Fiscal Policy

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 FISCAL POLICY

Submitted By:

Name Roll No
Jinal Chheda 16
Archana Ingrulkar 30
Sunita Pakhare 35

Submitted To: Ms.Sudha P.

Batch: GLC – HR

Institute of Technology and Management,

Kharghar, Navi Mumbai,
September, 2007

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 ACKNOWLEDGEMENT

We forward a great thanks to our faculty of economics Ms.Sudha for

assigning us this project to us. It has helped us greatly in broadening our
mind & knowledge in the subject. We also thank our library staff for
providing with the required data. We look forward for the same support in
the future from all of them.

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 INDEX

Sr.Nos. Contents

1. INTRODUCTION TO FISCAL POLICY

a. Objectives
b. Role of fiscal policy

2. INSTRUMENTS

a. Budget
b. Taxation
c. Public Expenditure
d. Government Borrowing
e. Deficit Financing

3. DISCRETIONARY FISCAL POLICY

a. Fiscal Policy to cure recession

b. Fiscal Policy to Control inflation

4. NON DISCRETIONARY FISCAL POLICY

5. EFFECTIVENESS OF FISCAL POLICY

6. FISCAL DEFICIT FOR PAST TEN YEARS

7. LIMITATIONS OF FISCAL POLICY

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Introduction
The most important instrument of government intervention in the country is that of Fiscal or
Budgetary policy. Fiscal policy refers to the taxation, expenditure and borrowing by the government.
The economists now hold the government intervention through Fiscal policy is essential in the matter
of overcoming recession or inflation as well as of promoting and accelerating economic growth,
which monetary policy will not hold alone. There is no doubt that the government budgetary or fiscal
policy must be sound, keeping in view the needs and requirements of a developing economy.
In short we can say that, it is a part of government policy, which is concerned with raising revenue
through taxation and other means and deciding on the level and pattern of expenditure.
The main problem faced by the capitalist economies instability prevailing in them. This instability
is reflected in the periodic occurrence of trade cycles, which are a general phenomenon in the free
market capitalist economies. During a recession or depression fiscal policy should help in increasing
demand.

Overview of Fiscal Policy

Economic Reforms have yielded credible gains in the external and monetary sector. Since the early
1990s. Inflation has climbed down from a peak of 17 per cent in August 1991 to about 5 per cent now.
The economy has grown at an average of over 6 per cent p.a. In a major structural change in the
economy, the share of the services sector continues to grow steadily. Tax reforms during this period
have laid the foundation of a robust, expanding tax base. Out of our total external debt of nearly US $
112 billion, only about 5 per cent is short-term debt. Gradual and cautious liberalization of the capital
account has sought to control short-term capital inflows and keep the maturity profile, end-use etc.
within prudential norms. These are very impressive achievements. Stability has been achieved in the
external sector and the central bank can now conduct autonomous monetary policy. However,
continued fiscal deficits are restraining the economy from realizing its full potential to grow and in
providing quality infrastructure, both physical and social, that can meet the growing needs of a
resurgent economy.

Objectives of Fiscal Policy in Developing Countries

In developing countries, taxation, the government expenditure, taxation and borrowing have to play
a very important role in accelerating economic development. Fiscal policy is a powerful instrument in
the hands of the government by means of which it can achieve the objectives of development. There
are several peculiar characteristics of a developing country, which necessitate the adoption of a specific
fiscal policy, which ensures a rapid economic growth. There are vast and diverse resources human and
material, which are lying underutilized. Such countries have weak infrastructure, i.e. they lack
adequate means of transport and communications, road ports, highway, irrigation and power and
technical know-how. Their population increasing at an explosive rate, which necessitates rapid
economic development to, met the requirements of the rapidly- growing population.

In order to overcome these handicaps, a suitable fiscal and taxation policy is called.

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 The principal objectives of fiscal policy in a developing economy are.

 To mobilize resources for economic growth, especially for the public sector.
 To promote economic growth in the private sector by providing incentives to save and
invest.
 To restrain inflationary forces in the economic in order to ensure price stability.
 To ensure equitable distribution of income and wealth so that fruits of economic growth are
fairly distributed.

ROLE OF FISCAL POLICY

In recent weeks, a number of signs have appeared suggesting that the recovery of the U.S.
economy from the recent recession is on a bumpy path. During the second quarter of 2002, real GDP
grew at an anemic annual rate of barely over 1%, well below market expectations. Unemployment,
after rising throughout 2001, has leveled off but has yet to show signs of declining. Adding some
gloom to the general outlook, the stock market continued to drop through most of July and has
remained volatile. This sluggish economic performance comes despite substantial stimulus from both
monetary and fiscal policy. Since January 2001, the Federal Reserve has reduced its benchmark policy
interest rate, the federal funds rate, from 6.52% in September 2000 to a current level of 1.75%. Fiscal
policy also has become more expansionary. The federal government budget has swung from a surplus
of $236 billion in 2000 (2.5% of GDP) to a projected 2002 deficit of $157 billion (1.5% of GDP) as the
government has increased expenditures and reduced taxes. This active use of fiscal policy during a
recession is somewhat unusual. During the last U.S. recession, in 1990, then President George H.W.
Bush resisted attempts to use fiscal policy to stimulate the economy. In fact, his Council of Economic
Advisers, in their February 1992 report, argued that increases in fiscal expenditures or reductions in
taxes might hamper the economy’s recovery. In contrast, during the current recession, both Congress
and the President have supported increases in expenditures and tax cuts as ways to stimulate economic
growth, culminating in the passage of the Economic Recovery Act in March 2002.The current
recession and the 1990–1991 recession offer contrasting examples of the use of fiscal policy, and they
also highlight some elements of the longstanding debate in economics over whether fiscal policy can
play a useful role in combating business cycle downturns. This Economic Letter discusses some of the
issues involved in using fiscal policy to help stabilize short-run fluctuations in the economy.

