MODULE-III (PUBLIC FINANCE)

 Government of India retains a big role in economy. In aftermath of LPG

reforms, it has pulled back substantially from private sector, yet its presence
is unquestionable and desirable in social sector, defense and security,
provision of public goods and services etc.
 It has huge bureaucracy which consumes enormous national resources.
Further, in line with modern concept of Market Socialism government
intervenes in case of market failures for which it needs to provide services or
goods significantly below cost.
 In effect, government’s expenditure generally surpasses its revenue which
results into Revenue or Fiscal deficit. In the first place, major source of
government revenue is from taxation, but there are non-tax sources too.
 At last, government resorts to deficit financing to fulfill its commitments.
All this happens under aegis of Finance Ministry.
 Finance Ministry (A Government Department Headed by a Minister)
This ministry is biggest subdivision of Government of India and has under it,
largest number of departments (5). It also has one Minister of State. Departments
under it are –
 Economic Affairs
 Expenditure
 Revenue (Income, Earnings)

 Financial Services
 Disinvestment

1. Economic Affairs
The Department of Economic Affairs, Ministry of Finance, is responsible
for advice on economic issues having a bearing on internal and external
aspects of the Indian economy including inflation, price control, foreign
exchange management, Official Development Assistance domestic finance
and preparation of the Union Budget, bilateral and multilateral engagement
with international financial institutions and other countries.

2. Expenditure
Expenditure is the spending of money on something, or the money that is
spent on something.

3. Revenue (Income, Earnings)

A state's annual income from which public expenses are met.
 4. Financial Services
Financial Services is a term used to refer to the services provided by
the finance market. Financial Services is also the term used to describe
organizations that deal with the management of money. Examples are the
Banks, investment banks, Insurance companies, Credit Card Companies and
Stock Brokerages.
5. Disinvestment
The withdrawal or reduction of an investment.

(Please explore sites and have a glance at subdivisions)

This ministry eclipses whole economic and financial system. All regulatory bodies and attached

offices relating to economics and finance come under it.

Non-banking financial company (NBFC) is a company registered under the
Companies Act, 1956 and is engaged in the business of loans and advances,
acquisition of shares/stock/bonds/debentures/securities issued by government or
local authority or other securities of like marketable.
RBI=Reserve Bank of India (Central Bank of India)
The Reserve Bank of India is India's central banking institution, which
controls the issuance and supply of the Indian rupee.

SEBI=The Securities and Exchange Board of India (SEBI) is the regulator for
the securities market in India. It was established in 1988 and given statutory
powers on 30 January 1992 through the SEBI Act, 1992.
IRDAI = The Insurance Regulatory and Development Authority of
India (IRDAI) is an autonomous, statutory body tasked with regulating and
promoting the insurance and re-insurance industries in India. It was constituted by
the Insurance Regulatory and Development Authority Act, 1999, an Act of
Parliament passed by the Government of India. The agency's headquarters are
in Hyderabad, Telangana, where it moved from Delhi in 2001.
IRDAI is a 10-member body including the chairman, five full-time and four part-
time members appointed by the government of India.

2. Expenditure: Plan and non-Plan

a) Plan Expenditure:
  As the name suggests, plan expenditure is directed toward building
productive social and physical assets or we can say achieving the goals of
development.
 Expenditure on all Centrally Sponsored Schemes like, NREGA (National
Rural Employment Guarantee Act (India)), ICDS (Integrated Child
Development Services) etc. are part Plan Expenditure.
 Gross budgetary outlay for plan – Central plan plus central assistance to
state and UTs
b) Non Plan Expenditure –
 Non-plan revenue expenditure is incurred on interest payments, subsidies
(mainly on food and fertilizers), wage and salary payments to government
employees, grants to States and Union Territories governments, pensions,
police, economic services in various sectors, other general services such as
tax collection, social services, and grants to foreign governments.
 It also includes defense, loans to public enterprises, loans to States, Union
Territories and foreign governments.

Rangarajan Committee in 2010 recommended that this distinction should be done away with.

