GS Notes

6. Economics Notes 20

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Elaborate Notes

Components of the Union Budget

The Union Budget of India, presented annually as the ‘Annual Financial Statement’ under Article 112 of the Constitution, is the most comprehensive account of the government’s finances. It is fundamentally structured into two parts: Receipts and Expenditures, which are further classified to provide a clear picture of the government’s fiscal operations.

  • Receipts: These represent the total income of the government. They are bifurcated into Revenue Receipts and Capital Receipts based on their impact on the government’s assets and liabilities.

    • Revenue Receipts: These are receipts that do not create any corresponding liability for the government nor lead to a reduction in its assets. They are regular and recurring in nature.

      • Tax Revenue: This is the primary source of government income.
        • Direct Taxes: These are levied on the income and profits of individuals and corporations. The incidence and impact of these taxes fall on the same entity. Examples include:
          • Personal Income Tax: Tax on the income of individuals.
          • Corporate Tax: Tax on the profits of companies. The history of corporate tax reforms in India includes recommendations from the Raja Chelliah Committee (1991), which suggested reducing rates and widening the tax base.
        • Indirect Taxes: These are levied on goods and services. The impact can be passed on from the producer/provider to the final consumer. Examples include:
          • Goods and Services Tax (GST): Introduced via the 101st Constitutional Amendment Act, 2016, it subsumed most central and state indirect taxes. It is a destination-based consumption tax.
          • Customs Duty: Levied on goods imported into India.
          • Excise Duty: Primarily levied on petroleum, liquor, and tobacco products.
      • Non-Tax Revenue: These are revenues earned by the government from sources other than taxes.
        • Interest Receipts: Interest earned on loans extended by the Central Government to states, Union Territories, and Public Sector Enterprises (PSEs).
        • Dividends and Profits: Income from the government’s investments in PSEs and other companies. This is a key component of the government’s non-tax revenue, often linked to the performance of state-owned entities.
        • Fees and Other Receipts for Services: These include fees for services like issuance of passports, spectrum auctions (a significant source since the 2010s), licenses, etc. They are categorised under social, economic, general, and fiscal services. For instance, spectrum auction proceeds are a major component of ‘economic services’ receipts.

    • Capital Receipts: These are receipts that either create a liability for the government (e.g., borrowings) or reduce its financial assets (e.g., disinvestment).

      • Debt-Creating Capital Receipts: These are essentially borrowings and represent a future repayment obligation.
        • Borrowings: This includes market borrowings (issuing government securities like T-bills and bonds), loans from the Reserve Bank of India (RBI), and loans from foreign governments and international financial institutions like the World Bank and IMF.
      • Non-Debt-Creating Capital Receipts: These receipts do not add to the government’s debt.
        • Recovery of Loans: Repayments of loans previously extended by the Central Government.
        • Disinvestment: The sale of government equity in Public Sector Undertakings (PSUs). The policy of disinvestment gained momentum post-1991 economic reforms, as recommended by the C. Rangarajan Committee (1993), to improve efficiency and raise resources.

  • Expenditure: This represents the total spending of the government. It is classified into Revenue Expenditure and Capital Expenditure.

    • Revenue Expenditure: This is expenditure that does not result in the creation of physical or financial assets. It is incurred for the normal functioning of government departments and maintenance of services. It is recurring in nature.

      • Interest Payments: A major component, representing interest paid on past borrowings. This is a ‘committed’ expenditure, meaning the government has little flexibility in reducing it in the short term.
      • Salaries, Pensions, and Administrative Expenses: Expenses for the day-to-day functioning of the government.
      • Subsidies: Financial support provided by the government on items like food (through PDS), fertilizers, and petroleum products to make them affordable for the public.
      • Grants to States and UTs: Financial assistance given to state governments, some of which may be used by the states for capital asset creation. This distinction is crucial for understanding the concept of Effective Revenue Deficit.
      • Defence Expenditure: Primarily includes salaries, pensions, and maintenance costs for the armed forces (often termed ‘Defence Revenue Expenditure’).

    • Capital Expenditure (Capex): This is expenditure that leads to the creation of physical or financial assets (e.g., infrastructure) or a reduction in financial liabilities (e.g., loan repayments). It is considered productive and growth-enhancing.

      • Creation of Physical Assets: Expenditure on land, buildings, machinery, and infrastructure projects like roads, bridges, and ports. The National Infrastructure Pipeline (NIP) is a modern example of a strategic push towards enhancing capex.
      • Investment in Shares: Government investment in PSUs or other companies.
      • Loans and Advances: Loans extended by the Central Government to states, UTs, and PSEs.
      • Repayment of Loans: Repayment of the principal amount of loans taken by the government reduces its liabilities.

