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Latest Economics NCERT Notes, Solutions and Extra Q & A (Class 9th to 12th)
9th 10th 11th 12th

Class 12th Chapters
Introductory Microeconomics
1. Introduction 2. Theory Of Consumer Behaviour 3. Production And Costs
4. The Theory Of The Firm Under Perfect Competition 5. Market Equilibrium
Introductory Macroeconomics
1. Introduction 2. National Income Accounting 3. Money And Banking
4. Determination Of Income And Employment 5. Government Budget And The Economy 6. Open Economy Macroeconomics

Chapter 5 Government Budget And The Economy

Government Budget — Meaning And Its Components

This chapter examines the role of the government in the economy through its budget. In a mixed economy, both the private sector and the government are important. The government budget is an annual statement of the government's estimated receipts and expenditures for a financial year (April 1 to March 31 in India). It reflects government policy and influences economic life.

Objectives Of Government Budget

Governments use the budget as a tool to achieve various objectives aimed at improving the welfare of the population. The key functions are:

Allocation Function Of Government Budget

The government provides certain essential goods and services, known as public goods, that the market mechanism (private producers selling to individual consumers) fails to provide efficiently or at all. This is because public goods have two key characteristics:

Because of these characteristics, private firms have little incentive to produce public goods, as they cannot easily collect payment. Therefore, the government must intervene to ensure their provision. This is usually done through public provision (financing via the budget) and sometimes public production (government directly producing the good).

Redistribution Function Of Government Budget

The market distribution of income may result in significant inequalities. The government uses fiscal tools (taxes and transfers) to influence the distribution of income and wealth in the economy, aiming for a distribution considered more equitable or 'fair' by society.

Progressive income taxation (higher tax rates for higher incomes) takes a larger proportion of income from the rich. Government transfers (like pensions, scholarships, subsidies) provide income support to lower-income households. These policies alter disposable income and help reduce income inequality.

Stabilisation Function Of Government Budget

Economies often experience fluctuations in income and employment (business cycles, like recessions and booms). The government uses fiscal policy (changes in expenditure and taxes) to influence aggregate demand and stabilise the economy.

This active intervention to manage fluctuations constitutes the stabilisation function.

Classification Of Receipts

Government receipts are classified based on whether they create a liability or reduce assets.

Revenue Receipts

These are receipts that do not create a liability or reduce the government's assets. They are non-redeemable. They include:

Capital Receipts

These are receipts that either create a liability for the government or reduce its financial assets. They include:

Capital receipts can be debt-creating (like borrowings) or non-debt creating (like recovery of loans and disinvestment proceeds).

Classification Of Expenditure

Government expenditure is classified based on whether it results in the creation of assets.

Revenue Expenditure

Expenditure that does not create physical or financial assets for the government. It covers the normal running expenses of the government and essential services. Key components include:

Revenue expenditure is often considered 'committed' expenditure, making it difficult to reduce significantly.

Capital Expenditure

Expenditure that leads to the creation of physical or financial assets or reduces financial liabilities. This type of expenditure adds to the economy's capital stock or strengthens the government's financial position. Examples include:

Capital expenditure is considered productive as it enhances the economy's capacity for future growth. Budget documents sometimes classify expenditure into 'plan' and 'non-plan', though this distinction is being phased out as it led to focusing on new schemes (plan) over maintaining existing assets (non-plan).

Chart showing components of Government Budget

The budget document also includes policy statements mandated by the Fiscal Responsibility and Budget Management Act (FRBMA), like the Medium-term Fiscal Policy Statement, Fiscal Policy Strategy Statement, and Macroeconomic Framework Statement, to provide a broader view of the government's fiscal strategy and its impact on the economy.


Balanced, Surplus And Deficit Budget

Comparing government expenditure and receipts reveals the budget outcome:

Measures Of Government Deficit

Several measures quantify the extent of government deficit, each with different implications:

Revenue Deficit

This is the difference between the government's revenue expenditure and revenue receipts.

