GRADE XII (2022-23)

FISCAL POLICY
ECONOMICS

Fiscal policy is defined as the policy under which the government uses the instruments of taxation, public
spending and public borrowing to achieve various objectives of economic policy.
Public Finance is the study of revenue and expenditure of the government at the centre, state and local
levels.
Instruments of the Fiscal Policy:
1. Taxation
2. Public Expenditure
3. Public Debt/Borrowing
TAXATION
Tax: “Tax is a compulsory contribution from a person to the government to defray all expenses incurred in
the common interest of all, without reference to special benefits conferred.” A tax is a compulsory
contribution, mandated by the law, which is a personal obligation with no quid pro quo.
Types of Taxes:
1. Direct Taxes
2. Indirect Taxes
Direct Taxes:
 A Direct Tax is one whose impact and incidence lies on the same person. The incidence of a direct
tax cannot be shifted to anyone else.
 Direct Tax is levied on the income and property of a person.
 Examples: Income Tax, Wealth Tax, Property Tax, Corporation Tax, Capital Gains Tax, etc…
**Impact means who the government collects the tax from and Incidence means who bears the actual
burden of that tax.
Indirect Taxes:
 An Indirect Tax is that tax which is initially imposed on and paid by one individual, but the
incidence (burden) of which is passed over to some other individual who ultimately bears it.
 Indirect tax is imposed on and collected from producers or sellers.
 Producers and sellers shift the incidence of the tax (burden) to the consumers by raising the prices of
the goods and services.
 Examples: GST, Service Tax, Entertainment Tax, Customs Duty
**Impact means who the government collects the tax from and Incidence means who bears the actual
burden of that tax.

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Proportional Taxation Progressive Taxation Regressive Taxation Degressive Taxation

A tax is called A tax is called progressive A tax is called A tax is called

proportional when the when the rate of taxation regressive when the degressive when the
rate of taxation remains increases as the income of rate of taxation rate of taxation
the same as the income the taxpayer increases. decreases as the initially increases with
of the taxpayer income of the an increase in the
increases. taxpayer increases. income and then
becomes constant as
the income of the
taxpayer increases
further.

The percentage of tax is The percentage of tax is The percentage of tax This is initially
constant for every level increasing for every higher is decreasing for every progressive and then
of income. The rich and level of income. The rich are higher level of becomes proportional.
poor are taxed at the taxed at a higher percentage income. The rich are
same rate. than the poor. taxed at a lower
percentage than the
poor.

Income Proportional Tax Progressive Tax Regressive Tax

Rs. (Lakh) Rate (%) Rate (%) Rate (%)
5 20 20 20
10 20 30 15

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PUBLIC EXPENDITURE
Public Expenditure refers to the expenses incurred by public authorities – central government, state
government, and local bodies – for its own maintenance as also for meeting the collective needs of the
citizens and/or for promoting their economic and social welfare.
Government spends on administration, maintenance of law and order, education, health, defence, public
transportation, etc…
TYPES OF PUBLIC EXPENDITURES:
1. Direct and Transfer Expenditure:
Expenditure incurred by the government on the purchase of goods and services and on current
services of factors of production is called government direct expenditure. Eg: defence, civil services,
educational services, judiciary, and investment expenditure are all direct expenditures.
Transfer expenditures are those expenditures which take the form of payments which are made
without corresponding returns of goods and factor services to the government. Eg: Interest of
National debt, old-age pensions, sickness benefits, etc…

2. Developmental and Non-Developmental Expenditure:

Developmental Expenditure is that which is incurred in promoting economic and social development
of the country. Expenditure such as, education, scientific services, public health, labour and
employment, transport and communication, agricultural and industrial development expenses are all
developmental expenditure.
Non-developmental expenditure is that which is incurred on non-developmental activities of the
government in the form of provision of essential general services of the government. Expenditure
such as, police, defence, administration of justice, general administration, interest payments,
pensions, retirement benefits, grants and aids to state governments for non-developmental purposes,
etc…
IMPORTANCE OF PUBLIC EXPENDITURE – EFFECTS OF PUBLIC EXPENDITURE
Effect of public expenditure on Production
1. Public expenditure on defence, administration, goods and services, creates income for the persons
who are involved in the production of these goods and services. This helps in increasing their
purchasing power.
2. Public expenditure on health, education, housing, sanitation, helps to improve the efficiency of the
people in the economy. Productive human capital leads to more production and more income of the
people.
3. Public expenditure is used to manufacture and procure essential raw materials and other important
inputs in the public sector. This helps to remove shortages of essentials like fertilizers, steel, etc… to
ensure smooth production.
4. Public expenditure is essential for development of basic and key industries such as capital goods
industry, to boost the production of the economy.
5. Public expenditure incurred in providing social security schemes such as old-age pensions,
unemployment allowances, etc… increases the purchasing power of the people. This also increases
their willingness to work as they feel secure of their future because of these policies of the
government.