In developing economies, the government has to play a very active role in promoting economic
development and fiscal policy is the instrument that the state must see. Hence the great importance of
public finance in underdeveloped countries desirous of rapid economic development. In a democratic
society, there is an inherent dislike for direct control regulation by the state. The entrepreneur would
not like to be ordered about to produce this or that, how much to produce or where to produce. Fiscal
incentives in the form of tax concessions, rebates or subside are, therefore, preferable. Similarly, the
consumers would not like to be told directly to curtail their consumptions or to consume this and not to
consume that. Taxation of articles whose consumptions is to be discouraged is therefore preferable.
Hence, a democratic state must rely on indirect methods of control and regulation and this is doing
through fiscal and monetary policies. Thus in democratic countries, fiscal policy is a powerful and least
undesirable weapon on which the states can rely for promoting economic development.

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 INSTRUMENTS OF FISCAL POLICY

I. BUDGET:-

Keeping budget in balance, in surplus or deficit, is in itself a fiscal instrument. When the
government keeps its total expenditure equal to its revenue, as a matter of policy, it means it has
adopted a balanced budget policy. When the government spends more than its expected revenue, as a
matter of policy, it is pursuing a deficit-budget policy. And when the government follows a policy of
keeping its expenditure substantially below its current revenue, it is following a surplus budget policy.

Provisions of FRBMA
The 2004-05 budget is claimed to have adequate provisions to achieve fiscal correction mandated
in the Fiscal Responsibility and Budget Management Act 2003 (FRBM) through enhancement of
revenue and reduction of revenue expenditure.

The main provisions of the FRBM Act in its original form were:

 Revenue deficit as a ratio of GDP should be brought down by 0.5 per cent every year and
eliminated by 2007-08;
 The fiscal deficit as a ratio of GDP should be reduced by 0.3 per cent every year and brought
down to 3 per cent by 2007-08;
 The total liabilities of the Union Government should not rise by more than 9 per cent a year;
 The Union Government shall not give guarantee to loans raised by PSUs and State
governments for more than 0.5 per cent of GDP in the aggregate;

Further, the Union Government should place three documents along with the budget, namely,
the Macroeconomic Framework Statement, the Medium Term Fiscal Policy Statement and the
Fiscal Policy Strategy Statement. In addition, the Finance Minister will have to make a statement at
the end of the second quarter on the trend of fiscal indicators and corrective measures if they
deviate from the budget estimates beyond the extent stipulated in the FRBM.

Revenue Deficit and Fiscal Responsibility and Budget Management Act (FRBMA)

Revenue deficit is the difference between the revenue expenditure and the revenue receipts (the
recurring income for the government). When a country runs a revenue deficit it means that the
government is unable to meet its running expenses from its recurring income.

The FRBMA was notified on July 2, 2004 and came into force on July 5, 2004. This Act requires
the reduction of fiscal deficit and elimination of revenue deficit by March 31, 2009. The idea seems to
be that deficit, if any, should be used to finance capital expenditure that leads to asset formation and
not on revenue expenditure, the benefits of which do not go beyond that particular year.

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 For the year 2005-06, Finance Minister P Chidambaram has chosen to overlook the requirements of
FRBMA. The fiscal deficit for the year has been budgeted at 4.5 per cent of the estimated GDP,

this will be 0.1 per cent less than the required reduction. The revenue deficit target for the year
2005-06, if FRBMA requirements were followed, it had to be at 1.8 per cent of the GDP. But it has
been budgeted at 2.7 per cent of the GDP.

Given the strong growth experienced by the Indian economy better progress could have been made
on this front. One reason for ignoring FRBMA for this year is the fact that the government has
increased grants to the states in line with the recommendations of the Twelfth Finance Commission.

The government might miss its revenue deficit target of 2.7 per cent of the GDP in the coming year
on account of a likely undershooting of tax revenue collections, as highly optimistic assumptions of tax
revenue growth have been made. This would lead to the budgeted fiscal deficit also shooting up.

II.TAXATION

A tax is a non quid pro quo payment by the people to the government. By this definition, taxation
means non quid pro quo transfer of private income to public coffers by means of taxes.

Taxation takes many forms in the developed countries including taxation of personal and corporate
income, so-called value added taxation and the collection of royalties or taxes on specific sets of
goods. Government may want to smooth out the nation's income in order to minimize the pejorative
effects of the business cycle or they may want to take steps designed to increase the national income.
They may also want to take steps intended to achieve specific social objectives deemed to be
appropriate by the political or legal process.