$ \text{Revenue Deficit} = \text{Revenue Expenditure} - \text{Revenue Receipts} $

A revenue deficit indicates that the government's current consumption and administrative expenses are greater than its current income. This implies that the government is dissaving; it is using borrowings (or selling assets) not just to finance investment but also to fund its daily running costs. A persistent revenue deficit suggests fiscal unsustainability and can lead to debt accumulation, potentially forcing cuts in productive capital or welfare spending, negatively impacting future growth and welfare.

Fiscal Deficit

This is the difference between the government's total expenditure and its total receipts, excluding borrowings. It represents the total borrowing requirement of the government to finance its expenditure.

$ \text{Gross Fiscal Deficit} = \text{Total Expenditure} - (\text{Revenue Receipts} + \text{Non-debt Creating Capital Receipts}) $

Total expenditure includes both revenue and capital expenditure. Non-debt creating capital receipts include things like recovery of loans and disinvestment proceeds. The fiscal deficit must be financed by borrowing. Therefore, it is a crucial indicator of the government's reliance on borrowing and its impact on the economy's debt burden and financial stability.

$ \text{Gross Fiscal Deficit} = \text{Net Borrowing at Home} + \text{Borrowing from RBI} + \text{Borrowing from Abroad} $

A large fiscal deficit implies high government borrowing, which can have implications like increasing public debt, potential inflationary pressure if financed by borrowing from the RBI (monetisation), and possibly crowding out private investment.

Revenue deficit is a part of fiscal deficit. If the revenue deficit constitutes a large portion of the fiscal deficit, it signifies that a significant part of borrowing is being used for consumption expenditure rather than capital formation.

Primary Deficit

This is the fiscal deficit minus interest payments on previous borrowings. It measures the borrowing requirement needed to finance current expenditures, excluding the burden of past debt.

$ \text{Gross Primary Deficit} = \text{Gross Fiscal Deficit} - \text{Net Interest Liabilities} $

($\text{Net Interest Liabilities} = \text{Interest Payments} - \text{Interest Receipts}$)

The primary deficit indicates the extent of fiscal imbalance in the current year's operations, leaving aside the interest burden from accumulated past debt. A decreasing primary deficit points towards improving fiscal health, even if the fiscal deficit is high due to large interest payments on historical debt.

S.No. Item % of GDP (2022–23 B.E.)
1. Revenue Receipts (a+b) 8.5
(a) Tax revenue (net of states’ share) 7.5
(b) Non-tax revenue 1.0
2. Revenue Expenditure of which 12.4
(a) Interest payments 3.6
(b) Major subsidies 1.2
(c) Defence expenditure 0.9
3. Revenue Deficit (2–1) 3.8
4. Capital Receipts (a+b+c) of which 6.7
(a) Recovery of loans 0.1
(b) Other receipts (mainly PSU disinvestment) 0.3
(c) Borrowings and other liabilities 6.4
5. Capital Expenditure 2.9
6. Non-debt Receipts [1+4(a)+4(b)] 8.9
7. Total Expenditure [2+5] 15.3
8. Fiscal deficit [7-6] 6.4
9. Primary Deficit [8–2(a)] 2.8

Based on Table 5.1 (2022-23 B.E.):


Fiscal Policy

Fiscal policy refers to the government's use of taxation and spending to influence the economy, particularly aggregate demand, output, and employment levels. Keynesian economics highlights the role of fiscal policy in stabilising the economy. Fiscal policy can result in budget deficits or surpluses, rather than just balanced budgets.

The government influences aggregate demand directly through its purchases of goods and services (G) and indirectly through taxes (T) and transfers (TR), which affect household disposable income and thus consumption.

Disposable Income ($Y_D$) is the income households have left after paying taxes and receiving transfers: $Y_D = Y - T + TR$. The consumption function becomes $C = \bar{C} + cY_D = \bar{C} + c(Y - T + TR)$.

Aggregate demand with government is $AD = C + I + G = \bar{C} + c(Y - T + TR) + \bar{I} + \bar{G}$.

