Government Budget and the Economy – Study Guide (Chapter 5)
1. Government Budget — Meaning and Components
Government Budget is a statement of the government’s estimated receipts (income) and expenditure for a financial year. It represents the government’s plan for managing public finances and policy priorities.
Main components:
- Receipts — Revenue receipts and capital receipts.
- Expenditure — Revenue expenditure and capital expenditure.
- Fiscal balance — The difference between total receipts and total expenditure.
2. Objectives of Government Budget
The budget serves the following economic and social objectives:
- Allocation: Allocating resources for public services and infrastructure.
- Distribution: Redistributing income through taxes and transfers to reduce inequality.
- Stabilization: Using counter-cyclical policies to control inflation and unemployment.
- Growth: Promoting long-term development through investment and incentives.
Budgets often aim to balance these goals, and sometimes trade-offs arise between them.
3. Role of Government
The government plays several roles in the economy:
- Providing public goods and basic infrastructure.
- Correcting market failures and regulation.
- Redistributing income and providing social security.
- Maintaining economic stability through demand management and sustainable policies.
4. Classification of Receipts
Government receipts are mainly of two types:
| Type | Includes | Characteristics |
|---|---|---|
| Revenue Receipts | Tax revenue (Income tax, GST), Non-tax revenue (fees, fines, interest) | Regular; does not create liability |
| Capital Receipts | Borrowings, recovery of loans, disinvestment | Generally creates liability or reduces assets |
Example: Tax collection is a revenue receipt; market borrowing is a capital receipt.
5. Revenue Receipts — Details
- Tax Revenue: Direct taxes (Income tax, corporate tax) and indirect taxes (GST, customs duty).
- Non-Tax Revenue: Dividends from public enterprises, fees, fines, interest income.
Revenue receipts are crucial to finance routine expenditures and welfare schemes.
6. Classification of Expenditure
Government expenditure is divided into two categories:
| Type | Includes | Purpose |
|---|---|---|
| Revenue Expenditure | Salaries, subsidies, interest payments, pensions | Regular spending; does not create assets |
| Capital Expenditure | Infrastructure, capital grants, loans | Creates assets or reduces liabilities |
Building a road — capital expenditure; salary of school teacher — revenue expenditure.
7. Balanced, Surplus and Deficit Budget
- Balanced Budget: Total receipts = total expenditure.
- Surplus Budget: Receipts > expenditure (government can repay debt or save more).
- Deficit Budget: Expenditure > receipts — government borrows to meet the gap.
Types of Deficit:
Fiscal Deficit: Total expenditure − (Revenue receipts + Non-debt capital receipts)
Revenue Deficit: Revenue expenditure − revenue receipts
Primary Deficit: Fiscal deficit − interest payment
Fiscal Deficit: Total expenditure − (Revenue receipts + Non-debt capital receipts)
Revenue Deficit: Revenue expenditure − revenue receipts
Primary Deficit: Fiscal deficit − interest payment
8. Measures of Government Deficit
| Measure | Definition / Formula |
|---|---|
| Fiscal Deficit | Total expenditure − (Revenue receipts + Non-debt capital receipts) |
| Revenue Deficit | Revenue expenditure − revenue receipts |
| Primary Deficit | Fiscal deficit − interest payment |
These indicators are used to assess the government’s financial health and borrowing capacity.
9. Fiscal Policy
Fiscal Policy refers to government policies on expenditure and taxation to influence the economy. According to Keynes, the government can actively manage demand.
- Expansionary Policy: Increase government spending or reduce taxes → increases aggregate demand and employment.
- Contractionary Policy: Reduce expenditure or increase taxes → decreases demand to control inflation.
During a recession, if private demand is weak, the government can increase public spending to restore full employment.
10. Changes in Government Expenditure — Effects
Changes in government expenditure affect aggregate demand and income via the multiplier effect:
ΔY = k × ΔG, where k = 1 / (1 − c(1 − t)) (if taxes exist)
- Increased public investment raises immediate demand and can stimulate private investment in the long run.
- Targeted transfers increase consumption of low-income households, enhancing multiplier effect.
Results depend on crowding-out, economy’s capacity, and the size of the multiplier.
11. Changes in Taxes
Tax changes affect disposable income and consumption:
- Tax Reduction: Increases disposable income → consumption & aggregate demand rise (depends on MPC).
- Tax Increase: Reduces disposable income → consumption & demand fall.
Tax-adjusted multiplier: k = 1 / (1 − c(1 − t)) where t = average/marginal tax rate
If tax rate (t) rises, the effective multiplier decreases and fiscal stimulus impact reduces.
12. Public Debt
Government borrows to finance deficits. Key points:
- Debt Sustainability: Debt/GDP ratio and interest payment capacity matter.
- Usage: Productive investment (infrastructure) vs revenue financing — productive investment can increase future revenue.
- Intergenerational Impact: Excessive borrowing may burden future generations with taxes.
Sound financial management balances current needs and long-term stability.
13. Fiscal Responsibility and Budget Management Act, 2003 (FRBMA)
FRBMA ensures fiscal discipline, transparency, and accountability. Key provisions:
- Set targets for fiscal indicators (e.g., reducing fiscal deficit as % of GDP).
- Commitment to medium-term debt reduction.
- Transparent reporting and budget disclosures.
Such frameworks provide credibility and long-term stability while allowing flexibility for unforeseen economic conditions.
14. Box — GST: One Nation, One Tax, One Market
Goods and Services Tax (GST) replaced multiple central and state indirect taxes, simplifying the tax system. Its effects:
- Tax Base Expansion: Better compliance and reduced cascading of taxes.
- Revenue Impact: Transitional revenue fluctuations; long-term improved collection.
- Market Effect: Integration of internal market and reduced state-level barriers.
GST’s impact on federal finances depends on center-state revenue sharing arrangements.
15. Summary Table — Key Definitions & Formulas
| Term | Definition / Formula |
|---|---|
| Fiscal Deficit | Total expenditure − (Revenue receipts + Non-debt capital receipts) |
| Revenue Deficit | Revenue expenditure − revenue receipts |
| Primary Deficit | Fiscal deficit − interest payment |
| Fiscal Policy | Government expenditure and taxation policy to stabilize the economy |
16. Practice Questions (Brief)
- Explain the difference between revenue and capital receipts with examples.
- How does an increase in government investment affect aggregate demand? Discuss briefly.
- Define fiscal deficit, revenue deficit, and primary deficit. Why is each important?
- Describe the main objectives of the fiscal responsibility framework.
17. Conclusion
The government budget is a central tool of economic policy — balancing allocation, distribution, and stabilization objectives. Effective budget management requires coordinated taxation, expenditure, and borrowing policies to ensure both growth and financial stability.