SOME IMPORTANT CONCEPTS

Part-1

Fiscal Policy

Fiscal policy is the use of government spending and taxation to influence the economy.
Governments typically use fiscal policy to promote strong and sustainable growth and reduce
poverty. The role and objectives of fiscal policy gained prominence during the global economic
crisis, when governments stepped in to support financial systems, jump-start growth, and mitigate
the impact of the crisis on vulnerable groups.

Before 1930, an approach of limited government, or laissez-faire, prevailed. With the stock market
crash and the Great Depression of 1930s, policymakers pushed for governments to play a more
proactive role in the economy. More recently, countries had scaled back the size and function of
government—with markets taking on an enhanced role in the allocation of goods and services—but
when the global financial crisis threatened worldwide recession, many countries returned to a more
active fiscal policy.

How Fiscal Policy is Implemented ?

Governments influence the economy by changing the level and types of taxes, the extent and
composition of spending, and the degree and form of borrowing.
Governments directly and indirectly influence the way resources are used in the economy. A basic
equation of national income accounting that measures the output of an economy—or gross domestic
product (GDP)—according to expenditures helps show how this happens:
GDP=C+I+G+NX
Where
GDP= Gross Domestic Product
C= Consumption
I= Investment
G= Government Expenditure
NX= Net Exports (Exports-Imports)

On the left side is GDP—the value of all final goods and services produced in the economy. On the
right side are the sources of aggregate spending or demand—private consumption (C), private
investment (I), purchases of goods and services by the government (G), and exports minus imports
(net exports, NX). This equation makes it evident that governments affect economic activity (GDP),
controlling G directly and influencing C, I, and NX indirectly, through changes in taxes, transfers,
and spending.

Types of Fiscal Policy

Fiscal policy that increases aggregate demand directly through an increase in government spending
is typically called expansionary or “loose.” By contrast, fiscal policy is often considered
contractionary or “tight” if it reduces demand via lower spending.

Objective of Fiscal Policy

Besides providing goods and services like public safety, highways, or primary education, fiscal
policy objectives vary. In the short term, governments may focus on macroeconomic stabilization—
for example, expanding spending or cutting taxes to stimulate an ailing economy, or slashing
spending or raising taxes to combat rising inflation or to help reduce external vulnerabilities. In the
longer term, the aim may be to foster sustainable growth or reduce poverty with actions on
the supply side to improve infrastructure or education.

Capital and Revenue Expenditure

Capital expenditures are for fixed assets, which are expected to be productive assets for a long

period of time. Revenue expenditures are for costs that are related to specific revenue transactions

or operating periods, such as the cost of goods sold or repairs and maintenance expense. Thus, the

differences between these two types of expenditures are as follows:

Timing. Capital expenditures are charged to expense gradually via depreciation, and over a long

period of time. Revenue expenditures are charged to expense in the current period, or shortly

thereafter.


Consumption. A capital expenditure is assumed to be consumed over the useful life of the related

fixed asset. A revenue expenditure is assumed to be consumed within a very short period of time.


Size. A more questionable difference is that capital expenditures tend to involve larger monetary

amounts than revenue expenditures. This is because an expenditure is only classified as a capital

expenditure if it exceeds a certain threshold value; if not, it is automatically designated as a revenue

expenditure. However, certain quite large expenditures can still be classified as revenue
expenditures, as long they are directly associated with revenue transactions or are period costs.


Plan and Non-Plan Expenditure

Plan expenditure refers to the estimated expenditure which is provided in the budget
to be incurred during the year on implementing various projects and programmes. So,
therefore, it represents current development and investment outlays that arises due to
the proposals in the current plan.

Non-Plan Expenditure refers to the estimated expenditure provided in the budget for
spending during the year on routine functioning of the government. It is all
expenditure other than plan expenditure.

Deficits

A deficit means an amount by which a sum falls short of some reference amount. Some type of
deficits are:

1. Revenue Deficit
A revenue deficit can be defined as the excess of revenue outflow over revenue receipts.In other
words, when the government tends to spend more on revenue expenditure than earn from its
revenue receipts, it is subjected to revenue deficit.
It can also be expressed as–

Revenue Deficit = Revenue Expenses – Revenue Receipts

Such a deficit also signifies that the government's earnings are not enough to keep the operations of

its departments and other services actively running. Furthermore, such a deficit leads to more

borrowing. Since loans have to be paid with interest, it further increases the bulk of revenue

expenditure. In turn, it leads to a greater revenue deficit and implies a repayment burden for the

future.
2. Fiscal Deficit
It can be described as the situation, wherein, a government's total expenditure exceeds its total
receipts, minus the borrowings within a financial year. It serves as a measure of the amount of
money that the government needs to borrow to meet its expenses, especially at a time when its
resources are insufficient. A higher fiscal deficit indicates that the government has to borrow a
substantial amount of money to meet its expenses.
It can also be expressed as-

Fiscal deficit = Total Expenditure – Total revenue (Excluding the borrowings)

Fiscal deficit tends to indicate the borrowing requirement of the government inclusive of loan
interest payment.

3. Primary Deficit
It is defined as fiscal deficit of a given year without the payment of interest on previous borrowings.
It indicates the borrowing requirement that excludes loan interest payment.

Primary deficit helps the government to figure out the amount of money they need to borrow to
meet all expenses other than loan interest payment. Notably, when this type of government deficit is
zero, it indicates that the government just needs to borrow an amount that would suffice to meet the
interest payment.
It can also be expressed as-

Primary Deficit = Fiscal Deficit – Loan Interest Payments

4. Effective Revenue Deficit

Effective Revenue deficit is a new term introduced in the Union Budget 2011-12. While revenue
deficit is the difference between revenue receipts and revenue expenditure, the present accounting
system includes all grants from the Union Government to the state governments/Union territories/
other bodies as revenue expenditure, even if they are used to create assets. Such assets created by
the sub-national governments/bodies are owned by them and not by the Union Government.
Nevertheless they do result in the creation of durable assets.

According to the Finance Ministry, such revenue expenditures contribute to the growth in the
economy and therefore, should not be treated as unproductive in nature. In the Union Budget
(2011-12) a new methodology has been introduced to capture the ‘effective revenue deficit’, which
excludes those revenue expenditures (or transfers) in the form of grants for creation of capital
assets.
So, effective revenue deficit can also be expressed as-

Effective Revenue Deficit= Revenue Deficit - Grant-in-aid for creation of capital assets

Grants for creation of capital assets, as a concept, was introduced in the FRBM Act through the
amendment in 2012. The Act defines grants for creation of capital assets as grants-in-aid given by
the Central Government to state governments, autonomous bodies, local bodies and other scheme
implementing agencies for creation of capital assets which are owned by these entities.

Homework : Read about the Impact of Fiscal Deficit on the economy