MACROECONOMICS

END TERM PAPER

Fiscal Policies and Current Accounts

in India

ABSTRACT

This paper examines the relationship between Fiscal policy and the Current account in the Indian
scenario. To highlight the post liberalization period, we have drawn from the data of the last two
decades (1992-2010) and have used multiple regression for our analysis. We have found that
changes in fiscal policy are indeed associated with changes in the current account, but the
relationship is far less than one-for-one. Considering Merchandise and Invisibles as the main
constituents of Current Account, we have analyzed their relationship with Total Tax, Revenue
expenditure and Capital expenditure.

Submitted by:
Group 11
Section C

Harsh Agarwal (2010139)

Madhumitha J (2010147)
Pankaj Arora (2010153)
Praveen Trivedi (2010156)
Sneha Hingorani (2010170)
Tirtheshwar Banerjee (2010173)
1|Fiscal policy and current account

CONTENTS
Table of Contents..................................................................................................................................................1

Fiscal Policy Parameters........................................................................................................................................3

1. Taxes..............................................................................................................................................................3
a) Direct taxes................................................................................................................................................3
b) Indirect taxes.............................................................................................................................................3
2. Expenditure...................................................................................................................................................4
a) Revenue expenditure.................................................................................................................................4
b) Capital Expenditure...................................................................................................................................5
c) Subsidies....................................................................................................................................................5

Current Accounts...................................................................................................................................................6
1. Merchandize Trade Account..........................................................................................................................6
2. Invisibles Account..........................................................................................................................................6
a) Services......................................................................................................................................................6
b) Investment Income....................................................................................................................................6
c) Transfer Payments.....................................................................................................................................7

Theoretical Studies................................................................................................................................................8
1. Direct impact through demand..................................................................................................................8
2. Impact through the real exchange rate.....................................................................................................8
3. Impact on interest rates and country risk premia......................................................................................8
1. Merchandise Account..................................................................................................................................11
2. Invisible Account..........................................................................................................................................12

Conclusion...........................................................................................................................................................14

Appendix.............................................................................................................................................................15
2|Fiscal policy and current account

References...........................................................................................................................................................21
3|Fiscal policy and current account

INTROD
N
The relationship between fiscal policy and the current account has long attracted interest among
academic economists and policymakers alike, from various angles. For many countries where current
account imbalances are especially large, a relevant question has been to what extent fiscal adjustment
can contribute to resolving external imbalances. Going forward, the implications of fiscal stimulus
first, and fiscal adjustment later, for current account developments will no doubt continue to generate
interest in the context of returning the global economy to strong, sustainable, and balanced growths as
the effects of the 2008–09 crises gradually abate.[CITATION Abb10 \l 1033 ]

This paper analyses the relationship between fiscal policy and the current account in India. We tried to
come up with some relationships between different parameters of fiscal and current account. The first
surge in India’s economic growth rate came in the early 1980s, when it increased to above 5% from
the average “Hindu” growth rate of 3.5% in earlier decades. Unfortunately, this spurt was achieved by
unsustainable fiscal expansion financed by domestic credit and external borrowing. Growth
accelerated to 5.8% during the 1980s, but in the second half of the decade, fiscal and current account
deficits widened significantly, causing serious macroeconomic imbalances and culminating in the
balance of payment (BOP) crisis of 1991. These triggered the series of economic reforms that have
been introduced, starting in 1991, to bring about macroeconomic stabilization and implement structural
measures to push up growth.[ CITATION htt102 \l 1033 ]

So in our analysis we have considered data for the last two decades, which reflects the post
liberalization trajectory of the country. Using the statistical technique of multiple regressions, we have
analyzed the relationship between fiscal policy and the current account.
4|Fiscal policy and current account

PARAMETERS
1. TAXES
To tax (from the Latin taxo; "I estimate") is to impose a financial charge or other levy upon a taxpayer
(an individual or legal entity) by a state or the functional equivalent of a state such that failure to pay is
punishable by law.

Taxes are also imposed by many subnational entities. Taxes consist of direct tax or indirect tax, and
may be paid in money or as its labour equivalent (often but not always unpaid labour). A tax may be
defined as a "pecuniary burden laid upon individuals or property owners to support the government a
payment exacted by legislative authority." A tax "is not a voluntary payment or donation, but an
enforced contribution, exacted pursuant to legislative authority" and is "any contribution imposed by
government whether under the name of toll, tribute, tallage, gabel, impost, duty, custom, excise,
subsidy, aid, supply, or other name."

a) Direct taxes
In the general sense, a direct tax is one paid directly to the government by the persons (juristic
or natural) on whom it is imposed (often accompanied by a tax return filed by the taxpayer).
Examples include some income taxes, some corporate taxes, and transfer taxes such as estate
(inheritance) tax and gift tax. In this sense, a direct tax is contrasted with an indirect tax or
"collected" tax (such as sales tax or value added tax (VAT)); a "collected" tax is one which is
collected by intermediaries who turn over the proceeds to the government and file the related
tax return. Some commentators have argued that "a direct tax is one that cannot be shifted by
the taxpayer to someone else, whereas an indirect tax can be."

b) Indirect taxes
The term indirect tax has more than one meaning.