Sound tax system, with moderate rates and a broad base, is an integral part of the prudent fiscal
policy. The expansion in the tax base is sought to be achieved through expansion in the scope of taxes,
specifically service tax, removal of exemptions and improvement in tax administration. With a decline
in non-tax revenue receipts as a proportion of overall revenue receipts, the burden of fiscal corrections
is expected to be mainly on tax revenues. However, the measures to increase the tax-GDP ratio must be
harmonized with the overall growth objective. The strategy seeks to increase tax compliance, improve
the efficiency of tax administration and with intense focus on recovery of arrears of tax revenues and
prevent further build-up of such arrears.

Agricultural taxation: This economic surplus mainly goes to rich farmers, landlords, intermediaries
in the absence of suitable taxation on agriculture. It has potential surplus & to achieve maximum
utilization of land through devising a system of land taxation which would penalize poor use of good
land.

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 Tax Reforms
In August 1991, the Government of India constituted a Tax Reforms Committee (TRC) to
recommend a comprehensive reform of both direct & indirect tax laws.

Following measures were taken to increase collection of income tax:

1. Historically, rates of income tax in India have been quite high, almost punitive. E.g. In 1973-94,
the maximum marginal rate of individual income tax was as high as 97.7%. This proved to be counter
productive. The income tax slabs were reduced & the rates themselves have been scaled down.
1. Prior to assessment year 93-94, taxation of partnership differed according to whether the firm
was registered or not under the I.T. Act, which was drastically modified through Finance Act,
92.
2. Tax rates for domestic companies have been reduced from 40% to 30%. The tax rate on foreign
companies has also been reduced from 55% to 40%.
3. The basic exemption limits for individuals & HUF have been reduced.
4. Dematerialization of TDS certificates will be made effective from 1.4.2008.
5. Scheme for submission of returns through Tax Return Preparers has been introduced.
6. Special tax benefits have been allowed to power sector, SEZs & shipping industries.

Indirect Tax Reforms:

1. Reducing peak rate of custom duties.
2. Rectifying anomalies like inverted duty structure.
3. Rationalising excise duties with a movement towards a median CENVAT
4. Introduction of state – level VAT for achieving a non-cascading, self-enforcing & harmonized
commodity taxation regime.
5. Introducing innovative financing mechanism like creation of a special purpose vehicle for
infrastructure projects.
6. Widening of service tax base and increase in compliance continues to show high buoyancy in
service tax revenue collection during 2006-07 also.

Fiscal policy also changes the burden of future taxes. When the government runs an expansionary
fiscal policy, it adds to its stock of debt. Because the government will have to pay interest on this debt
(or repay it) in future years, expansionary fiscal policy today imposes an additional burden on future
taxpayers. Just as taxes can be used to redistribute income between different classes, the government
can run surpluses or deficits in order to redistribute income between different generations.

Some economists have argued that this effect of fiscal policy on future taxes will lead consumers to
change their saving. Recognizing that a tax cut today means higher taxes in the future, the argument
goes; people will simply save the value of the tax cut they receive now in order to pay those future
taxes. The extreme of this argument, known as Ricardian Equivalence, holds that tax cuts will have no
effect on national saving, since changes in private saving will offset changes in government saving.
But if consumers decide to spend some of the extra disposable income they receive from a tax cut
(because they are myopic about future tax payments, for example), then Ricardian Equivalence will not
hold; a tax cut will lower national saving and raise aggregate demand. The experience of the eighties,
when private saving fell rather than rose in response to tax cuts, is evidence against Ricardian
Equivalence.

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 III.PUBLIC EXPENDITURE

Does increased government expenditure necessarily lead to a greater fiscal deficit?

Not necessarily. Suppose the government spends more on an electricity project for which the
contract is given to a PSU like BHEL. Then the money that the government spends comes back to it in
the form of BHEL's earnings. Similarly, suppose that the government spends on food-for-work
programmes, and then a significant part of the expenditure allocation would consist of food grain from
the Public Distribution System which would account for part of the wages of workers employed in
such schemes. This in turn means that the losses of the Food Corporation of India (which also includes
the cost of holding stocks) would go down and hence the money would find its way back to the
government. In both cases, the increased expenditure has further multiplier effects because of the
subsequent spending of those whose incomes go up because of the initial expenditure. The overall rise
in economic activity in turn means that the government’s tax revenues also increase. Therefore there is
no increase in the fiscal deficit in such cases.

Is it a Good Idea to Reduce Fiscal Deficits through Disinvestment?

No. The PSUs that the government has been disinvesting in are the profit making ones. Thus, while
the government earns a lump-sum amount in one year, it loses the profits that the PSU would have
contributed to the exchequer in the future. Therefore, it is not a good idea even if the objective is to
reduce the fiscal deficit.

The expenditure of the government can be classified into plan expenditure and non-plan
expenditure. Plan expenditure is an expenditure that the government plans to incur on a scheme to be
implemented in a given year. For example, in the year 2003-04 (as per the revised estimates for that
year), the government had allocated Rs 2588.62 crore (Rs 25.886 billion) for construction of national
highways.

Non-plan expenditure is defined as expenditure committed by the expenditure. Interest payments,

pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure. Non-plan
expenditure is generally an outcome of plan expenditure. For example, the national highways the
government constructed in the year 2003-04 and before need to be maintained. All the expenses going
towards this is treated as non-plan expenditure.Expenditure on both plan and non-plan front can be
categorised into capital and revenue expenditure. Capital expenditure includes that expenditure which
leads to creation of assets whereas revenue expenditure does not involve asset creation and is recurring
in nature.

