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PUBLIC FINANCE (BUDGET AND FISCAL POLICY)

Understanding Public Finance

• Public finance is a crucial branch of economics that deals with the assessment of government revenue and expenditures. It aims at modifying these financial activities to achieve desirable outcomes and avoid adverse effects. This field covers the management of public money, including aspects such as the money a government receives, spends, borrows, lends, and raises or prints. Often referred to as public economics, this domain does not only focus on the amount of resources a government should acquire but also emphasizes the efficiency with which these resources are utilized.

Components of Public Finance

• Public Revenue: This includes all forms of income that a government earns. It can be categorized into tax revenues (direct and indirect taxes), non-tax revenues (fees, fines, grants), and public debt (money borrowed by the government).
• Public Expenditure: This refers to the spending by the government aimed at achieving welfare and implementing policies. Public expenditure can be on infrastructure, healthcare, education, defense, etc.
• Financial Administration: Encompasses the management of public finances, including budgeting, audit, and other financial operations.
• Federal Finance: Involves the distribution of functions and resources among the different layers of government (central, state, local) to ensure efficient public service delivery.

The role of public finance has grown significantly post-World War II as governments worldwide have expanded their roles in the economy, focusing on delivering public goods and services that the market fails to provide efficiently, such as law enforcement, defense, and public welfare.

National Institute for Public Finance and Policy

• Established in 1976, this independent body aids in developing and reforming public policies across federal, state, and local governments in India by providing analytical research and advocating for policy initiatives.

Meaning of Budget

• The budget is essentially a financial plan that outlines expected revenues and expenditures over a specific period, traditionally a fiscal year. It serves as a critical tool for government financial planning but is also applicable to firms, companies, and corporations.

Evolution of the Budget in India

• The Union Budget of India, guided by Article 112 of the Constitution, is prepared by the Department of Economic Affairs in the Ministry of Finance. It was historically presented in two parts: the Railway Budget and the General Budget, which were merged in 2017 based on recommendations from the Bibek Debroy committee.

Important Terminologies:

Revised Estimates (RE)

• Revised Estimates represent the updated projections of budgetary figures for a given fiscal year. These figures are recalculated to reflect the most current understanding of the government’s or organization’s finances compared to the original Budget Estimates (BE) or Provisional Estimates (PE) made at the beginning of the fiscal year. REs account for the actual spendings and receipts up to a certain point in the fiscal year and project the expected situation until its end.
• Importance

• Current Fiscal Insight: RE provides a mid-year correction to budget estimates, giving a clearer picture of the financial health and the likely fiscal outcome by the year-end.
• Policy Adjustment: It allows policymakers to adjust their strategies based on the latest financial data, ensuring that fiscal policies remain relevant and effective.
• Resource Allocation: By understanding the current fiscal scenario, governments can make informed decisions about reallocating resources to meet unforeseen demands or to capitalize on unexpected fiscal space.

Quick Estimates (QE)

• Quick Estimates are a form of revised estimates that are prepared to reflect the most recent financial circumstances. They are typically more immediate and are utilized for making future projections for specific sectors or sub-sectors within a short time frame after the end of a period.
• Importance

• Timeliness: QEs offer a prompt update on financial data, which is crucial for quick decision-making and planning.
• Sectoral Analysis: They are particularly useful for analyzing specific sectors, providing quick insights that are essential for sector-specific policy formulation or adjustment.
• Projection Basis: QE serves as a basis for making short-term financial projections and adjustments, ensuring that economic plans remain aligned with the latest data.

Advance Estimates

• Advance Estimates are projections made ahead of the final stage of data collection for a particular period. Like RE and QE, Advance Estimates are interim data, but they are prepared in anticipation of financial outcomes before the actual data becomes available.
• Importance

• Forecasting: They are crucial for early forecasting of economic indicators, allowing governments and financial institutions to prepare for future economic conditions.
• Planning Tool: Advance Estimates serve as an important tool for financial and economic planning, providing an early indication of the likely fiscal and economic scenario.
• Policy Preparation: By offering an early glimpse into the expected financial outcomes, Advance Estimates enable policymakers to draft policies and strategies proactively to address projected challenges or leverage forecasted opportunities.

Golden Rule of Budget

• This fiscal guideline suggests that the government should borrow only to finance investments that will benefit future generations, and not for current expenditures. This principle aims to ensure that public debt is used responsibly and sustainably.

Variants of Budgets

• Balanced Budget: Expenditures equal revenues.
• Unbalanced Budget: Expenditures do not match revenues. It can be further classified into:
  • Surplus Budget: Revenues exceed expenditures.
  • Deficit Budget: Expenditures exceed revenues, indicating the government needs to borrow or use reserves to meet its spending requirements.
• These budget types and processes reflect the government’s approach to managing its finances, balancing immediate needs with long-term objectives, and ensuring fiscal responsibility and sustainability.

Various Approaches of Budgeting

• Budgeting is a critical financial planning tool used by governments to allocate resources efficiently and effectively towards achieving desired outcomes. Different approaches to budgeting aim to enhance the transparency, accountability, and efficiency of public expenditure. Here’s an expansion on various budgeting approaches including Outcome Budgeting, Performance Budgeting, and Gender-Based Budgeting.

