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Fiscal Policy

Fiscal Policy

Fiscal policy is the guiding force that helps the government decide how much money it should
spend to support the economic activity, and how much revenue it must earn from the system,
to keep the wheels of the economy running smoothly.

Through fiscal policy, the government of a country controls the flow of tax revenues and public
expenditure to navigate the economy. If the government receives more revenue than it spends,
it runs a surplus, while if it spends more than the tax and non-tax receipts, it runs a deficit. To
meet additional expenditures, the government needs to borrow domestically or from overseas.

Some of the key objectives of fiscal policy are economic stability, price stability, full
employment, optimum allocation of resources, accelerating the rate of economic development,
encouraging investment, and capital formation and growth. In India, the Union Finance Ministry
formulates the fiscal policy.

Deficit

The difference between earning and spending of any big organization or government is called
deficit.

To understand these, let us first understand what comprises the Budget as well as the Balance
of Payment accounts.

In respect of each financial year, the President shall cause a statement of the total revenues
and expenditure of the Government of India for that year, to be laid to both Houses of
Parliament. It is a constitutional obligation of the government to represent the Budget using the
distinction of Revenue/Current Account and Capital Account.

In Budget 2020-21, there will be:

1. Budget (Provisional) Estimates for 2020-21
2. Revised Estimates for 2019-20
3. Actual figures for 2018-19
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Composition of Budget:
The two main accounts, upon which a budget is based, are:
1. Revenue Account & 2. Capital Account

1. Revenue Account
All those transactions which have less maturity period (less than one year) or are recurring in
nature or those which do not result in asset creation, come under this head.
Revenue account can be classified into the following two accounts:
I. Revenue Receipts: shows income of the government over a short period
II. Revenue Expenditure: shows the expenditure of the government over a short period

2. Capital Account
Under this head, all those lump-sum transactions (not recurring) are covered, which have
maturity period of more than one year or which are used to create or dilute assets.
The capital account can be classified into the following two accounts:
III. Capital Receipts: shows income of the government over a long period
IV. Capital Expenditure: shows the expenditure of the government over a long period

I. Revenue/Current Receipts (day-to-day receipts of the Govt.)

a) Tax receipts:
● Direct tax receipts: CIT, PIT, MAT, etc.
● Indirect tax receipts: e.g., GST
b) Non-tax receipts:
i) Dividends of PSUs
ii) Interest incomes on loans given by the Govt.
iii) Fees, fines & user charges to Govt. for providing various services
iv) Grants received by the Govt.
v) Income from the mint

II. Revenue/Current Expenditure (day-to-day expenditures of the Govt.)

Developmental Expenditure Non- Developmental Expenditure
1. Expenditures incurred by the 1. Expenditure on law & order
government for providing various 2. Expenditure on defence
services like education, health, 3. Expenditure on subsidies
irrigation and other socio-economic 4. Expenditure on civil administration
services. like salaries, pensions, etc.
5. Grants given by the government
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2. Expenditure on maintenance & 6. Interest payments on loans

repair of assets like roads, bridges,
highways, etc.

III. Capital Receipts (lump sum receipts with repayment liabilities)

a) Receipts from disinvestment of PSUs
b) Receipts from the sale of assets by the government, e.g., sale of coal-blocks, Govt. lands &
buildings, etc.
c) Recovery of past loans (principal amount)
d) Borrowings (domestic as well as foreign) of the government from banks, financial
institutions, etc. (This part comprises huge repayment liabilities)

IV. Capital Expenditure (lump sum expenditure; mostly for capital asset creation)
a) Repayment of loans
b) Loans given to states & UTs
c) Expenditure on infrastructure

Budget is always balanced, i.e., Total Receipts (I + III) = Total Expenditure (II + IV)
The balancing component is the government’s borrowings.
Under the head of Capital receipts (III):
● Non-Debt-creating receipts comprise of components ‘a’, ‘b’ and ‘c’ of III, whereas
● Debt-creating receipts comprise of component ‘d’, i.e. borrowings

Types of Deficits:
1. Revenue Deficit = Revenue Expenditure – Revenue Receipts
● It is usually in the range of 2-3%
● 1st golden rule of FRBM Act, 2003: Revenue deficit should be zero.
● Kelkar Task Force (2003) stated that within 3 years of the implementation of GST, the
government would be able to bring RD to 0 (zero).
2. Fiscal Deficit = [Revenue Expenditure + Capital Expenditure] – [Revenue Receipts + Non-debt
creating portion (a, b, c) of Capital Receipts]
● Fiscal deficit represents the total borrowing requirements of the government.
● Higher fiscal deficit ≡ Higher interest rates ≡ lower credit rating of the country.
● 2nd golden rule of FRBM Act, 2003: Fiscal deficit should be below 3% of the GDP.
3. Primary Deficit (PD) = Fiscal Deficit – Interest Payments in Revenue Expenditure
● It would show the true position of the government finances if interest payments were
not there.
● Interest is paid on loans taken in past years.
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● PD generally lies at around 0.1-0.2% of GDP.

