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Public Finance

Study Material > Economics

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. Government adjusts its level of revenue and spending in order to monitor and influence a nation’s economy.
  • Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, according to these theory governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending which in turn curbs inflation, increases employment and maintains a healthy value of money.
  • Through this policy governments collect money from its different resources and utilise it in different expenditure which includes different projects of development, welfare etc...
  • Objectives of Fiscal Policy:
    1. To maintain and achieve full employment.
    2. To stabilise the price level.
    3. To stabilise the growth rate of the economy.
    4. To maintain equilibrium in the balance of payments.
    5. To promote economic development.
  • Fiscal policy influences growth performance of an economy mainly in two ways: 
    1. Influencing the resource mobilisation : In this area, India has done well as reflected in the tax-GDP ratio.
    2. Influencing the efficiency of resource allocation: This is reflected in the ratio of direct tax to indirect tax in gross tax revenue.
  • There are three parts of the Fiscal Policy (budget). They are: 
    1. Public Revenue
    2. Public Expenditure
    3. Public Debt

Public Revenue

  • Government is responsible for doing various social, economic and political duty for maximizing social and economic welfare. Government requires a large amount of money, which they get from different sources, for performing these duties. These sources of revenue to the government are called sources of public revenue.
  • Source of public revenue can be broadly divided into :
    1. Tax revenue
    2. Non Tax revenue
    3. Capital receipts

 

 

 Tax revenue

  • The tax is compulsory payment to the government without quid pro quo. The government does not repay back it to the payers nor does it do anything for the personal benefit to the payers. It is very effective fiscal tool essential for the achievement of different socio-economic objectives.
  • Taxes, in general, serve two functions of a revenue system:
    1. They provide funds, and
    2. They reduce private consumption and investment.
  • There are mainly two types of tax:
    1. Direct tax
    2. Indirect tax

Direct Taxes

  • Direct Taxes are taxes that are directly paid to the government by the taxpayer. It is borne by the person on whom it is levied. Direct taxes include the taxes that cannot be transferred or shifted to another person, for instance the income tax an individual pays directly to the government. In this case, the burden of the tax falls flatly on the individual who earns a taxable income and cannot shift the tax to others. The taxes imposed in income, profit, land, houses, vehicles etc are called direct taxes. Major types of direct taxes:
    1. Income Tax: It is a form of direct tax which is levied on individual’s total earnings by the Central Government.  It is the most effective tax vehicle for attaining equity, particularly if it is progressive tax.
    2. Corporate Tax: It is levied on the profit of the companies or corporations. Now, the corporate tax rate is 30%. It is the largest source of revenue of the Central Government.
    3. Wealth Tax: A wealth tax is a levy upon individuals, Hindu undivided family(HUF) and joint stock companies, on the basis of their net wealth. It is a minor source of revenue of the government, primarily imposed to reduce concentration of wealth in the society.
    4. Gift tax: gift taxis the tax on money or property that one living person gives to another. Many gifts are not subject to taxation because of exemptions given in tax laws. Donations given by the charitable institutions and companies are not covered under gift tax. Gift tax is imposed to check the evasion of estate duty and wealth tax. A gift tax has been abolished from India since 1998-99 budgets.

 Indirect tax

  • Indirect Taxes are applied to the manufacture or sale of goods and services. An Indirect Tax is one in which the burden can be shifted to others. The tax payers is not the tax bearer. The consumer is ultimately paying the tax by paying more for the product. An indirect tax is shifted from one taxpayer to another. Some of the major indirect taxes are: 
    1. Central Excise Duties: Central excise duties are imposed by the central government on the goods produced within the country except for certain goods, on which state governments are empowered to impose a tax. These goods include liquor, drugs etc.
    2. Custom duties: Imposed on commodities, which are to be imported or exported from India.
    3. Service Tax: It is imposed on the person, who avails any specified service.

Key differences between Direct and Indirect Tax

  1. Direct tax is levied and paid for by individuals, Hindu Undivided Families (HUF), firms, companies etc. whereas indirect tax is ultimately paid for by the end-consumer of goods and services.
  2. The burden of tax cannot be shifted in case of direct taxes while burden can be shifted for indirect taxes.
  3. Lack of administration in collection of direct taxes can make tax evasion possible, while indirect taxes cannot be evaded as the taxes are charged on goods and services.
  4. A direct tax can help in reducing inflation, whereas indirect tax may enhance inflation.
  5. Direct taxes have better allocative effects than indirect taxes as direct taxes put lesser burden over the collection of amount than indirect taxes, where collection is scattered across parties and consumers’ preferences of goods is distorted from the price variations due to indirect taxes.
  6. Direct taxes help in reducing inequalities and are considered to be progressive while indirect taxes enhance inequalities and are considered to be regressive.
  7. Indirect taxes involve lesser administrative costs due to convenient and stable collections, while direct taxes have many exemptions and involve higher administrative costs.
  8. Indirect taxes are oriented more towards growth as they discourage consumption and help enhance savings. Direct taxes, on the other hand, reduce savings and discourage investments.
  9. Indirect taxes have a wider coverage as all members of the society are taxed through the sale of goods and services, while direct taxes are collected only from people in respective tax brackets.
  10. Additional indirect taxes levied on harmful commodities such as cigarettes, alcohol etc. dissuades over-consumption, thereby helping the country in a social context.