Reason was that this distinction resulted in over focus on Plan expenditure and neglect of Non

plan expenditure. It projected Non Plan expenditure as a waste expenditure, and various welfare

lobbies kept pressurizing government to increase proportion of plan expenditure at cost of non-

plan. This resulted in substandard quality and under financing of basic responsibilities of

government which rely on Non-plan expenditure.

It is felt that in absence of this distinction, Non-plan expenditure can outpace Plan expenditure

and major Safety net schemes will suffer a set back.

Apart from this expenditure is also classified into, Capital and Revenue Expenditure. Former

involves creation of durable capital assets and latter is consumption expenditure with no durable

assets created.

Revenue: Tax and non-tax Revenue

As already said, expenditure of the government is dominantly financed by tax revenue.

1. Tax revenue

 Direct Taxes

What is a Direct Tax

A direct tax is paid directly by an individual or organization to the imposing entity.
A taxpayer, for example, pays direct taxes to the government for different
purposes, including real property tax, personal property tax, income tax or taxes on
assets.
 These involve taxes such as income tax, wealth tax, corporate tax etc.
Peculiar feature of direct tax is that person who is charged to tax himself is
liable to pay tax.

What is an Indirect Tax

An indirect tax is collected by one entity in the supply chain (usually a producer or
retailer) and paid to the government, but it is passed on to the consumer as part of
the purchase price of a good or service. The consumer is ultimately paying the tax
by paying more for the product.
  Indirect Taxes
In this case, tax is generally on transactions, commodities etc. In this case person
who pays tax can claim tax so paid from customer. This way whole burden is
shifted on ultimate consumer.

No DT IDT

1 Income tax, corporate tax, Excise duty, custom duty, service tax,
wealth tax etc. are examples value added tax etc.

2 Taxpayers pays direct taxes Taxpayers pays indirect taxes through

straight to the government dealer to the government

3 Tax payers has to register Dealer has to register with tax authorities
with tax authorities. not the tax payer

4 Do not have any impact on Any increase in IDT increase cost and
cost, price and demand of price but reduces demand of goods.
goods.

5 High income earners pays Do not discriminate bw rich and poor,

higher taxes, and low income burden of IDT is same on rich and poor.
earner pays less or nil direct IDT is tax on consumption, they affect
taxes inversely to lower income group.

6 Tax on income Tax on expenditure

 7 Imposed on income of Imposed on goods and services.
person

8 Determined on the basis of Determined on the basis of the value of

income or wealth of a person goods and services.

Value added Tax –

 A value-added tax (VAT) is a consumption tax levied on products at

every point of sale where value has been added, starting from raw
materials and going all the way to final retail purchase.
 VAT is commonly expressed as a percentage of total cost. For example, if a
product costs $100 and there is a 15% VAT, the consumer pays $115 to the
merchant. The merchant keeps $100 and remits $15 to the government.
 Let’s take a typical value chain of Manufacturer- wholesaler-retailer-
Consumer. Here value addition (in sale price) is at three stages viz. when
goods move from manufacturer, wholesaler and retailer to finally consumer.
Let respective sale prices be 100, 120 and 150.

If Indirect tax (say Sales tax) is 10%, it will be collected at three stages on same
product. So new prices will be Manuf. = 100+10% = 110; Wholesaler = 110 + 10%
(tax) = 121 + Rs 20 (profit) = 141; Retailer= 141+ 10% (tax) = 155 + 30 (profit) =
Rs 185. This way, with simple flat sales tax rate, consumer end up paying
substantially higher prices. He also paid tax on tax, which is called cascading effect
(note that Rs 141 at which 10% tax was claimed by retailer already includes Rs 21
of tax). Government got tax of 10+11+14.1 = Rs 35.1, for sale of Rs 185 which is
significantly higher that 10%.

To remove this distortion and cascading effect, Value added tax was introduced. In this case tax

was charged only on ‘value addition’ at every stage. At first stage 10% tax will be paid by

manufacturer and goods will be invoiced at 110, now wholesaler will sell at Rs 100 (actual cost)

+ Rs 20 Profit @ Rs 120 + 10% (VAT).

