Government Budget and the Economy

The government budget is an annual statement of the government's estimated receipts and expenditure for the coming financial year, presented in Parliament. Through the budget the government plans how it will raise money and how it will spend it to run the country and steer the economy.

The budget pursues several objectives, summed up as its three fiscal functions:

• Allocation function — providing public goods and services (defence, roads, law and order) that the market would not supply well, and steering resources toward priority areas.
• Distribution function — reducing inequality, by taxing the rich more (progressive taxes) and spending on the poor (subsidies, welfare).
• Stabilisation function — smoothing the ups and downs of the economy: spending more in a slowdown and less in a boom to keep output and prices stable.

The budget has two parts, each with receipts and expenditure:

• The revenue budget — revenue receipts (which neither create a liability nor reduce assets — mainly taxes, plus interest and profits) and revenue expenditure (day-to-day spending that creates no asset — salaries, pensions, interest, subsidies).
• The capital budget — capital receipts (which create a liability or reduce assets — borrowing, disinvestment) and capital expenditure (spending that creates assets or reduces liabilities — roads, schools, repaying loans).

The simple test: a revenue item is recurring and changes neither assets nor liabilities; a capital item changes assets or liabilities. This classification is the key to understanding the budget and its deficits.

When the government's expenditure is more than its receipts, the gap is a deficit. There are three important deficit measures, each telling us something different.

• Revenue Deficit = Revenue Expenditure − Revenue Receipts. It shows that the government's day-to-day spending exceeds its day-to-day income — meaning it is borrowing even to meet running costs, which is considered unhealthy because it creates no asset.
• Fiscal Deficit = Total Expenditure − Total Receipts (excluding borrowing) = the government's total borrowing requirement for the year. It is the most important and most-watched deficit, because it tells us how much the government must borrow. A high fiscal deficit adds to public debt and future interest payments.
• Primary Deficit = Fiscal Deficit − Interest Payments. It shows the deficit without the burden of past interest — i.e. the government's borrowing for current activities alone. A falling primary deficit shows the government is bringing its current finances under control.

A useful way to see them together: the fiscal deficit is the total borrowing; the primary deficit strips out the interest on old debt to show the "new" borrowing; and the revenue deficit warns if the government is borrowing just to cover running costs. For example, if total expenditure is ₹30 lakh crore and receipts (excluding borrowing) are ₹24 lakh crore, the fiscal deficit is ₹6 lakh crore; if interest payments are ₹4 lakh crore, the primary deficit is 6 − 4 = ₹2 lakh crore. Keeping these deficits at sustainable levels is a major goal of government finance.

Through the budget, the government carries out fiscal policy — the use of government spending and taxation to influence the level of demand, output, employment and prices in the economy. Fiscal policy (run by the government) and monetary policy (run by the RBI) are the two great tools of macroeconomic management.

Fiscal policy works mainly by changing aggregate demand:

• Expansionary fiscal policy — used in a slowdown or recession (deflationary gap). The government increases its spending and/or cuts taxes. This raises aggregate demand (directly through G, and indirectly by leaving people more income to spend), boosting output and employment. It usually means a larger deficit.
• Contractionary fiscal policy — used when there is inflation (inflationary gap). The government reduces its spending and/or raises taxes. This lowers aggregate demand and cools rising prices.

So the rule is simple: to fight unemployment, spend more and tax less (raise AD); to fight inflation, spend less and tax more (lower AD). The multiplier we studied earlier makes fiscal policy powerful — a given change in government spending changes income by a multiple of itself. Used wisely, fiscal policy can pull an economy out of recession or rein in inflation; used carelessly, it can create large deficits and debt. This is why the government tries to balance its goals of growth, full employment and price stability against the need to keep its deficits sustainable — the central challenge of budget-making.