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There are 3 major functions of the government in economic sector:

1. Allocation function
2. Distribution function
3. Stabilization function

(EXPLAINED IN DETAIL IN VIDEOS ON RECEIPTS & EXPENDITURES OF THE

GOVERNMENT)
ALLOCATION FUNCTION:
There are many public goods and services, which cannot be provided by the private sector
due to lack of possibility of making any kind of profit from them. These are goods like national
defence, government administration, supply of basic services like cheap housing, water
supply, free education et cetera.
The government takes on the responsibility of providing them. This function of the
government is called allocation function.

DISTRIBUTION FUNCTION:

In any society, there are rich and poor people. Rich are taxed more on their income compared
to the poor. This process of taxation is called progressive taxation. The reason for taxing rich
and poor differently is DISTRIBUTION function of the government. In a welfare state like India
with huge poverty, it is the responsibility of the government to try and reduce inequality of
income in the economy. This objective is achieved through distribution function, wherein
money is transferred from rich to the poor through progressive taxation and transfer
payments to the poor. Basic services like free education, free healthcare, free housing et
cetera are provided to the poor to enable them to earn more in the future by educating
themselves and growing as healthy living beings.

REDUCTION OF INEQUALITY = DISTRIBUTION FUNCTION

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STABILIZATION FUNCTION:
Stabilization function means pushing up an economy suppressed by lack of aggregate
demand. An economy may face long periods of unemployment and depression due to lack of
aggregate demand and vice versa. It is the responsibility of the government to stabilize such
an economy by creating or controlling aggregate demand.

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These 3 functions are carried out through Government Budget.

Government
Budget

Revenue Budget Capital Budget Expenditure

Revenue Centre's
Capital Receipts Transfers
Receipts Expenditure

Centrally
Non Debt Establishment
Tax Revenue Sponsored
Receipts Expenditure
Schemes

Finance
Non Tax Central sector
Debt Receipts Commission
Revenue schemes
Grants

Interest
Other grants
Payments

Revenue Budget-

Revenue budget consists of revenue receipts. These are transactions of recurring nature, which
do not add any capital/ asset to the nation. They are day to day/ administrative expenses made
to run the country and recurring receipts to be
received every year.

Revenue receipts-

Revenue receipts can be sub classified into tax receipts and non-tax receipts. Direct Tax receipts
are of 2 kinds (income tax and corporate tax) and there are multiple Indirect tax
receipts of both central and state government.

Non-tax receipts are receipts from fines, interest receipts on loans made by the government,
charges, dividends from PSUs, external grants etc.

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Capital Budget-

The capital budget outlines assets and liabilities of the government. Capital budget shows
capital receipts of the government:

Capital receipts-

Capital can be collected by the government through various sources- market borrowings by
issuing bonds etc; borrowing from RBI and commercial banks; loans received from foreign
governments and agencies like IMF, World Bank, NDB etc; recovery of loans forwarded
earlier; disinvestment proceeds; savings of the people in areas like small savings, provident
fund etc.

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Expenditures of the Government:

CENTRE’S EXPENDITURE
■ Establishment expenditure
■ Central sector schemes
■ Interest payments
■ Subsidies
■ Defence
■ Salaries & Pensions

TRANSFERS
■ Centrally sponsored schemes
■ Finance commission grants
■ Other grants

Any imbalance between government receipts and expenditures will result in either a deficit or
a surplus. Indian government experiences an overall deficit due to higher expenditures on
developmental and welfare activities.

There are various terms connected to government deficit:

Revenue deficit-

Revenue deficit is incurred when government’s revenue expenditure is more than its revenue
receipts.

Revenue deficit = revenue expenditure – revenue receipts

Revenue deficit means that the government is spending more on its day-to-day administrative
activities than its revenue earnings (recurring). This implies that the government will have to
finance not only expenditures for asset creation but also for consumption and administrative
expenditures. In case of a heavy revenue deficit, the government starts reducing expenditure
on capital creation and focuses on meeting revenue expenditures. This harms a country as
finances are used up for consumption rather than asset creation.

