UNIT 2nd

Economic
Environment

Nature of the Economy

Disparities in Income Distribution

Low per CAPITA Income
Dominance of Agriculture
Over-Population:
Unbalanced Economic Development
Lack of Industrialisation
Lack of Capital:
Operation of Economic Vicious Circles
Market Imperfections:
Limited Availability of Transport and
Communication Facilities

Low per CAPITA Income

Per capita income level is much low in India

as compared with other developed countries.
At present a new modify system of
comparing and calculating per capital income
has been adopted at international level in
which the per capita income of a country is
calculated on the basis of purchasing power
of currency of that particular country; while
old traditional method was based on
exchange rate of currencies.

Disparities in Income Distribution:

High degree of disparity in income/wealth

distribution is found in India. Though the
objective of establishing a socialistic society
was adopted in Second Five Year Plan but it
has not been yet achieved. According to the
data shown by National Sample Survey
Office (NSSO), 39% of rural population
possesses only 5% of all the rural assets
while, on the other hand, 8% top households
possess 46% of total rural assets.

Dominance of
Agriculture:

Land-labor ratio is not favourable in

India. Per capita land availability is
very low and, on the contrary, labor
use per hectare is very high in India.
Agriculture sector today provides
livelihood to about 65% to 70% of the
total population, contributes nearly
17% of Gross Domestic Product
(GDP).

Over-Population:

India is over-populated. In every decade Indian

population gets increased by about 24%. During 20012011, population increased by 17.64%. The compound
annual growth rate of population during 2001-2011
was 1.58% against the level of 1.95% during the
preceding decade 1991-2001. With this high growth
rate of population about 1.58 crores new persons are
added to Indian population every year. According to
2011 census, the total Indian population stands at a
high level of 121.02 crores which is 17.5% of the
world's total population. To maintain this 17.5% of
world population India holds only 2.42% of total land
area of the world.

Unbalanced Economic
Development:

India has not yet achieved the goal of

balanced economic development.
According
to
latest
World
Development Report 2007 about 64%
of total labor-force is dependent on
agriculture, 16% on industries and
the rest about 20% on trade,
transport, and other services.

Lack of Industrialisation

India lacks in large industrialisation

based on modern and advanced
technology, which fails to accelerate
the pace of development in .the
economy. Average annual growth rate
of industrial sector (including mining,
manufacturing,
and
power
generation) was 8.5% against the
target of 8.7% p.a.

Market Imperfections:

Indian economy faces a number of

market imperfections like lack of mobility
among production factors from one place
to the other and lack of specialisations
which hinder the optimum utilisation of
available resources. All these market
imperfections and their results are
important reasons for undeveloped state
of Indian economy.

Limited Availability of
Transport and Communication
Facilities

Transport and communications facilities do

play a vital role in economic development of
a country like India, but these facilities are
not yet extended to the required level.
Transport facilities are not available in
remote areas of the country due which
industrial development is not equally
distributed among various parts of the
economy. It also hinders the process of
exploiting available resources in the country.

Structure of the Economy

Proportionate contribution of different sectors
tends to change with the process of growth.
Central Statistics Organisation has divided the
economy into three basic sectors:
1)Primary

Sector: The primary sector of the economy

is the change of natural resources into primary
products. Most products from this sector provide raw
materials for other industries. The share of primary
sector has decreased from the past four decades.
) Mining:
) Fishing:
) Agriculture:

Cont..