Different Types of Deficit

A deficit occurs when expenditure exceeds revenue. Different deficit metrics provide different insights into the government’s fiscal health.

  • Revenue Deficit (RD):

    • Formula: RD = Revenue Expenditure (RE) - Revenue Receipts (RR).
    • Significance: It indicates that the government’s own regular income is insufficient to meet its day-to-day operational expenses. To finance this gap, the government has to resort to borrowing or selling its assets. This implies that borrowings are being used for consumption purposes rather than for investment, which is considered fiscally imprudent as it doesn’t create future income-generating assets. Bimal Jalan, former RBI Governor, has often highlighted the dangers of high revenue deficits leading to a potential debt trap.

  • Budgetary Deficit (BD):

    • Formula: BD = Total Expenditure - Total Receipts.
    • Historical Context: Before 1997, this was a key policy variable. It was financed by issuing ad-hoc Treasury Bills to the RBI, which was equivalent to printing money (deficit financing). This practice was discontinued from April 1, 1997, and replaced by the Ways and Means Advances (WMA) system to manage temporary mismatches. Consequently, the concept of Budgetary Deficit has become irrelevant for policymaking in India, and it is targeted to be zero.

  • Fiscal Deficit (FD):

    • Formula: FD = Total Expenditure - (Revenue Receipts + Non-Debt Creating Capital Receipts).
    • Significance: The fiscal deficit is the most important indicator of a government’s fiscal health. It represents the total borrowing requirement of the government from all sources during a fiscal year. A high fiscal deficit can lead to inflation (if financed by RBI), crowding out of private investment (as government borrowing absorbs a large share of savings), and an increase in public debt. The Vijay Kelkar Committee (2012) provided a roadmap for fiscal consolidation, emphasizing the need to curtail the fiscal deficit.
    • Relationship with other deficits: FD = Borrowings. Since Budgetary Deficit is now zero, Fiscal Deficit equals the total borrowings and other liabilities of the government.

  • Effective Revenue Deficit (ERD):

    • Formula: ERD = Revenue Deficit - Grants-in-aid for creation of capital assets.
    • Introduction: This concept was introduced in the Union Budget 2011-12. The rationale, as explained by then Finance Minister Pranab Mukherjee, was that while grants given to states are classified as revenue expenditure for the Centre, a portion of these grants is used by states to create capital assets. The ERD segregates this capital-forming component to provide a more accurate measure of the Centre’s consumption expenditure. It was formally incorporated via the 2012 amendment to the FRBM Act.

  • Primary Deficit (PD):

    • Formula: PD = Fiscal Deficit - Interest Payments.
    • Significance: It indicates the government’s borrowing requirement exclusive of the interest payments on past debts. A declining primary deficit shows that the government is making progress towards fiscal consolidation. If the primary deficit is zero, it means the government is borrowing only to meet its interest payment obligations, and the debt level will remain stable (relative to GDP, if the economy grows). A primary surplus indicates that the government’s revenues are sufficient to cover its non-interest expenses.

Fiscal Responsibility and Budget Management (FRBM) Act, 2003

  • Historical Context & Rationale: In the post-liberalization era of the 1990s, India faced persistent high fiscal deficits, a burgeoning public debt, and a high revenue deficit. This was a result of increasing public expenditure on subsidies, salaries, and interest payments without a commensurate increase in revenues. This fiscal profligacy was seen as a major impediment to macroeconomic stability and growth. The ideas of the Washington Consensus (a set of economic policy prescriptions for developing countries) promoted fiscal discipline as a cornerstone of sound economic management. To institutionalize this fiscal discipline, the FRBM Act was enacted in 2003 during the tenure of the NDA government led by Atal Bihari Vajpayee, with the law coming into effect in 2004.

  • Objectives:

    • To introduce transparency and accountability in the government’s fiscal operations.
    • To achieve long-term macroeconomic stability by setting targets for fiscal indicators.
    • To ensure inter-generational equity in fiscal management, preventing the burden of current expenditure from being passed on to future generations.
    • To provide flexibility to the RBI in managing monetary policy by limiting the government’s reliance on it for financing deficits.

  • Initial Targets (to be achieved by 2008-09):

    • Revenue Deficit: To be eliminated (i.e., brought to zero). A minimum annual reduction of 0.5% of GDP was mandated.
    • Fiscal Deficit: To be reduced to 3% of GDP. A minimum annual reduction of 0.3% of GDP was mandated.
    • Cessation of RBI Borrowing: The government was to cease borrowing directly from the RBI by ending the subscription to primary issues of government securities from April 1, 2006.
    • Annual Debt Limit: The government was required to limit the increase in its total liabilities.