Non Tax Revenue

  • Non Tax Revenue: Revenues collected from sources other than taxes are called non-tax revenue. Some of the non tax receipts are as follows:
    1. Fees: It is levied by the government for the services that it renders to the people. Like education fee, health fee, registration fee (birth, death, marriage, organization etc) license fee (driving, share broker, export, import, pistols) etc.
    2. Fines and penalties: Against the violation of rules and regulations the government charges the fines but if there is violation of law and order government charges penalties. Fines and penalties are not regular source of government revenue.
    3. Royalties: The government receives the royalties its production right, copy right, public land and building, capital equipment and plants for use to others. It obtains dividends from public enterprises, rents from public properties etc. this is also regular source of public revenue.
    4. Cess: The government collects different types of cess like road cess, pool cess etc in order to recover he construction cost and to reach the fund for maintenance of the construction.
    5. Grants and donation: The government receives the grants and donations from the people, business organization, NGOs, within the country or outside the country. It obtains grants from foreign government too.
    6. Escheats: The nationalized properties of people after the death being unclaimed are called escheats. This is irregular source of government revenue.
    7. Special Assessment: This payment is made by the owners of those properties, whose value has appreciated due to developmental activities of the government. For Ex: Construction of roads, Metro stations, sewerage etc appreciate the value of neighbouring property. Then a part of the developmental expenditure is recovered from the owners of such property by way of special assessment.
    8. Income from public Enterprises: Several public enterprises are owned by the government. Profits from these enterprises constitute the income of the government.

Capital Receipts

  • When revenue mobilised through tax and non-tax sources is insufficient to meet its expenditures, the central government will try to mobilise income through capital receipts. Capital receipts includes:
    1. Internal and external borrowings.
    2. Small savings.
    3. Provident funds.
    4. Loan recovery.

Public Expenditure

  • Public expenditure refers to Government expenditure i.e. Government spending. It is incurred by Central, State and Local governments of a country.
  • Public expenditure can be defined as, "The expenditure incurred by public authorities like central, state and local governments to satisfy the collective social wants of the people is known as public expenditure."
  • In developing countries, public expenditure policy not only accelerates economic growth & promotes employment opportunities but also plays a useful role in reducing poverty and inequalities in income distribution.
  • In democracy, public expenditure is an expression of people's will, managed through political parties and institutions.
  • Public expenditure can be financed through taxes, public debt, international aid.

Role of Public Expenditure in a developing country

  1. Social and Economic: Economic overheads like roads and railways, irrigation, power projects and social overheads like hospitals, schools, and colleges are essential for economic and social development.
  2. Balanced Regional Growth: For the development of backward areas huge public expenditure to be incurred.
  3. Development of Agriculture and Industry: Government incurred a huge public expenditure in the agriculture sector for the development of irrigation, good quality seeds, fertiliser, warehouse etc.
  4. Development of mining and Mineral Resources: Mineral resources like gas, petroleum, coal etc is essential for the economic development. Government incurred huge expenditure for the development of this sector.
  5. Subsidies: Government incurred huge expenditure on the subsidy of certain products or services which is essential for the development of particular sector. Like subsidy on Urea is necessary for the development of agricultural sector which in turn benefits everyone.

Classification of Public Expenditure

  • Hugh Dalton has classified public expenditure as follows :-
    1. Expenditures on political executives:e. maintenance of ceremonial heads of state, like the president.
    2. Administrative expenditure: to maintain the general administration of the country, like government departments and offices.
    3. Security expenditure: to maintain armed forces and the police forces.
    4. Expenditure on administration of justice: include maintenance of courts, judges, public prosecutors.
    5. Developmental expenditures: to promote growth and development of the economy, like expenditure on infrastructure, irrigation, etc.
    6. Social expenditures: on public health, community welfare, social security, etc.
    7. Public debt charges: include payment of interest and repayment of principle amount.