Assuming autonomous taxes ($T = \bar{T}$) and transfers ($TR = \overline{TR}$), and autonomous investment ($\bar{I}$) and government spending ($\bar{G}$), the equilibrium income ($Y^*$) is found by setting $Y = AD$:

$ Y = \bar{C} + c(Y - \bar{T} + \overline{TR}) + \bar{I} + \bar{G} $

$ Y - cY = \bar{C} - c\bar{T} + c\overline{TR} + \bar{I} + \bar{G} $

$ Y(1-c) = (\bar{C} - c\bar{T} + c\overline{TR} + \bar{I} + \bar{G}) $

$ Y^* = \frac{1}{1-c} (\bar{C} - c\bar{T} + c\overline{TR} + \bar{I} + \bar{G}) $

Let Autonomous Expenditure, $A = \bar{C} - c\bar{T} + c\overline{TR} + \bar{I} + \bar{G}$.

$ Y^* = \frac{1}{1-c} A $

Changes In Government Expenditure

An increase in government purchases (G) directly increases aggregate demand. This shifts the AD curve upwards. The effect on equilibrium income is amplified by the multiplier.

The Government Expenditure Multiplier is the ratio of the change in equilibrium income ($\Delta Y$) to the change in government spending ($\Delta G$). With lump-sum taxes and constant transfers, investment, and autonomous consumption, the multiplier is:

$ \text{Government Expenditure Multiplier} = \frac{\Delta Y}{\Delta G} = \frac{1}{1-c} $

An increase in G leads to a larger increase in Y because the initial spending creates income, which leads to increased consumption, generating more income, and so on (the multiplier process).

Graph showing effect of increase in government expenditure

In the graph, an increase in G shifts AD upwards (from $C+I+G-cT$ to $C+I+G'-cT$). The new equilibrium $E'$ is at a higher income level $Y'$.

Changes In Taxes

A change in lump-sum taxes (T) indirectly affects aggregate demand by changing disposable income. A tax cut increases disposable income, leading to higher consumption and shifting the AD curve upwards. A tax increase has the opposite effect.

The Tax Multiplier is the ratio of the change in equilibrium income ($\Delta Y$) to the change in lump-sum taxes ($\Delta T$). With constant government spending, transfers, investment, and autonomous consumption, the multiplier is:

$ \text{Tax Multiplier} = \frac{\Delta Y}{\Delta T} = \frac{-c}{1-c} $

The tax multiplier is negative because a tax increase leads to a decrease in income. It is also smaller in absolute value than the government expenditure multiplier ($|\frac{-c}{1-c}| < \frac{1}{1-c}$ since $c < 1$). This is because a change in taxes affects consumption indirectly through the MPC, whereas a change in G affects aggregate demand directly.

Graph showing effect of reduction in taxes

In the graph, a reduction in taxes ($T'$ < $T$) increases consumption and shifts AD upwards (from $C+I+G-cT$ to $C+I+G-cT'$). The new equilibrium $E'$ is at a higher income level $Y'$.

Example 5.1. Assume that the marginal propensity to consume is 0.8. The government expenditure multiplier will then be $\frac{1}{1 – c} = \frac{1}{1 – 0.8} = \frac{1}{0.2} = 5$. For an increase in government spending by 100, the equilibrium income will increase by $ \Delta Y = \frac{1}{1-c} \Delta G = 5 \times 100 = 500 $. The tax multiplier is given by $\frac{–c}{1 – c} = \frac{–0.8}{1 – 0.8} = \frac{–0.8}{0.2} = –4$. A tax cut of 100 ( $\Delta T= –100$) will increase equilibrium income by $\Delta Y = \frac{-c}{1-c} \Delta T = -4 \times (-100) = 400$. Thus, the equilibrium income increases in this case by less than the amount by which it increased under a G increase.

Within the present framework, if we take different values of the marginal propensity to consume and calculate the values of the two multipliers, we find that the tax multiplier is always one less in absolute value than the government expenditure multiplier. This has an interesting implication. If an increase in government spending is matched by an equal increase in taxes, so that the budget remains balanced, output will rise by the amount of the increase in government spending. Adding the two policy multipliers gives

The balanced budget multiplier = $ \frac{\Delta Y}{\Delta G} + \frac{\Delta Y}{\Delta T} = \frac{1}{1 – c} + \frac{–c}{1 – c} = \frac{1 – c}{1 – c} = 1 $