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Effect of Public Expenditure on Investment
1. Public expenditure on maintenance of law and order creates confidence in the minds of the investors
and hence encourages investment
2. Public expenditure can be directly used to create social overheads in the form of human capital.
3. Creation and maintenance of economic overheads such as power, irrigation, transport, etc…
motivates investors to invest in the economy. This promotes agricultural and industrial development
4. Government provides financial assistance and subsidies to the private sector and thereby stimulates
investment. Provision of subsidised fertilizers has helped boost the agricultural development in India.
Effect of Public Expenditure on Income Distribution:
1. Public expenditure incurred in providing social security schemes such as old-age pensions,
unemployment allowances, etc… helps the poorer sections of the society and helps create an even
income distribution
2. Public expenditure on free medical services, free education, etc.. helps the poor in a big way and
brings about some equality in income distribution
3. Public expenditure incurred in providing subsidies on articles of common consumption like
foodgrains can also help poor people and improve the income distribution
4. Public expenditures on subsidies and financial assistance given to the producers to set-up industries
in the backward regions, helps in reducing regional disparities
Effect of Public Expenditure on Economic Growth:
1. Public expenditure promotes economic development directly by developing economic overheads and
infrastructure and by establishing capital goods industries, basic and key industries, etc…
2. Public expenditure on health, education, housing, sanitation, helps to improve the efficiency of the
people in the economy. Productive human capital leads to more production and more income of the
people. This improves economic growth and development.
3. Public expenditure in the form of subsidies can help stimulate agricultural and industrial
development.
4. Public expenditure policy can be effectively used to reduce glaring disparities in income and wealth
as well as to reduce regional disparities.
5. Public expenditure helps in achieving growth with social justice.

PUBLIC DEBT
Public debt is the debt which the government owes to its subjects or to the nationals of other countries. It
refers to loans raised by the government from within the country or from outside the country.
STRUCTURE (TYPES) OF PUBLIC DEBTS
1. Internal and External Debt:
Internal Debt refers to the public loans floated within the country. The government borrows funds
from the individuals and institutions located within the country. Payment of interest on internal debt
does not pose much problem, as it causes redistribution of income within the country.
External debt refers to the loans taken by the government from the individuals, institutions and
governments of foreign countries as well as the loans taken from the international financial
institutions like World Bank and IMF, etc. Payment of interest on external debt is burdensome on the
economy, as it needs to be made in foreign currency, which leads to a BoP deficit.

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 2. Productive and Unproductive Debt:
Productive debt is the debt which is used by the government for directly productive purposes. It is
used for projects which yield incomes like, development of railways, power projects, irrigation
projects, establishment of industries. Productive debts can be paid back out of the government
revenues generated by the financed by these debts. Productive debts do not burden the government.
Unproductive debt is that debt which is used for undertaking projects which are not directly
productive. It is incurred on projects like financing a war, controlling floods, epidemics, etc… such
debts do not add to the productive capacity of the economy. They are a burden on the economy. It is
also called deadweight debt.

Methods of Debt Redemption:

1. Refunding: Refunding is the process by which the government raises new bonds to pay off the
maturing bonds. Government takes a fresh loan to repay the old loan. The money burden of the debt
is not liquidated, but it is postponed to a future date. The total burden of the debt continues to
accumulate. This method is usually adopted when the government is not in a position to repay its
outstanding debt for the time being
2. Debt conversion: The form of debt is changed. The process of conversion consists of converting a
high interest debt into a low interest debt. The government might have borrowed at a time when the
interest rate might have been high. But if the market rate is low, it may move to convert. The
government is able to reduce the financial burden of the debt thereby. This is possible only when the
government enjoys good credit worthiness.
3. Budgetary surplus: If the government budget is in surplus, it can be used to pay off its debts to the
people. A government may use its budgetary surplus to purchase back its own bonds and securities
from the market. As a result, there is automatic liquidation of the debt liability of the government.
Budgetary surplus is a rare phenomenon.
4. Terminal Annuities: The government pays its debt in equal annual instalments, which includes
interest as well as the principal amount of debt. The annual payments are called annuities. The
burden of debt goes on diminishing annually and by the time of its maturity, it is fully paid off.
5. Sinking Fund: The government establishes a separate fund known as the ‘sinking fund’ for the
purpose of repayment of debt. The government credits (deposits) a certain amount of its revenue
every year for repayment of outstanding debt along with interest. This helps the government clear the
dues on time
6. Statutory reduction in the rate of interest: Sometimes, the government takes a statutory decision
to reduce the rate of interest payable on its public debt. The creditors are forced to accept the reduced
rate of interest in view of the statutory powers of the government. The government adopts this
policy, usually only during time of financial crisis.
7. Capital Levy: Capital levy refers to a very heavy tax on property and wealth. It is a once and for all
tax imposed on capital assets of a certain value. It is imposed on the rich and propertied individuals
on a progressive scale. This system is usually suggested to pay off the war time debts by taxing rich
section of the community. It is usually not used in normal times for debt redemption.
8. Export Surplus: The methods discussed above are used to repay internal debt. External debt needs
to be repaid in foreign exchange. This can be done by creating export surplus. Productive foreign
loans are relatively easier to repay with export surplus, compared to unproductive foreign loans.
Deficit Financing – Meaning Only.
Deficit financing means meeting the deficit between government expenditure and revenue through the
creation of new money. Deficit financing means generating funds to finance the deficit which results from
excess of expenditure over revenue. The gap being covered by borrowing from the public by the sale of
bonds or by printing new money.
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