Outcome Budgeting

• Outcome Budgeting is a methodology that links the allocation of resources to the expected results or outcomes, enhancing the effectiveness and efficiency of public spending.

Key Features

• Implementation: Introduced in India in 2005, it assesses how well government programs and schemes translate budgetary allocations into tangible outcomes.
• Evaluation: Focuses on evaluating the performance of each ministry and department based on the correlation between their budgetary outlay and the actual work accomplished.
• Objective: Aims to ensure that funds are utilized for their intended purposes and that they yield the anticipated outcomes, such as improvements in societal welfare.
• Assessment Criteria: Differentiates between outputs (quantitative measure of services or goods produced) and outcomes (the impact of those outputs on society).

Advantages

• Enhances transparency and participation in the budgeting process.
• Improves accountability and effectiveness of government schemes.
• Promotes clarity in the roles and responsibilities of government officials.
• Encourages cost reduction by prioritizing investments in effective areas.

Challenges

• Complex and technically demanding.
• May introduce additional costs and complicate the budgeting process.
• Outcomes can be influenced by numerous factors beyond funding.

Outcome-Based Budgeting in India        

• Implemented to bring about a more transparent budgeting process.
• Faced challenges such as institutional resistance and the need for a robust fiscal tool to guide expenditure decisions.

Performance Budgeting

• Performance Budgeting is a method that aligns the allocation of resources with the results or outputs delivered by public sector organizations.

Key Concepts

• Focuses on the efficiency of public expenditure by linking funding to the outcomes of public services.
• Aims for improved prioritization of expenditure and effectiveness of services.

Advantages

• Facilitates clearer communication of program goals and expectations.
• Improves management within government agencies, enhancing organizational goals and program performance.
• Promotes more informed budgetary decision-making with a focus on performance outcomes.
• Increases transparency and accountability in government spending.

Considerations

• May not allow for new budget allocations in response to changing conditions mid-year.
• Requires setting budget priorities among various departments and programs.

Implementation of Performance Budgeting

• Involves classifying budgets according to strategic objectives and measuring performance consistently.
• Adopts a range of strategies from merely reporting performance to making resource allocation decisions based on performance.

Gender-Based Budgeting

• Gender-Based Budgeting is a strategic approach to budgeting that incorporates a gender perspective into the formulation, implementation, and evaluation of budgets, aiming to achieve gender equality and address disparities.

Importance

• Addresses the different impacts of resource allocation on men and women.
• Special focus on marginalized groups of women to ensure equitable distribution of resources.

Process

• Divides budget allocations into categories specifically benefiting women or pro-women schemes.
• Involves the establishment of Gender Budgeting Cells (GBCs) in ministries to conduct analyses and improve program designs for women.

Advantages

• Helps achieve gender equality and enhances human development and economic efficiency.
• Not limited to accounting but also influences policy-making and program design for women.

Challenges

• Decreasing budgetary allocations for gender equality and empowerment initiatives.
• Implementation challenges due to lack of dedicated personnel and monitoring mechanisms.

Gender Budgeting in India

• Recognized globally for influencing both expenditure and revenue policies and extending to state government levels.
• Implemented through phases including knowledge building, institutionalizing processes, capacity building, and enhancing accountability.

Zero-Based Budgeting (ZBB)

• Introduced by Edward Hilton Young in 1924, ZBB involves building the budget from zero every fiscal year, requiring justification for all expenses, both new and recurring.

Advantages of Zero-Based Budgeting

• Enhances Profitability Analysis: By justifying every expense, it’s easier to identify and eliminate non-performing activities.
• Accurate and Justifiable: Every part of the budget is reviewed and justified, ensuring more efficient resource allocation.
• Minimizes Redundancies: Encourages finding more economical alternatives by questioning every expense.
• Promotes Accountability: Every expenditure under ZBB needs to be fully justified, which controls unnecessary spending and encourages responsibility.

Disadvantages of Zero-Based Budgeting

• Encourages Short-Term Thinking: May prioritize immediate gains over long-term investments.
• Labor-Intensive: The extensive documentation required can be daunting and lead to inefficiency.
• Complexity and Cost: Implementing ZBB can be expensive and complex, posing challenges for smaller entities.
• High Demand for Resources: The comprehensive nature of ZBB demands significant time and workforce investment.
• Requires Experienced Management: Effective implementation of ZBB needs skilled managers well-versed in justifying and reviewing expenses.

Zero-Based Budgeting in India

• Early Adoption: The Department of Science and Technology adopted ZBB in 1983, and the Indian government followed in 1986, aiming to optimize expenditure budgets based on ZBB principles.
• Limited Application: Despite promotion during the seventh Five-Year Plan, ZBB’s application in India remains limited, reflecting the challenges of implementing such a detailed approach on a large scale.

Sunset Budgeting:

• Same as zero-based budgeting.
• Every allocated fund, for every scheme/activity has a pre-set deadline.

Issues and Challenges with Indian Budgeting

Unrealistic Budget Estimates

• A recurring issue in the Indian budgeting process is the setting of unrealistic budget estimates. This can lead to two major problems: the need for frequent revisions due to overestimation and the presence of unspent funds at the end of the fiscal year due to underutilization. Such inaccuracies hinder efficient fiscal planning and resource allocation.

Implementation Delays

• The limited availability of resources and the practice of spreading them too thin often result in only nominal provisions for certain projects. This leads to significant delays in project execution, undermining development goals and the effective use of allocated funds.

