Government Budget and the Economy

This page contains the NCERT Economics class 12 chapter 5 Government Budget and the Economy from Book II Introductory Macroeconomics. You can find the solutions for the chapter 5 of NCERT class 12 Economics, for the Short Answer Questions, Long Answer Questions and Projects/Assignments Questions in this page. So is the case if you are looking for NCERT class 12 Economics related topic Government Budget and the Economy question and answers.
1. Explain why public goods must be provided by the government.
Allocation Function of Government Budget
The government is responsible for providing certain goods and services that cannot be efficiently provided by the market mechanism, i.e., through exchanges between individual consumers and producers. These are known as public goods. Examples include national defense, roads, and government administration.
To understand the necessity of government provision of public goods, it’s important to distinguish between private goods (like clothes, cars, food items) and public goods. There are two major differences:
Non-Rivalrous Consumption: The benefits of public goods are available to all and are not restricted to one particular consumer. For example, the consumption of private goods like eating a chocolate or wearing a shirt excludes others from enjoying the same goods. However, public goods like a public park or measures to reduce air pollution benefit everyone. One person’s consumption of a public good does not reduce the amount available for others. This characteristic is known as non-rivalrous consumption.
Non-Excludability: In the case of private goods, anyone who does not pay for the goods can be excluded from enjoying its benefits. However, with public goods, there is no feasible way of excluding anyone from enjoying the benefits. This is why public goods are called non-excludable. It is difficult, and sometimes impossible, to collect fees for a public good. Non-paying users, known as ‘free-riders’, will not voluntarily pay for what they can get for free. The link between the producer and consumer, which occurs through the payment process, is broken in the case of public goods.
Due to these characteristics, the government must step in to provide for such goods. While public goods may be produced by the government or the private sector, public provision means they are financed through the budget and can be used without any direct payment.
2. Distinguish between revenue expenditure and capital expenditure.
Here is a comparison between revenue expenditure and capital expenditure:
Revenue Expenditure
Capital Expenditure
Revenue Expenditure is the expenditure incurred for purposes other than the creation of physical or financial assets of the central government. It includes expenses for the normal functioning of government departments and various services, interest payments on debt incurred by the government, and grants given to state governments and other parties.
Capital Expenditure includes expenditures of the government which result in the creation of physical or financial assets or reduction in financial liabilities. This encompasses expenditure on the acquisition of land, building, machinery, equipment, investment in shares, and loans and advances by the central government to state and union territory governments, PSUs, and other parties.
Interest payments on market loans, external loans, subsidies (like those on food and fertilizers), salaries of government employees.
Investment in infrastructure (roads, schools, hospitals), acquisition of land, building, machinery, equipment, investment in shares, loans and advances by the central government.
Impact on Assets/Liabilities
Does not lead to an increase in government assets or a decrease in government liabilities.
Leads to an increase in government assets or a decrease in government liabilities.
Budget Classification
Included in the revenue budget.
Included in the capital budget.
Non-plan revenue expenditure covers a vast range of general, economic, and social services of the government, including interest payments, defense services, subsidies, salaries, and pensions.
Plan capital expenditure relates to central plans and central assistance for state and union territory plans. Non-plan capital expenditure covers various general, social, and economic services provided by the government.
3. ‘The fiscal deficit gives the borrowing requirement of the government’. Elucidate.
The concept of ‘fiscal deficit’ and its relation to the government’s borrowing requirement can be elucidated as follows:
Fiscal Deficit and Government Borrowing
Definition of Fiscal Deficit: Fiscal deficit is defined as the difference between the government’s total expenditure and its total receipts, excluding borrowing. It is calculated as:
Gross Fiscal Deficit =
Total Expenditure – (Revenue Receipts+ Non-debt Creating Capital Receipts)
Borrowing Requirement: The fiscal deficit essentially indicates the total borrowing requirements of the government from all sources. When the government’s expenditures exceed its receipts, it results in a fiscal deficit, which needs to be financed through borrowing.