● High FD and Low PD show that the burden of interest payments is high.
PD has special significance:
• It shows what the Fiscal Deficit would’ve been for this particular year if no interests were
to be paid.
• It talks about the health of our economy.

1. PD = 0.
It implies FD = Payment of Interests from previous loans.
This implies that the present government has recognized the need to tighten its belt, is now
balancing its budget and FD is due to the mess created by previous governments who borrowed
irresponsibly.

2. PD = FD.
It implies that Payment of Interests from previous loans is 0, meaning we are taking loans to
meet other targets and not payment of past loans. This implies previous governments acted
very responsibly and balanced their budgets.

4. Effective Revenue Deficit = Revenue Deficit – Grants given out for capital asset creation
● It is also referred to as Real Deficit
● This term (ERD) was coined by Pranab Mukherjee.

What is Fiscal Consolidation?

Fiscal Consolidation refers to the policies undertaken by the Governments on national and sub-
national levels to reduce their deficits and accumulation of debt stock. Key deficits of
government are the revenue deficit and the fiscal deficit.

Tax-to-GDP ratio
Tax-to-GDP ratio represents the size of a country's tax kitty relative to its GDP. It is a
representation of the size of the government's tax revenue expressed as a percentage of the
GDP. Higher the tax to GDP ratio the better financial position the country will be in. The ratio
represents that the government is able to finance its expenditure. A higher tax to GDP ratio
means that the government is able to cast its fiscal net wide. It reduces a government's
dependence on borrowings.

The ratio stood at 10.97 per cent in FY19, and at 11.22 per cent in FY18. The ratio of central
taxes -to-GDP slid further in FY20 to a 10-year low of 9.88 per cent, driven by a decline in
collections from customs duties and corporation tax, while excise duty posted marginal growth.
It is only estimated to decline further, with revenues falling on account of a slump in economic
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activity.

Deficit Financing:
It refers to the method of Government that is followed to meet the excess of expenditure over
income in its budget. Generally, deficit financing can be achieved through borrowings from
market, borrowing from the RBI or drawing from the government cash balance held by the RBI.

Fiscal Reforms

Macro-economic imbalances characterized by high fiscal deficits and a growing revenue deficit
continued to remain a major source of concern for the Government during the past few years.
These concerns were compounded by the impact of the Gulf Crisis during 1990-91.

Long term fiscal policy (LTFP) was launched in coherence with 7th plan in 1985-1990:
• Restoring fiscal equilibrium
• Reforming tax structure
• Promoting socially desirable activities
• Market oriented development

Steps taken in LTFP

• Stability in tax laws
• Simplification of income tax
• Reduction of secrecy in budget
• No change in personal income tax rates more than once in 5 year
• Introduction of MODVAT
• Merging several excise duties into basic duty
• Abolition of surcharge on profits.

Performance of LFTP
• Tax revenue was better
• Non-tax revenue also performed better non plan expenditure was high
• Borrowings & budget deficit was high
• Contribution of public enterprise fell short
• Assistance to state & union territories was high
• Shows growing imbalance
• Govt. announced series of austerity measures i.e. rationalize major subsidies on exports,
food, fertilizers,
• Curtailing plan & non-plan budgetary support to public enterprises, improve tax
compliance, Stop further
• Accumulation of debt, Strategic investment in infrastructure and human resource, Look
after weak & less privileged.
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Govt. of India constituted a committee under the chairmanship of Dr. Raja. J. Chelliah to
examine the structure of direct and indirect taxes on 29th Aug. 1991.

Major recommendation of Interim report

• Revision of income tax exemption of Rs 28000
• Reduction of the number of income tax slabs
• Lowering tax rate with an entry rate of 20% & max. 40%
• Introduction of a presumptive tax on small retail traders whose annual turnover is
below Rs 5 lakhs
• Imposition of wealth tax of 1% of the value of non-financial asset exceeding the
exemption limit of Rs 15 Lakh
• Allowance exempted from tax limit to 10% of salary
• Limiting rent-free residential accommodation to 20% whose salary exceeds Rs 36000 to
20% or actual expenditure whichever is less
• Gradually switching to VAT to services & commodities
• Reduction of the multiplicity of rates of excise duty to 3 rates (10,15,20) percent
• Selective excise duty on non-essential commodities or commodities injurious to health
at a higher rate of 30%, 40%, 50%
• Enlargement of the tax base by including services like telephone, brokers non-life
insurance

Major recommendations of the final report

• Revenue audit
• Improvement in tax administration
• Reduction of the general level of tariff
• Simplification of the tariff system
• Reforms in domestic indirect taxes

These all decisions taken led to a decline in fiscal deficit from 8.4% to 5% and an increase in tax
revenue. However, there was a high current account deficit in balance of payment that needed
to be reduced with export promotion; also, revenue shortfalls in indirect taxes & a rise in public
expenditure was seen.