Inadequate Adherence to Plans

• A lack of consistency in allocation and implementation can derail long-term projects and goals. Budget plans designed to achieve specific objectives over several years require steadfast adherence to ensure success, which is often lacking.

Poor Correlation Between Expenditure and Implementation

• Frequently, there is a disconnect between the expenditure incurred and the actual progress on the ground for the schemes and projects for which the funds were allocated. This misalignment raises questions about the effectiveness of budget spending.

Improper Expenditure

• A common practice observed in many departments is the rush to spend allocated funds towards the end of the fiscal year, aiming to justify the demand for new funds in the following budget. Such spending is often not based on quality or need, leading to wasteful expenditure.

Mis-statement of Financial Position

• Some departments resort to parking funds in non-government accounts without adequately assessing the fiscal health of these institutions. This approach risks the budget money, as only a portion is insured, potentially leading to significant financial losses.

Ad Hoc Project Announcements

• Projects are sometimes announced without proper budget allocation or consideration of existing financial commitments. This ad hoc approach can strain the budget and divert resources from other critical areas.

Components of Government Budget

• A government budget is a financial statement presenting the government’s proposed revenues and spending for a financial year. The components of a government budget can be broadly categorized into revenue, non-revenue, and the specifics of expenditures and receipts within these categories.

Revenue

• Revenue comprises all forms of money generation for a government that do not increase its financial liabilities. This includes:

• Tax Incomes: These are the earnings collected from direct and indirect taxes. Direct taxes include income tax, while indirect taxes include goods and services tax (GST).
• Non-Tax Incomes: This category encompasses earnings from sources other than taxes, such as profits from public sector undertakings (PSUs), fines, penalties, and external grants.

• Foreign Grants: Financial aids received from foreign governments or international organizations.

Non-Revenue

• Non-revenue sources refer to the money production mechanisms that increase the financial liabilities of the government, primarily through borrowings. This category does not generate earnings for the government but raises capital for expenditure.

Revenue Budget

• The revenue budget details the expected revenue receipts and the planned revenue expenditure. Key points include:

• Revenue Receipts: These are incomes that do not create any liability or decrease in assets. They include tax and non-tax revenues but exclude borrowings.
• Revenue Expenditure: This includes all spending that does not result in asset creation, such as salaries, subsidies, and interest payments. These expenditures are typically recurrent and essential for day-to-day government operations.

• A revenue surplus budget indicates that expected revenues exceed planned expenditures, whereas a revenue deficit budget signifies the opposite.

Capital Budget

• The capital budget concerns with capital receipts and expenditures, focusing on creating long-term assets or reducing liabilities. It includes:

• Capital Receipts: These are the government’s income sources that either reduce assets or increase liabilities, such as loans from the public, foreign borrowings, or proceeds from disinvestments.
• Capital Expenditure: Spending aimed at asset creation or liability reduction. It encompasses investments in infrastructure (like roads, bridges), loans provided by the government, and expenditure on defense assets.

Receipts

• Receipts in a government budget are classified into capital and revenue receipts:

• Capital Receipts: Include money from asset sales, loans from states, and borrowings.
• Revenue Receipts: Comprise tax and non-tax revenues such as taxes from various sources, profits from PSUs, interest on loans provided, and services provided by the government.

Expenditure

• Government expenditures are classified as capital and revenue expenditures:

• Capital Expenditure: Involves investments in physical assets and loans to states or other entities. This category includes infrastructure development, defense spending, and investments in public enterprises.
• Revenue Expenditure: Covers costs that do not result in asset creation, including salaries, pensions, interest payments, subsidies, and social services expenses.

Plan Expenditure

• Plan expenditure refers to the government’s spending aligned with the national Five-Year Plans or its annual plans, focusing on various sectors and activities aimed at economic development. This classification of expenditure has been a part of the Indian budgetary system, primarily influenced by the (erstwhile) Planning Commission, now replaced by the NITI Aayog.
• Characteristics of Plan Expenditure

• Estimated by Ministries: Each ministry estimates its expenditure, which is then reviewed in the context of the country’s broader developmental plans.
• Includes Revenue and Capital Expenditure: Plan expenditure encompasses both revenue and capital expenditure. Revenue expenditure covers the costs necessary to maintain the operational activities of the government, such as salaries, subsidies, and maintenance. Capital expenditure, on the other hand, is directed towards creating assets, reducing liabilities, or investing in projects that would yield benefits in the future.
• Major Portion of Government Spending: Traditionally, plan expenditure forms a significant part of the total government spending, underscoring the government’s commitment to planned economic development.

• Examples

• Infrastructure Development: Investment in roads, bridges, schools, and hospitals.
• Social Sector Programs: Spending on health, education, and welfare schemes.
• Economic Services: Investments in agriculture, industry, and services to stimulate economic growth.

Non-Plan Expenditure

• Non-plan expenditure covers the expenses that fall outside the scope of the five-year plans. It includes the routine spending necessary for the functioning of the government and the economy but is not directly associated with the developmental plans.
• Characteristics of Non-Plan Expenditure

• Routine and Essential: This includes the day-to-day operational expenses of the government and its various departments.
• Major Components: Non-plan expenditure includes a wide range of expenses such as defense spending, interest payments on loans, subsidies, and salaries for government employees.
• Not Directly Tied to Development Projects: Unlike plan expenditure, non-plan expenditure does not directly contribute to economic development projects or schemes but is essential for the nation’s governance and social welfare.