Public Debt

  • Article 292 of the Indian Constitution states that the Government of India can borrow amounts specified by the Parliament from time to time. Article 293 of the Indian Constitution mandates that the State Governments in India can borrow only from internal sources. Thus the Government of India incurs both external and internal debt, while State Governments incur only internal debt.
  • Public debt or public borrowing is considered to be an important source of income to the government. If revenue collected through taxes & other sources is not adequate to cover government expenditure government may resort to borrowing. Such borrowings become necessary more in times of financial crises & emergencies like war, droughts, etc.
  • As per the recommendations of the 12th Finance Commission, access to external financing by the States for various projects is facilitated by the Central Government, which provides the sovereign guarantee for these borrowings. From April 1, 2005, all general category states borrow from multi-lateral and bilateral agencies (World Bank, ADB etc.) on a back-to-back basis viz. the interest cost and the risk emanating from currency and exchange rate fluctuations are passed on to States. In the case of special category states (North-eastern states, Himachal, Uttarakhand and J&K), external borrowings of state governments are given by the Union Government as 90 per cent loan and 10 per cent grant.
  • In India, total Central Government Liabilities constitutes the following three categories: 
    1. Internal Debt.
    2. External Debt.
    3. Public Account Liabilities.
  • Public Debtin India includes only Internal and External Debt incurred by the Central Government. The major instruments covered under Internal Debt are as follows:
    1. Dated Securities
    2. Treasury-Bills
    3. 14 Day Treasury Bills
    4. Securities issued to International Financial Institutions
    5. Securities issued against ‘Small Savings’
    6. Market Stabilization Scheme (MSS) Bonds
  • Another common division of government debt is by duration until repayment is due. Short term debt is generally considered to be for one year or less, long term is for more than ten years. Medium term debt falls between these two boundaries. A broader definition of government debt may consider all government liabilities, including future pension payments and payments for goods and services the government has contracted but not yet paid.
  • Public debt may be further classified into Funded debt and Unfunded debt.

Funded debt

  • Funded debt is repayable after a long period of time. The period may be 30 years or more. Funded debt has an obligation to pay fixed sum of interest subject to an option to the government to repay the principal. The government may repay it even before the maturity if market conditions are favourable. Funded debt is Undertaken for meeting more permanent needs, say building up economic & industrial infrastructure. The government usually establishes a separate fund to repay this debt. Money is credited by the government into this fund & debt is repaid on maturity out of this fund.

Unfunded debt

  • Unfunded debts are incurred to meet temporary needs of the governments. In such debts duration is comparatively short say a year. The rate of interest on unfunded debt is very low. Unfunded debt has an obligation to pay at due date with interest.
  • The State generally borrows from the people to meet three kinds of expenditure: 
    1. To meet budget deficit.
    2. To meet the expenses of war and other extraordinary situations.
    3. To finance development activity.

Finance Commission

  • It is a body set up under Article 280 of the Constitution. Its primary job is to recommend measures and methods on how revenues need to be distributed between the Centre and states. The President appoints a Finance Commission after every five years. Though President can appoint a new Finance Commission even before the expiry of five years, if he deems it necessary. Besides suggesting the mechanism to share tax revenues, the Commission also lays down the principles for giving out grant-in-aid to states and other local bodies. 
  • Former Governor of the Reserve Bank of India, Mr. Y.V. Reddy, is the Chairman of 14th Finance Commission.

Functions of Finance Commission

  1. Distribution of net proceeds of taxes between Center and the States, to be divided as per their respective contributions to the taxes.
  2. Determine factors governing Grants-in Aid to the states and the magnitude of the same.
  3. To make recommendations to president as to the measures needed to augment the Fund of a State to supplement the resources of the panchayats and municipalities in the state on the basis of the recommendations made by the Finance Commission of the state.
  4. any other matter related to it by the president in the interest of sound finance
  5. finance commission is autonomous body which is governed by the government of India

Budget

  • The Union Budget of India, also referred to as the Annual financial statement in the Article 112 of the Constitution of India, is the annual budget of the Republic of India.
  • As per the British legacy, the Union Budget of India used to be presented on the evening of last working day of the month of February to follow the British Budget. During the NDA regime, then Finance Minister Yashwant Sinha was the first to present the Budget on 28th February, 2001 at 11 a.m.

Preparation of Budget

  • The Budget is prepared by the budget division of Department of Economic affairs in the Ministery of Finance (MoF), after consulting with other ministries and Planning Commission.

Stages in Budget Enactment

  • The Budget goes through the following stages in the Parliament
    1. Presentation of the Budget on the floor of the House before the Lok Sabha.
    2. General discussion on the Budget.
    3. Vote of account.
    4. Scrutiny by departmentally related Standing Committees.
    5. Voting on demands for grants.
    6. Passing of Appropriation Bill(Article 114 of the Constitution of India.)
    7. Passing of Finance Bill (Under rule 219 of the Lok Sabha).
  • Vote on account cannot alter direct taxes since they need to be pass through a finance bill. In the budget both direct and indirect taxes can be alter.
  • Appropriation bill is introduced only after the general discussuin on budget proposals and the completion of voting on grants.
  • Common feature is that both include the previous year’s financial performance of the government.
  • A money bill cannot be reffered to joint committee but a finance bill can be.

Some definitions

  • Adjusted debt: Adjusted debt indicates the debt amount after factoring in the impact of external debt at current change rate and netting out Market Stabilization Scheme and NSSF liabilities not used for financing Central Government deficit. 

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