In the colloquial sense, an indirect tax (such as sales tax, a specific tax [a tax per unit], value
added tax (VAT), or goods and services tax (GST)) is a tax collected by an intermediary (such
as a retail store) from the person who bears the ultimate economic burden of the tax (such as
5|Fiscal policy and current account

the customer). The intermediary later files a tax return and forwards the tax proceeds to
government with the return. In this sense, the term indirect tax is contrasted with a direct tax
which is collected directly by government from the persons (legal or natural) on which it is
imposed.

An indirect tax may increase the price of a good so that consumers are actually paying the tax
by paying more for the products. Examples would be fuel, liquor, and cigarette taxes. An excise
duty on motor cars is paid in the first instance by the manufacturer of the cars; ultimately the
manufacturer transfers the burden of this duty to the buyer of the car in form of a higher price.
Thus, an indirect tax is such which can be shifted or passed on.

2. EXPENDITURE
Government spending or government expenditure is classified by economists into three main types.
Government acquisition of goods and services for current use to directly satisfy individual or collective
needs of the members of the community is classed as government final consumption expenditure.
Government acquisition of goods and services intended to create future benefits, such as infrastructure
investment or research spending, is classed as government investment (gross fixed capital formation),
which usually is the largest part of the government gross capital formation. Acquisition of goods and
services is made through own production by the government (using the government's labour force,
fixed assets and purchased goods and services for intermediate consumption) or through purchases of
goods and services from market producers. Government expenditures that are not acquisition of goods
and services, and instead just represent transfers of money, such as social security payments, are called
transfer payments. Government spending can be financed by seignior age, taxes, or government
borrowing.

a) Revenue expenditure
Revenue expenditure is the reserve of money used by an establishment to develop or raise
physical assets like equipment, industrial buildings or properties. The operations of an
establishment include everything from constructing structures to repairing parts of the building.
Revenue expenditure is beneficial for the current business year.

Any business establishment incurs an appreciable number of expenses to steadily maintain its
business operations. There are two broad categories of business expenditure a company can
incur. The first category of business expenditure comprises items incurred for running everyday
6|Fiscal policy and current account

operations of the establishment. The second category of expenditure comprises assets bought
by the company. This results in increased productivity and enhanced efficiency of the
establishment.

b) Capital Expenditure
It is the fund used by an establishment to produce physical assets like property, equipment or
industrial buildings. Capital expenditure is made by the establishment to consistently maintain
the operational activities.

Comparison: Revenue expenditure and capital expenditure - Capital expenditure results the
increase or acquirement of an asset, whereas revenue expenditure is necessary for the
sustenance of earning capacity.

c) Subsidies
A subsidy, often viewed as the converse of a tax, is an instrument of fiscal policy. Derived from
the Latin word ‘subsidium’, a subsidy literally implies coming to assistance from behind.
However, their beneficial potential is at its best when they are transparent, well targeted, and
suitably designed for practical implementation.

Like indirect taxes, they can alter relative prices and budget constraints and thereby affect
decisions concerning production, consumption and allocation of resources. Subsidies in areas
such as education, health and environment at times merit justification on grounds that their
benefits are spread well beyond the immediate recipients, and are shared by the population at
large, present and future. For many other subsidies, however the case is not so clear-cut.
Arising due to extensive governmental participation in a variety of economic activities, there
are many subsidies that shelter inefficiencies or are of doubtful distributional credentials.
[ CITATION htt101 \l 1033 ]
7|Fiscal policy and current account

ACCOUNTS
Current account is one of the two primary components of the balance of payments, the other being the
capital account. The current account is the sum of the merchandize trade account and
services/invisibles account. A deficit on current account means that the county’s receipt of foreign
currencies on account of trade and invisibles has been less than its payments.[ CITATION htt10 \l 1033 ]

1. MERCHANDIZE TRADE ACCOUNT

Merchandize Trade Account is a record of all international transactions for goods only in a year.
Goods include physical items like autos, steel, food, clothes, appliances, furniture, etc. The difference
between total receipts on account of exports of goods and total payments on account of imports of
goods is called balance of trade. However, these receipts and payments are not necessarily in country’s
own currency. Besides, receipts and payments on account of trade of goods, some other receipts and
payments also take place between countries. Exports and imports of goods are also called transactions
of visible items or merchandise.

