Economics: Class 12 (Part 1) — Chapter 5: Government Budget and the Economy

The government intervenes in the economy to increase public welfare through three primary functions:

1. Allocation Function: Government provides public goods (e.g., national defence, roads, public administration) which cannot be provided through market mechanisms.
   • Non-rivalrous: One person's consumption does not reduce the amount available for others.
   • Non-excludable: There is no feasible way to exclude anyone from enjoying the benefits of the good, leading to the free-rider problem.
   • Public Provision: Financed through the budget and used without direct payment (distinct from public production, where goods are directly produced by the government).
2. Redistribution Function: The government alters the distribution of income to achieve a "fair" distribution by making transfers and collecting taxes, thereby affecting personal disposable income.
3. Stabilisation Function: The government intervenes to expand or reduce aggregate demand to correct fluctuations in income and employment, preventing inflation or unemployment.

Government receipts are broadly classified into:

• Revenue Receipts: Receipts that do not lead to a claim on the government (non-redeemable). They are divided into:
  • Tax Revenues: Direct taxes (personal income tax, corporation tax) and indirect taxes (GST, customs duties).
  • Non-tax Revenues: Interest receipts, dividends and profits, fees, and cash grants-in-aid.
• Capital Receipts: Receipts that create liabilities or reduce financial assets (e.g., market borrowings, recovery of loans, and PSU disinvestment).

• Revenue Expenditure: Expenditure incurred for purposes other than the creation of physical or financial assets (e.g., interest payments, defence services, subsidies, salaries, and pensions).
• Capital Expenditure: Expenditure that results in the creation of physical or financial assets or the reduction of financial liabilities (e.g., acquisition of land, machinery, shares, and loans to state governments).

There are three primary measures of government deficit:

1. Revenue Deficit: Refers to the excess of government's revenue expenditure over revenue receipts.
   $$\text{Revenue Deficit} = \text{Revenue Expenditure} - \text{Revenue Receipts}$$
2. Fiscal Deficit: The difference between the government's total expenditure and its total receipts excluding borrowing.
   $$\text{Gross Fiscal Deficit} = \text{Total Expenditure} - (\text{Revenue Receipts} + \text{Non-debt Creating Capital Receipts})$$

   From the financing side:

   $$\text{Gross Fiscal Deficit} = \text{Net Borrowing at Home} + \text{Borrowing from RBI} + \text{Borrowing from Abroad}$$
3. Primary Deficit: Measures the borrowing requirement of the government excluding interest obligations on accumulated debt.
   $$\text{Gross Primary Deficit} = \text{Gross Fiscal Deficit} - \text{Net Interest Liabilities}$$

• Consumption Function with Lump-sum Taxes ($T$):
  $$C = \bar{C} + c(Y - T + \bar{TR})$$
• Government Expenditure Multiplier: Measures the change in equilibrium income due to a change in government purchases.
  $$\frac{\Delta Y}{\Delta G} = \frac{1}{1 - c}$$
• Tax Multiplier: Measures the change in income due to a change in taxes. It is negative and smaller in absolute value than the expenditure multiplier.
  $$\frac{\Delta Y}{\Delta T} = \frac{-c}{1 - c}$$
• Balanced Budget Multiplier: If an increase in government spending is matched by an equal increase in taxes, the balanced budget multiplier is unity ($1$).
  $$\frac{\Delta Y^*}{\Delta G} = \frac{1}{1 - c} + \frac{-c}{1 - c} = 1$$
• Proportional Income Taxes ($T = tY$): Reduces the marginal propensity to consume out of income to $c(1-t)$, acting as an automatic stabiliser.
  $$\text{Multiplier with Proportional Taxes} = \frac{1}{1 - c(1 - t)}$$

• Intergenerational Burden: Borrowing transfers the burden of consumption today to future generations through higher future taxes.
• Ricardian Equivalence: Consumers are forward-looking and increase savings today to pay for anticipated future taxes, offsetting the impact of government dissaving.
• Crowding Out: Government borrowing competes with private investment for savings, raising interest rates and reducing private capital formation.

Deficits can be reduced by increasing tax revenues (relying more on direct taxes) or reducing government expenditure through better planning and administration.

An institutional framework to bind the government to a prudent fiscal policy. Its main features include:

• Mandating the reduction of the fiscal deficit to not more than 3% of GDP.
• Eliminating the revenue deficit to build up a revenue surplus.
• Restricting the central government from borrowing directly from the Reserve Bank of India (RBI) except under temporary circumstances.

Implemented on 1 July 2017, GST is a comprehensive, destination-based indirect tax that replaced multiple central and state taxes.

• Key Feature: Input Tax Credit (ITC) mitigates the cascading effect of taxation by allowing credit for taxes paid at previous stages of the supply chain.
• Standard Rates: 0%, 3%, 5%, 12%, 18%, and 28%.