and does not offer any further scope for
additional resource mobilization. The service sector, which accounts for one-half of GDP,
also remains largely untaxed. So services need to be included under tax net to meet the
increasing financial requirements of the government. However all services cannot be
taxed as services like defence, public administration, domestic services, do not offer any
scope of taxation. Meanwhile, services like transport, communications, hotels,
restaurants, insurance, financial services, which have made tremendous progress in the
process of country’s economic development must contribute to share burden of fiscal
needs of the government.
Until 1994, there was no service tax and entire service sector was outside the tax net.
Initially service tax was levied on telephone services and general insurance. Over the
years more services have been added and the service tax rates have been raised to make
service sector a major contributor of revenue in the years to come.
Disinvestment:
To scale down and repay public debt, resources can be raised by sale proceeds by
adopting disinvestment programme of public enterprises. Under disinvestment the
government share in public enterprises is diluted through sale of their equity in the
market to private sector. Over the years public sector performance has dropped
substantially and they have proved as a drain on the exchequer and a burden on the
nation. There is growing need to recognize that privatizing public sector would be an
ideal way to make sure that the core of Indian industry grows, remain competitive, and is
enabled to compete internationally. It should also be ensured that returns from
privatization must be strictly used to retire public debt to enable a decrease in interest
burden. The proceeds from disinvestment must not be utilised to finance current
expenditure, as it would defeat the very logic of privatisation.

Expenditure Reforms and Management

Apart from augmenting public revenues, fiscal reforms aim at pruning public expenditure
through measures that reduce the growth rate of government’s non-productive expenses
such as administrative expenditure, wages and salaries of employees and unnecessary
expansion of manpower in government departments. All subsidies need to be reviewed
and cost-based user charges for public services, wherever feasible need to be imposed.
The main focus is on downsizing the government and streamlining administrative
structure. The Government has constituted Expenditure Reform Commission to study
areas of expenditure correction. These areas include minimization of cost of buffer stock
operations, rationalization of fertilizer subsidies, redeployment of surplus personnel in
various departments of government, and government maintained autonomous
organizations.
Public expenditure assumed significance as the mixed economy model adopted since
Independence was based on the fact that primary responsibility of building capital and
infrastructural base rested with the Government. Moreover since 1970s, issues of equity
and poverty alleviation, added another important dimension to public expenditure with
respect of redistribution of resources. The inadequate returns on huge capital outlays over
the years, and macroeconomic crisis of 1991 due to high fiscal imbalances led to a shift
in the focus from mere size to efficiency in public expenditure management. This was
done to facilitate adequate returns and restore macroeconomic stability. The cutbacks in
capital outlay for expenditure management in the first half of the 1990s, however, raised
issues over the inadequate infrastructural investment and the repercussions on the longterm
growth potential. During the latter half of 1990s, ever increasing Government
revenue expenditure was partly responsible for fiscal deterioration. With a renewed
commitment towards fiscal consolidation since 2003-04, there has been reprioritization
of expenditure. Now the guiding principles of public expenditure
management are emphasis of outcomes rather than outlays.
Along with emphasis on undertaking large-scale capital outlay, expenditure policy aimed
at promotion of equity and social justice by introducing social welfare and poverty
alleviation schemes. Rural development was to be attained with larger outlays and
increased lending by the newly nationalized banks. Several employment schemes were
launched and small-scale industry was given special privileges to create labour intensive
employment opportunities. Exchange control and industrial licensing were tightened
during this period.
Expenditure reforms under liberalization have two aspects:
ensuring consolidation to reduce the quantity of expenditure
introducing restructuring to change composition of government expenditure i.e.
shifting towards growth-inducing expenditure on infrastructure, human resource
development, and decrease in unwarranted subsidiesA viable expenditure control policy
should aim at:
adopting zero-based budgeting for all ongoing schemes
reassessing human resource requirements of government departments
reviewing subsidies to all sectors
introducing cost-based user charges for various activities
reviewing budgetary support to autonomous institutions
introducing greater commercialization of operations of public sector enterprises