A balanced budget multiplier of unity implies that a 100 increase in G financed by 100 increase in taxes increases income by just 100. This can be seen from Example 1 where an increase in G by 100 increases output by 500. A tax increase would reduce income by 400 with the net increase of income equal to 100. The equilibrium income refers to the final income that one arrives at in a period sufficiently long for all the rounds of the multipliers to work themselves out. We find that output increases by exactly the amount of increased G with no induced consumption spending due to increase in taxes. To see why the balanced budget multiplier is 1, we examine the multiplier process. The increase in government spending by a certain amount raises income by that amount directly and then indirectly through the multiplier chain increasing income by $ \Delta Y = \Delta G + c\Delta G + c^2\Delta G + . . . = \Delta G (1 + c + c^2 + . . .) $

But the tax increase only enters the multiplier process when the cut in disposable income reduces consumption by c times the reduction in taxes. Thus the effect on income of the tax increase is given by $ \Delta Y = – c\Delta T – c^2\Delta T + . . . = – \Delta T(c + c^2 + . . .) $

The difference between the two gives the net effect on income. Since $\Delta G = \Delta T$, from the two equations, we get $\Delta Y = \Delta G$, that is, income increases by the amount by which government spending increases and the balanced budget multiplier is unity. This multiplier can also be derived from equation 5.3 as follows $ \Delta Y = \Delta G + c (\Delta Y – \Delta T) $ since investment does not change ($\Delta I = 0$)

Since, $\Delta G = \Delta T$, we have $ \frac{\Delta Y}{\Delta G} = \frac{1 – c}{1 – c} = 1 $

Answer:

The example demonstrates the calculation of the government expenditure multiplier and the tax multiplier with MPC = 0.8. The government expenditure multiplier is $ \frac{1}{1-0.8} = 5 $. An increase in government spending by 100 leads to an income increase of $5 \times 100 = 500$. The tax multiplier is $ \frac{-0.8}{1-0.8} = -4 $. A tax cut of 100 ($\Delta T = -100$) leads to an income increase of $-4 \times (-100) = 400$. This shows that an equal change in government spending has a larger impact on income than a change in taxes of the same magnitude (in absolute terms).

The Balanced Budget Multiplier is the sum of the government expenditure multiplier and the tax multiplier when the increase in government spending is financed by an equal increase in taxes ($\Delta G = \Delta T$). In this case, the total change in income is the sum of the changes caused by $\Delta G$ and $\Delta T$ separately: $ \Delta Y_{\text{total}} = \Delta Y_G + \Delta Y_T = (\frac{1}{1-c})\Delta G + (\frac{-c}{1-c})\Delta T $. Since $\Delta G = \Delta T$, $ \Delta Y_{\text{total}} = (\frac{1}{1-c} - \frac{c}{1-c})\Delta G = (\frac{1-c}{1-c})\Delta G = 1 \cdot \Delta G $. The balanced budget multiplier is 1, meaning that when government spending and taxes increase by the same amount, equilibrium income increases by exactly that amount.

The example illustrates this: an increase in G by 100 increases income by 500. An increase in taxes by 100 (which is a tax cut of -100 with the tax multiplier) decreases income by 400 ($-4 \times 100 = -400$). The net effect on income for a balanced budget increase of 100 (G up by 100, T up by 100) is $500 + (-400) = 100$. So, the income increases by 1 times the increase in the budget.

Case Of Proportional Taxes

A more realistic assumption is that taxes are a constant fraction of income, i.e., $T = tY$, where $t$ is the proportional tax rate. In this case, the consumption function becomes $C = \bar{C} + c(Y - tY + TR) = \bar{C} + c(1-t)Y + cTR$.

The marginal propensity to consume out of income is now $c(1-t)$, which is smaller than $c$. This makes the AD curve flatter.

$ \text{AD} = \bar{C} + c(1-t)Y + c\overline{TR} + \bar{I} + \bar{G} $

$ \text{AD} = A + c(1-t)Y $, where $A = \bar{C} + c\overline{TR} + \bar{I} + \bar{G}$ is autonomous expenditure.

Equilibrium income is $ Y^* = \frac{A}{1 - c(1-t)} $.