Agriculture: Agriculture in India is the major sector of its

economy. Almost two-thirds of the total workforce earns their
livelihood through farming and other allied sectors like
forestry, logging and fishing which account 18% of the GDP.
These sectors provide employment to 60% of the country's
total population, About 43% of the country's total geographical
area is used for agricultural purposes. After independence
additional areas were brought under cultivation and new
methods, practices and techniques of irrigation and farming
were introduced by the government.
Fishing: Fish breeding has increased almost five times since
India got independence and is a prime industry in coastal
regions.
Mining: It is the term used for the extraction of useful
material from the treatment of ore, vein or coal seam.
Materials obtained from extraction may be base metals,
precious metals, iron, uranium, coal, diamonds, limestone, oil

Cont..
Secondary

Sector: The secondary sector of the economy includes

those economic sectors that create a finished usable product and
hence depend on primary sector industries for the raw materials.
The secondary sector contributes 24% of the share in Indian
economy. This sector includes:
i) Industry: India's industrial sector accounts for 27.6% of the GDP
and gives employment to 17% of the total workforce. Though
agriculture is the foremost occupation of the majority of the people,
the government had always laid stress on the industrial
development of the country. Thus policies and strategies were
framed to give a boost to India's industry. The government aims at
achieving self-sufficiency in production and protection from foreign
competition. Since independence, India is marching ahead to
become a diverse industrial base.
ii)Construction: The process of building or assembling of
infrastructure is known as a term commonly used in architecture and
civil engineering - "construction". Construction job is all about multitasking and needs the services from project manager, construction

Cont..

tertiary sector of economy involves the provision of services to

business as well as final consumers. Services may involve the
transport, distribution, and sale of goods from producer to
consumers as happen in wholesaling and retailing, or may
involve the provision of a service, such as in PEST control or
entertainment. The tertiary sectors account for 51% of the
GDP. The tertiary sectors includes:
i) Insurance,
ii) Banking, and
iii) Transport.

Cont.

The higher the productivity in primary and secondary

sector and lower the employment in these sectors, the
better it is. People need more and more services for
leading qualitatively better lifestyle. They need more
means of transport, more communication and
educational facilities, more training, more medical
facilities, entertainment, technical facilities, banking
facilities, etc.
Tertiary sector depends on scientific research and
innovative developments to increases productivity and
it provides engineering and construction consultancy
support services for all projects in all sectors. Developed
countries employ more than 80% the services sector.

Economic Policies

There are several economic policies which can have a very

great impact on business, important economic policies are
industrial policy, trade policy, foreign exchange policy,
monetary policy , fiscal policy and foreign investment and
technology policy.
Some types or categories of business are favourably
affected by government policy, some adversely affected,
while it is neutral in respect of others.
Similarly, an industry that falls within the priority sector in
terms of the government policy get a number of incentives
and other positive support from the government, whereas
those industries which are regarded as inessential may
have the odds against them.

Cont

Macroeconomic policy, as determined and changed

from time to time, impacts business conditions more
directly. The policy design can be a response to actual
economic conditions or problems or is developed to
create favourable conditions in the near future. The
basic objectives of macroeconomic policy is to
stimulate or maintain growth, achieve economic
stability, increase employment, stabilize balance of
payments, correct regional imbalances and make the
economy more competitive. Much depends on the
wisdom and philosophy of the riding government
and the quality of policy implementation and
economic administration.

Cont..

In open or globalising economies, the policy is

significantly affected by world economic conditions.
The countries which borrow heavily from multilateral
institutions like IMF and World Bank often have to
adjust their macroeconomic policy structure to the
lending criteria and condition imposed by these
institutions. Changes in the policy are also warranted
by international treaties, laws, conventions and
agreements. Quite often, political considerations have
an overriding influence on the policy design and
implementation. All these developments pose
formidable challenges to the business manager.

The main components of the policy are

the following: Monetary policy
Fiscal policy
Industrial policy
Trade policy

Monetary policy of India

Meaning

Monetary policyis the process by which

monetary authority of a country, generally
a central bank controls the supply of money
in the economy by exercising its control
over interest rates in order to maintain
price stability and achieve high economic
growth. IN India, the central monetary
authority is theReserve Bank of India(RBI).
is so designed as to maintain the price
stability in the economy.