He will collect Rs 12 from retailer and while paying this 12 to government he’ll deduct Rs 10 he

already paid to manufacturer as VAT. This is called input credit.

This was that product will reach customer as 100+20+30=150 + 10% = Rs 165 and customers

pays Rs. 150 to retailer and Rs 15 (10%) to government, through retailer. VAT though removed

cascading effects of sales tax, yet there is plethora of other indirect taxes (such as Service tax,

excise duty, custom duty, luxury tax etc.) which add up to the costs because of their cascading

effect.

Further, VAT is chargeable in different states at different rates. In case of goods sold from one

state to another CST is charged for which input credit is not allowed. All this create impediments

in intercourse of national markets and trades, which is much desirable for competitive markets,

industry and low prices.

Taxation subjects are divided between center and states as per lists in schedule seven under

article 246. For e.g. its gives Excise, customs, service tax to center and sales tax/vat to state.
This multiplicity of taxes has unfavorable impact on GDP as to avoid complexities; people

prefer to conceal their transactions. It is estimated that GST will push growth rate up by 1-1.5%.

Further, it obviously makes India performing poorly at indexes like ’ease of doing business’.

This is because all these taxes have separate compliance provisions and reporting mechanisms.

This increases compliance costs and time significantly.

More requirements for compliance naturally create more avenues for corruption and rent

seeking.

Goods and Service Tax

One of the biggest taxation reforms in India — the Goods and Service Tax (GST) — is all set to

integrate State economies and boost overall growth. GST will create a single, unified Indian

market to make the economy stronger. Finance Minister Pranab Mukherjee while presenting the

Budget on July 6, 2009, said that GST would come into effect from April 2010.

The basic principle governing behind GST is to have single Taxation System for Goods and

Services across the country. As already said, currently Indian economy has various taxes

on Goods and services such as VAT, Service Tax, Excise, Entertainment Tax, Luxury Tax Etc.

now in the new Proposal of GST; we will be having only two taxes on all goods and Services as

follows:

1. State Level GST (SGST)

2. Central Level GST (CGST)

A unified rate will be arrived at for e.g. (10+6), which will comprise of both Central and state

GST and collection will go to respective authority, center or state.

The Union Finance Minister introduced the said Bill in the Lok Sabha in December, 2014. The

proposed amendments in the Constitution will confer powers both to the Parliament and State

legislatures to make laws for levying GST on the supply of goods and services in the same

transaction.

GST will –

1. Simplify and harmonize the indirect tax regime in the country.

2. GST will broaden the tax base

It is feature of a good taxation regime that while keeping tax rates low they should attempt to

include as much people as possible under tax net.

3. Result in better tax compliance due to a robust IT infrastructure.

Due to the seamless transfer of input tax credit from one state to another in the chain of value

addition, there is an in-built mechanism in the design of GST that would incentivize tax

compliance by traders. It is thus, expected that introduction of GST will foster a common and

seamless Indian market and contribute significantly to the growth of the economy.

4. Reduce cost of collection for government: Currently government has huge bureaucracy

collecting different taxes. Integration will naturally result into downsizing of bureaucracy and

hence reduction of collection costs. Amusingly, in case of wealth tax (direct tax – charged over

wealth over Rs. 30 lakhs) collection is so low that, cost of collection is more than tax collected.

5. Impact on Inflation: In long term, GST will undoubtedly result in easing of inflation.

However as initially rates of integrated GST are expected to be kept as high as 16% or

more, it is well above current service tax, excise or VAT rates. In case of services, it will

increase prices directly. In case of other goods inflation depends upon their present
 component of taxation viz. excise, VAT, Custom etc. For e.g. some goods which are

currently exempted from excise (but are chargeable to VAT) will bear new burden of

excise in form of increased rate (approx. 16%) of GST.

Following are the salient features of this amendment Bill:

 A new Article 246A is proposed which will confer simultaneous power to Union and State

legislatures to legislate on GST.

 A new Article 279A is proposed for the creation of a Goods & Services Tax

Council which will be a joint forum of the Centre and the States. This Council would

function under theChairmanship of the Union Finance Minister and will have Ministers

in charge of Finance/Taxation or Minister nominated by each of the States & UTs

with Legislatures, as members. The Council will make recommendations to the Union

and the States on important issues like tax rates, exemptions, threshold limits, dispute

resolution modalities etc.