Components of Borrowing: The borrowing to finance the fiscal deficit includes:
Net borrowing at home, which includes borrowing directly from the public through debt instruments (like various small savings schemes) and indirectly from commercial banks through the Statutory Liquidity Ratio (SLR).
Borrowing from the Reserve Bank of India (RBI).
Borrowing from abroad.
Implications of Fiscal Deficit: The fiscal deficit is a key variable in judging the financial health of the public sector and the stability of the economy. A large fiscal deficit may indicate that a significant portion of government borrowing is being used to meet its consumption expenditure needs rather than for investment. This can have implications for the economy’s growth and stability.
Primary Deficit: To focus on present fiscal imbalances, the concept of the primary deficit is used. It is the fiscal deficit minus the interest payments, giving an estimate of borrowing on account of current expenditures exceeding revenues.
Debt Accumulation: Budgetary deficits, which are financed by borrowing, add to the stock of government debt. Continuous borrowing leads to the accumulation of debt, increasing the government’s obligation to pay interest, which in turn contributes to the debt.
This explanation highlights the relationship between fiscal deficit and government borrowing, emphasizing the importance of fiscal deficit as an indicator of the government’s borrowing needs and its implications for the economy.
4. Give the relationship between the revenue deficit and the fiscal deficit.
The relationship between the revenue deficit and the fiscal deficit can be explained as follows:
Revenue Deficit and Fiscal Deficit
Revenue Deficit: The revenue deficit refers to the excess of the government’s revenue expenditure over its revenue receipts. It is calculated as:
Revenue Deficit =
Revenue Expenditure – Revenue Receipts
This indicates that the government is dissaving and using up the savings of other sectors of the economy to finance a part of its consumption expenditure.
Fiscal Deficit: Fiscal deficit, on the other hand, is the difference between the government’s total expenditure and its total receipts, excluding borrowing. It is calculated as:
Fiscal Deficit =
Total Expenditure – (Revenue Receipts + Non-debt Creating Capital Receipts)
Relationship Between the Two:
The revenue deficit is a part of the fiscal deficit. The fiscal deficit includes not only the revenue deficit but also the capital expenditure minus non-debt creating capital receipts.
A large share of the revenue deficit in the fiscal deficit indicates that a significant portion of government borrowing is being used to meet its consumption expenditure needs rather than for investment. This can lead to a buildup of debt and interest liabilities.
The fiscal deficit reflects the total borrowing requirements of the government, including the amount needed to cover the revenue deficit.
When the government incurs a revenue deficit, it implies that it will have to borrow not only to finance its investment but also its consumption requirements.
This situation can force the government to eventually cut expenditure, often reducing productive capital expenditure or welfare expenditure, which can have adverse implications for growth and welfare.
This explanation highlights the interconnection between revenue deficit and fiscal deficit and the implications of these deficits on government borrowing and economic stability.
5. Suppose that for a particular economy, investment is equal to 200, government purchases are 150, net taxes (that is lump-sum taxes minus transfers) is 100 and consumption is given by {C = 100 + 0.75Y}
What is the level of equilibrium income?
Calculate the value of the government expenditure multiplier and the tax multiplier.
If government expenditure increases by 200, find the change in equilibrium income.
– Investment (I) = 200
– Government purchases (G) = 150
– Net taxes (T) = 100
The Consumption function {C = \overline{C} + cY} is given as {C = 100 + 0.75Y}
On comparison, we have
= 100 and
= 0.75
(a) Equilibrium Level of Income
We know that the formula for equilibrium income is given as:
{Y = \dfrac{1}{1 - c} (\overline{C} - cT + I + G)}
Substituting the given values:
{= \dfrac{1}{1 - 0.75} (100 - 0.75 × 100 + 200 + 150)}
{= \dfrac{1}{0.25} × (100 - 75 + 200 + 150)}
{= \dfrac{100}{25} × 375}
= 1500
So, the equilibrium income (Y) is ₹ 1500.
