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Fiscal Policy
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Contents
Fiscal Policy ........................................................................................................................................................ 2
Introduction ............................................................................................................................................... 2
Components of Fiscal Policy ...................................................................................................................... 2
Functions of Fiscal policy ........................................................................................................................... 3
Fiscal Imbalance ........................................................................................................................................ 4
Fiscal Deficit Financing .............................................................................................................................. 5
Consequences of Deficit Financing ........................................................................................................... 5
Measures to Check Fiscal Deficit............................................................................................................... 6
Trends in Fiscal Imbalance ........................................................................................................................ 6
Fiscal Consolidation ................................................................................................................................... 7
Fiscal Responsibility and Budget Management Act................................................................................. 8
Committee to review FRBM targets (N.K Singh Committee) ................................................................... 9

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Fiscal Policy
Introduction
• Fiscal policy is the policy of a government which deals with receipts and expenditures,
which together make up the budget.
• It is the means by which a government adjusts its levels of income and spending in order to
monitor and influence a nation’s economy.
• Fiscal policy relates to raising and spending money in quantitative and qualitative terms-
how and how much.
• The planning commission in its seventh five-year plan stated, “Through fiscal policy, the
government creates and sustains the public economy consisting of the provision of the
public services and public investment; at the same time, it is an important instrument for
reallocation of resources according to national priorities, redistribution, promotion of private
savings and investments, and the maintenance of stability.”

Components of Fiscal Policy

Revenue
Receipts
Receipts
Capital
Receipts
Fiscal Policy
Revenue
Expenditure
Expenditure
Capital
Expenditure
The fiscal policy of the government is a policy which acts as an instrument of development by
managing its receipts and expenditure. The receipts and expenditure are further of two types
respectively –
• Revenue receipts and Capital receipts
• Revenue expenditure and Capital expenditure

Revenue Receipts

• These are the receipts that neither creates a liability on the government nor reduces its
assets. Therefore, these are also known as non-redeemable receipts.
• Revenue receipts are divided into tax and non-tax revenues.

• Tax revenues
▪ Direct taxes (Personal income tax, corporation tax)
▪ Indirect taxes (Excise duty, custom duty, GST)

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• Non-Tax revenues –
▪ Interest receipts on account of loans given by central government
▪ Dividends and profits made by the government
▪ Fees and other receipts for services rendered by the government
▪ Fines received by the government
▪ Cash grants in aid from foreign countries and international organizations

Capital Receipts

• The receipts that either create liability on the government or reduces its assets are known
as capital receipts
• For ex – When government disinvests in a PSU, it reduces government’s asset. Loans
taken from various agencies which have to be returned creates liability on the government.
• The capital receipts can be debt creating and non-debt creating. For ex – If government
disinvests in a PSU, it is not taking debt from any agency and thus it is non-debt creating
receipt. On the other hand, loans taken from any agency is a debt creating receipt.

Revenue Expenditure

• It is the expenditure incurred for purposes other than the creation of physical or financial
assets.
• For ex – Salary of government employees, interest payments on debt incurred by the
government, grants given to state government or any other agency (even though some of
the grants may be meant for creation of assets), defence services, pensions, subsidies,
money spent on welfare schemes etc.

Capital Expenditure

• These are the expenditures which result in creation of a physical or a financial asset or
reduction in financial liabilities.
• For ex – Acquisition of land, building, machinery, equipment, investment in shares, loans
and advances by central government etc.

Functions of Fiscal policy

Three distinct functions that operate through the fiscal policy of the government are:

(1) Allocation function

(2) Distribution function
(3) Stabilization function

Allocation Function

• There are many public goods and services, which cannot be provided by the private sector
due to lack of possibility of making any kind of profit from them.
• These are goods like national defence, government administration, supply of basic services
like cheap housing, water supply, free education etc.
• The government takes on the responsibility of providing them. This function of the
government is called allocation function.
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Distribution Function

Reduction of inequality= distribution function

• In any society, there are rich and poor people. The government performs its distribution
function to reduce this gap. This is done by collecting money from rich via taxes and
distributing that amount among poor via social benefits like food subsidy, fertilizer subsidy,
welfare scheme etc.
• Basic services like free education, free healthcare, free housing et cetera are provided to
the poor to enable them to earn more in the future by educating themselves and growing as
healthy living beings.

Stabilization Function

• Governments need to correct fluctuations in income, employment, prices, inflation etc.