The Autonomous Expenditure Multiplier with proportional taxes is:

$ \text{Multiplier} = \frac{\Delta Y}{\Delta A} = \frac{1}{1 - c(1-t)} $

This multiplier is smaller than the multiplier with lump-sum taxes ($ \frac{1}{1-c} $) because a portion of any increase in income is automatically collected as taxes, reducing the amount available for induced consumption.

Graph showing AD with proportional taxes (flatter)

The graph shows that proportional taxes make the AD curve flatter compared to the case without taxes or with lump-sum taxes.

The Government Expenditure Multiplier with proportional taxes is:

$ \frac{\Delta Y}{\Delta G} = \frac{1}{1 - c(1-t)} $

Graph showing effect of increase in G with proportional taxes

The Tax Multiplier with proportional taxes is more complex, as a change in the tax rate $t$ changes the slope of the AD curve, while a change in autonomous transfers $\overline{TR}$ acts like a change in autonomous expenditure.

Proportional income taxes act as an automatic stabiliser. They automatically reduce the impact of fluctuations in income on disposable income and consumption. When income rises in a boom, tax collections automatically increase, siphoning off some of the extra income and dampening the rise in consumption. When income falls in a recession, tax collections automatically decrease, cushioning the fall in disposable income and consumption. This reduces the volatility of the business cycle without explicit policy changes.

Example 5.2. In Example 5.1, if we take a tax rate of 0.25, we find consumption will now rise by 0.60 (c (1 – t) = 0.8 × 0.75) for every unit increase in income instead of the earlier 0.80. Thus, consumption will increase by less than before. The government expenditure multiplier will be $ \frac{1}{1 – c(1 – t)} = \frac{1}{1 – 0.6} = \frac{1}{0.4} = 2.5 $ which is smaller than that obtained with lump-sum taxes. If government expenditure rises by 100, output will rise by the multiplier times the rise in government expenditure, that is, by $2.5 \times 100 = 250$. This is smaller than the increase in output with lump-sum taxes.

Answer:

This example illustrates the effect of introducing a proportional tax ($t=0.25$) on the multiplier. With MPC ($c$) = 0.8, the MPC out of income becomes $c(1-t) = 0.8 \times (1-0.25) = 0.8 \times 0.75 = 0.6$. This reduced induced spending per unit of income lowers the multiplier to $ \frac{1}{1-0.6} = \frac{1}{0.4} = 2.5 $. An increase in government expenditure of 100 now leads to an income increase of $2.5 \times 100 = 250$, which is smaller than the 500 increase seen with lump-sum taxes (where the multiplier was 5). This confirms that proportional taxes dampen the multiplier effect and act as an automatic stabiliser.

Discretionary fiscal policy refers to deliberate changes in government spending or taxes made by policymakers to stabilise the economy, as opposed to the automatic changes caused by built-in stabilisers.

Welfare transfers and even aspects of the private sector (like firms maintaining dividends or households trying to maintain living standards) can also act as built-in stabilisers, cushioning income fluctuations.

Transfers

An increase in government transfers (TR) to households also affects aggregate demand by increasing disposable income and hence consumption. However, unlike government spending on goods and services (G), transfers do not directly add to aggregate demand. The initial effect on AD is only the portion of the transfer that households spend based on their MPC ($c \cdot \Delta TR$).

The Transfer Multiplier (with lump-sum taxes) is:

$ \frac{\Delta Y}{\Delta TR} = \frac{c}{1-c} $

This multiplier is smaller than the government expenditure multiplier ($\frac{1}{1-c}$) because the initial injection into the spending stream is only $c \cdot \Delta TR$, not the full $\Delta TR$.

Example 5.3. We suppose that the marginal propensity to consume is 0.75 and we have lump-sum taxes. The change in equilibrium income when government purchases increase by 20 is given by $ \Delta Y = \frac{1}{1 – 0.75} \Delta G = \frac{1}{0.25} \times 20 = 4 \times 20 = 80 $. An increase in transfers of 20 will raise equilibrium income by $ \Delta Y = \frac{0.75}{1 – 0.75} \Delta TR = \frac{0.75}{0.25} \times 20 = 3 \times 20 = 60 $. Thus, we find that income increases by less than it increased with a rise in government purchases.