(b) Government Expenditure Multiplier and Tax Multiplier
Government Expenditure Multiplier:
The formula for the government expenditure multiplier is {\dfrac{1}{1 - c}}.
Given {c = 0.75}, the multiplier is
{= \dfrac{1}{1 - c}}
{= \dfrac{1}{1 - 0.75}}
{= \dfrac{1}{0.25}}
{= \dfrac{100}{25}}
= 4
Tax Multiplier:
The tax multiplier is given by {\dfrac{-c}{1 - c}}.
With {c = 0.75}, the tax multiplier is
{= \dfrac{-c}{1 - c}}
{= \dfrac{-0.75}{1 - 0.75}}
{= \dfrac{-0.75}{0.25}}
{= \dfrac{-75}{25}}
= -3
(c) New Equilibrium Income with Increase in Government Expenditure
If government expenditure increases by 200, the new equilibrium income can be calculated using the government expenditure multiplier.
– Increase in G = 200
– Government expenditure multiplier = 4
New equilibrium income {Y'} is calculated as:
{= \dfrac{1}{1 - c} (\overline{C} - cT + I + G + ΔG)}
{= \dfrac{1}{1 - 0.75}[100 - (0.75 × 100) + 200 + 150 + 200]}
{= \dfrac{1}{0.25}(100 - 75 + 200 + 150 + 200)}
{= \dfrac{100}{25} × 575}
= 2300
Now, the change in equillibrium income can be calculated as
ΔY =
New equilibrium income – Original equilibrium income
2300 – 1500
Thus, the change in equilibrium income due to an increase in government expenditure by 200 is ₹ 800.
6. Consider an economy described by the following functions:
{C = 20 + 0.80Y},
{I = 30},
{G = 50},
{\overline{TR} = 100}
Find the equilibrium level of income and the autonomous expenditure multiplier in the model.
If government expenditure increases by 30, what is the impact on equilibrium income?
If a lump-sum tax of 30 is added to pay for the increase in government purchases, how will equilibrium income change?
Given that
– Consumption (C): {C = 20 + 0.80Y}
– Investment (I): {I = 30}
– Government Purchases (G): {G = 50}
– Transfers {(\overline{TR}): \overline{TR} = 100}
Comparing {C = \overline{C} + cY} with {C = 20 + 0.80Y}, we have
= 20 and
= 0.80
(a) Equilibrium Level of Income and Autonomous Expenditure Multiplier
Equilibrium Level of Income:
The equilibrium level of income is determined where aggregate demand (AD) equals aggregate supply (AS). AS is represented by the income (Y) itself, and AD is the sum of consumption (C), investment (I), and government purchases (G).
The formula for equilibrium income is
{Y = \dfrac{1}{1 - c} (\overline{C} - cT + c\overline{TR} + I + G)}
Assuming lump-sum taxes (T) are zero (as it is not given in the problem), the formula simplifies to
{Y = \dfrac{1}{1 - c} (\overline{C} + c\overline{TR} + I + G)}
Substituting the given values:
{ = \dfrac{1}{1 - 0.80} (20 + + 0.80 × 100 + 30 + 50)}
{= \dfrac{1}{0.2} × (20 + 80 + 30 + 50)}
{= \dfrac{10}{2} × 180}
= 900
Autonomous Expenditure Multiplier:
The autonomous expenditure multiplier is {\dfrac{1}{1 - c}}.