• Government uses fiscal measures, such as taxation and public expenditure, to stabilise the
prices and control inflation.
• Government also generates employment by speeding up infrastructure development.

Fiscal Imbalance
• Fiscal imbalance is the gap between the expenditure and the receipts under the revenue
and capital accounts taken together.
• Any imbalance between government receipts and expenditures will result in either a deficit
or a surplus.
• Indian government experiences an overall deficit due to higher expenditures on
developmental and welfare activities.

Types of Deficits

Fiscal Deficit – It is the difference between the government’s total expenditure and its total
receipts excluding borrowing.

Gross fiscal deficit = Total Expenditure – (Revenue receipts + Non-Debt creating capital receipts)

Note – Non-debt creating capital receipts are those receipts which are not borrowings and
therefore do not give rise to debt. Examples are recovery of loans and the proceeds from the sale
of PSUs.

Revenue Deficit – It is the difference between revenue expenditure and revenue receipt of the
government.

Revenue Deficit = Revenue Expenditure – Revenue Receipts

Primary Deficit – It is the difference between the fiscal deficit and the previous year interest
payments of the government. The present government is also required to pay for debts of past
governments in the form of interest payments. Since, this debt and accumulated interest is not
created by the present government, it wants to remove this liability to arrive at the figure of deficit
created in the present. This figure is called as primary deficit.

Primary deficit = Fiscal Deficit – Net interest liabilities

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Effective Revenue Deficit – This term is introduced in the Union Budget 2012-13. It is the
difference between revenue deficit and grants-in-aid provide by the Central Government to States,
constitutional and statutory bodies, etc. for creation of capital assets. It signifies that amount of
revenue receipts that are used for consumption expenditure of the Central Government

Effective Revenue Deficit = Fiscal Deficit – Grants for creation of assets

Monetized Deficit – It refers to the borrowings made by the Central Government from RBI
through printing fresh currency. It is resorted to when Government cannot borrow from the market
to fund fiscal deficit. That fresh currency is provided by the RBI against special securities of the
Central Government. It increases the level of inflation in the economy due to increased money
supply in the economy

Fiscal Deficit Financing

Over the years, India’s budget has seen a fiscal deficit due to inadequacy of government revenues
for financing its expenditure. The gap between expenditure and revenue is filled through fiscal
deficit financing.
The fiscal deficit is financed through borrowings. Thus, it indicates the total borrowings
requirements of the government from all sources

Gross fiscal deficit = Total borrowings (domestic borrowings, international borrowings,

borrowings from RBI)

Note: Domestic borrowing include that amount which is directly borrowed from the public through
debt instruments (for example, the various small savings schemes) directly from commercial
banks through Statutory Liquidity Ratio (SLR)

Need of Deficit Financing

• Due to the failure of the government to mobilise the desired volume of surplus for the public
sector plans
• Due to the rapidly growing expenditure (mostly on unproductive non-development
activities).

Consequences of Deficit Financing

Advantages

• Increase in Production – Through deficit financing, government infuses additional

purchasing power in the economy. This leads to an increase in effective demand. To meet
this demand, the machinery and capital equipment lying hitherto unused will be pressed
into operation which accordingly will increase the production.

• Employment opportunities – The money raised through deficit financing is used in

infrastructure building and creating resources for employment generation.

• Economic development – The deficit financing can have a multiplier effect on economic
development as it encourages the government to utilize unemployed and underemployed
resources.
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Disadvantages

• Inflationary spiral: It implies greater borrowings by the Central Government. Borrowings

from RBI raise the money supply in the economy, which results in rise in the general price
level over a period of time (due to rise in aggregate demand). This leads to inflationary
spiral.

• Effect on GDP growth: It affects GDP growth as a significant amount of budgeted revenue
is spent on the payment of interest on borrowings by the Central Government, thus
resulting in reduced investment. This if not checked over a period leads to a vicious circle of
high fiscal deficit and low GDP growth.

• Crowding out of private investment: High fiscal deficit also leads to the ‘crowding out
effect’ as it leads to a situation when large borrowings by the Government to manage large
fiscal deficit reduce the availability of funds for private investors (as there is limited capital
available in the system). Private companies find it difficult to raise the same amount of
capital at the same cost (interest). This either delays investment or makes it more costly.