Fiscal Deficit-

Fiscal deficit can be defined in two ways-

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1. Fiscal deficit is the total borrowings taken by the government in a year to finance
its overall deficits

2. Fiscal deficit is the difference between the government’s total expenditure and
total receipts excluding borrowing

Interestingly, when you analyze both, you will realize that they mean the same thing.

Gross fiscal deficit = total expenditure – (revenue receipts + non-debt creating capital
receipts)

OR,
Gross fiscal deficit = total borrowings (domestic borrowings, international borrowings,
borrowings from RBI)

Primary Deficit-

The present government is also required to pay for debts of past governments in the form of
interest payments. Since, this debt and accumulated interest is not created by the present
government, it wants to remove this liability to arrive at the figure of deficit created in the
present. This figure is called as primary deficit.
Numerically,

primary deficit = gross fiscal deficit – (interest payments – interest receipts)

IMPACTS OF GOVERNMENT DEFICIT:

Government deficit impacts an economy both positively and negatively. We will understand
how government deficit is financed and how it impacts the country.

Financing government deficit-

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Government/
budgetary deLicit

borrowing from
domestic and printing money-
higher taxation international money creation
sources

Higher taxation results in a fall in Disposable Income of the people and negatively affects
Aggregate Demand in the economy. Disposable Income refers to net income of households
after taxation, which they can spend according to their needs. Lesser disposable income means
less demand for goods and services in the market.

Higher taxation is also bound to increase tax evasion as people take it as an unnecessary burden.

Since we are talking about taxation and tax evasion, let us also understand the inverted U
curve/ Laffer curve related to taxation.

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As can be seen in the graph, as tax rate increases (X- axis), government revenue increases up-
to a point (Y- axis). Beyond a certain point, government revenue starts reducing with a rise in
tax rate due to tax evasion and less tax compliance by the people. This relationship between
taxation and government revenue is called as laffer curve.

PRINTING OF MONEY AND WAYS & MEANS ADVANCES:

Printing of money used to be a widely used method of financing government deficit in India.

Whenever the government fell short of cash, it passed an order to RBI to print more money for
its financing.
This resulted in misapplication of money by the government and heavy money supply in the
economy. Since, RBI is the institution responsible for maintaining money supply in Indian
economy, money creation by the government defeated the purpose of RBI. Heavy money
supply in the economy also reduced value of money and spiked inflation because when people
have a lot of money in their hands, they demand more, resulting in higher inflation.

This act of the government (called as issue of ad-hoc treasury bills) was closed in 1997 and
replaced by WAYS AND MEANS ADVANCES.

WMAs are given by RBI to government and do not require any collateral. Its amount is limited
and arrived at the beginning of every fiscal year through consultation between GOI and RBI. If
the government violates the agreed amount by demanding more money, penalty rates are
charged upon it by RBI. WMAs are made at the prevailing Repo rate by RBI.

Given by RBI to Government

No collateral required

Made at prevailing repo rate

Penalty on the government for violating it

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WMAs have brought in fiscal discipline in the Government, as it has to pay higher rates for
borrowing above pre-agreed limit.

Borrowing from domestic and international sources-

By borrowing, the government transfers the burden of debt on future generations, who have
to reduce their consumption to pay back the debt. For example, if the government raises money
by issuing 30-year bonds to the people, it gets money today but has to pay back the entire sum
after 30 years.

Out of these 3 methods, borrowings are most widely used by the government today because
the impacts of borrowing are felt in the future.

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Impact of Deficits-

Deficits- Impact

Burden on Crowding out of

Future Inflationary Private
Generations Investment

Crowding out of Private Investments- when the government borrows heavily from the
market, it takes away financing options of private companies, as there is limited capital
available in the system. Private companies find it difficult to raise the same amount of capital
at the same cost (interest). This either delays investment or makes it more costly.