Given {c = 0.80}, the multiplier is
{\dfrac{1}{1 - 0.80}}
{= \dfrac{1}{0.2}}
{= \dfrac{10}{2}}
= 5
(b) Impact on Equilibrium Income with Increase in Government Expenditure
Given that:
Increase in Government Expenditure {ΔG = 30}
We use the formula for equilibrium income considering the increase in government expenditure:
{Y' = \dfrac{1}{1 - c} (\overline{C} + c\overline{TR} + I + G + ΔG)}
Substituting the values:
{= \dfrac{1}{1 - 0.80} [20 + (0.80 × 100) + 30 + 50 + 30]}
{= \dfrac{1}{0.20} (20 + 80 + 30 + 50 + 30)}
{= \dfrac{10}{2} × 210}
= 1050
Therefore, with an increase in government expenditure by 30, the new equilibrium income is ₹ 1050.
In otherwords, the equillibrium of level is increased by 1050 – 900 = 150
This calculation reflects the impact of the increase in government expenditure on the equilibrium income, considering the multiplier effect in the economy.
(c) Change in Equilibrium Income with Lump-Sum Tax to Finance Increased Government Purchases
– Increase in lump-sum tax {ΔT = 30}
– Marginal Propensity to Consume (c) = 0.80
– Original equilibrium income (Y) = 900 (as calculated previously)
The tax multiplier is calculated as:
{\text{Tax Multiplier} = \dfrac{-c}{1 - c}}
In otherwords,
{\dfrac{ΔY}{ΔT} = \dfrac{-c}{1 - c}}
The change in equilibrium income ({ΔY}) due to the tax change is:
{= \text{Tax Multiplier} × ΔT}
{= \dfrac{-c}{1 - c} × ΔT}
{= \dfrac{-0.80}{1 - 0.80} × 30}
{= \dfrac{-0.80}{0.20} × 30}
{= \dfrac{-80}{20} × 30}
= – 4 × 30
= – 120
The new equilibrium level of income {(Y")}, considering the tax increase, is:
{= Y + ΔY}
= 900 – 120
= 780
Therefore, with the addition of a lump-sum tax of 30 to finance the increase in government purchases, the new equilibrium income in the economy would be ₹ 780. This reflects a decrease in the equilibrium income due to the tax increase, considering the negative multiplier effect of taxes on the overall income.

In summary:

The equilibrium level of income is ₹ 900. The autonomous expenditure multiplier is 5.
An increase in government expenditure by 30 increases equilibrium income by 150.
Increasing the lump-sum tax by 30 results cause the equilibrium income decreased to 780 (or the equillibrium income dereases by 120).
7. In the above question, calculate the effect on output of a 10 per cent increase in transfers, and a 10 per cent increase in lump-sum taxes. Compare the effects of the two.
Given Values (from the previous problem) are:
– Marginal Propensity to Consume {MPC = c = 0.80}
– Autonomous Consumption {(\overline{C}) = 20}
– Investment {(I) = 30}
– Government Spending {(G) = 50}
– Transfers {(TR) = 100}
When there is 10% Increase in Transfers:
Original Transfers {}
= 100
Increase in Transfers {(ΔTR)}
= 10% of 100
{= \dfrac{10}{100} × 100}
= 10
Using the formula {ΔY = \dfrac{c}{1 - c} × Δ\overline{TR}}:
{= \dfrac{0.80}{1 - 0.80} × 10}
{= \dfrac{0.80}{0.20} × 10}
{= \dfrac{80}{20} × 10}
= 40
When there is a 10% Increase in Lump-Sum Taxes:
– Let’s assume original Lump-Sum Taxes {(T) = X} (an arbitrary value)
– Increase in Lump-Sum Taxes will then be
{= 10\text{\% of }X}
= 0.10X
Using the tax multiplier formula {ΔY = \dfrac{-c}{1 - c} × ΔT}:
{= \dfrac{-0.80}{1 - 0.80} × 0.10X}
{= \dfrac{-0.80}{0.20} × 0.10X}
{= \dfrac{-80}{20} × 0.10X}
{= - 0.40X}
{= - 40\text{\% of }X}
Comparison of the Effects:
Effect of Increase in Transfers: Output increases by 40.