• Examples

• Defence Spending: Expenditures related to national security and defense.
• Debt and Interest Payments: Payments made towards the interest and principal of the national debt.
• Subsidies: Money given in support of commodities and services that affect the general public, such as food, fuel, and fertilizers.

Plan vs. Non-Planned Expenditure

• The distinction between planned and non-planned expenditure was phased out in 2017-18, following recommendations from the Rangarajan committee in 2011. The new classification system focuses on “Capital and Revenue Expenditure” to establish a clear link between government earnings, spending, and outcomes, especially after the abolition of the Planning Commission. This change aimed at enhancing budget transparency and improving the alignment of government expenditures with actual outcomes.

Evolution and Current Trends

• In recent years, the Indian government has moved towards a more consolidated classification of expenditures, merging plan and non-plan expenditures into a single category to ensure a more holistic approach to budgeting. This shift aims to eliminate the artificial distinction between the two, enabling a more flexible and outcome-oriented allocation of resources. Despite this change, understanding the traditional distinction between plan and non-plan expenditures is crucial for comprehending historical budgetary practices and their evolution towards current methodologies.

Understanding Capital Expenditure (CapEx) in a Company

• Capital Expenditure, commonly known as CapEx, plays a pivotal role in a company’s growth and maintenance of its operations. It refers to the funds that a company allocates toward acquiring, upgrading, and maintaining its physical assets, such as properties, plants, buildings, technology, and equipment. This type of expenditure is essential for companies aiming to expand their operational capabilities or improve existing resources.

Key Aspects of CapEx

• Asset Acquisition and Upgrades: CapEx covers significant investments in physical assets, ranging from the purchase of land and buildings to investments in technology and heavy machinery. It is a vital component for businesses looking to enhance or expand their operational infrastructure.
• Exclusion of Short-Lived Items: Items with a lifespan of less than one year do not qualify as capital expenditures. This distinction ensures that CapEx focuses on long-term assets that provide value over time, rather than immediate or consumable expenses.
• Balance Sheet Representation: Unlike regular operational expenses, capital expenditures are recorded as investments on a company’s balance sheet. This treatment reflects the enduring value and long-term benefits of these assets to the company.
• Industry Variability: The level of CapEx can vary significantly across industries, with capital-intensive sectors like oil exploration, telecommunications, and manufacturing typically incurring higher capital expenditures due to the nature of their operations.
• Calculation of CapEx: CapEx can be calculated by adding the change in property, plant, and equipment (PP&E) to the current depreciation. This formula helps in understanding the investment made in tangible assets and their depreciation over time.

Expenditure Management Commission (EMC)

• In an effort to enhance fiscal discipline and expenditure management, the Indian government, under Finance Minister Arun Jaitley in the 2014-15 budget speech, announced the formation of the Expenditure Management Commission (EMC). This body plays a crucial role in recommending major expenditure reforms to help the government manage its fiscal deficit effectively.

Role of the EMC

• Recommending Body: The EMC acts as an advisory body, providing recommendations on how to implement significant expenditure reforms.
• Fiscal Deficit Management: Its primary focus is to propose strategies that can help the government maintain fiscal deficits at manageable levels, thereby ensuring economic stability and sustainable growth.

Concept of Deficit and Its Types

• The term “deficit” is often used in financial discussions to indicate a situation where expenses surpass revenues, liabilities exceed assets, or imports outdo exports. This concept is integral to understanding a country’s economic condition, especially in the context of government finances. Various types of deficits give insight into different aspects of fiscal health and economic management.

Revenue Deficit

• Definition: A revenue deficit occurs when the government’s total revenue expenditure exceeds its revenue receipts.
• Formula: Revenue Deficit = Revenue Expenditure – Revenue Receipts
• Implications: Indicates the government is spending more on day-to-day operations than it is earning, leading to potential asset reduction, inflationary pressures, and increased debt burden.
• Measures to Reduce: These include increasing tax rates, introducing new taxes, curbing unnecessary expenditure, and enhancing non-tax revenues.

Effective Revenue Deficit (ERD)

• Introduction: This concept was introduced to refine how revenue deficits are calculated by excluding capital grants used for asset creation from the calculation.
• Significance: It provides a clearer picture of the government’s fiscal management by acknowledging that some revenue expenditures contribute to creating productive assets.
• Calculation: ERD = Revenue Deficit – Grants for Creation of Capital Assets

Capital Deficit

• Clarification: There’s no formal term as “capital deficit” in standard economic discourse. However, the concept of a capital shortage is often discussed, referring to the insufficient capital available for public or governmental spending.

Fiscal Deficit

• Definition: The fiscal deficit is the difference between the government’s total expenditure and its total receipts, excluding borrowings, in a fiscal year.
• Formula: Fiscal Deficit = Total Expenditure – (Revenue Receipts + Non-debt Creating Capital Receipts)
• Implications: A fiscal deficit indicates the government’s borrowing requirement and impacts economic stability, influencing inflation, debt repayment burdens, and future economic growth.
• Measures to Reduce: To mitigate the fiscal deficit, governments can aim to increase revenues, rationalize subsidies, promote disinvestment, curb public spending, broaden the tax base, and adopt austerity measures.

