Government Budget and the Economy - ratheeshthapasya

CHAPTER 4

          GOVERNMENT BUDJET AND THE ECONOMY

v    Govt. budget and the economy

v    Components of Govt. Budget

v    Measures of Govt. Deficit

v    Public Debt

v    FRBMA

Government Budget and the economy

The government performs three functions in an economy.

1.   Allocation  function

2.   Distribution function and

3.   Stabilization function

1.   Allocation functions

Government uses its resources for the production of and distribution of public goods. This is allocation function.

2.   Distribution function

Government solves the inequality in the distribution of income and wealth through its fiscal policies – tax and public expenditure.

3.   Stabilization function

Business cycle occurs due to the change in aggregate demand. Government uses budget to control business cycle and to make stable the economy.

Goods can be classified into

1.   public goods and

2.   private goods

Public goods

• Provided by the government for the common use.
• Non excludable – no one can be denied from its consumption
• Non rival – consumption of one person does not limit its availability to others.
• Cannot be sold in the market through market mechanism.
• E.g. Road, street light, defence, law and order.

Private good

• Are sold in the market through price mechanism.
• Excludable from the consumption to those who do not pay for it.
• Rival in consumption – can be used only one at a time.
• E.g. Cloth, car, food items etc.

                                    Government Budget

• Annual financial statement of the government which shows the estimated expected income and expenditure.
• In India financial year is from 1^st April to March 31^st.
• Article 112 of the Indian constitution insists that government should present the budget in the parliament.

Components of the Government budget

Government budget has two account – capital account and revenue account.

Revenue account

• Shows current receipts of the government and expenditures incurred from these receipts.
• It has two components – revenue receipts and revenue expenditure.

Revenue receipts

• Receipts of the government that does not decrese the assets or increases the liability of the government.
• They are non-redeemable – cannot be reclaimed from the govt.
• Revenue receipts are classified in to - tax revenue and non tax revenue.

Tax revenue

• Most important source of the government’s revenue.
• Taxes are of two types – direct tax and indirect tax

1. Direct tax

• Directly imposed by the government on the income of the persons and firms.
• Here the impact and incidence of the tax fall on the same person.
• Impact means immediate money burden and incidence means the ultimate or final resting place of the burden of a tax.
• E.g. Income tax, corporate tax, wealth tax, gift tax, estate duty.

2. Indirect tax

• Levied by the government indirectly.
• Here the impact and incidence of the tax falls on different persons.
• Tax burden can be shifted.
• E.g. Sales tax, excise duty (tax levied on the goods produced within in the domestic territory), customs duty (tax on exports and imports), service taxes, entertainment taxes etc.

Non tax revenue

• Revenue other than the tax sources.

They include

• Interest receipts of loans given by the govt.
• Profit of the public enterprises and dividends on investment made by the government.
• Fees charged on the services rendered by the govt. e.g.  court fee, license fee, passport fee.
• Fines and penalties
• Special assessment –imposed by the government when it undertakes developmental activities in a particular area.
• Escheats – ownership of the property which has no heir reaches the govt.
• Grants in aid from foreign governments and other international organizations.

Revenue expenditure

• Expenditure of the government which doesn’t create liabilities or reduce the assets of the government.
• Expenditures incurred for the normal functioning of the government

It includes

• Interest payments
• Salaries and pension of the employees
• Grants in aids given to the state governments
• Subsidies
• Expenditures incurred on control of natural calamities, defence, law and order

Revenue expenditure can be classified into plan revenue expenditure and non plan revenue expenditures.

Capital account

• An account of government’s assets and liabilities
• It shows the capital requirements of the govt and pattern of their financing
• The capital account consist of  - capital receipts and capital expenditures

Capital receipts

          They are the receipts of the government which reduces the assets or creates the liabilities of the government.

They include

• Borrowing – government raises funds from open market, foreign governments, RBI, commercial banks, other international organizations. This increase government’s liabilities as the borrowings must be repaid in future.
• Recovery of loans and advances
• Disinvestment – receipts from the sale of shares of the public enterprises. It reduces the assets of the government
• Small scale savings – post office savings accounts, national saving certificates, provident funds.