  • Pause and Amendments: The path of fiscal consolidation was paused in 2008-09 due to the Global Financial Crisis, which necessitated a fiscal stimulus to support the economy. Subsequently, the Act was amended in 2012 (which introduced the concept of ERD) and 2015.

Amendments and Key Documents under FRBM

  • N.K. Singh Committee (2016-17): A committee to review the FRBM Act was constituted under N.K. Singh. Its key recommendations included:

    • Adopting a Debt-to-GDP ratio as the primary anchor for fiscal policy, targeting a combined (Centre + States) ratio of 60% by 2023 (40% for the Centre and 20% for the States).
    • Setting targets for Fiscal Deficit (as an operational target) and Revenue Deficit.
    • Establishing a Fiscal Council to provide independent assessments of the government’s fiscal performance.
    • Introducing a clearly defined ‘escape clause’ that would allow for deviations from fiscal targets in specific circumstances like a national calamity, war, or a severe economic downturn (defined as a fall in real output growth of at least 3 percentage points).

  • Documents Mandated by the Act: To ensure transparency, the government is required to present the following documents in Parliament along with the Union Budget:

    • Medium-Term Fiscal Policy Statement: This sets out three-year rolling targets for key fiscal indicators like RD, FD, Tax/GDP ratio, and total outstanding debt as a percentage of GDP.
    • Macroeconomic Framework Statement: This provides an assessment of the economy’s growth prospects, including GDP growth, inflation, and the balance of payments. It presents the underlying assumptions for the budget projections.
    • Fiscal Policy Strategy Statement: This outlines the government’s strategic priorities regarding taxation, expenditure, and debt management. It explains how the current fiscal policies align with the principles of prudent fiscal management and the targets set in the Medium-Term Fiscal Policy Statement.

Prelims Pointers

  • Article 112: The Union Budget is presented as the ‘Annual Financial Statement’ under this article of the Constitution.
  • Revenue Receipts: Do not create liability or reduce assets. Examples: Income Tax, GST, Dividends from PSUs, Fees for services.
  • Capital Receipts: Either create a liability or reduce assets. Examples: Borrowings, Disinvestment proceeds, Recovery of loans.
  • Revenue Expenditure: Does not create assets. Examples: Salaries, Pensions, Subsidies, Interest Payments.
  • Capital Expenditure: Creates assets or reduces liabilities. Examples: Construction of highways, Investment in shares, Loans given to states.
  • Revenue Deficit (RD): Formula is RE - RR.
  • Fiscal Deficit (FD): Formula is Total Expenditure - (Revenue Receipts + Non-Debt Creating Capital Receipts). It is equal to the total borrowing requirements of the government.
  • Primary Deficit (PD): Formula is FD - Interest Payments. It indicates the borrowing for current year’s expenses, excluding interest on past debt.
  • Effective Revenue Deficit (ERD): Formula is RD - Grants for Capital Asset Creation. Introduced in the 2011-12 Budget and incorporated into the FRBM Act in 2012.
  • FRBM Act, 2003: Enacted to institutionalize fiscal discipline. Came into force in 2004.
  • Initial FRBM Targets (by 2008-09):
    1. Eliminate Revenue Deficit.
    2. Reduce Fiscal Deficit to 3% of GDP.
  • N.K. Singh Committee (2016): Formed to review the FRBM Act.
  • Key Recommendations of N.K. Singh Committee:
    • Use Debt-to-GDP ratio as the primary anchor for fiscal policy.
    • Target a Debt-to-GDP ratio of 60% by 2023 (40% Centre, 20% States).
    • Formally define an ‘escape clause’ for deviating from targets.
    • Establish an independent Fiscal Council.
  • Documents under FRBM Act:
    1. Medium-Term Fiscal Policy Statement
    2. Macroeconomic Framework Statement
    3. Fiscal Policy Strategy Statement
  • Washington Consensus: A set of free-market economic policy prescriptions that included fiscal discipline, which influenced India’s reform path.