Answer:

This example shows that with MPC = 0.75, the government expenditure multiplier is $ \frac{1}{1-0.75} = 4 $. An increase in G by 20 leads to an income increase of $4 \times 20 = 80$. The transfer multiplier is $ \frac{0.75}{1-0.75} = 3 $. An increase in transfers by 20 leads to an income increase of $3 \times 20 = 60$. This confirms that the transfer multiplier is smaller than the government expenditure multiplier, as transfers must first pass through the consumption function (multiplied by MPC) to impact aggregate demand.


Debt

When a government runs budget deficits year after year, it often finances these deficits by borrowing, which leads to the accumulation of government debt. Deficits represent a flow, while debt represents a stock – accumulated deficits over time.

Perspectives On The Appropriate Amount Of Government Debt

Whether government debt is a burden and how it should be financed are debated topics. Unlike individual debt, a government has unique abilities like taxation and currency printing (though printing money can be inflationary).

One argument is that government borrowing imposes a burden on future generations. When the government borrows by issuing bonds today and plans to repay them (with interest) in the future through higher taxes, these taxes fall on the future working population, reducing their disposable income and consumption. This might reduce national savings available for private investment, potentially slowing future growth and thus burdening the future generation.

A counter-argument, known as Ricardian equivalence (after David Ricardo), suggests that forward-looking consumers will anticipate future tax increases associated with current government borrowing. They will save more today to offset these expected future taxes, so total national saving remains unchanged. This perspective argues that government borrowing and taxation are equivalent ways of financing expenditure from the perspective of their impact on national saving, assuming rational and forward-looking individuals who care about their descendants.

The argument that "debt does not matter because we owe it to ourselves" applies primarily to domestic debt, where interest payments redistribute income within the country. However, debt owed to foreigners clearly represents a burden, as resources (goods/services) must be sent abroad to make interest payments and principal repayments.

Other Perspectives On Deficits And Debt

Deficit Reduction

Reducing government deficits typically involves increasing government receipts or decreasing government expenditure.

Implementing fiscal responsibility legislation (like FRBMA in India) is another approach to enforce fiscal discipline and commit governments to deficit reduction targets. It's important to note that deficits can fluctuate with the state of the economy; a recession can automatically increase deficits due to falling tax revenues and rising welfare spending, even if fiscal policy settings remain unchanged.


Fiscal Responsibility And Budget Management Act, 2003 (Frbma)

The Fiscal Responsibility and Budget Management Act (FRBMA) was enacted in India in 2003 to institutionalize fiscal discipline. It provides a legal framework for the government to pursue a prudent fiscal policy, aiming for long-term macroeconomic stability and inter-generational equity.

Main Features

The Act aims to curb excessive government borrowing and spending, though concerns have been raised about its potential impact on necessary welfare expenditures. Many states in India have also enacted similar legislation.

Frbm Review Committee

Recognizing changes in the Indian economy since the FRBMA's enactment in 2003, a review committee was formed to assess the Act's framework and suggest adjustments to align it with the country's current and future growth path while maintaining fiscal prudence.


Gst: One Nation, One Tax, One Market

The Goods and Services Tax (GST), implemented in India on July 1, 2017, is a major indirect tax reform. It is a comprehensive, destination-based consumption tax applied to the supply of goods and services across the country. It aims to create a unified national market and simplify the tax structure.

Under the previous system, taxes were often levied at multiple stages without full credit for taxes paid on inputs, leading to a cascading effect (tax on tax). GST addresses this through the Input Tax Credit (ITC) mechanism, where businesses can claim credit for taxes paid on their inputs (goods and services used in production) and deduct this from their tax liability on the output. The tax is effectively levied only on the value addition at each stage of the supply chain.

GST subsumed a large number of central and state indirect taxes (e.g., Central Excise Duty, Service Tax, VAT, Entry Tax, etc.). It has standardized tax laws, procedures, and rates across India. While some items (like petroleum products and alcohol) were initially kept out, it aims for a broad coverage. GST has multiple standard rates (0%, 3%, 5%, 12%, 18%, 28%).

Key benefits of GST include: