Chapter 5 Government Budget and Economy

A good that is non-rival and non-excludable is referred to as public good. Non-rival means that consumption by one individual does not affect the consumption of another individual. Whereas, non-excludable implies that no individual can be excluded from using the good. For example, parks, roads, national defence, etc.

These goods must be provided by the government because of the following reasons:

1. The benefits of public goods can be easily enjoyed by anyone without affecting the consumption of other individuals. There arises market failure.
2. No individual can be excluded from using public goods as it is available to all. The link between the producer and the consumer becomes non-functional, necessitating government interference through public provisions.

Fiscal deficit is the excess of total expenditure over total receipts. That is, when total government expenditure is greater that total government receipts, the government faces fiscal deficit.

Fiscal deficit is estimated as:

Total Expenditure (revenue + capital) - Total Receipts (excluding borrowings).

Fiscal deficit gives an indication to the government about the total borrowing requirements from all sources. Fiscal deficit can be financed through domestic borrowings and/or borrowings from abroad. Greater fiscal deficit implies greater borrowings by the government.

The relationship between the revenue deficit and the fiscal deficit can be explained through the following points:

1. Revenue deficit is the difference between government’s revenue expenditures and government’s receipts.

Revenue deficit = Revenue expenditures - Revenue receipts
On the other hand, fiscal deficit is the difference between the total expenditure and the total receipt of the government.
Fiscal deficit = Total Expenditure - Total Receipts (excluding borrowings)

2. The term ‘fiscal deficit’ is used in a broader sense than the term ‘revenue deficit’.
3. As revenue deficit increases, the proportion of fiscal deficit also increases.

I = 200
G = 150
T = 100
C = 100 + 0.75 Y

So, C (Autonomous consumption) = 100

And, MPC (c) = 0.75

(a) Equilibrium level of income

Y =
=
=
=

(b) Government expenditure multiplier

= 4

Tax multiplier
= -3

(c) ∆G = 200

New equilibrium income

Therefore , change in equilibrium income = 2300 – 1500 = Rs 800

(a) C = 20 + 0.80 Y

I = 30
c = 0.80
G = 50
T = 100

Equilibrium level of income

Y =
=
Expenditure multiplier

(b) Increase in government expenditure

∆G = 30

New equilibrium expenditure

Equilibrium level of income increase by 150 (1050 - 900)

(c) Tax multiplier

So,
=
=
= -120

New equilibrium level of income = Y+ ∆Y

= 900 + (-120)
= Rs 780

MPC = 0.80
= 20
I = 30
G = 50
TR = 100
ΔTR = 10

Equilibrium level of income =
= Rs 940

Change in income = 940 - 900 = Rs 40

Increase in lump-sum tax ΔT = 10

Change in Income
= 10 ×
= - 10 × 4
= - 40

From the above results, we can conclude that increase of 10 percent in transfers will raise the income by 40%.

And, increase of 10% in tax will lead to a fall in the income by 40%.

(a) C = 70 + 0.70 YD

I = 90
G = 100
T = 0.10 Y
Y = C + I + G
Y = 70 + 0.70 Y + 90 + 100
Y = 70 + 0.70 YD + 190
Y = 70 + 0.70 (Y - T) + 190
Y = 70 + 0.70 Y - 0.70 × 0.10 Y + 190
Y = 70 + 0.70 Y - 0.07Y + 190
Y = 70 + 0.63 Y + 190
Y = 260 + 0.63 Y
Y - 0.634 = 260
0.37 Y = 260
Y =
Y = 702.7

(b) T = 0.10Y
= 0.10 × 702.7
= 70.27

Government expenditure = 100

Tax revenue = 70.27

As, G > T, Government has a deficit budget, not a balanced budget.

In case of proportional taxes

∆Y =

(a) MPC = 0.75 and ∆G = 20

= = 50

(b) Transfer decrease by 20

∆Y =
= = 60

The tax multiplier is smaller in absolute value than the government expenditure multiplier, as the government expenditure affects the total expenditure and taxes through the multiplier. Tax multiplier also influences disposable income that affects the overall consumption level.

The reason is explained through the following example.

Let’s assume MPC be to 0.80.

Then, the government expenditure multiplier
Tax multiplier
= - 4

This shows that government expenditure multiplier is more than tax multiplier.

The relation between government deficit and government debt can be explained through the following points.

1. Government deficit is the excess of total expenditure over total receipt of the government; whereas, government debt is the amount of liability, owed by the government to the public, foreign and other institutions.

2. The term government deficit implies increase in the debt of the government. In other words, if the government continues to borrow to finance deficit, it leads to additional debt.

Government debt or public debt refers to the amount or money that a central government owes. This amount may be borrowings of the government from banks, public financial institutions and from other external and internal sources. Public debt definitely imposes a burden on the economy as a whole, which is described through the following points.

1. Adverse effect on productivity and investment: A government may impose taxes or get money printed to repay the debt. This however reduces the peoples ability to work, save and invest, thus hampering the development of a country.

2. Burden on younger generations: The government transfers the burden of reduced consumption on future generations. Higher government borrowings in the present leads to higher taxes levied in future in order to repay the past obligations. The government imposes taxes on the younger generations, lowering their consumption, savings and investments. Hence, higher public debt has negative effect on the welfare of the younger generations.

3. Lowers the private investment: The government attracts more investment by raising rates of interests on bonds and securities. As a result, a major part of savings of citizens goes in the hands of the government, thus crowding out private investments.

4. Leads to the drain of National wealth: The wealth of the country is drained out at the time of repaying loans taken from foreign countries and institutions.

Fiscal deficits are not necessarily inflationary; though, they are generally regarded as inflationary. When the government expenditure increases and tax reduces, there is a government deficit and there will be a corresponding increase in the aggregate demand. However, the firms might not be able to meet the growing demands, forcing the price to rise. Hence fiscal deficits are inflationary in this sense. But on the other hand, initially if the resources are underutilised (due to insufficient demand) and output is below full employment level, then with the increase in government expenditure, more factor resources will be employed to cater to the increasing demand without exerting much pressure on price to rise. In this situation, a high fiscal deficit is accompanied by high demand, greater output level and lesser inflationary situation. Hence, whether the fiscal deficits are inflationary or not depends on how close is the original output level to the full employment level.

The ways of government budget deficit reduction are the following:

(i) Decreasing Expenditure

a) The expenditure of government should be decreased by making government activities more planned and effective.
b) The government can encourage private sector to undertake capital projects.

(ii) Increasing Revenue

a) Higher taxes imply higher income earned by the government. Also, new taxes may add to the revenues of the government.
b) The government can sell shares of Public Sector Undertakings (PSU disinvestment) to increase its revenue.

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