The construction of the national highways in the year 2004-05 would involve expenditure on
aggregate, bitumen or cement (depending upon the nature of the road) and certain machinery. This
expenditure would be classified as capital expenditure. The labour charges would be classified as
revenue expenditure. Once the plan expenditure is over the maintenance of the road would start. The
expenditure on this would be non-plan and can be further categorized into non-plan capital expenditure
and non-plan revenue expenditure.

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 The government wants to invest in infrastructure, power, primary education, health and water
supply to put India on the fast track to growth. But it simply doesn't have the money to implement its
strategy. The deficit is essentially servicing current consumption and not financing capital investment,
which should be the case. The current situation leads to a very interesting conclusion. We all know that
deficit financing involves the government financing its excess expenditure over revenue through
borrowing.Conventional wisdom tells us that money that is borrowed needs to be invested in areas
where the return generated is greater than interest to be paid on the debt (i.e. the return generated
should be greater than the cost of capital). But the government cannot always work with the profit
motive in mind. The government is not earning enough to pay back the interest on its debt. So what is
it doing? It is taking in more debt to repay its earlier debt and the interest that is to be paid on the
existing debt. Not a healthy sign one must say.

Government is keen that the funds reach the ultimate beneficiaries as speedily as possible rather
than remaining in the pipeline with the long chain of intermediaries, including State Governments.
While the House approves the expenditures for specified objectives, there is avoidable delay in
meeting those objectives. The Government has tightened the fiscal discipline in this regard. The
Ministries have been advised to keep a close watch on the position of unspent balances available with
the State Governments and implementing agencies, and insist upon furnishing of utilization certificates
for funds released earlier, wherever due under the Rules, before releasing more funds.

In a bid to improve transparency and accountability, Ministries/Departments are expected to release

a summary of their monthly receipts and expenditure to general public (through their website, etc.) and
in particular, disclose scheme – wise funds released to different States.

IV. GOVERNMENT BORROWING:

Government borrowing is another fiscal Method by which savings of the community may be
mobilized for economic development. In developing economies, the government resort to borrowing in
order to finances schemes of economic development. Government or what is also called public
borrowing becomes necessary because taxation alone cannot provide sufficient funds for economic
development. Besides, too heavy taxation has an adverse effect on private saving and investment.

Government borrowing takes 2 forms: (a) market loans and (b) small savings. In case of market
borrowing the government sells to the public, negotiable government securities of varying terms and
duration and treasury bills for financing capital project long-term government bounds are floated in the
capital market. This form of public borrowing is more important for mobilizing resources for
development. The treasury bills, which represent short-term, borrowing, are intended to meet only the
current government expenditure. New bonds may be issued for meeting old maturing bonds. The small
saving represented public borrowing which are not negotiable and are bought and sold in the capital
market. For mobilizing small savings, various types of saving certificates are issued, e.g., National
Savings certificates, national Developments certificates, Rural development Bonds, Postal certificates
and Postal Accounts, Compulsory Deposits, etc. A widespread campaign is necessary to attract small
saving.

Borrowing is the quickest Mode of raising funds: -Tax finance is not so expeditious because
passing of tax laws, assessment of taxes based on those laws and their collections involves
considerable delay. Besides, public debt does not involve any burden if it is devoted productive works.
The subscribers to Government loans are able to find remunerative investment whereas the
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government can pay the principal and interest out of the income yielded by investment finance from
loans. Thus public borrowing is not only necessary but also desirable.
There is another advantage in Government Borrowing. Government borrowing is anti-inflationary.
The underdeveloped countries are victims of inflation since they have to resort to deficit financing for
finding funds for economic development. Since deficit financing is inflationary, public borrowing is
preferable to deficit financing. Public borrowing mops up the surplus purchasing power with the
people. If thus checks consumption and so a rise in prices. At the same time idle balances are absorbed
in productive activity.
Borrowing is resorted to meet the uncovered gap between total expenditure and total non-debt
receipts of the Central Government. Central Government policy towards borrowing to finance its fiscal
deficit places greater reliance on domestic market borrowings over external debt. Thus, the
Government finances major part of its deficit through resources raised at market determined interest
rates. Central Government is taking several steps to moderate the carrying cost of debt and clean-up its
debt/liability portfolio. Debt restructuring measures along with the policy of fiscal rectitude as
prescribed under FRBMA is expected to moderate the overall public debt burden.
Public borrowing generates additional productive capacity; the funds raised by public borrowing
can be utilized for building up economic infrastructure for economy through schemes for the
development of irrigation, transport, power and communication. They can help also in building up of
the agricultural and industrial base of the economy. Therefore public borrowing plays a very important
role in accelerating economic development of underdeveloped economies. Public debt promotes saving
and investment, the two most crucial determinants of economic growth.

Some of the obstacles:

The success of borrowing policy in developing countries, like there are no organized money and
capital markets and in those where such markets exist, they constitute a very a small proportion of total
money market of the country.

Moreover the resources of the organized money market may be too inadequate to fulfill the needs
both of the private and public sectors. In the financial market the competition for funds between the
government and private sector will raise rate of interest and this will have a highly distinctive effect on
the expansion of investment in the private sector. In India the rates of interest on loans of government
have been raised quite substantially. Since banks and others prefer to invest in government securities
because they are safe (i.e., risk less). This has reduced the fund for private investment.
It is necessary that financial institution be developed and extended into rural areas of the economy
in order to inculcate the habit of thrift in he population and to mobilize for productive purposes the
amount of savings originating in this sector. Besides, for the mobilisation of savings it will be
necessary to check and regulate the diversion of savings into unproductive investment such as real
estate, gold and jewelry and inventory accumulation.
Suitable techniques of borrowing must also be devised. Bonds issued by government should be
adjusted to the preferences of the general public; bonds of large denomination and long maturity may
be offered to the institutional investors.