Capital expenditures

• Expenditures that creates assets or reduces the liabilities of the government.

They include

• Expenditure on the purchasing land, buildings, machineries, tools etc
• Investment on shares
• Loans given to state and foreign governments, PSUs etc.

Capital expenditure can be further classified in to plan capital expenditure and non plan capital expenditure.

Measures of government budget

          When government spends more than its revenue, it incurs budget deficit.  Budget deficit can be classified into three

1.   Revenue deficit

2.   Fiscal deficit

3.   Primary deficit

Revenue deficit

• It refers to the excess of government’s expenditure over revenue receipts
• Revenue deficit = revenue expenditure – revenue receipts.
• Revenue expenditure is essential for the smooth functioning of the government. It cannot be reduced suddenly. When revenue deficit occurs, government reduces capital expenditures which are productive. This will adversely affects the economic growth and welfare

Fiscal deficit

• It is the difference between the government’s total expenditure and its total revenue excluding borrowing.
• Fiscal deficit = total expenditure – total revenue excluding borrowing
• It shows the amount that the nation has to be borrowed.
• It is a parameter of the stabilization of the country.
• Fiscal also includes the revenue deficit.

Primary deficit

• It is government borrowing (fiscal deficit) excluding the payment for net interest payments.
• Primary deficit = fiscal deficit – net interest liabilities.
• It shows the borrowing requirements of the government for the purpose other than the interest payments.

Type of government budget

1. Balanced budget – if the estimated receipts and estimated expenditure of the government, budget is called balanced budget. (revenue = expenditure)
2. Surplus budget – if the estimated receipts are greater than expenditure of the government, budget is surplus budget.
3. Deficit budget – if the estimated receipts are less than the estimated expenditures of the government, budget is called deficit budget.

Income determination in three sector economy

          A three sector model consists of household, firms and government. When government is included into this system, there will be Government expenditure, imposition of taxes, and provision of transfer payments. All these affect the aggregate demand

          The tax imposed by the government may be lump sum tax or proportional tax.

Lump sum tax – equal amount is imposed a tax from everyone in the economy.

Proportional tax – if the tax changes with the change in income, then it is known as proportional tax. Here government charges a certain percentage of income as tax.

Income determination when lump sum tax

The components of aggregate demand in three sector model are

1.   Household consumption  demand

Government imposes lump sum tax (T) and gives transfer payments (TR), then disposable income is 

          Y_D = Y – T +TR

Therefore C = +   c Y_D

2.   Firm’s investment demand ( I )

3.   Government expenditure  (G)

Thus final equation for AD in a three sector model is

AD = + +  +  - cT + c + cY

Where + +  +  - cT + c is the autonomous component and vertical intercept

 i.e. ,  =+ +  +  - cT + c

The equilibrium income determination in a three sector model

          At equilibrium Y = AD

If equilibrium income is

                    =

 =

The change in equilibrium income when government expenditure changes

When government expenditure increases, the autonomous component of AD curve will increase, the slope remains constant.  So the AD curve shifts parallally upwards. Then equilibrium income will increase.  The change in income (ΔY) will be greater than change in government expenditure (ΔG). This is due to the operation of multiplier.

Government expenditure multiplier

          The ratio between change in income and change in government expenditure is known as government multiplier.

 =    

The change in equilibrium income when governments transfer payment changes

The equilibrium income increases when the government increases the transfer payment (  ) as this increases the AD.

Transfer payment multiplier

          It is the ratio between the change in transfer payments to change in income.

 =    

The value of transfer payment multiplier is less than the value of government expenditure multiplier.

The change in equilibrium income due to change in tax (lump sum tax)

          When government reduces the taxes, it increases the disposable income of the people and therefore the consumption and aggregate demand in the economy increases. So the AD curve shifts upwards parallel to the initial curve, so the equilibrium income increases.

         

Tax multiplier

          It is the ratio between the changes in income to change in tax.

 =    

         

Tax multiplier is a negative multiplier. Its value is smaller than the government expenditure multiplier.

Increase in income through government expenditure is larger than the tax cut

Balanced budget multiplier

          When we add government expenditure () and tax multiplier (), we will get balanced budget multiplier

              =  = 1

The value of balanced budget multiplier is equal to one.

