Topic 4 roles of government policy

types of government budgets

A government budget is an annual financial statement that outlines the estimated

government expenditure and expected government receipts or revenues for the
forthcoming fiscal year. Depending on the feasibility of these estimates, budgets are
of three types -- balanced budget, surplus budget, and deficit budget. Mentioned
below are brief explanations of these three types of budgets:

BALANCED BUDGET
A government budget is said to be a balanced budget if the estimated government
expenditure is equal to expected government receipts in a particular financial year.
Advocated by many classical economists, this type of budget is based on the
principle of “living within means.” They believed the government’s expenditure
should not exceed its revenue. Though an ideal approach to achieving a balanced
economy and maintaining fiscal discipline is a balanced budget. Theoretically, it’s
easy to balance the estimated expenditure and anticipated revenues but when it
comes to practical implementation, such balance is hard to achieve.

SURPLUS BUDGET
A government budget is said to be a surplus budget if the expected government
revenues exceed the estimated government expenditure in a particular financial
year. This means that the government’s earnings from taxes levied are greater than
the amount the government spends on public welfare. A surplus budget denotes the
financial affluence of a country. Such a budget can be implemented at times of
inflation to reduce aggregate demand.

DEFICIT BUDGET
A government budget is said to be a deficit budget if the estimated government
expenditure exceeds the expected government revenue in a particular financial
year. This type of budget is best suited for developing economies, such as India.
Especially helpful at times of recession, a deficit budget helps generate additional
demand and boost the rate of economic growth. Here, the government incurs
excessive expenditure to improve the employment rate. This results in an increase in
demand for goods and services which helps in reviving the economy. The

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government covers this amount through public borrowings (by issuing government
bonds) or by withdrawing from its accumulated reserve surplus.

SOURCES OF GOVERNMENT REVENUE

1. Tax revenue:
Tax is the compulsory payment paid by the people to the government. The taxpayer
does not get direct benefits while paying taxes, but they may get indirect benefits
from various services provided by the government. Tax revenue is two types:
a) Direct tax:
If direct tax is levied on someone then the burden can’t be shifted to others
so, direct taxes are non-transferable. Generally, direct taxes are imposed on
the income and property of a person. The main sources or components of
direct taxes are:
* Land revenue and registration tax: The government charges tax on the
purchase of land and house.
* Property, profit & income tax: Government charges a certain amount of tax
on income, property & profit, or the general people.

b) Indirect tax:
If tax is levied on goods and services and the burden of tax can be shifted
from one person to another then, it is called an indirect tax. The producer can
shift the burden of tax to ultimate consumers by raising the price of
commodities. The main sources of a component of indirect tax are:
* Custom duty: The government can collect revenue by imposing a tax on the
import and export of goods and services.
* Tax on consumption & production of goods and services: Government can
collect revenue by imposing a tax on the consumption and production of
goods and services such as excise tax, entertainment tax, and value-added
tax.
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2. non-tax revenue:
The income received by the government from various sources other than tax is
known as non-tax revenue. There are various sources of non-tax revenue which are:
a) Dividend tax:
The revenue is received from the profit of government investment in various
sectors like financial institutions, industrial sector, and service sectors.
b) Receipts from the sale of government commodities & services:
It consists of income from drinking water, irrigation, electricity, education, etc.
c) Fines and penalties:
People pay a large amount of money to the government in the form of fines
and penalties.
d) Principal and interest payment:
It consists of the repayment of principal and interest on debt by the
corporations to the government.
e) Royalty and sale of fixed assets:
It includes the income received from mine royalty and sales of mine and
government-fixed assets such as land, and buildings.

Types of government expenditure

Government Expenditure:
Government expenditure refers to the expenditure made by the government and its
various agencies for the promotion of public welfare. The sources of government
expenditure are classified under two headings which are as follows:
1. Operating or Management expenditure:
Expenditure made on normal government services or administrative functions is
called regular expenditure. It is related to expenditure on day-to-day activities like
payment of salaries, pension, payment of interest, and principal for external and
internal debt. The regular expenditure consists of the following headings:

a) General Administration: Salaries and emoluments are the largest

expenditure component followed by supplies and services. Pension payments
are made to pensioners for their welfare.
b) Supplies and services: It includes travel allowance, postage and stamp,
fax and telephone, stationery and computer maintenance, and furniture. A
transfer payment is a payment by the government to individuals which does
not involve any change of goods and services.