The proposed GST has been designed keeping in mind the federal structure enshrined in the

Constitution and will have the following important features:

1. Central taxes like Central Excise Duty, Additional Excise Duties, Service Tax, Additional

Customs Duty (CVD) and Special Additional Duty of Customs (SAD), etc. will be

subsumed in GST. (Note that ‘basic custom duty’ in not included)

2. At the State level, taxes like VAT/Sales Tax, Central Sales Tax, Entertainment Tax, Octroi

and Entry Tax, Purchase Tax and Luxury Tax, etc. would be subsumed in GST.

3. All goods and services, except alcoholic liquor for human consumption and Petroleum

and petroleum products will be brought under the purview of GST.

 4. Both Centre and States will simultaneously levy GST across the value chain. Centre

would levy and collect Central Goods and Services Tax (CGST), and States would levy

and collect the State Goods and Services Tax (SGST) on all transactions within a State.

5. In case of interstate trade – The Centre would levy and collect the Integrated Goods

and Services Tax (IGST) on all inter-State supply of goods and services. There will be

seamless flow of input tax credit from one State to another. Proceeds of IGST will be

apportioned among the States.

6. GST is a destination-based tax. All SGST on the final product will ordinarily accrue to

the consuming State. It means that as goods will move in value chain from producer to

consumer, whole GST burden/price will be recovered from consumer. (As explained in

example for VAT above)

7. GST rates will be uniform across the country. However, to give some fiscal autonomy to

the States and Centre, there will a provision of a narrow tax band over and above the

floor rates of CGST and SGST.

8. It is proposed to levy a non-vatable additional tax of not more than 1% on supply of

goods in the course of inter-State trade or commerce. This tax will be for a period not

exceeding 2 years, or further such period as recommended by the GST Council. This

additional tax on supply of goods shall be assigned to the States from where such

supplies originate. Because GST is a destination based tax, tax will accrue to states in

which goods are ultimately sold. So, to compensate states from which goods originated this

(non-vatable tax) is proposed.

Finance Minister expects that if they are able to push GST through state legislature smoothly,

then they can roll out GST in 2016. As this tinkers with federal fiscalism of the nation and
require amendment in Schedule 7 and so many other federal articles (246A-279A), it is supposed

to be passed by atleast half of state legislatures along with in both houses of parliament by

special majority. So, it is to be seen that, whether current government able to do so.

Tax reforms have been in news for some time. GST is one of the major reform for which

government is working. Some other topics and issues are –

1. Minimum Alternate Tax- Government has, in order to attract investments in various

backward geographic locations, or in exports or in certain crucial industry like Food

processing or in SEZ/EOU, keep rolling out tax holiday schemes. Under these schemes

investment as per some conditions, attracts a certain tax exemption for a certain period.

Overtime, businesses started exploiting these schemes to fullest by ‘aggressive tax planning’.

Under these planning companies often used some or other loophole to secure more tax

exemption than was reasonably due under spirit of the scheme. Reliance Industries was

particularly notorious for this about a decade back. Eventually, these companies declared

significant profits and dividends year after year, but ‘taxable profit’ as per income tax rule

remained nil. Note that ‘book profits’ and ‘Taxable Profits’ are different. Adjustments are made

into former to arrive at latter. So say with aggressive tax panning ‘book profits’ are Rs 100

Crore, but after adjustments ‘taxable profits’ comes out to be NIL.

To remedy this Minimum alternate Tax was introduced under which Minimum Floor rates were

introduced on which companies will, notwithstanding any exemptions it enjoy, was liable to

taxes. This rate was kept high.

By this move situation moved to opposite extreme. Now bonafied investor, who invested only

because of concessions were forced to pay taxes. This kept investment away from Indian Special

economic zones and other incentivized destinations.