2. INVISIBLES ACCOUNT
Services are a part of invisibles. These include shipping, banking, insurance and consultancy services,
foreign travel, investment income, transfer payments etc.

a) Services
These services like banking, insurance, shipping and consultancy services etc. are provided by
one country to the other countries. When a country gets such services from other countries, it is
called import of services for which payments in foreign currencies are made. When a country
provides these services to other countries, it is called exports of services for which it gets
payments in foreign currencies.

b) Investment Income
8|Fiscal policy and current account

A country may receive interests on loans given to other countries. It may also receive dividends
on investments made by its people in other countries. These receipts are also in foreign
currencies. Similarly payments of interest and dividends on loans and investments by people of
other countries result in outflow of foreign currencies.

c) Transfer Payments
People of a country may receive gifts etc. from their friends and relatives living abroad. These
are called ‘unilateral transfers’. Similarly people of a country may be sending gifts to their
relatives and friends. Thus such transfer payments also result in inflow and outflow of foreign
currencies.[ CITATION htt10 \l 1033 ]
9|Fiscal policy and current account

STUDIES
The major factors through which fiscal policy affects the current account include the following:
1. Direct impact through demand : The way in which fiscal policy can affect the external
account is through changes in the government’s consumption or investment demand for tradable
goods. As Government often accounts for a large part of domestic demand, so that, depending on
the import propensity, shifts in the government import demand function translate into movements
in the trade balance. A fiscal expansion, whether implemented through a tax reduction or spending
increase, will tend to increase demand (including for imports) and the trade deficit.[CITATION
Abb10 \l 1033 ]

2. Impact through the real exchange rate : Fiscal policy can also affect the current account by
altering the real exchange rate. Increased government spending on non-tradable (such as the
services or real estate sectors) can lead to appreciation, which in turn can tilt private consumption
toward, and production away from, tradable.[ CITATION Abb10 \l 1033 ]

3. Impact on interest rates and country risk premia : Fiscal tightening can reduce interest
rates, including on external debt, thereby improving the current account balance. At the same time,
lower risk can also increase capital inflows, which can boost demand and real appreciation
pressures and eventually worsen the current account (expansionary fiscal contractions).
Conversely, fiscal expansions that are deemed unsustainable can generate capital flight and force
a rapid external account adjustment.

The relative strength of these mechanisms, and thus the net impact of fiscal policy on the current
account, is determined by model assumptions. In practice, it will depend of country characteristics. For
example, in a small emerging market, the current account impact of a fiscal consolidation may well be
adverse if the capital inflow response to a declining risk premium outweighs any direct demand
contraction effects. In a large economy, a fiscal expansion may induce a private sector response that
often combines a real depreciation (effected, possibly, by firms reducing mark-ups to try and gain
10 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

market share) and rising consumption demand, so that the impact on the trade balance is difficult to
predict.

S
We used the data from last 20 years of different parameters involved in fiscal policy and net current
balance and use multiple linear regression methodology

The equation to calculate Net Current Account is as:-

NCA = -68444.6 + -1.066 Td+ 0.90 Ti + -0.419 Rex + 0.853 Cex + 0.700 S

Here

NCA – Net Current Account

Td - Direct Tax

Ti - Indirect tax

Rex - Revenue Expenditure

Cex - Capital Expenditure

S - Subsidy

But when we look up at correlation between different independent variables, we found that Revenue-
expenditure (Rex) and subsidy(S); and indirect (Ti) and direct taxes (Td) are highly correlated. In such
case there will be error in distinguishing the independent effect of each variable.

Figure No.1
11 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Also we have observed that subsidy is not significant variable in estimating the net current account (as
p=.525 >> .05).

Figure No.2

Hence we ignored the subsidy variable and used total tax variable combining direct and indirect
variable.

Improved equation –

NCA = -12573.3 -.074 T + 0.212 Rex+ 1.292 Cex

Here T – Total Tax

12 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Figure No.3

We found that Total tax variable is lesser significant variable in determining Net capital account.

Now we studied the impact of fiscal policy variables on major ingredients (Merchandise and Invisible
account) of net current balance.

1. MERCHANDISE ACCOUNT
In the case of Merchandise as a dependent variable, we have the following independent variables:-

i) Capital Expenditure.
ii) Revenue Expenditure.
iii) Total Tax.