There are other headings of regular expenditure such as revenue

administration, economic administration & planning, judicial administration,
foreign services, economic services, loan and investment, loan repayment
and interest, insurance, rentals, and miscellaneous.

2. Development & capital expenditure: Expenditure made on the development

activities is called development expenditure. It is related to long-term expenditure
on development programs. The development consists of the following headings:

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 a) Defence and security: It is used for infrastructure and military base
development, weapon procurement, military research and development,
military aid, and others.
b) Social services: It includes the expenditure made on the development of
education drinking water and health.
c) Economic services: These include the expenditure made on planning &
statistics of a nation. Includes the provision of agricultural and rural
development, trade and industry, transport, public utilities, and others.
d) General administration: It is the smallest portion of the total development
expenditure. It includes renovation, refurbishment, and maintenance of
government facilities such as government buildings, judicial courts, and
others.
There are other headings of development expenditures such as economics
services and miscellaneous.

SOURCES OF PUBLIC DEBT

Public debt is the sum of the borrowings of the Central/Federal government of a
country. We also call it Sovereign debt or National debt. There are multiple sources of
public debt. Governments across the world borrow through these sources to meet
their expenses for day-to-day operations as well as for the development of the nation.
The amount of public debt of a country tells a lot about its financial health and
stability. The expenditures of all the governments mostly exceed their income. In other
words, the budgets of most governments have a budget deficit. Hence, they must
rely upon various sources of public debt to meet the budget deficit. We often classify

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public debt by the time of its repayment like for non-government firms. A debt of one
year or lesser is known as short-term debt. However, the debts for which the
repayment period goes beyond one year but for less than ten years are generally
called a Medium-Term Debt. While in the case of Long-Term Debts stretch beyond 10
years and can go up to 25 to 50 years. The governments must pay interest on such
debts. Short-term debts generally have a higher rate of interest, and hence are costly.
Long-term debts have the lowest rates of interest.

What are the Various Sources of Public Debt?

A government can raise debt either internally from domestic sources or go beyond
the boundaries of the nation for external debt. Debt can be from individuals,
organizations and businesses, financial institutions, and even other governments. The
most common sources of public debts are:

Government Securities
Governments issue government securities as an investment option for individuals and
financial institutions. These securities are in the form of treasury bonds, notes, market
securities, cash management bills, and treasury bills and are generally sold by way of
auctions. They have a definite maturity period and pay interest or make coupon
payments at regular intervals. People and organizations invest in such securities
because they have the complete backing of the government. Their repayment is
assured hence they are treated as risk-free securities. The returns are also generally
reasonable, better than the FDs of banks. Also, they can hold them till maturity or sell
them in the secondary markets and exit. Governments use the proceeds of these
securities to fund their day-to-day operations. Also, they can allocate the proceeds
to some special developmental and welfare projects. By doing so, they can raise
urgent money for the project and avoid disturbing their budget. They need not
implement any additional taxes or cut spending in other sectors to fund such
impromptu expenditure. Many times, the government, along with the Central bank of
the country, uses these government securities to perform open market operations. In
times of inflationary trends with excess money in the economy, they sell these securities
in the open market. People and institutions buy them which reduces the money supply
in the market and thus excess liquidity and wasteful spending are thereby controlled.
Similarly, they purchase back these securities from the market to increase the money
supply in times of deflationary trends and a low supply of money in the market.