2. Retrospective Taxation – few years back Hutchison (Telecom Company based in Hong

Kong) sold its stake in Hutch Essar to Vodafone PLC, and reaped huge profits. But all this profit

which accrued in India, escaped from income tax by exploiting loopholes in the law. This was

enormous loss to exchequer. Since this event, income Tax department had been desperately

trying to recover tax from Vodafone. For this government in 2012 budget gave itself power for

retrospective amendment in Income Tax and finance acts. Through this government can make

new laws or change current laws or cancel amendment, all with force from backdate. Note that

Article 20 prohibits retrospective legislation in case of criminal law only and it allows same for

civil laws.

3. General Anti Avoidance Rules – It was to be introduced wef. 1stApril, 2014 to check

aggressive tax planning and flouting of income tax laws. It gives more power to Income

Tax officials on how treat a suspicious entry in books of accounts. Onus to prove that entry

is bonafied is on assesse. But, budget 2014 didn’t mention anything about GAAR, after

budget, MoS for finance replied in parliament, “GAAR will be applicable from 1st April

2015.”

All this (MAT, retrospective taxation and GAAR) gave Indian Government and Income Tax

department much bad name in eyes of all types of investors and business community. State was

accused of unleashing ‘tax terrorism’ on businesses to make good its own weaknesses and

messed up fiscal situation.

The government tried to revive investor sentiment by constituting anexpert committee chaired

by Parthasarathi Shome to re-examine the provisions on GAAR and retrospective

amendments. The committee recommended a significant curtailment of GAAR and cautioned

against retrospective amendments, except in the rarest of rare cases.

4. Tax Administration Reforms Commission (TARC) – Also under Mr. Parthasarathi

Shome (This is different from above mentioned expert panel). Its terms of reference, as name

suggests included overall reforms in tax organization structure, processes, practices so as to

reduce cost of tax collection and increase tax base. This involved capacity building of Tax

departments in order to minimize tax evasion etc. Major recommendations were –

 Merge Central Board of Direct Taxes and Central Board of Excise and Customs (these are

currently under department of revenue and oversees direct and indirect taxes, respectively)

 Abolish post of revenue secretary and instead “council of chairmen of boards” should be

appointed for job.

 Work of Dept. Of Revenue be allocated to above two boards, it will result in better

efficiency in collection.

 At least 10 % of tax administration budget should be spent on tax-payer services

 Income Tax return – should include wealth tax return, Pre filled returns could be

considered.

 PAN number should be made common business identification number, to be used by

other government departments also such as customs, central excise, service tax, DGFT and

EPFO

 Avoid retrospective amendments in TAX LAWS , results in Protracted disputes

  Tax council headed by the chief economic advisor in the finance ministry be set up to

develop a common tax policy, analysis and legislation for both direct and indirect taxes

 Efficient and speedy payments of tax refunds and Passbook scheme for TDS

Tax being main source of government finance is central for resource mobilization in economy.

But in India Tax to GDP ratio is quite low. Combined (state center) tax to GDP ratio is only

15%. In other developing countries it is as high as 35%. For center alone in India it is (11-12%).

Main reason is narrow taxation base and huge Tax Expenditure (or Tax foregone) by government

of India.

Tax Expenditure/Tax Foregone/ Tax Subsidies

The statutory rates of taxes as notified by respective laws are divergent from the actual or

effective rates of taxes, which is attributable to tax provisions that allow

 deductions or exemptions from the taxpayers’ taxable expenditure, income, or investment,

 deferral of tax liability,

 preferential tax rates

These provisions allow people to pay lower taxes by claiming deductions under various rules.

Consequently, significant amount of tax is legally not received by government. This point

remains most potent weapon in hands of left leaning parties to attack government.

A tax expenditure statement was laid before the Parliament for the first time in 2006-07 and it

seeks to list the revenue impact of tax incentives or tax subsidies that are a part of the tax system

of the central government.

Introduction of MAT significantly reduced tax foregone.

While the magnitude of tax expenditures or revenue forgone from central taxes is showing an

upward trend for both direct and indirect taxes, it is imperative to introduce sunset clause with

every provision which facilitates tax expenditure.