Objectives of the monetary policy of

India, as stated by RBI, are:

Price Stability:- Price Stability implies promoting

economic development with considerable emphasis on
price stability. The centre of focus is to facilitate the
environment which is favorable to the architecture that
enables the developmental projects to run swiftly while
also maintaining reasonable price stability.
Controlled Expansion Of Bank Credit:- One of the
important functions of RBI is the controlled expansion
of bank credit and money supply with special attention
to seasonal requirement for credit without affecting
the output.
Promotion of Fixed Investment:- The aim here is to
increase the productivity of investment by restraining
non essential fixed investment.

Cont.

Restriction of Inventories:- Overfilling of stocks and

products becoming outdated due to excess of stock
often results is sickness of the unit. To avoid this
problem the central monetary authority carries out this
essential function of restricting the inventories. The
main objective of this policy is to avoid over-stocking
and idle money in the organization
Promotion of Exports and Food Procurement
Operations :- Monetary policy pays special attention in
order to boost exports and facilitate the trade. It is an
independent objective of monetary policy.
Desired Distribution of Credit:- Monetary authority has
control over the decisions regarding the allocation of
credit to priority sector and small borrowers. This
policy decides over the specified percentage of credit
that is to be allocated to priority sector and small

Cont

Equitable Distribution of Credit:- The policy of Reserve Bank

aims equitable distribution to all sectors of the economy and all
social and economic class of people
To Promote Efficiency:- It is another essential aspect where
the central banks pay a lot of attention. It tries to increase the
efficiency in the financial system and tries to incorporate
structural changes such as deregulating interest rates, ease
operational constraints in the credit delivery system, to
introduce new money market instruments etc.
Reducing the Rigidity:- RBI tries to bring about the flexibilities
in the operations which provide a considerable autonomy. It
encourages more competitive environment and diversification. It
maintains its control over financial system whenever and wherever
necessary to maintain the discipline and prudence in operations
of the financial system.

monetary policy instruments

Quantitative methods
(based upon lending or credit creating capacity of comm.
banks)

Bank rate
Open market operations(OMOs)
Legal reserve requirement
Statutory liquidity requirements

Monetary operations

Monetary
operations
involve
monetary
techniques which operate on monetary
magnitudes such asmoney supply, interest
rates and availability ofcreditaimed to
maintainPriceStability, Stable exchange rate,
HealthyBalance of Payment,
Financial
stability, Economic growth.RBI, the apex
institute ofIndiawhich monitors and regulates
themonetary policyof the country stabilizes
the price by controllingInflation.RBI takes into
account the following monetary policies:

Open Market
Operations

An open market operation is aninstrumentof

monetary policywhich involves buying or selling
of governmentsecuritiesfrom or to the public
andbanks. This mechanism influences the
reserve position of the banks, yield on
governmentsecurities and cost of bank credit.
The RBI sellsgovernment securitiesto contract
the flow of credit and buys government securities
to increase credit flow. Open market operation
makes bank rate policy effective and maintains
stability in government securities market

Cash Reserve Ratio

Cash Reserve Ratio is a certain percentage of

bank depositswhich banks are required to
keep with RBI in the form of reserves or
balances .Higher the CRR with the RBI lower
will be the liquidityin the system and viceversa.RBI is empowered to vary CRR between
15 percent and 3 percent. But as per the
suggestion by the Narshimam committee
Report the CRR was reduced from 15% in the
1990 to 5 percent in 2002. As of October
2013, the CRR is 4.00 percent.

Statutory Liquidity
Ratio

Every financial institution has to maintain a

certain quantity of liquid assets with
themselves at any point of time of their total
time and demand liabilities. These assets can
be cash, precious metals, approved securities
like bonds etc. The ratio of the liquid assets to
time and demand liabilities is termed as the
Statutory liquidity ratio
.
There
was
a
reduction of SLR from 38.5% to 25% because
of the suggestion by Narshimam Committee.
The current SLR is 23%