To overcome these, subsidies were rationalized, zero-based budgeting was used in finding out
expenditure prioritization, focus on ongoing projects rather than starting a new one. A number
of initiatives were taken to strengthen infrastructure & the social sector:

• IDFC was set up

• 200 crores were provided in the budget to NHA
• Social programmes aimed for primary education, drinking water, health centres, mid-day
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meal, rural development

• Guarantee scheme to cover dues of PSUs like NTPC, Coal India
• NABARD share capital augmented Rs 500 crores
• One page return Saral was introduced
• Tax holiday given for industrial activity in backward area
• Small scale exemption limit enhanced 30-50-lakh
• Various budget focus on infrastructure, HR development, weaker sections of society,
modernization of traditional industries

Fiscal Responsibility and Budget Management Act, 2003 (FRBMA)

FRBM Act is fiscal sector legislation enacted by the government of India in 2003, aiming to ensure
fiscal discipline for the centre by setting targets including reduction of fiscal deficit and
elimination of revenue deficit. It is a legal step to ensure fiscal discipline and fiscal consolidation
in India.
Objectives of FRBM
● To ensure inter-generational equity in fiscal management
● Long-term macro-economic stability by achieving sufficient revenue surplus
● Remove fiscal impediments in the effective conduct of monetary policy
● Prudential debt management through limits on the central government’s borrowings,
debt and deficits
● Greater transparency in fiscal operations of the central government and
● Introduce transparent fiscal management systems in the country
Features of FRBM
1. The central government shall not borrow from the Reserve Bank of India except by way of
advances to meet temporary excesses of cash disbursements over cash receipts.
2. Quarterly review of the trends in receipts and expenditure in relation to the budget be placed
before both the Houses of Parliament.
3. The central government shall lay before both Houses of Parliament three statements –
Medium-term Fiscal Policy Statement, The Fiscal Policy Strategy Statement, and
Macroeconomic Framework Statement along with the Annual Financial Statement.
4. The actual deficits may exceed the targets specified only on grounds of national security or
natural calamity or such other exceptional grounds as the central government may specify.
Apart from the above, there were several other features and targets relating to fiscal deficit,
revenue deficit, etc. However, due to the 2007 international financial crisis, these targets were
never met, hence they were initially postponed and subsequently suspended in 2009.
Amendments to FRBM Act
1. Through Finance Act 2012, amendments were made to the FRMBA 2003, through which it
was decided that in addition to the existing three documents, Central Government shall lay
another document - the Medium Term Expenditure Framework Statement (MTEF) – before
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both Houses of Parliament. “Medium-term Expenditure Framework” statement will set forth
a three-year rolling target for expenditure indicators.
2. Effective Revenue Deficit: As per the amendments in 2012, the Central Government has to
take appropriate measures to reduce the fiscal deficit, revenue deficit and to eliminate the
effective revenue deficit by March, 2015 and thereafter build up adequate effective revenue
surplus and also to reach revenue deficit of not more than 2% of GDP by March, 2015 and
thereafter as may be prescribed by rules made by the Central Government.
3. As per the Finance Act 2015, the target dates for achieving the prescribed rates of effective
deficit and fiscal deficit were further extended. The effective revenue deficit which had to be
eliminated by March 2015 will now need to be eliminated only after 3 years i.e., by March
2018. The 3% target of fiscal deficit is now to be achieved by 2018-19.
The targets set under the Act were postponed several times as they were never met however
some other goals of the Act including phasing out of government borrowing from the RBI were
successfully implemented.
Fiscal Indicators – Rolling Targets as a Percentage of GDP

(SOURCE: MEDIUM TERM FISCAL POLICY CUM FISCAL POLICY STRATEGY STATEMENT)

COMMITTEE (2016) TO REVIEW FRBM ACT

The committee headed by Mr. N.K. Singh suggested a draft Debt Management and Fiscal
Responsibility Bill, 2017 to replace the earlier Fiscal Responsibility and Budget Management Act,
2003 (FRBM Act).
The most notable recommendations are as follows:
1. The committee asked the governments to continue on the fiscal and revenue deficit targets,
but they should use debt as primary target to fiscal policy instead of deficits. The
government should target 60% debt-GDP target with a 38.7% limit for the centre and 20%
limit for state governments together to be achieved by 2023.
2. It recommended a fundamental shift in fiscal consolidation by targeting overall government
(states + centre) debt, which the rating agencies track rather than the current practice of
focusing on the Centre’s fiscal deficit.
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3. The government should create an autonomous Fiscal Council with a chairperson and 2
members appointed by central government for a four-year term. The functions of the Fiscal
Council would be to prepare multi-year fiscal forecasts, recommend changes in fiscal strategy
and advise the government if it needs to deviate from fiscal targets.

4. The government can also deviate from the path on the advice of Fiscal Council in cases of
national security, war, calamities and collapse of agriculture etc.
5. There should be some flexibility in the deficit targets on both sides, downwards when growth
is good and upwards when it is not. This is called the escape clause. The Committee set 0.5%
as escape clause for the fiscal deficit target.
6. Both monetary and fiscal policies must ensure growth and macroeconomic stability in a
complementary manner. Hence there should be a congruence of Fiscal and Monetary Policy.