Mains Insights

1. Public Expenditure Management: A Post-Liberalization Challenge

The 2019 Mains question highlights the core dilemma of Indian fiscal policy post-1991. Public expenditure management became challenging due to the need to balance conflicting objectives:

  • Balancing Fiscal Prudence with Welfare Imperatives:

    • Cause: The post-1991 reforms, influenced by the Washington Consensus, emphasized fiscal consolidation (reducing deficits) to achieve macroeconomic stability and attract foreign investment (FDI). This necessitated expenditure control.
    • Effect/Challenge: Simultaneously, the political economy demanded a focus on inclusive growth and social welfare. Schemes like the Mid-Day Meal Scheme (formalized nationwide in 1995), TPDS, and Antyodaya Anna Yojana required significant public expenditure. This created a classic “guns versus butter” trade-off, or in India’s case, a “reforms versus welfare” dilemma. The FRBM Act institutionalized the pressure for fiscal prudence.

  • Shift in Expenditure Quality:

    • Cause: There was a growing consensus, articulated in successive Five-Year Plans (starting with the 8th Plan, 1992-97), that public spending should be of high quality. ‘Second-generation reforms’ focused on shifting expenditure from consumption (revenue expenditure like subsidies) to investment (capital expenditure like infrastructure).
    • Effect/Challenge: Managing this shift is difficult. Revenue expenditure (salaries, pensions, interest payments) is often ‘committed’ and politically sensitive to cut. Capital expenditure has long gestation periods, and its benefits are not immediately visible, making it politically less rewarding than populist subsidy schemes.

  • Complexities of Fiscal Federalism:

    • Cause: The role of states in development has increased. Recommendations of successive Finance Commissions (e.g., 14th and 15th FC) have increased the vertical devolution of taxes to states (from 32% to 41-42%).
    • Effect/Challenge: The Centre needs to manage its own finances while also providing grants and supporting states through Centrally Sponsored Schemes. States were also brought under the FRBM framework (via amendments and state-level acts) to ensure overall national fiscal stability, adding another layer of management complexity.

2. The Fiscal Deficit Debate: Stimulus vs. Consolidation

A central debate in Indian economic policy revolves around the optimal level of fiscal deficit.

  • Argument for Fiscal Consolidation (Pro-FRBM view):

    • Rationale: A high fiscal deficit leads to higher government borrowing, which can “crowd out” private investment by raising interest rates. It can also be inflationary if financed by the central bank. A high debt burden diverts resources to interest payments, reducing funds for development.
    • Proponents: This view is often associated with neoclassical economists and institutions like the IMF. In India, committees like the Vijay Kelkar Committee (2012) and the N.K. Singh Committee (2017) have provided roadmaps for fiscal consolidation.

  • Argument for Fiscal Stimulus (Keynesian view):

    • Rationale: During economic downturns (like the 2008 crisis or the COVID-19 pandemic), private demand collapses. In such situations, the government should increase its spending (even if it leads to a higher deficit) to boost aggregate demand, stimulate economic activity, and prevent a deep recession. The ‘escape clause’ in the FRBM Act is a nod to this logic.
    • Proponents: This view, rooted in the work of John Maynard Keynes, argues that fiscal consolidation during a slowdown can be counter-productive. The Economic Survey 2020-21 also argued for a counter-cyclical fiscal policy, prioritizing growth over rigid deficit targets during the pandemic.

3. Quality of Deficit and Expenditure

  • The Concept: It is not just the size of the deficit that matters, but also its composition. A fiscal deficit is considered to be of ‘poor quality’ if it is driven by a high revenue deficit.
  • Analysis:
    • High Revenue Deficit: A high RD within the FD implies that a large part of the government’s borrowing is being used to finance consumption expenditure (like salaries and subsidies) rather than creating assets. This increases future liabilities without creating corresponding income-generating assets, potentially leading to a debt trap.
    • High Capital Expenditure: Conversely, if the fiscal deficit is used to fund capital expenditure (e.g., building roads, ports), it boosts the economy’s productive capacity, creates jobs, and generates future tax revenues. This type of deficit is considered more sustainable and growth-enhancing. The government’s recent focus on raising the share of ‘Capex’ in the budget reflects this understanding.

4. Ethical Dimensions of Budgeting (GS Paper IV)

  • Inter-generational Equity: The FRBM Act is an instrument of inter-generational equity. By limiting debt accumulation, it ensures that the present generation does not finance its consumption by placing an unsustainable burden of repayment on future generations.
  • Transparency and Accountability: Mandating documents like the Macroeconomic Framework Statement and Fiscal Policy Strategy Statement enhances transparency. It allows Parliament and the public to scrutinize the government’s fiscal choices and hold it accountable.
  • Distributive Justice: Budgetary allocations reflect the government’s commitment to social justice. The use of tools like Gender Budgeting and allocations for vulnerable sections (SC/ST sub-plans) are ethical imperatives to ensure that the benefits of public expenditure reach the marginalized. Managing the trade-off between universal subsidies and targeted support is a key ethical and economic challenge.

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