Bank Rate Policy

Thebank rate, also known as the discount rate, is

the rate of interest charged by the RBI for providing
funds or loansto the banking system. This banking
system involves commercial and co-operative
banks, Industrial Development Bank of India, IFC,
EXIM Bank, and other approved financial institutes.
Funds are provided either through lending directly or
rediscounting or buying money market instruments
like commercial bills andtreasury bills. Increase in
Bank Rate increases the cost of borrowing by
commercial banks which results into the reduction in
credit volume to the banks and hence declines the
supply of money. Increase in the bank rate is the
symbol of tightening of RBI monetary policy. As of 1
January 2013, the bank rate was 8.75% and from

Credit Ceiling

In this operation RBI issues prior

information or direction that loans to
the commercial banks will be given
up to a certain limit. In this case
commercial bank will be tight in
advancing loans to the public. They
will allocate loans to limited sectors.
Few
example
of
ceiling
are
agriculture sector advances, priority
sector lending.

Credit Authorization Scheme

Credit Authorization Scheme was

introduced in November, 1965 when
P C Bhattacharya was the chairman
of RBI. Under this instrument of credit
regulation RBI as per the guideline
authorizes the banks to advance
loans to desired sectors

Repo Rate and Reverse Repo

Rate
Repo

rate is the rate at which RBI lends to commercial banks

generally against government securities. Reduction in Repo
rate helps the commercial banks to get money at a cheaper
rate and increase in Repo rate discourages the commercial
banks to get money as the rate increases and becomes
expensive. Reverse Repo rate is the rate at which RBI
borrows money from the commercial banks. The increase in
the Repo rate will increase the cost of borrowing and lending
of the banks which will discourage the public to borrow money
and will encourage them to deposit. As the rates are high the
availability of credit and demand decreases resulting to
decrease in inflation. This increase in Repo Rate and Reverse
Repo Rate is a symbol of tightening of the policy. As of
October 2013, the repo rate is 7.75 % and reverse repo rate is
6.75%.

Current Rates
Indicator Current rate
Inflation 6.46%
Bank rate 8.75%
CRR 4.00%
SLR
23.00%
Repo rate 7.75%
Reverse repo rate 6.75%
Marginal Standing facility rate 8.75%
BaseRate 9.80% - 10.25%
SavingsDepositRate 4.00%*
Term DepositRate 8.00% - 9.05%

QUALITATIVE INSTRUMENTS
Qualitative

instruments of monetary policy seek to

alter the terms or direction of credit in an economy.
These measures are selectively rather than generally
applied so that they impact the distribution rather
than the quantum of credit. The central bank, with
the help of these instruments, may increase die flow
of credit to certain sectors which act as the growth
drivers or leading sectors of the economy or which
are socially important (like agriculture and small
scale industry) and reduce the flow of credit to
sectors which are not essential or are inefficient.
Similarly, credit may be restricted in areas which are
prone to inflation or speculation. There can even be
political considerations behind allocation of credit

Cont.
Some of the common forms of qualitative instruments
are the following:
Changes
in Margin Requirements:- Margin
requirements for lending may be varied according to
the type of securities, assets or commodities to be
financed. A higher margin requirement reduces the
quantum of finance for a specific industry or purpose.
Differential Interest Rates :- Central bank may
prescribe different rates of interest for lending to
different sectors or for different activities. For example,
lower interest rate could be required for priority sectors
such as small-scale industry, exports and agriculture
and higher rates may be permitted for sectors to which
the central bank intends to reduce credit.

Cont.
Some of the common forms of qualitative instruments
are the following:
Restrictions on Bill Discounting :- The Central
bank may disallow restricted discounting of bills
against price restive products.
Restrictions on Clean Advances:- There could be
restriction on clean advances in areas where
speculation is rife or hoardings are common (like
trading and warehousing segments).
Central banks, particularly in developing countries,
keep on fine-tuning selective credit controls to control
speculation, inflation or undesirable changes in the
distribution of scarce credit.