Revenue foregone forms significant part of GDP at 4-5%

Read these articles – 1 and 2

Non Tax Revenue

Non-tax revenues of the centre mainly consist of interest and dividend receipts of the

government, receipts from the services provided by central government like supply of central

police force, issue of passport and visa, registration of companies, patents and licence fees,

royalty from offshore oil fields, Coal mines and various receipts from the telecom and other

sectors.

Further, there are sometimes handsome proceeds in from of non-debt capital receipts, which

arise from disinvestments. Disinvestments targets last year were failed at miserably and this year

government is quite optimistic about reaping benefits from good stock valuations at stock

markets. Disinvestment was discussed at length here.

Budgetary Deficits

So far we saw government finances in following form –

High spending in social and physical infrastructure which is often as per plan expenditure, even

higher non-plan commitments, low tax to GDP ratio and high tax foregone, all this boil downs to

Deficits i.e. spending more than earning. There are different forms of budget deficit viz. primary

Deficit, Revenue Deficit, Fiscal Deficit.

Whenever we are told that government expenditure has exceeded itsreceipts, in short that we

have incurred budget deficit, before arriving at any conclusion we need to ask some further

questions before arriving at any conclusions.

These questions may be like – was ‘capital receipts’ or ‘borrowings’ used to finance revenue

expenditure? If so this is undesirable and correction in this should be prime focus of government.

If revenue expenditure is less than Revenue income than Revenue deficit takes place. (RE-

RI = RD) In this situation deficit will be financed by capital receipts. Capital receipts come from

productive investments. Under resource mobilization we are attempting to tilt national income,

away from consumption, towards savings and then eventually towards productive investment.

But, note here what’s happening? Here Investment resources are sold off to fund consumption.

Our 2nd question will be – was capital (or even revenue) expenditure financed through

borrowings? If so we have incurred fiscal deficit. It is arrived at as – (Total Expenditure – Total

Income) – borrowings = fiscal deficit

There may be situation where Revenue deficit was nil, but Fiscal Deficit was positive, this

indicates that borrowing, were used to finance capital asset creation. Now policymakers and

observers are keen to see that assets which are created on back of borrowings are productive

enough to serve the interest rates.

Case 1 (don’t get disturbed by small figures)

Hypothetically, say when under MSP regime, wheat is procured from farmer by FCI at Rs 15/ kg

and then through state PDS, this is sold at discounted prices of Rs. 1. Deficit of Rs. 14 has been

incurred. Now at the yearend government has to pay farmer its due. It got just 1 rupee from

consumer, it will give balance money from tax it collected. Now again tax it collected comes out

to Rs. 10.

Now we can say revenue deficit of Rs 3 has been Incurred (Rs. 14-11)
Now government sold some PSU and is able arrange Rs 2 from that, now fiscal deficit will be

Rs. 1, which will be borrowed by the government. (So Fiscal Deficit = Borrowing)

Case 2

Note that if earning from PSU was Rs 3 than there was no Fiscal Deficit.

Case 3

Wheat procured is for Rs. 15 and some Dam is created by Govt. for Rs 5. Wheat sold for PDS @

1, tax collected is Rs 14. Now revenue deficit is Nil. And government sold some PSU for 2.

Fiscal deficit is Rs 3 which will be financed by borrowing.

This is much tenable situation. In fact Fiscal Deficit is used to create demand in economy and it

is method of Redistribution of resources. Note in this example that Tax collected of Rs. 14 has

moved from taxpayers to farmers and Targeted beneficiaries of PDS. Also note that, Spending of

Rs. 15 + 5 is more than income of government i.e. Rs. 17. Now there is Rs 3 more in circulation

and this on one hand will revive demand and on other, it will create inflationary conditions.

It was John Keynes which in aftermath of Great Depression propagated that governments should

incur fiscal deficits to revive demand.

Third question that can be asked is – How much flexibility do we have to curtail our

expenditure?

Interest on borrowings is non flexible and non-negotiable expenditure. So it is excluded from

fiscal deficit to arrive at Primary deficit. So primary deficit = Fiscal Deficit – interest on

borrowings

Fiscal Discipline and FRBM act

Government is welfare state and strives to promote welfare. But as explained above it has

financial constraints. By intervention government should attempt to build capacity of people to

survive and grow themselves in market. But at same time government has to set minimum

standards and provide safety nets to disadvantaged and vulnerable people of the society.

