Economics | Fiscal Policy Explained

This marathon article follows article on inflation and monetary policy. If you haven’t read them, read them first by clicking here. Inflation explained, monetary policy explained. This article is very important for exam and essential to understand subsequent economic survey cahpters.

In the last article we saw role of RBI in controlling money supply and interest rates and thus influencing growth- inflation dynamics. Government similarly affects this dynamics through its policy known as fiscal policy.


What is fiscal policy?

fiscal policy is the use of government revenue collection (mainly taxes but also non tax revenues such as divestment, loans) and expenditure (spending) to influence the economy.

Fiscal policy thus contains essentially two components-

Revenue Collection- (primarily taxation)- Govt collect taxes which are of two types

Source- Quora

1. Direct tax -A direct tax is generally a tax paid directly to the government by the person on whom it is imposed. Eg-. Income tax<your income, you pay tax>, corporation tax<Corporate profits, they directly pay tax>, wealth tax<your wealth, you directly pay tax>, capital gains tax<value of your asset increases, you pay tax>, securities transaction tax<you trade, you pay>

2. Indirect tax-An indirect tax is indirectly paid by consumers. Govt taxes goods and services # manufacturer/ seller/ service provider pay the taxes # he increases the prices to recover taxes # indirectly consumers end up paying taxes. In effect, tax is shifted from one taxpayer to another, by way of an increase in the price of the goods and services. Eg. Excise duty<union tax on manufacturing>, custom duty<union tax on imports and exports>, service tax<union tax on services>, sales tax or VAT<state level tax on sale of goods, that’s why price of petrol is different in all the states>, central sales tax<tax levied by union but given to states on interstate movement of goods>

Q. What Is Minimum Alternative Tax (MAT)? Is it a direct or indirect tax? What is the rationale for imposing it?

Indirect tax is generally considered regressive in nature as tax remains the same no matter how much you earn. So, for instance, if tax on diesel is 20%, a poor farmer would have to pay the same tax to run his tube-well as Ambani has to pay to drive his Audi. On the other hand, in direct taxes, less you earn, less you have ti pay<Brackets in income tax>.

Of course, governments try to make indirect tax structure a bit less regressive by taxing luxury products more. For instance, taxes on SUVs are higher than taxes of small cars. Also, govt by way of higher taxes try to shift consumption away from some product such as cigarette, tobacco etc.<sin tax>.

What would happen if govt increased taxes?

When government increases taxes, it basically leaves less money in the hands of people # less money # less consumer demand # apply demand supply principle # less demand for goods # prices fall # corporate will delay investment # job loss # slowdown in the economy

As we saw when RBI raises rates or sucks out liquidity through open market sales of government securities, it tightens money supply and reduces demand resulting in prices fall. It is said to be following dear or contractionary monetary policy.

Similarly when government raises taxes, it reduces consumption demand and it is known as contractionary fiscal policy. On the other hand when government slashes rates to stimulate consumption to kick start the economy, it is known as expansionary fiscal policy.

Expenditure (spending)- Government spend money which also provides demand to the economy. If government decides to spend more by borrowing, it increases aggregate demand and it is known as expansionary fiscal policy.

Basically contractionary policy- increase taxes, slash spending is followed when inflation is high to bring down demand and thus cool down prices and expansionary policies to pump prime the economy by creating the demand through decreased taxes and higher spending.

Estimates of spending and taxation are presented in budget which also mentions various deficits like fiscal deficit, revenue deficit, effective revenue deficit. Want to know more about them, click here

Plan v/s non plan expenditure

Plan expenditure– expenditure on schemes and projects covered by the five-year Plans (road construction, railway line construction etc.)

Non-plan expenditure: Ongoing expenditure by the government not covered by the Plans <routine expenditure to run the govt>. Eg. Interest payment, Subsidies, salaries, pension, defense expenditure etc.

Please note that bot plan and non plan expenditure includes revenue and capital expenditure. It’s not that the plan expenditure is equivalent to capital expenditure while non plan is revenue expenditure. To know the difference b/w revenue and capital expenditure, click here

Q. Plan v/s non plan classification of expenditure should be scrapped. Comment.

Budget is an important part of fiscal policy as revenue and expenditure statements are presented during the budget. Let’s understand in brief, where all the revenue comes from and where all the money goes.

We can clearly see, among non debt creating receipts (not borrowings), maximum earning is from corporate tax followed by income tax.

Always remember these facts on revenue and expenditure side by heart

  • direct taxes> Indirect taxes
  • Corporate tax>Income tax>Excise>Service tax>custom
  • Non plan expenditure> Plan expenditure (more than double)
  • Interest payment>>subsidies and defense  <subsidies and defense are almost equal. Every year including this year defense is budget higher amount but eventually, subsidies turn out to be higher during revised estimates>
  • Food subsidies>> Fertilizer subsidies >> Fuel subsidies

When government reduces its fiscal deficit, it is known as fiscal consolidation. Learn everything about fiscal consolidation here

Clearly it can be achieved in two ways, reduce spending or increase taxes or combination of two. Here we discuss one component of spending known as subsidy in some detail. Everyday we read about subsidy rationalization, cutting or increasing subsidies and passionate arguments on both sides.