Measures of Money supply in India

M1: Money with the public (currency
notes and coins) + Demand Deposits
of Banks (on current and saving
account) + other deposits with RBI
M2: M1 + Saving bank deposits with
post offices
M3: M1 + Time deposits with Banks
M4: M3 + all deposits of post offices

Problems of monetary policies

There exist a Non-Monetized Sector

In many developing countries, there is an
existence of non-monetized economy in
large extent. People live in rural areas
where many of the transactions are of the
barter type and not monetary type.
Similarly, due to non-monetized sector the
progress of commercial banks is not up to
the mark. This creates a major bottleneck in
the implementation of the monetary policy.

Problems of monetary policies

2.Excess Non-Banking Financial

Institutions (NBFI)
As the economy launch itself into a higher
orbit of economic growth and development,
the financial sector comes up with great
speed. As a result many Non-Banking
Financial Institutions (NBFIs) come up. These
NBFIs also provide credit in the economy.
However, the NBFIs do not come under the
purview of a monetary policy and thus nullify
the effect of a monetary policy.

Problems of monetary policies

Existence of Unorganized Financial Markets

The financial markets help in implementing the
monetary policy. In many developing countries
the financial markets especially the money
markets are of an unorganized nature and in
backward conditions. In many places people like
money lenders, traders, and businessman
actively take part in money lending. But
unfortunately they do not come under the
purview of a monetary policy and creates hurdle
in the success of a monetary policy.

Problems of monetary policies

Higher Liquidity Hinders Monetary Policy

In rapidly growing economy the deposit base
of many commercial banks is expanded. This
creates excess liquidity in the system. Under
this circumstances even if the monetary
policy increases the CRR or SLR, it does not
deter commercial banks from credit creation.
So the existence of excess liquidity due to
high deposit base is a hindrance in the why of
successful monetary policy.

Problems of monetary policies

5.Money Not Appearing in Banking System

Large percentage of money never comes in the
mainstream banking economy. Rich people,
traders, businessmen and other people prefer
to spend rather than to deposit money in the
bank. This shadow money is used for buying
precious metals like gold, silver, ornaments and
land; and in speculation. This type of lavish
spending gives rise to inflationary trend in
mainstream economy and the monetary policy
fails to control it.

Problems of monetary policies

6.Time Lag Affects Success of

Monetary Policy
The success of the monetary policy
depends on timely implementation of it.
However, in many cases unnecessary
delay is found in implementation of the
monetary policy. Or many times timely
directives are not issued by the central
bank, then the impact of the monetary
policy is wiped out.

Problems of monetary policies

7. Monetary & Fiscal Policy Lacks Coordination

In order to attain a maximum of the above objectives it is
necessary that both the fiscal and monetary policies
should. go hand in hand. As both these policies are
prepared and implemented by two different authorities,
there is a possibility of non-coordination between these
two policies. This can harm the interest of the overall
economic policy.
These are major obstacles in implementation of monetary
policy. If these factors are controlled or kept within limit,
then the monetary policy can give expected results. Thus
though the monetary policy suffers from these limitations,
still it has an immense significance in influencing the
process of economic growth and development.

Conclusion
It

refers all the actions of the government or the

central bank of a country which affect, directly or
indirectly, supply of money, credit, rate of
interest and the banking system. Basically, it
affects the cost and availability of credit in the
economy. For individual firms, the policy changes
affect their liquidity, cost of capital and tend to
induce them to adjust their debt-equity ratios. A
restrictive monetary policy seeks to raise the rate of
interest, reduce money supply growth rate and restrict
the flow of credit and is generally aimed to fight
inflation. A liberal or accommodating monetary
policy is generally meant to fight recession and
stimulate demand through credit liberalization,
monetary expansion and fall in the rate of interest. In

FISCAL POLICY OF INDIA

Meaning

Fiscal Policy is that part of government

economic policy which deals with taxation,
expenditure,
borrowing
and
the
management of public debt in the economy.
Arthur Smithies, "A policy under which the
government uses its expenditure and
revenue programmes to produce desirable
effects and to avoid undesirable effects on
national
income,
production
and
employment."