Effect of Increase in Taxes: Output decreases by 40% of the original tax amount (X).
In this scenario, the increase in transfers leads to a definite increase in output by 40. The effect of an increase in taxes depends on the original tax amount, leading to a decrease in output by 40% of the original tax amount.
8. We suppose that {C = 70 + 0.70Y_D}, {I = 90}, {G = 100}, {T = 0.10Y}
Find the equilibrium income.
What are tax revenues at equilibrium income? Does the government have a balanced budget?
Given that:
Consumption Function: {C = 70 + 0.70Y_D} (Where {Y_D} is disposable income which is obtained by subtracting the taxes (T) from Income (Y))
Investment (I): 90
Government Spending (G): 100
Taxes (T): 0.10Y (10% of income)
(a) To Finding the Equilibrium Income:
The equilibrium income is determined where aggregate demand equals aggregate supply. Aggregate demand (AD) is given by {C + I + G}. Since {Y_D = Y - T} and {T = 0.10Y}, the consumption function can be rewritten as.
{C = 70 + 0.70(Y - 0.10Y)}
The equilibrium condition is
{= AD}
{⇒ Y}
{= C + I + G}
{⇒ Y}
{= 70 + 0.70(Y - 0.10Y) + 90 + 100}
{⇒ Y}
{= 260 + 0.70 × 0.9Y}
{⇒ Y}
{= 260 + 0.63Y}
Rearranging to solve for {Y}, we have
{Y - 0.63Y = 260}
{⇒ Y = \dfrac{260}{0.37}}
{⇒ Y ≈ 702.70}
So, the equilibrium income is approximately ₹ 702.70.
(b) Tax Revenues at Equilibrium Income:
Tax revenues are 10% of the equilibrium income:
{⇒ T = 0.10 × 702.70}
{⇒ T = 70.27}
Balanced Budget Analysis:
A balanced budget occurs when government spending equals tax revenue. Here, government spending (G) is 100, and tax revenue (T) is approximately 70.27. Since G > T, the government does not have a balanced budget. In this case, the government is running a deficit because its spending exceeds its tax revenues.
9. Suppose marginal propensity to consume is 0.75 and there is a 20 per cent proportional income tax. Find the change in equilibrium income for the following
Government purchases increase by 20
Transfers decrease by 20.
Given that:
Marginal Propensity to Consume (MPC): 0.75
Proportional Income Tax Rate: 20% (0.20)
(a) Government Purchases Increase by 20:
The government expenditure multiplier in the presence of a proportional income tax is given by:
{\text{Multiplier} = \dfrac{1}{1 - c(1 - t)}}
Where {c} is the MPC and {t} is the tax rate.
Substituting the given values:
{= \dfrac{1}{1 - 0.75(1 - 0.20)}}
{= \dfrac{1}{1 - 0.75 × 0.80}}
{= \dfrac{1}{1 - 0.60}}
{= \dfrac{1}{0.40}}
{= \dfrac{100}{40}}
= 2.5
For an increase in government spending by 20, the change in equilibrium income ({ΔY}) is:
{= \text{Multiplier} × ΔG}
= 2.5 × 20
= 50
(b) Transfers Decrease by 20:
The change in equilibrium income due to a change in transfers is given by:
{ΔY = \dfrac{c}{1 - c} Δ\overline{TR}}
Substituting the given values:
{= \dfrac{0.75}{1 - 0.75} × -20}
{= \dfrac{0.75}{0.25} × -20}
{= \dfrac{75}{25} × -20}
= 3 × -20
= – 60
Thus, for a decrease in transfers by 20, the equilibrium income decreases by 60.
An increase in government purchases by 20 leads to an increase in equilibrium income by 50.
A decrease in transfers by 20 leads to a decrease in equilibrium income by 60.