Inflationary- By increasing supply of money in the economy, deficit financing results in more
inflation. This was considered at the time of 2008 financial crisis, when Indian government
decided to launch MGNREGA at a larger scale to provide wages to people and tackle the
financial crisis by maintaining domestic demand. As money supply increased, the economy
faced high inflation.

FISCAL RESPONSIBILITY AND BUDGET MANAGEMENT ACT:

• The Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) is an Act of the
Parliament of India to improve fiscal discipline, reduce India's fiscal deficit, improve
macroeconomic management and the overall management of the public funds by
moving towards a balanced budget.

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• Though the Act aims to achieve deficit reductions prima facie, an important

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objective is to achieve inter-generational equity in fiscal management. This is

because when there are high borrowings today, it should be repaid by the future
generation. But the benefit from high expenditure and debt today goes to the
present generation. Achieving FRBM targets thus ensures inter-generation equity by
reducing the debt burden of the future generation.
• Other objectives include: long run macroeconomic stability, better coordination
between fiscal and monetary policy, and transparency in fiscal operation of the
Government.
• Prohibits borrowing by Government from RBI - Making Monetary Policy independent
of Fiscal Policy.
• Prevent monetization of Government deficit - Ban on purchase of primary issues of
Central government by RBI from 2006

The Act mandates 4 Documents to be laid before Parliament:

• Medium Term Fiscal Policy Statement:

• 3 year rolling targets for 4 fiscal indicators with respect to GDP at market
price and the strategy to attain them.
• 4 fiscal targets are: Revenue Deficit, Fiscal deficit, Tax to GDP Ratio and
Total Outstanding Debt as percentage of GDP.

• Fiscal Policy Strategy Statement

• Macro-economic Framework Statement

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• Medium Term Expenditure Framework Statement: This has been added in 2012 and
presented in Monsoon Session.

The main purpose of FRBMA was to eliminate revenue deficit of the country (building revenue
surplus thereafter) and bring down the fiscal deficit to a manageable 3% of the GDP by March
2008.

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Due to the 2008 international financial crisis, the deadlines for the implementation of the
targets in the act was initially postponed and subsequently suspended in 2009.

The FRBM rule had set a target reduction of fiscal deficit to 3% of the GDP by 2008-09. This was
to be realized with an annual reduction target of 0.3% of GDP per year by the Central
government. Similarly, revenue deficit had to be reduced by 0.5% of the GDP per year with
complete elimination by 2008-09. The targets were revised following global financial crisis and
presently a committee by N K SINGH is reviewing the structure of FRBM Act.

Committee to review FRBM targets (NK Singh committee):

✓ Fiscal Deficit of 3% by March 2020

✓ Fiscal Deficit to be cut to 2.8% by 2021; 2.5% by FY 2023

✓ The deviations from the stipulated fiscal deficit target shall not exceed 0.5 percentage
points in a year (Escape Clause)
✓ Reduce revenue deficit to GDP ratio steadily by 0.25 percentage points each year
✓ Revenue deficit should be 2.05 per cent of GDP in current fiscal, declining to 1.8 per
cent in the next and 1.55 per cent in 2019-20. This should be brought down to 0.8 per
cent in FY2023
✓ The combined debt-to-GDP ratio of the centre and states should be brought down to
60 per cent by 2023 (comprising of 40 per cent for the Centre and 20% for states) as
against the existing 49.4 per cent, and 21per cent respectively.

Year Debt/GDP Fiscal Deficit Revenue Deficit

2017 49.4% 3.5 2.3
2023 38.7% 2.5 0.8
When can Escape Clause be used?

The escape clause can be used only during the time of following essential circumstances:

✓ Over-riding consideration of national security, acts of war, calamities of national

proportion and collapse of agriculture severely affecting farm output and incomes.

✓ Far-reaching structural reforms in the economy with unanticipated fiscal implications.

✓ Sharp decline in real output growth of at least 3 percentage points below the average
for the previous four quarter

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