Meaning

Professor G: K. Shaw, "We define fiscal

policy to encompass any decision to
change the level of composition or timing
of government expenditure or to vary the
burden, structure or frequency of tax
payment."
A. G. Buchlar, "By fiscal policy is meant the
use of public finance or expenditure, taxes,
borrowing and financial administration to
further our national income objective."

Objectives of Fiscal Policy of India

Main objectives of the fiscal policy adopted by
the government of India are as under :
Mobilisation of real and financial resources for
the public sector without hampering the
expansion of resources for the private sector.
Promotion and acceleration of capital formation
in the public private sectors.
Removal of unemployment.
Promotion and maintenance of price stability.
Reduction of economic inequality.
Reduction of regional disparities.
To achieve favourable balance; of payment.

COMPONENTS OR INSTRUMENTS
of Fiscal Policy of India
The following are the important components of
the Budget. With the help of them the objective
of fiscal policy are achieved

Taxation Policy
Public Expenditure Policy,
Public Debt Policy,
Deficit Financing Policy.

Taxation

Taxes are imposed in many ways. We can

distinguish taxes as direct tax and indirect
tax.
Direct taxes are those the burden of which is
borne by those on whom it is imposed.
Income tax is an example of direct tax.
Indirect taxes are those which are imposed
on an entity at some point in the system, but
whose burden can be shifted to some other
entiry of entities, excise duty, custom duty,
etc. are examples of indirect tax.

cont.. Taxation

Direct taxes are increased during inflation

which leads to a fall in disposable income in the
economy. This reduces the purchasing power of the
people and hence aggregate demand. Lower
demand results in fall in the general price level
curbing inflation.
During recession taxes are reduced so as to
increase disposable income in the economy. This
leaves people with more purchasing power and
leads to a rise in aggregate demand. Increasing
demand induces more investment to come in and
finally results in rise in income and output taking the
economy towards recovery.

Public Expenditure Policy

All public expenditure is classified into :
Non Plan Expenditure : Non Plan expenditure of the
central govt. is divided into revenue expenditure and
capital expenditure
Revenue expenditure includes : interest payment, defence
revenue expenditure, major subsidies (export, food and
fertilizer), interest and other subsidies, debt relief to
farmers, postal deficit, police, pension and other
general services, social service, economic service
(agriculture,
industry,
power,
transport,
communications, science and technology, etc.) and
grants to states and union territories, and to foreign
governments.
Capital non-plan expenditure includes such items such as
defence capital expenditure, loans to public enterprise,
loans to states and territories and loans to foreign
governments.
Plan Expenditure : Plan expenditure is meant to finance
central pin ns drawn up for agriculture, rural

Cont..Public Expenditure Policy

Public expenditure is decreased or at least not

increased in time of inflation. This is done so that
additional income does not go into the economy. This
puts a check on demand in the economy and has an
anti inflationary impact as lower demand leads to
reduction in prices.
During
recession
public
expenditure
is
increased and it is believed to be necessary to
bring out the economy from recession. Increase
in public expenditure, whether revenue or capital
results in higher income and investment in the
economy. This creates more demand and private
investment is also encouraged.

PUBLIC DEBT Policy

Public debt refers to the borrowings of the Central
and State governments. Gross public debt is the
gross financial liability of the government. Net public
debt is the gross debt minus the value of capital
assets of the government and loans and advances
given by the government to other sectors.
Debt obligation of the central Govt. are broadly
divided into two categories:
(1) Internal debt:
(2) External Debt :

PUBLIC DEBT Policy

(1) Internal debt: This includes loans raised within the
country, like
Others, comprising balance of expired loans, compensation and
other bonds such as National Rural Development Bonds and
Capital Investment Bonds
Current market loans,
Special Bearer Bonds
Treasury Bills
Special floating and other loan
Special securities issued to the RBI
Small savings
Provident funds
Other accounts
Reserve funds and deposits.
(2) External Debt : External debt is raised in foreign currency
and a substantial part of it is also repayable in foreign currency.
External debt represents loans raised by a country from outside
sources and includes debt raised by the government and by
non-government sources such as NRI deposits, commercial

