1. Fiscal policy: meaning and instruments
- Meaning: the government's deliberate use of its revenue, expenditure and borrowing to influence aggregate demand, output, employment and prices.
- Instruments: (1) taxation; (2) public expenditure; (3) public borrowing (public debt).
- Objectives: price stability, full employment, growth, a fairer distribution of income, and better allocation of resources.
- Use: against excess demand, raise taxes, cut non-essential spending, borrow from the public (contractionary); against deficient demand, cut taxes, raise public works spending, put idle savings to use (expansionary).
- Not fiscal: the repo rate, reserve ratios and open market operations are monetary tools of the central bank.
| Situation | Taxes | Public expenditure | Borrowing |
|---|---|---|---|
| Excess demand, rising prices | Raise | Cut non-essential spending | Borrow from the public to absorb spending power |
| Deficient demand, unemployment | Cut | Raise, especially on public works | Borrow idle savings and spend them |
| Fiscal policy | Monetary policy | |
|---|---|---|
| Run by | Government | Central bank |
| Tools | Taxes, spending, borrowing | Repo rate, reserve ratios, open market operations |
| Works through | Incomes and public demand | Cost and availability of credit |
Key terms
- Fiscal policy
Policy on government taxes, spending and borrowing used to influence the economy.
- Expansionary fiscal policy
Lower taxes or higher public spending to raise aggregate demand.
- Contractionary fiscal policy
Higher taxes or lower public spending to reduce aggregate demand.
2. Public revenue; tax and fee
- Public revenue: the income of the government from taxes and non-tax sources (fees, fines, interest, dividends and profits of public enterprises, grants).
- Tax: a compulsory payment; there is no quid pro quo (no specific service in return).
- Fee: a payment for a specific service (registration, licence); only users pay.
- Impact: on the person who pays the tax to the government. Incidence: on the person who finally bears its money burden.
| Tax | Fee | |
|---|---|---|
| Compulsory? | Yes | Only for those who take the service |
| Service in return? | No direct return | A specific service |
| Example | Income tax | Driving-licence fee |
Key terms
- Tax
A compulsory payment to the government with no direct return of a service.
- Fee
A payment for a specific service provided by the government.
- Incidence of a tax
The final resting place of the money burden of a tax.
3. Direct and indirect taxes
- Direct tax: impact and incidence on the same person; cannot be shifted. Examples: income tax, corporation tax.
- Indirect tax: imposed on one person, passed on to another through prices. Examples: the Goods and Services Tax (in force since 1 July 2017), customs duties.
- Merits of direct taxes: can be progressive (equity), certain for taxpayer and government, and taxpayers are aware of them. Demerits: open to evasion, inconvenient lump-sum payments.
- Merits of indirect taxes: wide coverage, convenient small payments, hard to evade at sale, can discourage harmful goods. Demerits: regressive in effect, raise prices, uncertain yield.
| Direct tax | Indirect tax | |
|---|---|---|
| Impact and incidence | Same person | Different persons |
| Can it be shifted? | No | Yes, through prices |
| Examples | Income tax, corporation tax | GST, customs duty |
| Can be progressive? | Yes | Mostly not; regressive in effect |
Key terms
- Direct tax
A tax whose burden falls on the person on whom it is imposed.
- Indirect tax
A tax whose burden can be shifted to others, usually through prices.
4. Progressive, proportional and regressive taxes
- Classify by the average rate (tax ÷ income × 100) as income rises: progressive if it rises, proportional if constant, regressive if it falls.
- Slab calculation: each rate applies only to the income inside its slab. Imagined Taranagar (nil up to ₹2,50,000; 10 per cent on income from ₹2,50,001 to ₹6,00,000; 20 per cent on income above ₹6,00,000): ₹5,00,000 pays ₹25,000 (5 per cent); ₹10,00,000 pays ₹1,15,000 (11.5 per cent).
- Marginal rate: the rate on the last rupee of income (the slab it falls in).