Equilibrium income when there is proportional tax

          Proportional tax means that the government collects a constant fraction (t) of the income in the form of tax.

If the t is rate of tax, Y is the income, then total amount of tax T,

          T = tY

Aggregate Demand when there is proportional tax

The equation of AD curve when there is proportional tax is 

          AD =  + +  +  + c + c (1 – t) Y

Here

 c (1 – t) Y , is the slope

Vertical intercept  = + +  +  + c

Therefore the equation of AD is

                             AD =  + c (1 – t) Y

Equilibrium income determination

Equilibrium income in a three sector model with proportional tax is 

                    =

The multipliers when the economy imposes proportional Taxes

1.   Investment multiplier

                                  =    

2.   Government expenditure multiplier

                                 =    

3.   Transfer Payment Multiplier

                                                 =   

Effects of change in Proportional tax rate

          When there is a reduction in the proportional tax, the marginal propensity consume increases. It increases the aggregate demand and therefore the AD curve shifts upwards with the change in vertical intercept.

The value of investment, government and expenditure multipliers when there is lump sum tax is higher than the when there is proportional tax.

                  

The increase in income through multiplier process is lesser for proportional tax than lump sum tax.

                  

                            

Automatic Stabilizers

          Automatic stabilizers are policies that work in an economy without any external force.

It controls the working of multipliers

It controls the inflation and keeps price stability.

Government transfer payments like unemployment allowance is an automatic stabilizer

Proportional tax as an Automatic Stabilizer

          Proportional tax is an automatic stabilizer.

If there is proportional tax, when GDP in an economy increases, then the tax amount will increase automatically.  So the disposable income will decrease.  Therefore the level of consumption will not increase as fast as income.  With the change in GDP, the tax amount will increase or decrease if there is proportional tax

Discretionary Fiscal policy

The deliberate actions of the government to stabilize the economy are often referred to as discretionary fiscal policy.

Fiscal Policy includes changes in investment, public expenditure, and tax policy.

Public Debt

          Budgetary deficits must be financed either by taxation, borrowing or printing currency. Governments mostly relies borrowing to reduce the budget deficit, it is known as Public Debt.

Perspectives on Government Debt

Public debt is a liability for coming generation.  By borrowing, the government transfers the burden of reduced consumption on future generations. This is an argument against public debt.

Ricardian Equivalence is the argument against the above view. It is put forwarded by the David Ricardo. People are forward looking, so that spending depends not only on their current income but also on their future income.  They understand that borrowing today means higher taxes in the future. Further, the people will be concerned about the future generations.  So they would increase saving now, which will fully offset the increased government dissaving, keeping national savings unchanged. 

Some other perspectives on debt and deficit

          One of the main criticisms of deficit is that they are inflationary. When government expenditure increases or taxes are reduced, the aggregate demand will increase.  If the firms cannot increase their output in par with this increase their output in par with this increase in AD, there may occur increase in general price level (inflation).

          If the government borrows more, it may lead to a situation that the private investors can’t get enough funds from the capital market for investment.  This can be referred as Crowding out effect

Deficit Reduction

Government deficit can be reduced by two ways.

a.    By an increase in taxes.

b.    By reduction in government expenditure.

In India, the government has adopted some measures to reduce deficits, they are

1.   Increase the direct taxes

2.   Increase the revenue by the sale of the shares of the public undertakings (PSUs)- Disinvestment

3.   Reducing the government expenditure by proper planning and through efficient administration

Fiscal Responsibility and Budget Management Act (FRBMA)

          FRBMA was passed in 2003. It ensures that the government should be responsible for the reduction of fiscal deficit.

1.   The act mandates the central government to take appropriate measures to reduce fiscal deficit to not more than 3 % of GDP and to eliminate the revenue deficit by March 2009, and thereafter build up adequate revenue surplus.

2.   It requires the reduction in fiscal deficit by 0.3 % if GDP each year and the revenue deficit by 0.5 percent.

3.   The actual deficits may exceed the targets specified only on grounds of the national security or natural calamity.

4.   The central government should borrow from RBI only by means of advances.

5.   Measures to be taken to ensure greater transparency in fiscal operations.