Primary Deficit

• Definition: The primary deficit focuses on the current fiscal deficit, excluding interest payments on past debts.
• Formula: Primary Deficit = Fiscal Deficit – Interest Payments
• Relevance: This metric helps to understand the extent of borrowing that goes towards funding current expenditures rather than servicing past debts.

Key Takeaways

• Revenue Deficit: Highlights inefficiency in managing day-to-day government operations, leading to potential asset reduction and inflation.
• Effective Revenue Deficit (ERD): Provides a more nuanced view of the revenue deficit by accounting for expenditures that create capital assets.
• Fiscal Deficit: Indicates the total borrowing needs of the government and has broader implications for economic stability and growth.
• Primary Deficit: Offers insight into the amount of new borrowing that is actually used for current expenditures rather than servicing old debt.

Concept of Deficit Financing

• Deficit financing represents a fiscal strategy where governments fund a budget deficit through borrowing or creating new money. This approach is usually adopted when a government’s total expenditure exceeds its total income, leading to a need for additional funds to support economic activities and development projects.

Methods of Deficit Financing

• Internal Borrowings: This involves the government raising funds domestically through the issuance of bonds and securities to the public, central banks, and commercial banks.
• Printing Currency: The government may instruct its central bank to print more money, thereby directly increasing the money supply.
• External Aid: This includes funds received from international organizations or countries, often at low or no interest rates.
• External Borrowings: Borrowing funds from international financial markets or institutions. While it avoids the crowding-out effect seen with internal borrowings, it can be seen as diminishing national financial autonomy.

Need for Deficit Financing

• Fiscal Deficit Targets: To achieve set fiscal goals when existing funds are insufficient.
• Economic Growth: When the imperative for growth outweighs the potential inflationary impact of deficit financing.
• Increasing Expenditure: To cover rapid increases in spending that outpace income growth.

Impact of Deficit Financing

• Inflation: Increasing aggregate demand through higher expenditure can lead to inflationary pressures.
• Economic Growth: Can stimulate growth by providing additional resources for spending and investment.
• Liquidity: Helps meet the economy’s liquidity needs, facilitating financial transactions and economic activity.
• Instability: If mismanaged, it can lead to economic instability.

Crowding Out Effect

• This phenomenon occurs when government borrowing leads to higher interest rates, making borrowing more expensive for the private sector and potentially reducing private investment. It represents a key downside of excessive reliance on internal borrowings for deficit financing.

Deficit Financing in India

India’s experience with deficit financing can be divided into three distinct phases:

The First Phase (1947–1970)

• This period lacked a formal concept of deficit financing, with deficits primarily categorized as budgetary deficits.

The Second Phase (1970–1991)

• Characterized by significant deficit financing, this phase was marked by unsound economic fundamentals leading to a financial crisis by 1991. Key factors included the expansion of public sector undertakings (PSUs), rising government expenditure, centralized planned development, and the lack of economic rationale behind plan expenditures.

The Third Phase (1991 onwards)

• Initiated with economic reforms, this phase focused on encouraging private sector investment, rationalizing government expenditure, enhancing tax and non-tax revenues, and developing financial markets.

Monetized Deficit

• Introduced in India from the 1997-98 financial year, the monetized deficit concept refers to the part of the fiscal deficit financed by the Reserve Bank of India (RBI) through the creation of new money.

Evolution

• Initially, the RBI was obligated to subscribe to government treasury bills and securities. This practice was voluntary post-1997, with the introduction of Ways and Means Advances.
• From 2007, the RBI no longer compulsorily subscribes to government securities but manages the government’s borrowing program, indicating a shift towards market-based government borrowing.

Types of Monetisation

• Direct Monetisation: The RBI directly funds the government’s deficit against bonds or securities, a practice phased out post-1997.
• Indirect Monetisation: Occurs when the RBI engages in Open Market Operations (OMOs) or buys bonds in the secondary market.

Issues with Monetization

• Inflation: Increases in the money supply can lead to higher inflation rates.
• Interest Rates: May lead to higher interest rates, impacting borrowing costs.
• Financial Stability: Poses risks to the overall stability of the economy.

Fiscal Responsibility and Budget Management Act (FRBM), 2003

• The Fiscal Responsibility and Budget Management Act, passed in 2003, aims to instill fiscal discipline in India’s economy, improve public fund management, and reduce fiscal deficits.

Background of FRBM Act

• Economic Context: During the 1990s and early 2000s, India faced significant fiscal challenges, characterized by high fiscal deficits, revenue deficits, and a burgeoning Debt-to-GDP ratio.
• Impact of Borrowing: Excessive borrowing led to adverse consequences, with a substantial portion of borrowed funds being diverted to servicing interest payments, leaving limited resources for productive investments.
• Need for Regulation: In response to these challenges, the FRBM Act was enacted in 2003 to regulate government borrowings and promote fiscal discipline.

Objectives of the FRBM Act

• Transparent Fiscal Management: Introduce transparent fiscal management practices to enhance accountability and efficiency in public spending.
• Debt Distribution: Achieve a more equitable and manageable distribution of public debt over time to ensure long-term financial stability.
• Fiscal Deficit Reduction: Reduce revenue and fiscal deficits to maintain fiscal sustainability and macroeconomic stability.
• Monetary Policy Flexibility: Provide the Reserve Bank of India (RBI) with necessary flexibility to manage inflation effectively.