10. Explain why the tax multiplier is smaller in absolute value than the government expenditure multiplier.
Explanation of Multiplier Differences
The tax multiplier is smaller in absolute value than the government expenditure multiplier due to the nature of how each type of fiscal policy affects aggregate demand and equilibrium income in an economy:
Direct vs Indirect Impact:
Government Expenditure Multiplier: Government spending directly adds to aggregate demand. An increase in government spending by a certain amount directly increases aggregate demand by the same amount.
Tax Multiplier: Changes in taxes affect aggregate demand indirectly. A tax cut increases disposable income, but only a fraction of this additional income (determined by the Marginal Propensity to Consume, or MPC) is spent, thus indirectly influencing aggregate demand.
Fraction of Income Spent: The MPC is typically less than 1, meaning that only a portion of the change in disposable income due to tax changes contributes to the change in aggregate demand.
Formulae for Multipliers:
Government Expenditure Multiplier: {\dfrac{1}{1 - c}}
Tax Multiplier: {\dfrac{-c}{1 - c}}
Example Illustration
Let’s consider an example with the following parameters:
Marginal Propensity to Consume (MPC): 0.8
Change in Government Spending {(ΔG)}: ₹ 100
Change in Taxes {(ΔT)}: ₹ 100
Calculating Multipliers:
Government Expenditure Multiplier: {\dfrac{1}{1 - 0.8} = 5}
Tax Multiplier: {\dfrac{-0.8}{1 - 0.8} = -4}
Applying the Multipliers:
Impact of Government Spending Increase: Increase in equilibrium income {= 5 × 100 = ₹~500}.
Impact of Tax Increase: Decrease in equilibrium income {= -4 × 100 = -₹~400}.
The government expenditure multiplier (5) is larger in absolute value than the tax multiplier (-4).
A ₹ 100 increase in government spending results in a ₹ 500 increase in equilibrium income.
Conversely, a ₹ 100 increase in taxes leads to a ₹ 400 decrease in equilibrium income.
The smaller absolute value of the tax multiplier is due to the fact that only a fraction (MPC) of the change in disposable income translates into a change in consumption, whereas the entire amount of government spending directly impacts aggregate demand.
This example clearly demonstrates the difference in the absolute values of the government expenditure and tax multipliers. The government expenditure multiplier has a more substantial impact on aggregate demand and equilibrium income compared to the tax multiplier, which is smaller in absolute value due to its indirect effect through changes in disposable income and consumption.
11. Explain the relation between government deficit and government debt.
The relationship between government deficit and government debt is a fundamental concept in public finance. Here’s an explanation of how these two are related:
Government Deficit
A government deficit occurs when a government’s expenditures exceed its revenues within a given fiscal year. This deficit is essentially the amount by which the government is short of funds in that year.
Deficits are often covered by borrowing, which leads to the issuance of government bonds or taking loans from domestic or international sources.
Government Debt
Government debt, also known as public debt or national debt, is the total amount of money that the government owes to creditors. It accumulates over time and consists of the sum of all past deficits, minus any surpluses.
Each year’s deficit adds to the debt because the government needs to borrow money to finance the deficit.
Relationship Between Deficit and Debt
Cumulative Effect: The government debt is the accumulation of yearly deficits (and surpluses, if any). Each year’s deficit directly adds to the total debt.
Borrowing: When a government runs a deficit, it borrows money to cover the shortfall. This borrowing increases the total debt.
Interest Payments: Part of the government’s annual expenditure includes interest payments on existing debt. These interest payments can lead to further deficits if they are significant and not covered by the government’s revenues, thereby increasing the debt further.
Economic Impact: Persistent deficits can lead to a continuously increasing debt-to-GDP ratio, which may raise concerns about the sustainability of a government’s fiscal policy. High levels of debt can affect a country’s credit rating and the cost of borrowing.
Suppose a government has a debt of ₹ 1,000 billion at the start of the year.
During the year, it runs a deficit of ₹ 100 billion.
By the end of the year, the total debt would increase to ₹ 1,100 billion, assuming no other changes (like repayment of existing debt).
In summary, a government deficit in a given year increases the overall government debt, as deficits are financed through borrowing. The total government debt is the cumulative result of all past years’ deficits and surpluses.
12. Does public debt impose a burden? Explain.
The question of whether public debt imposes a burden is a topic of considerable debate in economics. The answer can vary based on the context, including the economic environment, the purpose for which the debt is incurred, and how the debt is managed. Here are some key points to consider:
Yes, Public Debt Can Impose a Burden
Future Taxation: Public debt must eventually be repaid, which often requires raising taxes in the future. This can be seen as transferring the burden of current spending to future generations who will have to bear the higher taxes.
Interest Payments: Governments must make interest payments on their debt. High levels of debt can lead to significant portions of government budgets being allocated to interest payments, potentially at the expense of other spending priorities like education, healthcare, or infrastructure.
Crowding Out Effect: If the government borrows heavily from domestic markets, it can lead to a ‘crowding out’ of private investment, as the government borrowing might increase interest rates, making it more expensive for businesses to borrow and invest.
Inflationary Pressures: If debt is monetized (i.e., the government prints money to pay off the debt), it can lead to inflationary pressures, reducing the purchasing power of money and potentially harming economic stability.
Reduced Flexibility: High levels of debt can reduce the government’s ability to respond to future crises or recessions, as more resources are tied up in servicing debt.
No, Public Debt May Not Impose a Burden
Investment in Productive Projects: If the borrowed funds are used for productive investments (like infrastructure, education, or research and development), these can spur economic growth, which can offset the costs of the debt.
Stimulating Economic Growth: In times of economic downturns, increased government spending (financed by borrowing) can help stimulate the economy and can be crucial in avoiding deeper recessions or depressions.
Sustainable Debt Levels: If the economy grows at a rate higher than the interest rate on the debt, the debt can be sustainable. In such cases, the burden of debt may not be as significant, especially if the debt-to-GDP ratio remains stable or declines.
Intergenerational Equity: One could argue that if public debt is used to finance long-term investments that benefit future generations (like infrastructure or reducing climate change impacts), it is fair for future generations to bear some of the costs.
Whether public debt imposes a burden depends on various factors. If managed wisely and used for productive purposes, public debt can be beneficial and sustainable. However, excessive or poorly managed debt can lead to economic challenges and impose a burden on future generations through higher taxes, reduced government spending capacity, and potential economic instability.
13. Are fiscal deficits inflationary?
Are Fiscal Deficits Inflationary?
Inflationary Potential: Fiscal deficits can be inflationary under certain conditions. When the government increases spending or cuts taxes, it leads to an increase in aggregate demand. If firms are unable to produce the higher quantities demanded at ongoing prices, prices may rise, leading to inflation.
Context-Dependent: However, the inflationary impact of fiscal deficits is not a given and depends on the economic context. For instance, if there are unutilized resources in the economy, and output is limited by lack of demand, a high fiscal deficit accompanied by higher demand can lead to greater output without necessarily being inflationary.
Crowding Out Effect: The document also discusses the ‘crowding out’ effect, where government borrowing to finance deficits competes with corporate bonds and other financial instruments for the available supply of funds. This can reduce the amount of savings available for private sector investment, potentially leading to inflation.
Impact on Savings and Investment: It is argued that if government deficits succeed in raising production, there will be more income and, consequently, more saving. In such a scenario, both the government and the private sector can borrow more without necessarily causing inflation.
Role of Economic Conditions: The inflationary impact of fiscal deficits also depends on the state of the economy. For example, in a recession, a deficit might increase due to falling tax revenues, but this does not necessarily mean an expansionary fiscal policy or inflationary pressure.
Fiscal deficits can be inflationary, especially if they lead to an increase in aggregate demand that outpaces the economy’s productive capacity. However, the actual impact is context-dependent and varies based on the state of the economy, the availability of resources, and the effectiveness of the deficit in stimulating production and income. In some cases, deficits can increase output and savings, mitigating inflationary pressures.
14. Discuss the issue of deficit reduction.
Deficit Reduction
Government Deficit Reduction Strategies: The government can reduce its deficit either by increasing taxes or by reducing expenditure. In India, there has been a focus on increasing tax revenue, with a greater reliance on direct taxes, as indirect taxes are regressive and impact all income groups equally.
Revenue Generation through PSUs: Another strategy has been to raise receipts through the sale of shares in Public Sector Undertakings (PSUs).
Expenditure Reduction: The major thrust for deficit reduction has been towards reducing government expenditure. This can be achieved by making government activities more efficient through better planning and administration.
Efficiency in Government Programs: A study by the Planning Commission highlighted the inefficiency in government programs, suggesting that cash transfers could lead to increased welfare compared to the current subsidy models.
Scope of Government Activities: Reducing the scope of government by withdrawing from certain areas is another approach. However, cutting back on vital areas like agriculture, education, health, and poverty alleviation could adversely affect the economy.
Self-imposed Constraints: Governments in many countries, including India, have put in place self-imposed constraints to prevent increasing expenditure over pre-determined levels. The Fiscal Responsibility and Budget Management Act (FRBMA) in India is an example of such a measure.
Fiscal Responsibility and Budget Management Act (FRBMA): The FRBMA, enacted in 2003, is a legislative provision aimed at ensuring fiscal prudence and macroeconomic stability. It mandates the central government to reduce the fiscal deficit to not more than 3 percent of GDP and to eliminate the revenue deficit, thereby building up adequate revenue surplus.
Deficit reduction is a critical aspect of fiscal policy, involving a balance between increasing revenues and reducing expenditures. While increasing taxes and selling PSU shares are methods to increase revenue, reducing expenditure requires careful consideration to avoid adverse impacts on essential services and economic growth. The FRBMA in India serves as an institutional framework to guide and enforce prudent fiscal management.
15. What do you understand by G.S.T? How good is the system of G.S.T as compared to the old tax system? State its categories.
What is GST?
Goods and Services Tax (GST) is a comprehensive, multi-stage, destination-based tax that is levied on every value addition. Implemented from July 1, 2017, in India, GST replaced a plethora of indirect taxes with a unified tax structure. It’s applicable throughout the country with a single rate for one type of goods or service.
Comparison with Old Tax System
Cascading Tax Effect:
Pre-GST: Taxes were imposed not on the value added but on the total value of the commodity or service, leading to a cascading effect of tax.
Post-GST: GST is discharged at every supply stage, with the credit of tax paid at the previous stage available for set-off at the next stage, effectively taxing only the value addition at each stage.
Input Tax Credit (ITC):
Pre-GST: There was minimal facility for the utilization of Input Tax Credit, causing inefficiencies.
Post-GST: GST allows for a comprehensive Input Tax Credit mechanism, reducing the tax burden on the end consumer and improving business efficiency.
Tax Structure Simplification:
Pre-GST: A complex structure with numerous central and state taxes and cesses.
Post-GST: A unified tax structure, amalgamating many central and state taxes, simplifying the tax regime.
Economic Impact:
Pre-GST: Disparities in taxation across the country, affecting the uniformity of the market.
Post-GST: Establishes parity in taxation across the country, promoting a more integrated and inclusive national market.
Categories of GST
In general, GST is categorized into:
CGST (Central GST): Levied by the Central Government on intra-state sales.
SGST (State GST): Levied by the State Government on intra-state sales.
IGST (Integrated GST): Levied by the Central Government for inter-state sales.
GST represents a significant shift from the previous tax regime, aiming to reduce the cascading effect of taxes, simplify the tax structure, and create a unified national market. Its implementation has streamlined the tax process, making it more efficient and business-friendly, while also ensuring a uniform tax rate across the country.