Debt Reforms
Governments obtain money by incurring public debt when they raise public loans. Such
loans can be raised internally as domestic debt or externally as foreign debt.
Internal borrowings of Government are mainly required to meet budgetary deficit.
External borrowings assist in meeting deficit in balance of payments.
Public loans may be raised for short, medium or long terms to meet an economy’s
requirements of development. Long-term borrowing by a government are justified when
gains of a capital project undertaken by it are likely to be reaped in the long run i.e. by
more than one generation of taxpayers. The financing of such projects should place the
repayment burden on present as also the future generations. If long-term capital projects
are financed from current revenues or short-term borrowings, future generations would
enjoy free riding. Thus, it is fair and efficient, that projects with long-term benefits are
financed through long-term borrowings.
The mounting debt and debt-servicing liabilities of States have garnered considerable
attention in recent years. The non-Plan revenue gap of States is looked after by Finance
Commission while Planning Commission takes care of the Plan gap, both on revenue and
capital accounts. Some disturbing features of debt profile of States and its management
are:
diverting borrowed funds to meet revenue expenditure
using loans in unproductive enterprises, or enterprises while being productive
show signs of poor performance, and currently yield low or negative returns
lack of provisions for depreciation or amortization funds Debt-related relief to the States
may be provided in various forms, such as writeoffs, rescheduling of the loans to shift the
timing of repayments, consolidation of past loans on common terms, and reduction of interest
rate.

Fiscal Responsibility and Budget Management Act, 2003

In view of continuing deterioration in fiscal condition of the country, the FRBM bill was
passed by the Parliament in 2000 to create FRBM Act in August 2003. The FRBM Act aims
at making Central Government more responsible for achieving long-term macroeconomic
stability, through prudent fiscal management. Provisions of the Act seek to place limits on
government’s borrowings and recurring deficits, remove impediments in effective conduct of
monetary policy, and ensure prudential debt management. The Act aims at placing various
checks on unproductive governmental spending, curtailing revenue expenditure on
administration and other activities, while emphasizing on the need to create sufficient
revenue surpluses.

Kelkar Committee Report on Fiscal Reforms

The Government of India appointed a committee headed by Vijay Kelkar, to outline the
strategy to meet the fiscal objective of FRBM Act. The committee was officially named
‘The Task Force on Implementation of Fiscal Responsibility and Budget Management
Act 2004’. The recommendations of Kelkar Committee deal with a wide range of reforms
in direct taxes, indirect taxes, and government expenditure.
For direct taxes, the committee recommended some concessions in personal income tax
provisions with no tax was to be levied on income upto Rs. 1 lakh per annum; a tax rate
of 20% on income between Rs.1 lakh to 4 lakhs and a 30% tax on income above Rs. 4
lakh. There should be withdrawal of numerous exemptions such as those given on PPF,
post office saving schemes, and standard deduction given to salaried employees. It was
felt that the structure of exemptions needs to be removed in light of reduction in tax rates
in the last two decades. The gap between peak rate for personal income tax and corporate
tax needs to be removed. For corporate tax, it was suggested to reduce it from the present
level of 35.875% to 30%.
The major highlight of Kelkar Committee report was that it aimed at overhauling the
manner in which goods and services were taxed both at the Central and State levels.
Taking into consideration various distortions in existing indirect tax structure and flaws
in administration, Kelkar Committee proposed a single nationwide tax called Goods and
Service Tax (GST) to replace the Central Excise, Central Value Added Tax (Cenvat),
Central Service Tax, Central Sales Tax, and state taxes like state sales tax, electricity tax,
entry taxes, stamp duties, octroi etc. The committee proposed a standard central rate of 12%
(to replace cenvat of 16%) and a
standard state rate of 8% to make GST a 20% value added tax. The proposed rate is
comparable to standard VAT rates in developed countries.
For custom duties the committee proposed a substantial decrease in tariff rates. Recognizing
that industry needs to be competitive and have ASEAN level of tariffs, it was recommended
that a three tier custom duty structure of 5, 8 and 10% should be adopted. While there would
be loss of revenue but this change was considered necessary to remain competitive in the era
of globalization.
Kelkar Committee also proposed an expansion of tax base with fewer and lower taxes.
Tax procedures should be simplified and there should be a decrease in the cost of compliance.
It was believed that a high GDP growth rate adopted with a system that ensures better tax
compliance through incentives, facilities and reduced cost of compliance will raise tax
revenues.
This would ensure that an important objective of FRBM Act, ie, the centre’s revenue deficit
be eliminated by 2008-9, and the total borrowings are contained within 3% of the GDP.
Kelkar Committee also made suggestions for strengthening tax administration, identifying tax
evaders and evolving a taxpayer friendly system.