So, What is subsidy?

In a layman’s term, it can be understood as converse of a tax in that using taxation government takes money from consumers while subsidy in effect transfer money from government to consumers.

For instance, taxes on grain would increase their market price from say 10 rs a kg to 12 rs a kg, in effect taking 2 rs from you for every kg of grain you buy. On the other hand subsidy under PDS would reduce price of grain from 10 rs to say 2rs in effect transferring 8 rs to your pocket. In this way, they are converse of indirect taxes.

When government directly transfers money in your bank account without any condition i.e. unconditional direct benefit transfer, subsidy becomes converse of direct taxes.

In India government (central and state) subsidize a lot of things from food to fertilizer to kerosene and LPG etc. Tax concessions can also be considered as implicit subsidy. Subsidies increase government spending and thus puts pressure on government finances.

So what’s the rationale for subsidy?

Like indirect taxes, subsidies can alter relative prices and budget constraints and thereby affect decisions concerning production, consumption and allocation of resources.

So purpose of subsidies is two fold-

  1. Increasing consumption of items government considers important such as health, education, nutritious food etc or renewable energy in modern times.
  2. Redistributive effect i.e. to provide minimum level of protection to the poor <welfare function, tax the rich, distribute in poor>

For objective one to be fulfilled government should subsidize merit goods.

What are merit goods?

A good which would be under-consumed (and under-produced) in the free market economy

But why are they under-consumed?

They are associated with positive externality i.e. they also benefit public but since consumers and producers will take account of only private benefits, they are likely to consume less than desired. For instance, consider education, not only a person is educated and earns more <private benefit> but more productive individual would also benefit society in the form of higher taxes <societal benefit> 

For objective two (redistribution) to be achieved, subsidies should be well targeted i.e. reach the poor with minimal leakages. This requires proper targeting without which there would be inclusion errors (rich getting subsidy and exclusion errors (poor not getting subsidy). Exclusion errors are the worst since they direct affect the poor <kerosene meant for poor not reaching him, how will she light her house>

Subsidy rationalisation is this process of better targeting to weed out unintended beneficiaries as well as phasing out subsidies on non merit goods.

So, what are the adverse consequences of bad subsidies (non merit, not well targeted)?

  1. Fiscal effects– directly increase fiscal deficit and thus total government debt <10% of total govt spending is for subsidies> <While golden rule of borrowing is, borrow to invest >
  2. Allocative effects– result in inefficient resource allocation <producers will produce more of subsidized good even when not required>
  3. perverse distributional effects endowing greater benefits on the better off people <subsidized diesel being used to run SUVs>
  4. Shortages and black marketing <subsidized urea being diverted to non agricultural uses, scarcity leading to black marketing harms the poorest farmers the most>
  5. Tendency to self-perpetuate. They create vested interests and acquire political hues <Exit problem discussed in economic survey chapter two, click here to read>

For instance, High MSP for wheat and rice and subsidized water and electricity illustrates all such effects, an example of bad bad subsidy.

  • Perverse distributional effects– better off farmers of Punjab and Haryana getting benefited<no procurement from eastern belt, poor farmers of Bihar, Jharkhand not getting benefits>
  • Fiscal effects– finances of central as well as state govt getting stretched, discoms in debt <high deficit # high debt # high interest cost # high deficit = vicious circle>
  • Allocative effects– pulses and oilseeds are not grown resulting in shortages <procurment only of grains, no incentive to produce pulses>
  • environmental effect– water table going down, soil getting salty and arid
  • Health effect– Groundwater pollution due to high fertilizer use, burning of husks resulting in air pollution

How subsidies distort the market (in a comical way) is best understood by Railway subsidies <Example from last year’s economic survey> 

  • Govt subsidizes passenger fares resulting  in losses. Railways cannot generate sufficient internal resources to finance capacity expansion investments;Result-Trains always run late, very slow services, whole economy becomes unproductive
  • Of course the passenger fare is cross subsidized by high freight tariffs . It results in diversion of freight traffic to road transport which is costlier. Result- not only financial and efficiency costs but also acute costs associated with emissions, traffic congestion, and road traffic accident (RTA) <And we all know passengers on two wheeler or those walking die the most in the RTA i.e. poorer segments of society>
  • High freight cost raises the cost of manufactured goods that all households, including the poor, consume. <subsidized passenger fare but costly goods, no one knows who gains who losses but these distortions decreases the overall efficiency and thus whole economy suffers.>

What’s the solution?

End perverse subsidies while investing in state capacity to deliver basic goods and merit goods such as health, education, skills etc. Incentivize research and development, environment friendly technologies etc. Borrow only to invest. Adhere to FRBM targets of zero revenue deficit.

