Chapter 5 — Government Budget and the Economy

Allocation (providing public goods markets cannot supply), redistribution (changing income distribution through taxes and transfers to achieve a fair distribution), and stabilisation (intervening to raise or reduce aggregate demand to correct unemployment or inflation).

Public goods are non-rivalrous (one person's consumption does not reduce availability for others) and non-excludable (no feasible way to stop non-payers from benefiting). Because of free-riders, private producers cannot collect fees, so the market will not supply these goods and the government must provide them through the budget.

Revenue receipts (tax revenue and non-tax revenue) do not create a claim on the government and are non-redeemable. Capital receipts — such as borrowings and proceeds from PSU disinvestment — either create a liability (loans must be repaid) or reduce the government's financial assets, and so are redeemable.

Revenue expenditure is incurred for normal government functioning, interest payments, and grants; it does not create physical or financial assets. Capital expenditure results in the creation of assets (land, buildings, machinery, shares) or reduction in financial liabilities.

Revenue deficit = revenue expenditure − revenue receipts. A high revenue deficit means the government is dissaving — using savings from other sectors to finance consumption. It forces borrowing not just for investment but for current spending, building up debt and interest liabilities, and may crowd out productive capital or welfare expenditure.

Fiscal deficit = total expenditure − (revenue receipts + non-debt-creating capital receipts). It represents the government's total borrowing requirement. It is financed through net borrowing from the public, borrowing from the RBI, and borrowing from abroad. In 2024-25, the fiscal deficit was 5.6% of GDP.

Primary deficit = fiscal deficit − net interest liabilities. It focuses on present fiscal imbalances by removing the interest burden on past accumulated debt, showing how much the government is borrowing to meet current expenditure (excluding interest payments). In 2024-25, it was 2.0% of GDP.

Government spending directly increases aggregate demand by the full amount of the increase. A tax cut, however, first raises disposable income, and only a fraction c (MPC) of that goes to consumption. So the first-round effect on spending is c times the tax cut, not the full amount. Hence the tax multiplier (−c/(1−c)) is one less in absolute value than the expenditure multiplier (1/(1−c)).

If government spending increases by an amount exactly matched by an equal tax increase so the budget stays balanced, income rises by exactly that amount. The balanced budget multiplier equals 1. For example, if G and T both rise by 100 and MPC = 0.8, G raises income by 500 but the tax increase reduces it by 400, giving a net rise of 100.

With a proportional income tax (T = tY), when GDP rises, tax revenue rises faster, reducing disposable income and dampening the increase in consumption. During a recession, GDP falls but tax liability falls too, so disposable income and consumption do not drop as sharply. This reduces fluctuations without any deliberate policy decision, acting as a built-in shock absorber.

Named after David Ricardo, Ricardian equivalence holds that borrowing today and taxing today are equivalent means of financing government expenditure. Forward-looking consumers anticipate that current government borrowing means higher future taxes; they save more now to offset that burden, leaving national savings unchanged. It implies a budget deficit financed by bonds has the same macroeconomic impact as one financed by current taxes.

The Fiscal Responsibility and Budget Management Act 2003 binds the central government to reduce fiscal deficit to not more than 3% of GDP, eliminate the revenue deficit, cut fiscal deficit by 0.3% of GDP each year, restrict RBI borrowing to temporary cash shortfalls, and lay three fiscal statements before Parliament (Medium-term Fiscal Policy, Fiscal Policy Strategy, and Macroeconomic Framework). Exceptions are allowed for national security or natural calamity.

GST (Goods and Services Tax) is a single comprehensive destination-based indirect tax operational from 1 July 2017. It replaced a large number of central taxes (Central Excise Duty, Service Tax, Central Sales Tax) and state taxes (VAT, Entry Tax, Luxury Tax, Octroi, etc.). Unlike the earlier system — which imposed taxes on the total value of goods including taxes paid at previous stages (cascading) — GST allows Input Tax Credit at every stage so tax is effectively levied only on value added. It has six standard rates: 0%, 3%, 5%, 12%, 18%, and 28%.

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