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 V.DEFICIT FINANCING

Deficit financing refers to “created money”, i.e., creation of additions purchasing power in the
form of currency notes. According to the Indian planning commission, deficit financing is equal to the
net increase in the purchasing power of the economy arising out of the operations of the government.
Deficit financing is said to have been practiced whenever government expenditure exceeds the
government receipts from the public, etc. such an excess of expenditure is financed by borrowing from
the Central Bank.
When Government borrows from central bank which is a note-issuing authority, the Central
bank simply issues more notes and gives them to the Government against Government securities. Thus
in the last analysis deficit financing means the creation of new currency. It may be noted that in India
Net Bank Credit from RBI by the central Government is called Deficit Financing. In fact when central
government borrows from RBI and the latter issues new currency it is called monetization of
government debt. It is the monetization of debt that lead to the expansion in money supply due to
Government’s fiscal deficit that was earlier called deficit financing. However, in the modern
terminology it is now called monetization of fiscal deficit.

NEED FOR DEFICIT FINANCING:

The developing countries keen to promote rapid economic growth, the resources required for
development far exceeds the amount which can be raised by normal means of resource mobilization,
viz., taxation, borrowing, surpluses from public enterprises, etc. the uncovered gap is made up by
deficit financing. Rapid economic development can be achieved only by setting up the rats of
investment. But wherefrom are the developing countries to raise the additional resources? In the
absence of sufficient foreign aid forthcoming from friendly countries and international organizations,
the additional funds must come from domestic resources. For this purpose voluntary savings must be

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stepped up. These savings are then mopped up through national small savings schemes to add to
resources available to the government.

Fiscal Policy Can Be Divided In Two Types.

FISCAL
POLICY

Discretionary Non-Discretionary
policy Policy

To cure Recession To Control Inflation Personal Income

taxes

Increase in Govt Raising Taxes to Transfer Payments

Expenditure Control Inflation

Reduction of taxes Disposing of Budget Corporate Income

Surplus taxes

Corporate Dividend
policy

I) DISCRETIONARY FISCAL POLICY FOR STABILISATION

Fiscal policy is an important instrument to stabilises the economy, that is, to overcome recession
and control inflation in the economy. By discretionary policy we mean deliberate change in the
Government expenditure and taxes to influence the level of national output and prices. Fiscal policy
generally aims at managing aggregate demand for goods and services. To cure recession expansionary
fiscal policy and to control inflation contractionary fiscal policy is adopted.

A) Fiscal Policy to cure recession:

The recession occurs when aggregate demand decreases due to fall in private investment. Private
investment may fall when businessmen become highly pessimistic about making profits in future,
resulting in decline in marginal efficiency of investment. A fall in private investment expenditure,
aggregate demand curve shifts down creating a deflationary or recessionary gap.
There 2 fiscal methods to get the economy out of recession.
 Increase in Government Expenditure.

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  Reduction of taxes.

i) Increase in Government Expenditure to Cure Recession: This is the important tool to cure
depression. Government may increases expenditure by starting public works, such as buildings roads,
dams, ports telecommunication links, irrigation works electrification of new areas etc. Government
buys various types of goods and materials and employs workers. The effect of this increase in
expenditure is both direct and indirect. The direct effect is the increase in incomes of those who sell
materials and supply labour for these projects. The output of these public works also goes up together
with the increase in incomes, and for those who get more income they spend further on consumer
goods depending on their marginal propensity to consumer. This creates the multiplier. As during the
period of recession there exists excess capacity in the consumer good industries, the increase in
demand for them bring about expansion in their output which further generates employment and
incomes for the unemployed workers and so the new income are spent and serpent further and the
process of multiplier goes on working till it exhausts itself.
How large should be the increase in expenditure so that equilibrium is established at full
employment or potential level of output. This depends on magnitude of GNP gap caused by
deflationary gap on the one hand and the size of multiplier depends on the marginal propensity to
consume. The impact of increase in government expenditure in a recessionary condition is illustrated in
the following figure. Suppose to begin with economy is operating at full-employment or potential level
of output YF with aggregate demand curve C+I2+G2 intersecting 45o line at point E2 .Now due to some
adverse happening (say due to the crash in the stock market), investor’s expectations of making profits
form investment projects become dim causing a decline in investment. With the decline in investment,
say equal to E2B, aggregate demand curve will shift down to new position C+I1+G1 that will bring the
economy to the new equilibrium position at point E1 and thereby determine Y1 level of output or
income. The fall in output will create involuntary unemployment of labour and also excess capacity
(i.e. idle capacity stock) will come to exist in the economy. Thus emergence of deflationary gap equal
to E2B and the reverse working of the multiplier has brought about conditions of recession if the
government increases its expenditure by E1H, the aggregate demand curve will shift upward to original
position C+I2+G2 and as a result the equilibrium level of income will increase to the full employment
or potential level of output Yf and in this way the economy would be lifted out of depression.

45o

E C+I2+G2
X E2
P
E H C+I1+G1
N
D
I Deflationary Gap
T
U
R E1
E
Y= G 1
Potential
45 0
output 1-MPC

Y1 YF

NATIONAL INCOME

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 ii) Reduction in Taxes to Overcome Recession: The reduction in taxes increases the disposable
income of the society and causes the increase in consumption spending by the people. If tax reduction
of Rs.200 crores is made by the Finance Minister, it will lead to Rs.1520 crores in consumption,
assuming marginal propensity t6o consume is 0.75 or ¾. Thus reduction in taxes will cause an upward
shift in the consumption function. It is worth nothing that reduction in taxes has only an indirect effect
on expansion and output through causing a rise in consumption function. Like the increase in
government expenditure, the increase in the consumption achieved through reduction in tax will have a
multiple effect on increasing income, output and employment.
Example: -There is some instances in history of capitalist world, especially USA when taxes were
reduced to stimulate the economic. In 1964,the President Kennedy reduce personal and business tax by
about $12 billion to give a boost to the American economy when there was high unemployment and
lower capacity utilization in American economy. This tax cut was quiet successful in reducing
unemployment substantially at expanding national Income through full utilization of excess capacity.
Again, over the period 1981-84, president Reagan made a very large tax reduction to get out of
recession and to achieve expansion in National Income to reduce unemployment. However, tax
reduction by President Reagan play a significant role for bringing about the recovery.

B) Fiscal Policy to Control inflation: When due to large increases in consumption demand
by the households or investment expenditure by the entrepreneurs, or biggest budget deficit caused by
too large an increase in Government Expenditure, aggregate demand increases beyond what the
economy can potentially produce by fully employing its given resources, it gives rise to the situation of
excess demand which results in inflationary pressures in the economy. This inflationary situation can
also arise if too large an increase in money supply in the economy occurs. In these circumstances
inflationary gap occurs which tend to bring about rise in prices. If to check the emergence of successful
steps exceeds demands or close the inflationary gap are not taken, the economy will experience a
period a period of inflation or rising prices. For the last few decades, both the developed and
developing countries of the world have faced problems of demand-pull inflation. Both have faced an
alternative way of looking at inflation is to view it from the angles of business cycles. After recovery
from recession, when during upswing an economy finds itself in conditions of boom and become
overheated prices start rising rapidly. Under such circumstances anti cyclical fiscal policy calls for
reduction in aggregate demand. Thus fiscal policy measures to control inflation are

1) Reducing Government expenditure and;

2) Increasing taxes.
If in the beginning the government is having balanced budget, then increasing taxes
while keeping government expenditure constant will yield budget surplus. The creation of budget
surplus will cause downward shift in aggregate demand curve and will therefore help in easing
pressure on prices. If there is a balanced budget to begin with and the government reduces its
expenditure, say on defense, subsidies transfer payments, while keeping taxes constant, this will also
create budget surplus and result in removing excess demand in the economy.

i) Raising Taxes to Control Inflation: As an alternative to reduction in Government expenditure,

the taxes can be increased to reduce aggregate demand .For these purpose especially personal direct
taxes such as income tax, wealth tax, corporate tax can be raised. The hike in taxes reduces the
disposable in the comes of the people and thereby force them to reduce their consumption demand
ii) Disposal of Budget Surplus: the government either reduces its expenditure or raises taxes to
lower aggregate demand for goods and services. Reduction in expenditure or hike in taxes results in
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decrease in budget deficits {if occurring before such step} or in the emergency of the budge serapes if
the government was having balances budget prior to the adoption of anti-inflationary fiscal policy
measures. Assume that anti-inflationary fiscal policy results in budget surplus. Anti-inflationary impact
of budget surplus depends to a good extent on hoe the government disposes of this budget surplus.

There are two ways in which budget surplus can be disposed of: -

1) Reducing Or Retiring Public Debt: The budget surplus created by Anti-inflationary policy can
be use by the government pay back the outstanding debt. However, using budget surplus for retiring
public debt will weaken its anti-inflationary effect. In plying of the debt of held by the public the
government will be returning the money to the public which it has collected through taxes. Further, this
will also add to the money supply with public. General public will spend a part of the money so
received, which will raise consumption demand. Beside, retiring of public debt will result in the
expansion of money supply in the money market, which will tend to lower the rate of interest. The
lower rate of interest will stimulate consumption and investment demand while anti-inflationary policy
requires that they should be reduced.
2) Impounding Public Debt: - To realize a large anti-inflationary effect of budget surplus it is
desirable to impound the surplus fund. The impounding surplus fund means that they should be kept
idle. Thus by impounding the budget surplus, the government shall be withdrawing some income or
purchasing power from the income-expenditure stream and thus will not create any inflationary
pressure to offset the deflationary impact of the budget. To conclude, the impounding of the budget
surplus is the better method of disposing of budget surplus than of paying of public debt.

II) NON_DISCRETIONARY FISCAL POLICY: AUTOMATIC STABILIZERS

There is an alternative to use of discretionary fiscal policy, which generally involves the
problem of, large in recognizing the problem of recession or inflation and large of the taking
appropriate action to tackle the problem. In this Non-discretionary fiscal policy, the tax structure and
expenditure are so designed that taxes and government spending vary automatically inappropriate
direction with the changes in National Income. That is, these taxes and expenditure pattern without any
special deliberate action by the government and parliament automatically raise aggregate demand in
times of recession and reduce aggregate demand in times of boom and inflation and there by help in
insuring economic stability. These fiscal measures are therefore called automatic stabilizers or built-in
stabilizers. Since these automatic stabilizers do not require any fresh deliberate policy action or
legislation by the government, they represent non-discretionary fiscal policy. Built-in-stability of tax
revenue and government expenditure of transfer payment of subsidies is created because they vary
with national income. These taxes and expenditure automatically bring about appropriate change in
aggregate demand and reduce the impact to recession and inflation that might occur in an economy at
sometimes. This means that because of existence of this automatic or built-in-stabilizers recession and
inflation will be shorter and less intense than otherwise is the case. Important automatic fiscal stabilises
compensation, welfare benefits corporate dividends.

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  Below are some taxes and revenue from which varies directly with the change in
national income:

1) Personal Income Taxes: -The tax rate structure is so designed that revenue from these taxes
directly varies with income. Moreover, personal income taxes have progressive rates: The higher rates
are changed are from the upper income brackets. As a result, when national income increases during
expansion and inflation, increasing percentage op the people’s income is paid to the government. Thus,
through causing a decline in their disposable income this taxes automatically reduce people’s
consumption and therefore aggregate demand. This decline n aggregate demand because of imposition
of progressive personal income tax tender’s to check inflation from becoming more severe. On the
other hand, when national income decline’s at times of recession, the tax revenue declines as well
which prevent aggregate demand from falling by same proportion as the decline in income.

2) Corporate Income Taxes: -Companies, or corporations as they are called now, also pay a
percentage of their profits as tax to the Government. Like personal income taxes, corporate income tax
rate is also generally higher at higher levels of corporate profits. As recession and inflation affect
corporate taxes greatly, they have a powerful stabilizing effect on aggregate demand; the revenue from
them rises greatly during inflation and boom which tends to reduce aggregate demand, and revenue
from them falls greatly during recession which tends to offset the decline in aggregate.

3) Transfer payments: Unemployment compensation and welfare benefits: When there is recession
and as a result unemployment increases, the Government has to spend more on compensation for
unemployment and other welfare programmes such as food stamps, rent-subsidies to farmers. This hike
in Government expenditures tends to make recession short-lived and less intense. On the other hand,
when at times of boom and inflation national income increases and therefore unemployment falls, the
government curtails its programme of social benefit, which result in lowering government expenditure.
The smaller spending by the government help to control inflation.

4 ) Corporate Dividend Policy: With economic fluctuation, corporate profits also rise and fall.
However, corporations do not so quickly increase or reduce dividend in turn with fluctuation in profits
and follow a fairly stable dividend policy. This permit the individuals to spend more during recession
and spend less then would have the case if dividends were lowered in time of recession and raised in
condition of boom and inflation. Thus, fairly stable dividends tend to cushion recession and curb
inflation by sabilising consumption.

EFFECTIVENESS OF FISCAL POLICY

The critics of Keynesians theory has pointed out that expansionary effect of fiscal policy is not as
larger as Keynesians economists suggest. In Keynesians theory it is asserted that the Government
increases its expenditure, without raising its taxes or when it reduces taxes without changing
expenditure it will have a large expansionary effect of national income. In other words deficit budget
would lead to the large increase in aggregate demand and thereby help to expand national output and
income. However it has been pointed that the above analysis of the effect expansionary fiscal policy of
budget deficit ignores the effect of increase in government expenditure or budget deficit on private
investment. It has been argued that the increase in government expenditure or creation of budget deficit
adversely affects private investment which offsets to a good extent the expansionary affects of budget
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deficit. This adverse effect comes about as increase in Government expenditure or reduction in taxes
causes rate of interest to go up. There are two ways in which rise in rate of interest is explained.
First, within the framework of Keynesian theory increase in government expenditure leads to the
rise in the national output which raises the transaction demand for money. Given the supply of money
in the economy, the increase in transactions demand for money will cause the rate of interest to go up.
Secondly, in order to finance its budget deficit the government will borrow funds from the market.
This will raise the demand for the loanable funds which will bring about rise in the rate of interest.

Whatever the mechanism the budget deficit or increase in Government expenditure to achieve
expansion in national income and output will cause the rate of interest to go up. The rise in the rate of
interest will discourage private investment. As we know from the theory of investment, at a higher rate
of interest, private investment declines. Thus, increase in government expenditure or fiscal policy of
budget deficit crowds out private investment. This fall in private investment as a result of the rise in
rate of interest will be quiet substantial and will greatly offset the expansionary effect of the increase in
the government expenditure. On the contrary, if investment demand is relatively inelastic, the rise in
rate of interest will lead to only a small decline in private investment and therefore crowding out effect
will be relatively small.

Differences in the Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession (when business and consumer confidence is very low and
perhaps where deflationary pressures are taking hold) monetary policy may be ineffective in increasing
current national spending and income. The problems experienced by the Japanese in trying to stimulate
their economy through a zero-interest rate policy might be mentioned here. In this case, fiscal policy
might be more effective in stimulating demand. Other economists disagree – they argue that short term
changes in monetary policy do impact quite quickly and strongly on consumer and business behavior.
Consider the way in which domestic demand in both the United States and the UK has responded to
the interest rate cuts introduced in the wake of the terror attacks on the USA in the autumn of 2001

However, there may be factors which make fiscal policy ineffective aside from the usual crowding
out phenomena. Future-oriented consumption theories hold that individuals undo government fiscal
policy through changes in their own behavior – for example, if government spending and borrowing

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rises, people may expect an increase in the tax burden in future years, and therefore increase their
current savings in anticipation of this.

CHART SHOWING PRIMARY, REVENUE AND FISCAL DEFICIT

FOR 10 YEARS

The FRBM Rules envisage an annual reduction of at least 0.3 percentage points in fiscal deficit and
0.5 percentage points in revenue deficit. In BE 2006-07, Government had projected Revenue Deficit to
be at 2.1 per cent of GDP i.e., 0.5 percentage points lower than the BE 2005-06. The Revenue Deficit
estimates have shown improvement at 2.0 per cent of GDP at RE 2006-07. Similarly, Fiscal Deficit,
which was budgeted to decline from 4.3 per cent of GDP in BE 2005-06 to 3.8 per cent of GDP in BE
2006-07 has shown further improvement at 3.7 per cent of GDP in RE 2006-07. This improvement has
been possible due to high economic growth, increased revenues and prudent expenditure management
practices.

FISCAL INDICATORS – ROLLING TARGETS AS A PERCENTAGE OF GDP

(AT CURRENT MARKET PRICES)

Revised Estimates Budget Estimates Targets for Targets for

2006-07 2007-08 2008-09 2009-10
Revenue Deficit 2.0 1.5 0.0 0.0
Fiscal Deficit 3.7 3.3 3.0 3.0

Gross Tax 11.4 11.8 12.3 12.7

Revenue
Total outstanding 64.4 61.4 58.6 56.0
liabilities
at the end of the
year

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 FISCAL DEFICIT AND INTERNAL DEBT

TABLE 17
TRENDS IN FISCAL DEFICITS
Gross
Fiscal Fiscal Revenue Revenue Primary Primary
Year Deficit Deficit as Deficit Deficit as Deficit Deficit as
% of % of % of
(Rs. crs) GDP (Rs. crs) GDP (Rs. crs) GDP
1996-97 56242 4.1 32654 2.4 -3236 -0.2
1997-98 73204 4.8 46449 3.1 7567 0.5
1998-99 89560 5.1 66976 3.8 11678 0.7
1999-00 104717 5.3 67596 3.5 14468 0.7
2000-01 118816 5.6 85234 4.0 19502 0.9
2001-02 140955 6.2 100162 4.4 33495 1.5
2002-03 145072 5.9 107880 4.4 27268 1.1
2003-04 123272 4.5 98262 3.6 -816 0.0

2004-05 125202 4.0 78338 2.5 -1732 -0.1

2005-06 (RE) 146175 4.1 91821 2.6 16143 0.5

2006-07 (BE) 148686 3.8 84727 2.1 8863 0.2

2006-07
(Provisional up to 108201 - 84483 - 20258 -
November)
RE= Revised Estimates BE= Budget Estimates

Source: Ministry of Finance and Controller General of Accounts..

TABLE 18

DEBT POSITION OF THE CENTRE (INTERNAL DEBT)

Amount Outstanding at the end of March (Rs. crores)
2000- 2001-
DEBT 01 02 2002-03 2003-04 2004-05 2005-06 2006-07
(RE) (BE)
Internal debt 80369 102068 127597
(Total) 8 913061 9 1141706 1 1355943 1522031
I) Market 42879
Loans 3 516517 619105 707965 758995 867368 984645
37490
II) Others 5 396544 401584 433741 516976 488575 537386
As % of GDP 38.1 40.0 41.7 41.4 40.7 39.9 38.9

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RE= Revised Estimates BE= Budget Estimates

Source: Ministry of Finance and RBI

Limitations of fiscal policy

1. Formulation of an appropriate fiscal policy requires reliable forecasting of the target variables,
like GNP, consumption, investment and its determinants, technological changes, and so on. But
no one has yet discovered a foolproof method of economic forecasting.’
2. The Overall effect of changes in the policy instruments, like, changes in government spending
and taxation is determined by the rate of dynamic multiplier. Forecasting the multiplier is in
itself an extremely difficult task and a time consuming process. Therefore, by the time the full
impact of one policy change is realized, economic conditions change necessitating another
change in the fiscal policy.
3. A decision and execution lag in case of discretionary fiscal policy makes both working and
efficacy of fiscal policy shrouded with uncertainty.
4. Working and effectiveness of fiscal policy in underdeveloped countries is severely limited by a)
low levels of income, b) small proportion of population in taxable income groups, c) existence
of large non - monetized sector, d) all pervasive corruption and inefficiency in administration,
especially in tax collection machinery.
5. Countries which are excessively dependent on fiscal policy for their economic management,
the governments are often forced to have recourse to internal and external borrowings and
deficit financing. Excessive borrowings take such countries close to debt trap and deficit
financing beyond the absorption capacity of the economy accelerates the pace of inflation,
which further creates other control problems.

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 BIBLIOGRAPHY

1. Macroeconomics Theory and policy – H.L. Ahuja

2. Macroeconomics Theory and policy – D.N. Dwivedi
3. Budget news – 1st March 2007
4. Ministry of Finance and RBI

REFERENCE:

1. Budget news.
2. www.indiabudget.nic.in
3. www.google.com

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