For this to happen successfully in long term, require governments to observe strict fiscal

discipline. There is always immense pressure on government for spend its resources for

competing interests. In turn government is always vulnerable for giving in blindly to such

demands, due to political compulsions. Going too much beyond its resources may be beneficial

in short term but for long term it results in to piling up of debt and ever increasing interest

payments and as a result high inflation.

Deficit results in Inter-Generational inequity – Deficit simply means today government is

living beyond its means, and to finance its expenditure it borrows money, which is to be paid

backing future. This borrowing will accumulate interest overtime and after some time Principle

along with interest will be paid by government by charging future tax payers, who are forced to

pay for expenditure not being incurred over them.

Deficit ruins monetary policy of RBI – RBI makes monetary policy by monitoring supply of

money in the economy. Main target behind this is inflation. As we have seen in foregoing

discussion, that fiscal (and other) deficits increases money supply in the market, an inflationary

trend is created.

Fiscal Responsibility and Budget Management act

The main purpose 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.
However, due to the 2007 international financial crisis, the deadlines for the implementation of

the targets in the act was initially postponed and subsequently suspended in 2009. In 2011, given

the process of ongoing recovery, Economic Advisory Council publicly advised the Government

of India to reconsider reinstating the provisions of the FRBMA.

Further, the Act prohibits borrowing by the government from the Reserve Bank of India, thereby,

making monetary policy independent of fiscal policy. The Act bans the purchase of primary

issues of the Central Government securities by the RBI after 2006, preventing monetization of

government deficit.

After reinstatement of FRBM act new targets were agreed at. Accordingly current year target is

4.1% last year was 4.6%.

It should be noted that, government used undesirable means to contain deficit last year.

Government PSUs were forced to shell out huge dividends, some expenses were differed on next

years and worst was that there was huge cut on plan expenditure. This crumbled centrally

Sponsored schemes such as NREGA.

Government Borrowings

Fiscal deficit is nothing but borrowings of the government. Government has three sources viz.

Borrow from RBI, Borrow from Open Market or Borrow from abroad.

In case it borrows from abroad it has to see that long term borrowings don’t are not financing

revenue consumption and productive assets are created against them. This is also true for

domestic borrowings.
Government keeps issuing bonds and Banks subscribes to these as they are required to invest in

these bonds to comply with Statutory Lending Ratio (22% of net time and demand deposits).

There is well built primary and secondary debt market in which bond securities are subscribed to.

If fiscal deficit is high, it will result in increased inflation and money demanded by government

from any of the source will be high. Here as demand for money becomes high, bond yields will

shoot up and bond prices will fall. Say 6% Bond already trading at 98 will fall to 96, this will

increase yield which is now Rs. 6 @ Rs 96 bond. This increased yield will become new rate at

which money can be raised by government.

If money becomes too expensive government will have to resort to‘monetization of

deficit’ which is most undesirable. It means government will sell new bonds to RBI, which will

pay Government newly printed currency. This will increase money supply in economy without

any corresponding increase in real economy.

Debt to GDP ratio

This ratio measures government debt to percentage of GDP. Factors influencing it are

 Fresh Fiscal Deficit – increases the ratio

 Retirement of old debt – decreases the ratio

 Interest rate of debt

 GDP growth rate

Last two factors are most interesting, if GDP growth rate is above interest rate on debt, then ratio

tends to decline overtime, this happened in India upto few years back, when growth rate was
high. But with slowing down of economy, and growth rate falling below rate of return has

resulted in rise in this ration.

This is serious concern, because GDP is directly proportional to tax collection. If ratio rises,

more tax will go to serving interests and fiscal deficit will be higher.

India’s debt to GDP ratio is much comfortable and is hovering around 50%. Further, India’s debt

majorly consists of ‘long term’ and domestic debt. In contrast countries like China have majorly

external debt and their Debt is more than their GDP. This is case with most of the developed

countries. Japan’s ratio is whopping 250% of its GDP, because of very low tax collections there.