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The Central Bank, Commercial Banks, and Non-Banking Financial Institutions
Governments borrow from the Central bank, commercial banks as well as specialized
non-banking financial institutions in an indirect manner. Commercial banks buy
government bonds from the government in lieu of money. They generally maintain
deposits with the Central bank of the country and use these deposits for such a
purchase in times of urgency. The same is the case with other non-banking financial
institutions. In normal times, the Central bank generally does not buy the bonds directly
from the government to fund its needs. But in times of a distressed and troubled
economy, there are no takers for the government bonds. It is then that the Central
bank comes into action. The central banks are vested with special powers that entitle
them to buy the government bonds directly from the government rather than buying
the same from the market. The government gets money in return as public debt.

Foreign Assistance or External Debt

Governments take loans from foreign governments, banks, and other financial
institutions also to fund their needs. They also arrange funding and aids from various
international bodies for welfare programs or developmental projects. Such
international bodies are International Monetary Fund (IMF), World Bank, Asian
Development Bank, and so on. These debts can be given for a specific purpose like
building a power plant or building a Special Economic Zone (SEZ), etc. There may be
conditions in the loan agreement that may compel the borrowing nation to buy inputs
or materials for the project from the loan-providing nation, make necessary changes
in their various business policies and regulations, and keep the budget deficit in a
certain range, and so on. Also, governments take external aid in cases of natural
disasters, famines, medical catastrophes, etc. when they are unable to finance their
basic survival needs. Such assistance is generally for the long term and at a low rate
of interest. Delay in repayment or refusal to repay foreign aid is a matter of grave
concern for any country. Such defaults are sovereign defaults. They tarnish the
country’s reputation in the international community. Also, it will hamper its chances of
getting further financial aid from any other country in the future.

GOVERNMENT POLICY: FISCAL POLICY

Fiscal policy is the use of GOVERNMENT SPENDING and TAXATION to influence the
economy. When the government decides on the goods and services it purchases, the
transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy.
The primary economic impact of any change in the government budget is felt by
groups—a tax cut for families with children, for example, raises their disposable
income. Discussions of fiscal policy, however, generally focus on the effect of changes
in the government budget on the overall economy. Although changes in taxes or
spending that are “revenue neutral” may be construed as fiscal policy—and may
affect the aggregate level of output by changing the incentives that firms or
individuals face—the term “fiscal policy” is usually used to describe the effect on the
aggregate economy of the overall levels of spending and taxation, and more
particularly, the gap between them.
Fiscal policy is an important tool for managing the economy because of its ability to
affect the total amount of output produced—that is, gross domestic product. The first
impact of a fiscal expansion is to raise the demand for goods and services. This greater
demand leads to increases in both output and prices. The degree to which
higher demand increases output and prices depends, in turn, on the state of the
business cycle. If the economy is in recession, with unused productive capacity and
unemployed workers, then increases in demand will lead mostly to more output
without changing the price level. If the economy is at full employment, by contrast, a
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fiscal expansion will have more effect on prices and less impact on total output. This
ability of fiscal policy to affect output by affecting aggregate demand makes it a
potential tool for economic stabilization.

TYPES OF FISCAL POLICY

1. Discretionary fiscal policy

The government makes changes to tax rates and or levels of government

spending.

a. Expansionary Fiscal Policy

Expansionary fiscal policy is where the government spends more than it takes
in through taxes. This may involve a reduction in taxes, an increase in spending,
or a mixture of both. In turn, it creates what is known as a budget or fiscal deficit.
During recessionary periods, a budget deficit naturally forms. This is because
unemployment tends to increase, meaning lower income from tax receipts
which generally account for half of the government revenue. At the same time,
governments want to ensure full employment. It is therefore faced with a tough
decision between increasing the budget deficit further or trying to fight the
recession. At the same time, governments are equally forced to pay higher
amounts in unemployment and other social security benefits, thereby
increasing government spending, whilst tax revenues fall. Expansionary fiscal
policy uses lower taxes and/or higher spending to ultimately boost prosperity
and economic growth. By reducing taxes, consumers have more money in
their pockets to go out, spend, and stimulate the economy.

b. Contractionary fiscal policy

Contractionary fiscal policy is where the government collects more in taxes
than it spends. A government may wish to do this for several reasons. primarily,
it is used to help stem inflation. For instance, the more governments tax, the less
disposable income consumers have. In turn, this reduces aggregate demand
which may seem like a bad thing, but it helps reduces inflation. So, a
contractionary fiscal policy will take money away from consumers.
Consequently, they demand less from individual businesses. This then sends a
signal to those businesses that demand is starting to decline. So, they stop
raising prices so quickly, thereby reducing the rate of inflation. With that said,
governments may wish to impose a contractionary policy to reduce or control
their debt. Although we have discussed lower taxation, governments can also
resort to lower spending otherwise known as austerity to do so.

2. Non-discretionary fiscal policy

The non-discretionary fiscal policy consists of policies that are built into the system so
that an expansionary or contractionary stimulus can be given automatically. The
welfare state and the progressive income tax serve as built-in policies. Non-
discretionary fiscal policy, as the word suggests, is not at the discretion of the
government. For example, progressive taxation pushes people into higher income tax

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 brackets during boom times, substantially increasing their tax bills and reducing
government budget deficits (or increasing government surpluses).

GOVERNMENT POLICY: MONETARY POLICY

Monetary policy refers to central bank activities that are directed toward influencing
the quantity of money and credit in an economy. By contrast, fiscal policy refers to
the government's decisions about taxation and spending. Both monetary and fiscal
policies are used to regulate economic activity over time. The government influences
economic activity through two approaches: monetary policy and fiscal policy. Through
monetary policy, the government exerts its power to regulate the money supply and level of
interest rates. Through fiscal policy, it uses its power to tax and spend. Central banks have
four main monetary policy tools: the reserve requirement, open market operations,
the discount rate, and interest on reserves. Most central banks also have a lot more
tools at their disposal. Here are the four primary tools and how they work together to
sustain healthy economic growth.
INSTRUMENT OF MONETARY POLICY

i. Reserve Requirement
The reserve requirement refers to the money banks must keep on hand overnight. They
can either keep the reserve in their vaults or at the central bank. A low reserve
requirement allows banks to lend more of their deposits. It's expansionary because it
creates credit.

ii. Minimum Liquidity Requirement

The liquidity coverage ratio is the requirement whereby banks must hold an amount of
high-quality liquid assets that's enough to fund cash outflows for 30 days. Commercial
banks must keep liquidated assets issued by Bank Negara Malaysia (BNM) such as treasury
bills and government securities.

iii. Open Market Operations

Open market operations are when central banks buy or sell securities. These are bought
from or sold to the country's private banks. When the central bank buys securities, it adds
cash to the banks' reserves. That gives them more money to lend. When the central bank
sells the securities, it places them on the banks' balance sheets and reduces its cash
holdings. The bank now has less to lend. A central bank buys securities when it wants an
expansionary monetary policy. It sells them when it executes tight monetary policy.

iv. Discount Rate

The discount rate is the rate that central banks charge their member banks to borrow at
their discount window. Because it's higher than the fed funds rate, banks only use this if
they can't borrow funds from other banks. 9

Using the discount window also has a stigma attached. The financial community assumes
that any bank that uses the discount window is in trouble. Only a desperate bank that's
been rejected by others would use the discount window.

v. Interest Rate on Excess Reserves

Interest on reserves also supports the fed funds rate target. Banks won't lend Fed funds for
less than the rate they're receiving from the Fed for these reserves.

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GOVERNMENT POLICY: DIRECT CONTROL POLICY

A control that is directly imposed upon the manufacturing, pricing, and distribution
of specific goods in contrast with an indirect or general control (such as credit and
fiscal policy) that affects the economy in its entirety and specific goods only
indirectly. Direct controls are imposed by the government which expressly forbid or
restrict certain kinds of investment or economic activity. Sometimes, direct
government controls over prices and wages as a measure against inflation have
been advocated and implemented.
The following are measures taken by the government under the direct control policy
to combat macroeconomics problems.

• Controlling the price of raw material

• Controlling the increase in salary and wages
• Controlling of price consumer goods
• Development of new land
• Improve level of education
• Creation of new employment opportunities
• Upgrade skills and technical education and retraining

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