- A flat per-family levy is regressive: ₹6,000 is 3 per cent of ₹2,00,000 but 0.6 per cent of ₹10,00,000.
| Income (₹) | Tax (₹) | Average rate (per cent) |
|---|---|---|
| 2,00,000 | 0 | 0 |
| 5,00,000 | 25,000 | 5 |
| 10,00,000 | 1,15,000 | 11.5 |
| 8,00,000 | 75,000 | 9.375 |
| Kind | Rate as income rises | Imagined example |
|---|---|---|
| Progressive | Rises | Taranagar slabs: 0, 10, 20 per cent |
| Proportional | Stays the same | Flat 10 per cent of all income |
| Regressive | Falls | A flat ₹6,000 levy per family |
Key terms
- Progressive tax
A tax whose rate rises as income rises.
- Proportional tax
A tax charged at the same rate on every income.
- Regressive tax
A tax whose burden falls as a share of income as income rises.
5. Public expenditure
- Meaning: spending by central, state and local governments on goods and services, salaries, transfers (pensions, scholarships, subsidies) and assets.
- Kinds: developmental (raises productive capacity) and non-developmental (administration, interest).
- Importance: (1) infrastructure private firms will not provide; (2) human capital: education and health; (3) employment and stability in slumps, through the multiplier; (4) reducing inequality through transfers and free services; (5) defence and law and order.
- Imagined Sahyagiri: total ₹600 crore; education and health ₹300 crore (50 per cent).
| Kind of spending | Imagined example | Effect |
|---|---|---|
| Developmental | Check dams, schools, roads | Raises productive capacity |
| Non-developmental | Interest on old loans, administration | Keeps the state running |
| Transfer payment | Old-age pensions, scholarships | Moves income; nothing produced in return |
Key terms
- Public expenditure
Spending by central, state and local governments.
- Transfer payment
A payment made without any good or service in return, such as a pension.
6. Public debt, its redemption, and deficit financing
- Public debt: government borrowing that must be repaid with interest. Internal (from citizens, banks, institutions at home) and external (from abroad; heavier burden, needs foreign exchange).
- Methods of redemption: sinking fund (a fixed sum yearly into a separate fund; ₹600 crore over 12 years = ₹50 crore a year); conversion (high-interest into low-interest loans; ₹400 crore from 9 to 6.5 per cent saves ₹10 crore a year); surplus budget; terminal annuity (equal yearly instalments; ₹300 crore over 15 years = ₹20 crore); capital levy (one-time tax on wealth); refunding (new loans repay old ones; only postpones repayment).
- Deficit financing: in the Indian sense, meeting a budget gap by borrowing from the central bank, which creates new money; overuse leads to inflation.
| Method | How it works | Reduces debt? |
|---|---|---|
| Sinking fund | Set aside a fixed sum every year; repay at maturity | Yes |
| Conversion | Replace high-interest loans with low-interest ones | Cuts interest burden |
| Surplus budget | Use revenue above expenditure to repay | Yes |
| Terminal annuity | Repay in equal yearly instalments | Yes |
| Capital levy | One-time tax on wealth used to repay | Yes |
| Refunding | Raise new loans to repay maturing ones | No, only postpones |
| Internal debt | External debt | |
|---|---|---|
| Borrowed from | Citizens, banks, institutions at home | Foreign governments, banks, institutions |
| Repayment | Money moves within the country | Resources go abroad, often in foreign currency |
| Burden | Lighter | Heavier |
| Old bonds | New bonds | |
|---|---|---|
| Amount (₹ crore) | 400 | 400 |
| Interest rate | 9 per cent | 6.5 per cent |
| Yearly interest (₹ crore) | 36 | 26 |
Key terms
- Public debt
Loans raised by the government that must be repaid with interest.
- Sinking fund
A fund built by setting aside a fixed sum every year to repay a loan at maturity.
- Deficit financing
Meeting a budget gap by borrowing from the central bank, creating new money.
Exam tips
Common mistakes
- Listing the repo rate or CRR as fiscal tools (they are monetary).
- Calling a tax progressive because the rich pay more rupees: compare rates.
- Applying the top slab rate to the whole income.
- Saying refunding reduces debt: it only postpones it.
- Defining deficit financing as "any deficit": it is meeting the gap by borrowing from the central bank.
How marks are usually awarded
- 1 mark: a correct option or a one-line answer.
- 2 marks: two points, or a point with an example.
- 3 marks: three distinct points, or a calculation with a conclusion.
- 5 marks (and ISC 4- and 8-mark questions): parts answered separately, with working and a reasoned judgement.
Budget components and the revenue, fiscal and primary deficits are in the next chapter.