  • Direct Benefit Transfer (DBT) using  JAM number trinity, read the economic survey chapter here
  • JanDhan i.e. Bank accounts, Adhar i.e biometric identification and mobile i.e. mobile banking
  • It will result in direct transfer of money to bank account of beneficiaries and cut down leakages as intermediaries are removed.
  • Biometric authentication will remove ghost accounts i.e same person getting subsidy twice from two different names.
  • Mobile banking will give access to bank accounts for easy deposit and withdrawal

But problem of identification of beneficiaries still remains and it requires better and more robust data collection, publishing names of beneficiaries at gram panchayat level for people to raise objections, jan sunwai (public hearing), social audits and such transparency mechanisms

Pitfalls of DBT

  1. Where transfers are unconditional, people may just spend money on desi liquor <objective of changing consumption pattern defeated>. For instance, if govt transferred 6000 rs to every pregnant women it’s possible that money will go in the bank account of husband and instead of better nutrition for pregnant lady, he will buy desi liquor.

solution- transfer money in the hand of oldest woman and provide her information so that she can take informed decision in the best interest of family

  1. Conditional transfers might give rise to its own kind of corruption. For instance if money is transferred for check up by a nurse, she might demand bribe for certifying you indeed showed up for check up.
  2. Private market may not exists for people to buy goods and services from the market. For instance, if PDS shops are closed, where would people buy ration from?
  3. Banking infrastructure poor <as we saw in the JAM article, last mile banking access is jamming the JAM>
  4. Real value of subsidy amount will be eroded with inflation. solution- link subsidy with CPI inflation. But generally food inflation higher than CPI, then what?
  5. There is concern that biometric fingerprinting may not work for rural manual labourers.
  • what happens to corporate tax breaks and subsidies going to not so poor?Government decision to phase out corporate tax exemption while simultaneously bringing down tax rates down to 25% level is welcome in this regard.
  • It will remove major distortions and end favours to select few corporate groups

Government should rationalize subsidies so they are targeted better and use money thus made available to invest in physical and social infrastructure.In this way by rationalizing subsidies government can bring down fiscal deficit and overall debt level. Bringing fiscal deficit under control, reduces aggregate demand, this cooling down prices.

Now it’s time to solve some previous year IAS prelims questions 

#1. The sales tax you pay while purchasing a toothpaste is a

  1. tax imposed by the Central Government.
  2. tax imposed by the Central Government but collected by the State Government
  3. tax imposed by the State Government but collected by the Central Government
  4. tax imposed and collected by the State Government

#2.To obtain full benefits of demographic dividend, what should India do?

  1. Promoting skill development
  2. Introducing more social security schemes
  3. Reducing infant mortality rate
  4. Privatization of higher education

#3. In India, deficit financing is used for raising resources for

  1. economic development
  2. redemption of public debt
  3. adjusting the balance of payments
  4. reducing the foreign debt

#4. There has been a persistent deficit budget year after year. Which of the following actions can be taken by the government to reduce the deficit?

1. Reducing revenue expenditure
2. Introducing new welfare schemes
3. Rationalizing subsidies
4. Expanding industries

Select the correct answer using the code given below:

(a) 1 and 3 only
(b) 2 and 3 only
(c) 1 only
(d) 1, 2, 3 and 4

#5. With reference to Union Budget, which of the following, is/are covered under Non-Plan Expenditure?

  1. Defense -expenditure
  2. Interest payments
  3. Salaries and pensions
  4. Subsidies

Select the correct answer using the code given below.

  1. 1 only
  2. 2 and 3 only
  3. 1, 2, 3 and 4
  4. None

#6. Which one of the following is not a feature of “Value Added Tax”? (2011)

  • (a.) It is a multi-point destination-based system of taxation
  • (b.) It is a tax levied on value addition at each stage of transaction in the production-distribution chain
  • (c.) It is a tax on the final consumption of goods or services and must ultimately be borne by the consumer
  • (d.) It is basically a subject of the Central Government and the State Governments are only a facilitator for its successful implementation

#7. Under which of the following circumstances may ‘capital gains’ arise? (2012)

  1. When there is an increase in the sales of a product
  2. When there is a. natural increase in the value of the property owned
  3. When you purchase a painting and there is a growth in its value due to increase in its popularity

Select the correct answer using the codes given below :

  • (a) 1 only
  • (b) 2 and 3 only
  • (c) 2 only
  • (d) 1, 2 and 3

#8. Consider the following actions by the Government:

  • 1. Cutting the tax rates
  • 2. Increasing the government spending
  • 3. Abolishing the subsidies

In the context of economic recession, which of the above actions can be considered a part of the “fiscal stimulus” package?

A. 1 and 2 only
B. 2 only
C. 1 and 3 only
D. 1, 2 and 3

#9..Consider the following statements:

In India, taxes on transactions in Stock Exchanges and Futures Markets are

  • 1. Levied by the Union
  • 2. Collected by the State .

Which of the statements given above is/are correct?

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2

Answers 1-d,2-a,3-a,4-a,5-c,6-d,7-b,8-a,9-a.

To read more conceptual articles related to economy click

Economics Concepts Simpified


By B2B

Revisiting the Basics

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