Salient Features of the FRBM Act

• Medium-term Policy Statement: Mandates the government to project four fiscal indicators – revenue deficit, fiscal deficit, tax revenue, and total outstanding liabilities – in a medium-term policy statement, all as a percentage of GDP.
• Deficit Targets: Sets specific targets for fiscal and revenue deficits to be achieved over a defined period.
• Parliamentary Obligations: Requires certain fiscal policy-related documents to be tabled in Parliament alongside the annual budget documents.
• Escape Clause: Includes an “Escape Clause” allowing for deviation from fiscal deficit targets in exceptional circumstances, such as national calamities or emergencies.

Recommendations of the NK Singh Committee

• Debt Management and Fiscal Responsibility Bill: Proposes replacing the FRBM Act with the Debt Management and Fiscal Responsibility Bill 2017.
• Debt-to-GDP Ratio: Recommends setting the debt-to-GDP ratio targets for the centre and state governments by 2022-23.
• Fiscal Deficit Target: Suggests a fiscal deficit target of 2.5% of GDP by FY 2022-23.
• Autonomous Fiscal Council: Advocates for the establishment of an autonomous fiscal council to improve fiscal data quality and provide advisory support on fiscal matters.
• Flexibility in Targets: Allows for flexibility in targets under specific circumstances like national calamities or war.
• State Debt Path: Proposes tailored debt paths for states based on their fiscal health and prudence, recommended by the 15th Finance Commission.
• Policy Coordination: Emphasizes the need for synergy between monetary and fiscal policies to achieve macroeconomic stability.

Public Expenditure

• Definition: Public expenditure refers to the spending incurred by the government to meet the demand for goods and services by the people. It constitutes a significant component of Gross Domestic Product (GDP).

Importance of Public Expenditure:

• Demand and Inflation Management: Adjusting public expenditure levels can help manage demand and control inflation within an economy.
• Income Distribution and Resource Allocation: It plays a crucial role in distributing income more equitably and allocating resources efficiently.
• Economic Stability and Growth: Public spending on infrastructure, welfare schemes, and various sectors like agriculture and manufacturing fosters economic stability and growth.
• Poverty Reduction and Inequality: By redistributing income, public expenditure can contribute to poverty reduction and narrowing income inequalities.
• Stabilizing Private Sector: During times of economic downturn or when the private sector faces challenges, public expenditure can act as a stabilizing force.

Causes for Increase in Public Expenditure

• Developmental projects
• Rising inflation
• Growing global population
• Expansion of welfare states
• Increased spending on security
• Urbanization
• Expansion of public sector
• Economic measures to support private sector growth

Challenges and Recommendations:

• Fiscal consolidation targets restrict public expenditure in India, necessitating a balance with private investment, especially in critical areas like health and education.
• Both the quantity and quality of public expenditure need enhancement, with a focus on increasing the tax-to-GDP ratio and attracting more private investment.

Public Debt/National Debt

• Definition: Public debt refers to the total amount of loans undertaken by the government, including both external and internal debt, and is to be repaid from the Consolidated Fund of India.

Debt-to-GDP Ratio

• India boasts a relatively low debt-to-GDP ratio of 170%, with the household sector accounting for 36%, non-financial private sector 88%, and government debt 82% of GDP.
• The debt-to-GDP ratio is a critical indicator of a country’s ability to repay its debts and influences investor decisions regarding investment in the country.

Sources of Public Debt

• Dated government securities (G-secs)
• Treasury Bills (T-bills)
• External assistance
• Short-term borrowings

Reasons for Borrowing/Public Debt

• Government borrowing is necessitated when expenditures exceed income, which may occur due to low tax revenue or high expenditure needs.
• Complex tax systems and tax evasion can result in inadequate tax collections, leading to borrowing.
• Misuse of public funds, corruption, and inefficiencies in project implementation may also contribute to increased borrowing.
• Borrowing is often required for funding welfare schemes and development initiatives crucial for growth and development.

Internal Debt

• Internal debt refers to the debt borrowed from within the country. It constitutes a significant portion, around 93%, of the overall public debt. Internal debt sources primarily include commercial banks and financial institutions. This type of debt can be further classified into two broad categories:

Marketable Debt

• Dated government securities (G-Secs) and treasury bills (T-bills) are examples of marketable debts issued through auctions.
• These securities are traded in the market, providing liquidity to investors.

Non-Marketable Debt

• Includes intermediate T-bills (e.g., 14-day maturities) issued to state governments and public sector banks.
• Special securities issued to the National Small Savings Fund (NSSF) also fall under non-marketable debt.

External Debt

• External debt, on the other hand, is borrowed from individuals, organizations, or governments outside the country. It can include debt from commercial banks, international financial organizations, or individual lenders. Both the principal amount and the interest are usually paid in the currency in which the debt was taken. Types of external debt include public and publicly guaranteed debt, non-guaranteed private sector external debt, central bank deposits, and loans from institutions like the IMF.

Types of Debt

Productive Debt

• Debt incurred for projects or assets that generate income, such as railway infrastructure or electricity plants.
• The generated income can be used to pay off yearly interest and principal, albeit putting pressure on taxpayers and the government.