DEFICIT FINANCING

Deficit Financing can be defined as "the financing of

deliberately created gap between public revenue and
public expenditure or a budgetary deficit, the
method of financing resorted to being borrowing of a
type that results in a net addition to national outlay
or aggregate expenditure." Therefore, we can say it
is deliberate unbalancing of the budget in such a
way
that
government
expenditure
exceeds
government revenue. In India, great reliance has
been placed on deficit financing for mobilizing
resources for the plans. Deficit financing has been
explained in different ways :

DEFICIT FINANCING

Revenue Deficit = Revenue expenditure Revenue Receipts

Budget Deficit = Total expenditure - Total Receipts
Fiscal Deficit = Revenue Receipts (Net tax revenue
+ non tax revenue) + Capital Receipts (only
recoveries of loans and other receipts) - Total
expenditure (plan and non-Plan)
OR
= Budget Deficit + Government's market borrowing
and liabilities.
Primary Deficit : Primary deficit is obtained by
subtracting interest payment (a component of non
Plan expenditure) from fiscal deficit. Therefore, the
primary deficit is the deficit of the current year and it
is accordingly triggered by an expansionary fiscal
policy during the year

LIMITATIONS OF FISCAL POLICY

In theory inflation or recession can easily be overcome
by the fine-tuning of fiscal policy. However, in reality
the situation is complex and many economists argue
for ignoring fiscal policy as a tool for managing
aggregate demand focusing instead on the role that
monetary policy can play in stabilising demand and
output. They give the following limitations of fiscal
policy:
1. Recognition Lags and Policy Time Lags
It takes time for government policy-makers to
recognise that aggregate demand is growing either
too quickly or too slowly and a need for some active
changes in spending or taxation exists.

LIMITATIONS OF FISCAL POLICY

2. Fiscal Crowding-Out
The "crowding-out hypothesis" became popular in the
1970s and 1980s when free market economists argued
against the rising share of national income being taken
by the public sector. The essence of the crowding out
view is that a rapid growth of government spending
leads to a transfer of scarce productive resources from
the private sector to the public sector. For example, if
the government seeks to increase aggregate demand
by reducing taxation, or by increasing government
spending, then this may lead to a budget deficit. To
finance
the
deficit
the
government
will
have to resort to public borrowing. Attracting
individuals and institutions to provide funds to
government through debt instruments may require

LIMITATIONS OF FISCAL POLICY

3.
Reaction to Tax Cuts - Rational
Expectations
According to a school of economic thought that
believes in 'rational expectations', when the
government sells government securities to fund a tax
cut or an increase in expenditure, then a rational
individual will realise that at some future date he will
face higher tax liabilities to pay for the interest
repayments. Thus, he should increase his savings as
there has been no increase in his permanent income.
The implications are clear. Any change in fiscal policy
will have no impact on the economy if all individuals
are rational. Fiscal policy in these circumstances may
become ineffective.

Union Budget
The Constitution of India provides that No tax can be levied or collected except by
authority of law.
No expenditure can be incurred for public
funds except in the manner provided in
Constitution.
The executive authorities must spend public
money only in the manner sanctioned by
Parliament in the case of the Union and by
the State legislature in the case of a State.

Union Budget

Union Budget, which is a yearly affair, is a comprehensive display of the

Governments finances. It is the most significant economic and financial event
in India. The Finance Minister puts down a report that contains Government of
Indias revenue and expenditure for one fiscal year. The fiscal year runs from
April 01 to March 31.
The Union budget is preceded by an Economic Survey which outlines the
broad direction of the budget and the economic performance of the country.

The Budget is the most extensive account of the Government`s finances, in

which revenues from all sources and expenses of all activities undertaken are
aggregated. It comprises the revenue budget and the capital budget. It also
contains estimates for the next fiscal year called budgeted estimates.
Barring a few exceptions -- like elections Finance Minister presents the
annual Union Budget in the Parliament on the last working day of February.
The budget has to be passed by the Lok Sabha before it can come into effect
on April 01.