Measures to Check Fiscal Deficit

• By reducing expenditure through:
▪ Rationalisation of subsidies
▪ Reduction in revenue expenditure in terms of bonus, LTC, leaves encashment, etc. to
Government employees
▪ Curtailing other avoidable revenue expenditure

• By increasing revenue through:

▪ Increasing the tax base in the economy
▪ Checking tax evasion
▪ Restructuring the public sector enterprises through disinvestment and utilising the
received fund in strategic sectors like health and education.

Trends in Fiscal Imbalance

Central Government deficits
(% of GDP at current Market prices)

Period Revenue deficit Gross fiscal Gross primary

deficit deficit
1980-81 1.4 5.6 3.8
1990-91 3.2 7.6 4.0
1991-92 2.4 5.4 1.4
1997-98 3.0 5.7 1.5
2005-06 2.5 4.0 0.4
2009-10 5.2 6.5 3.2
2019-20 3.3 4.6 1.6
2020-21 7.3 9.2 5.8
2022-23 3.8 6.4 2.8
(Estimated)

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• Central Government’s revenue deficit, fiscal deficit and primary deficit rose substantially
from 1980-81 to 1990-91.
• Major steps were taken in 1991-92, like 5% cut in expenditure of all ministries and
departments. It leads to reduction in all type of deficits.
• Since 1997-98, all types of deficits rose. Reasons were-
o First, reduction in tax rates adversely affected the tax revenue.
o Second, non-development expenditure continued increasing.
• All types of deficits declined after the enactment of Fiscal reforms and Budget
Management (FRBM) Act in 2004.
• Increased after the financial year 2008-09 due to the global slowdown.
• It declined from 2009-10 to 2019-20.
• Because of COVID-19, the fiscal situation deteriorated considerably in 2020-21.
• Due to stringent economic measures taken by the government since 2020, the economy is
getting strengthened and therefore, in 2022-23, all deficits are expected to show a decline

Fiscal Consolidation
It is a process through which the economy’s fiscal health is improved by taking measures to
reduce fiscal deficit to a manageable label. Fiscal consolidation provides macro-economic stability;
reduces wasteful expenditure; increases the income; can enable government to spend more on
infrastructure and social sectors.
Fiscal responsibility and budget management act was enacted in 2004 to provide an
institutional framework and binds the government to adopt prudent fiscal policies.

A number of steps have been taken by the government of India to reduce its fiscal deficit –

• Revenue front
▪ Tax Revenue reforms in terms of introduction of GST, abolition of wealth tax,
rationalisation of tax exemptions, improving efficiency of the tax collection along with
tax stability.
▪ Improvement of stable capital receipts in terms of disinvestment and privatisation.
▪ Use of surplus forex reserves in external lending and purchasing high quality
sovereign bonds

• Expenditure front

▪ Rationalization of subsidies, salaries and PF of government employees

▪ Pension reforms
▪ Cutting down of interest burden (by lesser borrowings, payment of debts, promoting
external lending etc.)
▪ Reducing budgetary support to loss making PSUs
▪ Tackling leakages through digitalization
▪ Allocation of resources to priority and strategic sectors

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Fiscal Responsibility and Budget Management Act

The Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) is an Act of the Parliament
of India to improve fiscal discipline, reduce India's fiscal deficit, improve macroeconomic
management and the overall management of the public funds by moving towards a balanced
budget.

The act was enacted to support India’s economy which was undergoing through high fiscal deficit,
high revenue deficit and high debt-GDP ratio in 1990s and 2000s.

Objectives of FRBM Act

• Efficient management of expenditure, revenue and debt.

• Macroeconomic stability
• Better coordination between fiscal and monetary policy
• Achieving a balanced budget

Major highlights of the act

• To reduce fiscal deficit by 0.3% per annum and reach the levels of 3% fiscal deficit by 2008-
09.
• To reduce revenue deficit by 0.5% per annum and to eliminate revenue deficit by 2008-09.
• Fiscal deficit and revenue deficit may exceed the targets only on the ground such as
national security, calamity or any other exceptional grounds.
• Government not to borrow from RBI except by Ways and Means Advances (WMAs) to meet
temporary excess of cash disbursement over cash receipts.
• The finance minister to make quarterly review of trends in receipts and expenditure in
relation to the budget and place the review before the parliament.
• Along with the budget and demands for grants, the Government to lay the following three
statements before the parliament every financial year:
▪ Fiscal Policy Strategy Statement
▪ Medium-term Fiscal Policy Statement
▪ Macro-economic Framework Statement
▪ Medium term expenditure statement

Fiscal Policy Strategy Statement

The Strategy Statement outlines the strategic priorities of Government in the fiscal
area for the ensuing financial year relating to taxation, expenditure, lending and
investments, administered pricing, borrowings and guarantees.