Unproductive Debt

• Debt incurred for assets that do not generate income, leading to losses on interests and principal.

Redeemable/Terminable Debt

• Debt for which the government promises repayment on a fixed future date.

Irredeemable Debt/Perpetual Debt

• Debt taken without any promise of repayment on a specified date.

Funded Debt

• Long-term debt with repayment beyond one year.

Unfunded Debt

• Short-term debt borrowed for 6-12 months.

Short Term and Long Term Debt

• Short-term debt is repaid within a year, while long-term debt is repaid over a longer period.

Advantages of Public Debt

• Facilitates economic activities and increases production and the standard of living.
• Helps in dealing with crises and disasters.
• Assists in resource allocation and is considered a secure investment.

Disadvantages of Public Debt

• Large interest repayments burden the government.
• Default risks leading to bankruptcy.
• Extravagant spending can occur, as seen in cases like Greece.
• Risk of international interference and debt trap diplomacy.
• Burden shifted to the public for repayment.

Public Debt Management in India

• The Reserve Bank of India (RBI) manages public debt for the Union government as per the RBI Act of 1934.
• RBI oversees all financial transactions on behalf of the government, including cash balance deposits.
• The NK Singh Committee suggested a debt-to-GDP ratio to maintain debt sustainability.

Making Public Debt Sustainable

• Privatization of loss-making PSUs.
• Adherence to the Fiscal Responsibility and Budget Management (FRBM) Act 2003.
• Leveraging the Public Financial Management System (PFMS).
• Implementing the PPP model in social sector schemes.
• Investing in infrastructure.
• Harmonizing the tax regime.
• Focusing on renewable energy to reduce import bills.

Fiscal Policy

• Fiscal policy is a critical tool in the hands of governments to steer the economy towards desired outcomes. It involves the management of government revenue collection (such as taxes and divestment) and spending to influence economic activity.

Definition and Role of Fiscal Policy

• Fiscal policy entails the strategic management of government revenue and expenditure to shape economic conditions. It serves as a mechanism for the government to regulate economic growth, stabilize prices, promote employment, and address inequalities.

The difference between fiscal policy and monetary policy:

Fiscal Policy Tools and Operations

• Surplus vs. Deficit: Governments can operate in a surplus when revenue exceeds expenditure or in a deficit when expenditure surpasses revenue. Borrowing, drawing from reserves, or printing money are common methods to cover deficits.
• Revenue Sources: Revenue streams include taxes, non-tax revenues (e.g., divestment, loans), and foreign exchange reserves.
• Government Expenditure: This encompasses spending on infrastructure, defense, social services, subsidies, and administrative expenses.

Objectives of Fiscal Policy

• Economic Growth: Governments aim to maintain a steady growth rate by investing in key sectors such as infrastructure, healthcare, and education.
• Price Stability: Fiscal policy endeavors to control inflationary pressures through measures such as subsidies and regulating supplies.
• Employment Generation: Promoting full employment is a key goal achieved through public sector projects, incentives for private investment, and job creation schemes.
• Income and Wealth Distribution: Fiscal measures are employed to reduce disparities by imposing progressive taxes and providing welfare programs.
• Balance of Payments: Governments intervene to promote exports, curb imports, and maintain equilibrium in trade balances.
• Effective Administration: Fiscal policy ensures adequate funding for essential services like defense, judiciary, and law enforcement.

Types of Fiscal Policy

• Expansionary Fiscal Policy: This approach involves injecting more money into the economy through tax cuts and increased government spending to stimulate growth, typically employed during economic downturns.
• Contractionary Fiscal Policy: Aimed at reducing economic activity, this policy involves withdrawing money from the economy through increased taxes and reduced government spending to combat inflation.
• Neutral Fiscal Policy: When government spending equals tax revenue, it maintains economic stability without actively stimulating or contracting economic activity.

Importance of Fiscal Policy

• Capital Formation: Fiscal policy facilitates investment in both public and private sectors, driving economic growth and development.
• Resource Mobilization: Through taxation and other revenue streams, fiscal policy mobilizes funds for government initiatives and projects.
• Savings Promotion: By incentivizing savings through tax breaks and other measures, fiscal policy encourages individuals to save, thus increasing overall savings rates.
• Private Sector Growth: Tax incentives and reduced regulatory burdens provided by fiscal policy foster entrepreneurship and private sector expansion.
• Income Redistribution: Progressive taxation and welfare programs under fiscal policy aim to reduce income and wealth inequalities.

Fiscal Consolidation

• Fiscal consolidation refers to the process undertaken by governments to reduce their fiscal deficits and bring their finances to a sustainable and manageable level. It is an essential aspect of fiscal policy aimed at maintaining economic stability, controlling debt levels, and fostering long-term growth.

Roadmap for Fiscal Consolidation

• The Vijay Kelkar Committee presented a comprehensive roadmap for fiscal consolidation, outlining various steps and strategies to achieve this goal effectively.