The R-square value of this analysis comes out to be 96.2%. This means that the change in Dependent
variable (which is Total Merchandise in this case) can be determined by the independent variable to an
extent of 96.2%
13 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Figure No.4

Equation is –

MA = 32160 -.481 T - 0.264 Rex+ 1.579 Cex

Here

MA – Merchandise Account

The findings from the analysis are that Total Tax and capital expenditure are most critical in
determining the Total Merchandise value. Moreover, following conclusions can be drawn:-

If Total tax increases by 1%, then total merchandise value decreases by 0.481%.

If Revenue Expenditure increases by 1%, then total merchandise decreases by 0.264%.

If Capital expenditure increases by 1%, then total merchandise increases by 1.579%.

2. INVISIBLE ACCOUNT
In the case of Invisible output as a dependent variable, we have the following independent variables:-

i. Capital Expenditure.
ii. Revenue Expenditure.
iii. Total Tax.

The R-square value of this analysis comes out to be 98.3%. This means that the change in total
Invisible account can be determined by the independent variable to an extent of 98.3%.

The findings from the analysis are that Total Tax is the most critical in determining the Total Invisible
Output. However we can also take Capital expenditure into consideration as it has 76% accuracy.
14 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Figure No.5

Equation is –

IA = -44733.9 + .407 T + 0.052 Rex – 0.287 Cex

Here IA – Invisible Account

Moreover, following conclusions can be drawn:-

i) If Total tax increases by 1%, then total invisible output increases by 0.407%.

ii) If Revenue Expenditure increases by 1%, then total invisible account increases by 0.052%.

III) If Capital expenditure increases by 1%, then total invisible account decreases by 0.287%.
15 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

The study has analysed the relationship between fiscal policy and the current account. Its contribution
consists of the breadth of its empirical investigation, in terms of regression technique and collection of
data of last two decades. In a simple analysis of episodes of large adjustment in the current account and
fiscal policy, we have found that the association between fiscal policy and the emergence or unwinding
of large external imbalances is limited. Changes in fiscal policy are indeed associated with changes in
the current account, but the relationship is far less than one-for-one.

Further, while analysing the significance of the tax revenue and government expenditure on the current
account balance of India, we found that Tax, which constitutes direct and indirect tax, as a whole has
very less significance in determining the change in the total current account of India but when we
decompose the constituents of current account as merchandise account and invisible account and find
the significance of tax in determining them, we find it to be substantial. This implies the fact that the
impact of tax on two components of current account tend to nullify the effect of each other when
considered collectively.

Also, we found that total Tax and capital expenditure are most critical in determining the Total
Merchandise value. The effect on current account by merchandise is as If Total tax increases by 1%,
total merchandise value decreases by 0.481%, if Capital expenditure increases by 1%, total
merchandise increases by 1.579%. In determining the Total Invisible account, Total Tax is the most
critical. However we can also take Capital expenditure into consideration as it has 76% significance.
The effect on current account by invisibles is as if Total tax increases by 1%, total invisible account
increases by 0.407%, if Capital expenditure increases by 1%, then invisible output decreases by
0.287%.
 16 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

X
Exhibit – 1: data from last 20 years of different parameters involved in fiscal policy and net current balance

TAX EXPENSE NET CURRENT ACCOUNT

Revenue Total
Direct Indirect Tax Merchan Invisibl Service Transfe Current
Year Expenditu Capital Subsidy Exp Income
Taxes Taxes Revenues dise es s rs Account
re
1990-91 14267 73297 87564 73516 31782 12158 105298 -16933 -433 1761 4539 -6733 -17366
1991-92 19047 83627 102674 82292 29122 12253 111414 -6494 4259 3133 10522 -9396 -2235
1992-93 22485 92007 114492 92702 29916 10824 122618 -17239 4475 2698 12280 -10503 -12764
1993-94 25310 96407 121718 108169 33684 11605 141853 -12723 9089 1677 17670 -10258 -3634
1994-95 33868 112418 146286 122112 38627 11854 160739 -28419 17836 1883 26726 -10773 -10583
1995-96 41476 131264 172741 139861 38414 12666 178275 -38061 18415 -702 29833 -10716 -19646
1996-97 47179 150126 197305 158933 42074 15499 201007 -52561 36279 2621 45425 -11767 -16282
1997-98 54626 159746 214371 180335 51718 18540 232053 -57805 36922 4943 45183 -13204 -20883
1998-99 57253 172727 229980 216461 62878 23593 279340 -55478 38689 9114 44542 -14967 -16789
1999-00 70937 200607 271544 249078 48975 24487 298053 -77359 57028 17670 54789 -15431 -20331
2000-01 80755 220218 300973 277839 47753 26838 325592 -56737 45139 7905 59967 -22733 -11598
2001-02 82506 226441 308947 301468 60842 31210 362310 -54955 71381 15889 75560 -20068 16426
2002-03 100799 252101 352900 338713 74535 43533 413248 -51697 82357 17644 81403 -16690 30660
2003-04 125186 282912 408097 362074 109129 44323 471203 -63386 127369 46381 101696 -20708 63983
2004-05 156146 329229 485375 384329 113923 45957 498252 -151765 139591 68831 93135 -22375 -12174
2005-06 195412 381184 576596 439761 66362 47520 506123 -229664 185927 102611 109432 -26116 -43737
2006-07 267771 456252 724023 514609 68778 57125 583387 -279962 235579 133064 135749 -33234 -44383
2007-08 355607 521889 877496 594433 118238 70926 712671 -367664 304185 156244 168452 -20511 -63479
2008-09 393125 576723 969848 793798 90158 129708 883956 -543158 411544 228309 204338 -21103 -131614
2009-10 423683 602777 1026460 906355 115192 131025 1021547 -555659 374901 162525 247365 -34989 -180757
 17 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Exhibit-2: Tax and current account

1200000

1000000

800000
Direct Taxes
600000
Indirect
Taxes
400000 Tax
Revenues
Amount (in200000
thousand crores)
Merchandis
0 e
0 5 10 15 20 Invisibles25
-200000 Services
YEARS  Transfers
-400000 Income

-600000

-800000
 18 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Exhibit-3: Government Expenditure and current account

120

100
Revenue
80 Expendit
ure
60 Capital
Subsidy
40 Total
Exp
Amount (in thousand crores)
20 Merchan
dise
Invisibles
0
0 5 10 15 20 25 Services
-20 Transfers
Income
-40 Current
Account
-60

-80
 19 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Exhibit-4: Fiscal deficit and Current Account

600000

400000

200000
Fiscal deficit
Amount (in thousand crores) Merchandise
0 Invisibles
0 5 10 15 20 25 Services
-200000 Transfers
YEARS  Income
Current Account
-400000

-600000

-800000
20 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Exhibit 5: Indian government expenditure

Year Revenue   of which   Capital Loans Capital of which Total

  expenditure Defence Interest Subsidies expenditure and outlay Defence expenditure

  expenditure payments   advances   expenditure

        (7+8)     (2+6)
1982-83 18742 4494 3938 2262 12049 7384 4665 527 30791
1983-84 22251 5189 4795 2902 13283 8053 5230 642 35534
1984-85 27691 6324 5974 4038 15941 9194 6747 737 43632
1985-86 33924 7021 7512 4796 18742 11087 7655 967 52666
1986-87 40860 9179 9246 5451 22056 12797 9259 1298 62916
1987-88 46174 8861 11251 5980 22087 12793 9294 3107 68261
1988-89 54106 9558 14278 7732 25005 14750 10255 3783 79111
1989-90 64210 10194 17757 10474 28698 16890 11808 4222 92908
1990-91 73516 10874 21498 12158 31782 19652 12130 4552 105298
1991-92 82292 11442 26596 12253 29122 17723 11399 4905 111414
1992-93 92702 12109 31075 10824 29916 16297 13619 5473 122618
1993-94 108169 14978 36741 11605 33684 20454 13230 6867 141853
1994-95 122112 16426 44060 11854 38627 23736 14891 6819 160739
1995-96 139861 18841 50045 12666 38414 24316 14099 8015 178275
1996-97 158933 20997 59478 15499 42074 27878 14196 8508 201007
1997-98 180335 26174 65637 18540 51718 34193 17526 9104 232053
1998-99 216461 29861 77882 23593 62878 44037 18841 10036 279340
1999-00 249078 35216 90249 24487 48975 24938 24037 11855 298053
2000-01 277839 37238 99314 26838 47753 23008 24745 12384 325592
2001-02 301468 38059 107460 31210 60842 34284 26558 16207 362310
2002-03 338713 40709 117804 43533 74535 * 31668 29101 14953 413248
2003-04 362074 43203 124088 44323 109129 * 28768 34150 16863 471203
2004-05 384329 43862 126934 45957 113923 * 28910 52338 31994 498252
2005-06 439761 48211 132630 47520 66362 11337 55025 32338 506123
2006-07 506767 51542 146192 53463 74870 9706 65164 34458 581637
RE

2007-08 557900 54078 158995 54330 82621@ 7498 75123@ 41922 640521@
BE

[ CITATION htt103 \l 1033 ]

21 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

Exhibit 6: Indian Current Account data

[ CITATION htt103 \l 1033 ]

22 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

S
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