CLASS: XII

SECTION: CEF
SUBJECT: ECONOMICS
SESSION: 2022-23
UNIT: GOVERNMENT BUDGET AND THE ECONOMY
NOTES

Meaning and Objectives of Government Budget

Government Budget is a financial statement of budgetary receipts and budgetary expenditure of the government
during a fiscal year.

Objectives of Government Budget

1. Reallocation of resources
Reallocation of resources refers to redistribution of resources from one use to another. Government through its
budgetary policies tries to reallocate resources to ensure fulfillment of various socio-economic objectives. The
government may influence the allocation of resources through:

a) Taxation policy
a. Imposition of heavy taxes: Heavy taxes can be imposed on production units engaged in producing
harmful products like liquor, cigarettes, tobacco, etc. Thus, it discourages those occupations which are
not beneficial to the society by imposing taxes at higher rates.
b. Subsidies and Tax concessions: Subsides and tax concessions can be given to the private sector
industries to encourage production of those products which are beneficial to people. For example,
government can give subsidies and tax concessions to the enterprises who are willing to undertake
electricity generation, especially in backward areas. In this way, budgetary incentives (tax concessions,
subsidies, etc.) can be used to influence allocation of resources in the country.

b) Expenditure policy (Direct participation in production) There are many non-profitable economic activities which
are not undertaken by the private sector either due to lack of enough profits or due to huge investment
expenditure involved, e.g. water supply, sanitation, street lighting, maintaining law and order, national
defiance, government administration, measures to reduce air pollution, etc. These are called public goods.
Therefore, government can directly produce these goods and services in public interest in order to create social
welfare. For example, more expenditure by the government on maintaining law and order raises the sense of
security among the people. Any such expenditure raises welfare of the people.
2. Reduction in income inequalities or Redistribution of income
Inequalities of income and wealth reflect a section of society being deprived of even basic necessities. Thus, arises
the need for reducing income inequalities in the society, i.e. reducing the gap between rich and poor. Every
government tries to reduce inequality of income among masses so as to ensure progress of the people with lesser
monetary resources. Inequalities of income can be reduced either by rationalisation of taxation policy or regulating
the expenditure policy of the government or both.

a) Taxation policy (progressive income taxation)

The redistribution objective is sought to be achieved through progressive income taxation, in which higher the
income, higher is the tax rate. The government puts a higher rate of taxation on incomes of the rich people and
lower rates of taxation on lower income groups. This will reduce the inequalities of income as the difference
between personal disposable incomes of higher income and lower income groups will fall.

b) Expenditure policy (transfer payments and subsidies) The amount collected through taxes can be used by the
government for spending on welfare of the poor people. It can provide them transfer payments and subsidies.
For example:
i. Providing free services like education and health to the poor people.
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 ii. Providing essential items of food grains almost free to the families living below the poverty line.
iii. Free LPG kitchen gas connections and subsidized LPG gas to the families living below the poverty line.

Increased expenditure by the government on such transfer payments and subsidies will have twin effects:
First, it will increase their disposable income and thus will reduce the income inequalities, i.e., the gap between rich
and poor.
Secondly, spending on free services to the poor raises their standard of living and thus increases their welfare.

3. Economic stability or Price stability: Economic stability (or price stability) means absence of large-scale
fluctuations in general price level in the economy. Too much fluctuations in prices is not good for the economy as
they create uncertainties in the economy. Stability in price level in the country is necessary to create business
environment.
Government can exercise control over price fluctuations through its taxation policy and expenditure policy.

a) Under inflationary situations

Inflationary tendencies emerge due to aggregate demand being higher than aggregate supply under conditions
of high employment. Therefore, during periods of inflation government may discourage spending by increasing
taxes and reducing its own expenditure. This will decrease aggregate demand to correct inflationary situation. To
raise aggregate supply, tax concessions and subsidies for private sector enterprises can also be used by the
government.

b) Under deflationary situations

During periods of recession (or high rate of unemployment), government can reduce taxes to encourage
demand as well as increase its own expenditure. Government can also use subsidies to encourage spending by
people. It will increase the personal disposable income of people and thus, will raise the level of aggregate
demand. It will combat deflationary situation in the economy.

4. Economic growth
Economic growth implies a sustainable increase in real GDP of an economy, i.e., an increase in volume of goods and
services produced in an economy. Government budget can be an effective tool to ensure the economic growth in a
country.

a) Taxation policy and subsidies

If the government provides tax rebates and other budgetary incentives for productive ventures and projects, it
will stimulate savings and investments in the economy and thus, economic growth. For example, suppose the
government decides to give tax concessions (or tax rebates) and subsidies to investors for making investments in
backward regions. Tax concessions aim at reducing cost and thus, making profits. Similarly, subsidies aim at
reducing prices of products to encourage sales and earning more profits. Thus, tax concessions and subsidies
both aim at raising profits. When profits increase, savings and investment will also increase. It will lead to
economic growth.

b) Expenditure policy
Spending on infrastructure in the economy promotes the production activities across different sectors.
Government expenditure is a major factor that generates demand for different types of goods and services,
which induces economic growth in the country.
However, before planning such expenditure, tax rebates and subsidies, the government should check the rate of
inflation and tax rates. Also, there may be the risk of debt trap if loans are too high to finance the expenditure.

Components of Government Budget

Although the Government Budget relates to the budgetary receipts and budgetary expenditure of the government
for a particular financial year, the impact of it will be there in subsequent years. Therefore, there is a need to have
two accounts — the revenue account (also called revenue budget) and the capital account (also called capital
budget).
Revenue Budget: Those receipts and expenditure that relate to the current financial year only are included in the
revenue budget. Therefore, revenue budget includes both revenue receipts and revenue expenditure.
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Capital Budget: Those receipts and expenditure that concern the assets and liabilities of the government are
included in the capital budget. Therefore, capital budget includes both capital receipts and capital expenditure.
Thus, major components of Government Budget are:
(i) Revenue Receipts (ii) Capital Receipts
(iii) Revenue Expenditures (iv) Capital Expenditures

Capital Receipts
Capital receipts are those receipts of the government which either create a liability (e.g. borrowings) or lead to
reduction in assets (e.g. recovery of loans, sale of shares in Public Sector Undertakings, etc.).

Components of capital receipts are:

1. Debt creating capital receipts

Debt creating capital receipts are borrowings made by the government. When government takes fresh loans, these
loans will have to be returned and interest will have to be paid on these loans. So, borrowings are debt creating
capital receipts of the government. For example,

i. loans raised by the government from the public (called market borrowings),
ii. borrowing by the government from the Reserve Bank of India (RBI) and commercial banks and other
financial institutions through the sale of treasury bills,
iii. loans received from foreign monetary authorities and international organisations like IMF, etc.

2. Non-debt creating capital receipts

Non-debt creating capital receipts are those capital receipts which are not borrowings and therefore, do not give rise
to debt. For example,

i. Proceeds from sale of shares in Public Sector Undertakings (PSUs) (This is referred to as PSU disinvestment.)
ii. Recovery of loans

Revenue Receipts

Revenue receipts are those receipts of the government that neither create a liability nor lead to reduction in assets.
For example: income tax, profit of PSU, dividends, fees and fines etc.

Components of revenue receipts: Revenue receipts are divided into tax and non-tax revenues

1. Tax revenue

Tax revenue/tax receipt is the revenue earned by the government from taxes levied on income, wealth and
commodities. For example, corporation tax, personal income tax, excise tax, customs duties, etc.

Tax revenues are classified into direct and indirect taxes:

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 i. Direct taxes: Direct taxes are those taxes which cannot be shifted to the other person/entity. Their
monetary burden is borne by those on whom they are levied. A direct tax is collected directly from the
income earners. For example, personal income tax falls directly on individuals and corporation tax falls
directly on firms. The payer and bearer of a direct tax is the same person.
Other direct taxes include Interest tax, Wealth tax, Gift tax, Estate duty (now abolished), etc.
ii. Indirect taxes: Indirect taxes are those taxes which can be shifted to another person/entity. Their monetary
burden is ultimately borne by final users of goods and services, rather than the person on whom the tax is
levied. For example, Goods and services tax (GST), Entertainment tax, Sales tax, Excise tax, Customs duties,
Service tax, etc.

2. Non-tax revenues

Non-tax revenues/Non-tax receipts are the revenue earned by the government from sources other than taxes.
Examples:

i. Interest receipts on loans advanced by the Central Government

ii. Dividends and profits on investments made by the Central Government

iii. Fees and other receipts for services rendered by the government

iv. Cash grants in aid from foreign countries and international organisations.

Capital Expenditure
Capital expenditure is an expenditure of the Government which either leads to creation of assets (e.g. construction
of school buildings, hospitals, etc.) or reduces its liabilities (e.g. repayment of loans).

Examples:

i. Expenditure on the acquisition of land, building, machinery, equipment, etc.

ii. Investment in shares
iii. Loans and advances by the central government to state and union territory governments, PSUs and other
parties
iv. Construction of school buildings, hospitals, etc.
v. Repayment of loans

Revenue Expenditure
Revenue expenditure is that expenditure of the government that neither creates any asset nor reduces any liability.
Examples:

i. Interest payments on loans

ii. Grants given to state governments and other parties (even though some of the grants may be meant for
creation of assets).
iii. Defense services expenditure
iv. Salaries and pensions
v. Expenditure on education and health
vi. Subsidies

Measures of Government Deficit – Revenue Deficit, Fiscal Deficit and Primary Deficit

The government may spend an amount equal to the revenue it collects. This is known as a balanced budget. If it
needs to incur higher expenditure, it will have to raise the amount through taxes in order to keep the budget
balanced.

When tax collection exceeds the required expenditure, it is called a surplus budget.
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The most common feature of government budget is the situation when expenditure exceeds revenue. This is known
as a deficit budget.
When a government spends more than it collects by way of revenues, it incurs a budget deficit. More formally, it
refers to the excess of total expenditure (both revenue and capital) over total receipts (both revenue and capital).

There are various measures that capture government deficit and they have their own implications for the economy.

Table 4.1: The government budget of a hypothetical economy (2020-21)

Items (Rs in lakh crore)

1. Revenue Receipts (a + b) 70

(a) Tax revenue (net of states’ share) 60

(b) Non-tax revenue 10

2. Revenue Expenditure 100

(a) Interest payments 50

(b) Defense expenditure 20

(c) Other expenditures (salary, 30

subsidies, etc.)
30
3. Revenue Deficit (2 – 1)

4. Capital Receipts (a + b + c) 165

(a) Borrowings 120

(b) Recovery of loans 40

(c) Other receipts (mainly PSU 5

disinvestment)
135
5. Capital Expenditure
235
6. Total Expenditure (2 + 5)
120
7. Fiscal Deficit [4(a) = 6 – {1 + 4(b) + 4(c)}]
70
8. Primary Deficit [7 – 2(a)]

Revenue Deficit

Meaning

Revenue deficit refers to excess of government’s revenue expenditure over its revenue receipts.

Revenue deficit = Revenue expenditure – Revenue receipts

The revenue deficit indicates that the government will not be able to meet its revenue expenditure from its current
income (i.e., revenue receipts).

Implications

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When the government incurs a revenue deficit, it implies that the government is dissaving and is using up the savings
of the other sectors of the economy to finance a part of its consumption expenditure. This situation means that the
government will have to borrow not only to finance its investment but also its consumption requirements. This will
increase borrowings of the government and the burden of interest liabilities, and eventually force the government to
cut expenditure. Since a major part of revenue expenditure is committed expenditure (mainly interest payments and
defense expenditure), it cannot be reduced.

Often the government reduces productive capital expenditure, (e.g., expenditure on the acquisition of land, building,
machinery, equipment, etc.) or welfare expenditure (e.g. subsidies though underpricing of essential goods, and
services like education and health).

This would mean lower growth and adverse welfare implications.

Fiscal Deficit

Meaning
Fiscal deficit is the difference between the Government’s budgetary expenditure and its budgetary receipts
excluding borrowings.

Fiscal deficit = Total expenditure – Total receipts net of borrowings

Since total expenditure includes both revenue expenditure and capital expenditure, and total receipts net of
borrowings is the sum total of revenue receipts and non-debt creating capital receipts, therefore:

Fiscal deficit = (Revenue expenditure + Capital expenditure) - (Revenue receipts + Non-debt creating capital receipts)

Fiscal deficit indicates the total borrowing requirements of the government from all sources.

The fiscal deficit will have to be financed through borrowings. Therefore, Fiscal Deficit = Borrowings

From the financing side:

Fiscal Deficit = Net borrowing at home* + Borrowing from RBI + Borrowing from abroad

Thus, it indicates the total borrowing requirements of the government from all sources.

*Net borrowing at home includes that directly borrowed from the public through debt instruments ( for example, the
various small savings schemes) and indirectly from commercial banks through Statutory Liquidity Ratio (SLR).

Relationship between the revenue deficit and the fiscal deficit

Revenue deficit is a part of fiscal deficit.

Explanation:

Fiscal deficit = Total expenditure – Total receipts

excluding borrowings

= (Revenue expenditure + Capital expenditure) – (Revenue receipts + Non-debt creating capital receipts)

= (Revenue expenditure – Revenue receipts) + Capital expenditure – Non- debt creating capital receipts

= Revenue deficit + Capital expenditure – Non-debt creating capital receipts

Clearly, revenue deficit is a part of fiscal deficit. Thus, a large share of revenue deficit in fiscal deficit indicates that a
large part of borrowings is being used to meet the government’s consumption expenditure needs rather than
investment.

Implications of Fiscal Deficit

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 1. A large fiscal deficit means large number of borrowings. This creates a large burden of interest payment and
repayment of loans in the future.
2. Fiscal deficit equals borrowings of the government. Such borrowings are generally financed by issuing new
currency which may lead to inflation. However, if the borrowings are for infrastructural development this
may lead to capacity building and may not be inflationary.

Thus, fiscal deficit is a key variable in judging the financial health of the public sector and the stability of the
economy.

Primary Deficit

Meaning

Primary deficit is the difference between fiscal deficit and the interest payments made by the government.

Primary deficit = Fiscal deficit – Interest payments

Implications
 Primary deficit indicates borrowing requirements of the government other than to make interest payments
on past debts.

Explanation: Fiscal deficit is nothing but total borrowings of the government during the current year. Total
borrowings also include borrowing on account of interest payments. Therefore, out of total borrowings requirement
(i.e., fiscal deficit) if we deduct borrowing on account of interest payments, we get the primary deficit, which
indicates borrowing requirements of the government other than to make interest payments.

Thus, Fiscal Deficit = Primary Deficit + Interest Payments

 If primary deficit in a government budget is zero, it means fiscal deficit is equal to interest payment.
Explanation: Primary deficit = Fiscal deficit – Interest payments

If primary deficit is zero, then

0 = Fiscal deficit – Interest payments

⇒ Fiscal deficit = Interest payments

It implies that the government has to borrow only on account of interest payments.

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