Steps Taken for Fiscal Consolidation

• Implementation of Fiscal Responsibility and Budget Management (FRBM) Act of 2003: This legislation provides a legal framework for fiscal discipline, setting targets for reducing fiscal deficits and managing government debt levels.
• Implementation of Goods and Services Tax (GST) Act: The introduction of GST aimed to streamline indirect taxation, improve tax compliance, and increase government revenues.
• Insolvency and Bankruptcy Bill: This legislation provides a framework for resolving insolvency and bankruptcy cases efficiently, thereby improving the financial health of companies and reducing the burden on the banking sector.
• Direct Benefit Transfer (DBT): DBT enables the targeted delivery of government subsidies and welfare benefits, reducing leakages and ensuring that benefits reach the intended beneficiaries more effectively.
• Improving Tax Collections: Efforts to enhance tax collections include implementing better compliance mechanisms, expanding the tax base, and increasing the tax-to-GDP ratio, all of which contribute to higher government revenues.
• Disinvestment Targets: Setting disinvestment targets encourages the government to divest its stake in public sector enterprises, unlocking value and generating funds to reduce fiscal deficits.

15th Finance Commission Recommendations

• The 15th Finance Commission made several recommendations aimed at promoting fiscal consolidation while ensuring equitable distribution of resources among states.
• 41% of the divisible pool to be given to states in 2020-21.

Horizontal Devolution Criteria

• Needs-Based Criteria: Allocation based on factors like population, area, forest cover, and ecological considerations.
• Equity-Based Criteria: Allocation based on income distance, with higher weightage given to states with lower per capita income.
• Performance-Based Criteria: Allocation based on demographic performance and tax efforts, incentivizing states to improve their fiscal management and revenue generation.

Types of Grants Recommended

• Revenue Deficit Grants: Aimed at addressing revenue deficits in states.
• Sectoral Grants: Targeted towards sectors like nutrition, health, education, and judiciary to address specific developmental needs.
• Performance-Based Incentives: Provided based on performance across six broad criteria, encouraging states to focus on key areas of development and governance.

Empowerment of Local Bodies

• Grants to Panchayati Raj Institutions (PRI): Providing grants to all tiers of PRI and allowing them to pool resources for effective implementation of developmental projects.
• Urban Governance: Increasing the share of local bodies in grants to address urbanization challenges and improve infrastructure in urban areas.

Disaster Risk Management

To address the challenges of disaster risk management, the recommendations include:

• Promoting Local-Level Mitigation: Setting up mitigation funds at the state and national levels to support local-level mitigation activities and enhance resilience against natural disasters.

UPSC PREVIOUS YEAR QUESTIONS

1.  Which one of the following effects of the creation of black money in India has been the main cause of worry to the Government of India? (2021)

1.  Diversion of resources to the purchase of real estate and investment in luxury housing
2.  Investment in unproductive activities and purchase of precious stones, jewellery, gold, etc.
3.  Large donations to political parties and growth of regionalism
4.  Loss of revenue to the State Exchequer due to tax Evasion

2.  Which one of the following is likely to be the most inflationary in its effects? (2021 and 2013)

1.  Repayment of public debt
2.  Borrowing from the public to finance a budget deficit
3.  Borrowing from the banks to finance a budget deficit
4.  Creation of new money to finance a budget deficit

3.  In India, deficit financing is used for raising resources for _____________ (2013)

(a) economic development
(b) redemption of public debt
(c) adjusting the balance of payments
(d) reducing the foreign debt

4.  In the context of the Indian economy, non-financial debt includes which of the following? (2020)

1.  Housing loans owed by households
2.  Amounts outstanding on credit cards
3.  Treasury bills

Select the correct answer using the code given below:

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

 5.  Consider the following statements: (2017)

1.  Tax revenue as a percent of GDP of India has steadily increased in the last decade.
2.  Fiscal deficit as a percent of GDP of India has steadily increased in the last decade.

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

6.  There has been a persistent deficit budget year after year. Which action/actions of the following can be taken by the Government to reduce the deficit? (2016)

1.  Reducing revenue expenditure
2.  Introducing new welfare schemes
3.  Rationalizing subsidies
4.  Reducing import duty

Select the correct answer using the code given below.

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

7.  Which of the following is/are included in the capital budget of the Government of India? (2016)

1.  Expenditure on acquisition of assets like roads, buildings, machinery, etc.
2.  Loans received from foreign governments.
3.  Loans and advances granted to the States and Union Territories.

Select the correct answer using the code given below.

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

8.  With reference to the expenditure made by an organisation or a company, which of the following statements is/are correct?

1.  Acquiring new technology is capital expenditure.
2.  Debt financing is considered capital expenditure, while equity financing is considered revenue expenditure.

Select the correct answer using the code given below:

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

9.  Find correct Statement(s): (2015)

1.  The Department of Revenue is responsible for the preparation of the Union Budget that is presented to the Parliament.
2.  No amount can be withdrawn from the Consolidated Fund of India without authorization from the Parliament of India.
3.  All the disbursements made from Public Account also need authorization from the Parliament of India.

Select the correct answer using the Code given below:

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

10.  Which one of the following is responsible for the preparation and presentation of the Union Budget to the Parliament? (CSE-2010)

(a) Department of Revenue
(b) Department of Economic Affairs
(c) Department of Financial Services
(d) Department of Expenditure

11.  Distinguish between Capital Budget and Revenue Budget. Explain the components of both these Budgets. (2021)

12.  What are the reasons for the introduction of the Fiscal Responsibility and Budget Management (FRBM) act, 2003? Discuss critically its salient features and their effectiveness. (2013)