Medium- term Fiscal Policy Statement

It sets out the three-year rolling targets for five specific fiscal indicators in relation
to GDP at market prices, namely (i) Revenue Deficit, (ii) Fiscal Deficit, (iii) Effective
Revenue Deficit (iv) Tax to GDP ratio and (v) Total outstanding Central
Government Debt at the end of the year.

Macro-economic Framework Statement

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This includes an assessment regarding the GDP growth rate, fiscal balance of the
central government and the external sector balance of the economy.
Monetary management and financial intermediation, banking sector, agriculture
and industry are also covered by the statement.

Medium Term Expenditure Statement

This statement provides a three-year rolling target for the expenditure indicators
with specifications of underlying assumptions and risks involved.

The set targets could not be achieved by the end of 2008-09. One of the major reasons
behind such failures was the 2008 international sub-prime crises.

FRBM Amendment Act 2012

• A new concept Effective revenue deficit was introduced.

• To target Effective Revenue Deficit in place of Revenue deficit. Therefore, a target was set
to reduce effective revenue deficit to 0% by 31st March 2015.
• Fiscal deficit should be reduced to 3% of GDP by 31st March 2015. The minimum annual
reduction target was 0.3% of the GDP
• Medium-term Expenditure Statement to be placed in the parliament along with the Union
Budget.

Committee to review FRBM targets (N.K Singh Committee)

• It was formed under the chairmanship of N.K. Singh in 2016. It submitted its report in 2017.
• Major recommendation of the committee –
▪ Fiscal deficit: Should be reduced to 3% of GDP by 2020-21, and to 2.5% of GDP by
2022-23. (Accepted by the government)
▪ Revenue deficit: Should be decreased by 0.25% every year and reach to 0.8% by
2022-23. (Not accepted by the government)
▪ Debt to GDP Ratio: Overall government debt to GDP ratio should be reduced to 60%
up to 2022-23 with 40% threshold for the centre and 20% for the states. (Accepted by
the government)
▪ An autonomous fiscal council should be created to give suggestions for healthy fiscal
targets. (Not accepted by the government)
▪ The centre should not borrow from RBI except in the case of –
o Any temporary shortfall
o RBI subscribes government securities to finance any deviations
o RBI purchases government securities from the secondary market

Year Debt/GDP ratio Fiscal deficit Revenue deficit

(in % to GDP) (in % to GDP)
2017 (End March) 68.9% 3.5 2.1
(Centre- 49.6%,
States- 24.9%)
2023 (target) 60% 2.5 0.8
(Centre- 40%
States- 20%)

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Following the recommendations of N.K Singh committee, government amended the FRBM act in
2018.

FRBM Amendment Act 2018

• To limit the fiscal deficit up to 3% of GDP by 31st March 2021

• General government debt shall not exceed 60% by the end of 2024-25
• Central government debt shall not exceed 40% of GDP by the end of 2024-25
• The government should not provide guarantees in excess of 0.5% of GDP in any financial
year, beginning 2004-05
• Any deviation from fiscal deficit target shall not exceed 0.5% of GDP in a financial year.
• Whenever there is a deviation from the fiscal deficit target the government has to lay down
the reasons explaining the deviation, in both the houses of the parliament.
• The central government shall not borrow from RBI except through the means of Ways and
Advances

Escape Clause

• It was inserted in the act through FRBM amendment act 2018

• As per the escape clause, deviations of up to 0.5% of GDP from the stipulated fiscal deficit
target may be allowed under special circumstances.
• Those special situations include national security concerns, natural calamities, collapse of
agricultural sector, far-reaching structural reforms with unanticipated fiscal implications.
• Government of India invoked the escape clause in FY 2020-21 budget. The finance minister
pegged the revised estimate of fiscal deficit as a percentage of GDP for FY 20 and FY 21 at
3.8% and 3.5% of GDP respectively.
• In budget 2022-23, the finance minister announced that the government aims to reduce the
fiscal deficit to below 4.5% of GDP by 2025-26

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