Union Budget

TheUnion Budget of India, referred to as

the Annual Financial Statement[1]in Article 112
of theConstitution of India, is the annual
budget of theRepublic of India, presented
each year on the last working day of February
by theFinance Minister of IndiainParliament.
The budget, which is presented by means of
the Financial Bill and the Appropriation bill has
to be passed by the House before it can come
into effect on April 1, the start of India's
financial year.

STATE BUDGETS

Like the Union Government, State Governments,

too, have their own budgets. Estimates of
receipts and expenditure are presented by the
State Governments to their legislatures before
the beginning of the financial year and legislative
sanction of expenditure is secured through
similar procedure.
As in the case of the Union Government, the
Constitution has provided for the establishment
of a Consolidated Fund, a Public Account and a
Contingency Fund for each State.

FINANCES OF THE UNION AND

STATES
The Constitution of India has earmarked separate sources of
revenue for the Union and the States.
Sources of Revenue for the Union
The Union List in the Constitution includes the following
revenue subjects:
1.Taxes on income other than agricultural income;
2.Duties and customs, including export duties;
3.Duties of excise on tobacco and other goods manufactured
or produced in India, except alcoholic liquors for human
consumption and opium, Indian hemp and other narcotic"
drugs and narcotics;
4.Corporation tax;
5.Taxes
on the capital value of assets, exclusive of
agricultural land, of individual companies taxes on the
capital of companies;
6.Estate duty in respect of property other than agricultural

Cont..

7.
8.

9.
10.
11.
12.
13.

Duties in respect of succession to property other

than agricultural land;
Terminal taxes on goods of passengers carried by
the railways, by sea, or air; taxes on railway
fares and freight;
Taxes other than stamp duties on transactions on
stock exchanges;
Rate of stamp duty on bills of exchange;
Taxes on sale or purchase of newspapers and on
advertisements published therein;
Fees in respect of any of the matters in the Union
List, but not including fees taken in any court;
Any tax not mentioned in the State List or
Concurrent List.

Cont..

Sources of Revenue for the State

The State List in the Constitution includes the
following revenue subjects:
1.Land revenue, including the assessment and
collection of revenue, the maintenance of land
records, survey for revenue purposes and records of
rights and alienation of revenue.
2.Taxes on agricultural income.
3.Duties in respect of succession to agricultural
lands.
4.Estate duty in respect of agricultural land.
5.Taxes on lands and buildings.
6.Taxes on mineral rights, subject to any limitations
imposed by Parliament by law relating to mineral
development.

7.Duties

Cont..

of excise on the following goods

manufactured or produced elsewhere in India: (a)
alcoholic liquors for human consumption; (b) opium,
Indian hemp and other narcotic drugs and narcotics.
8.Taxes on the entry of goods into a local area for
consumption, use or sale therein.
9.Taxes on the consumption or sale of electricity.
10.Taxes on the sale or purchase of goods (other
than news papers). Taxes on advertisements (other
than those on newspapers).
11.Taxes on goods and passengers carried by road or
inland water ways.
12.Taxes on vehicles, whether mechanically
propelled or not, used on roads.

14.Taxes

on animals and boats.

Cont..

15.Tolls.
16.Taxes

on profession, trades, callings and

employment.
17.Capitation taxes.
18.Taxes on luxuries, including taxes on
entertainment, amusements, betting and gambling.
19.Rates of stamp duty in respect of documents other
than those specified.
20.Fees in respect of any of the matters in this list but
not including fees taken in any court.
21.Fisheries.
22.Forests.
23.Irrigation, water storage and water power.

Cont..

Concurrent List
The main revenue items in the Concurrent List under
the Constitution are:

Stamp duties other than duties or fees collected by

means of judicial stamps but including rates of
stamp duty.
Fees in respect of any of the matters in this list but
no including fees taken in any court.

The Finance Commission

Under the Constitution of India, a Finance Commission is to

be constituted every fifth year or at such earlier time as the
President considers necessary to make recommendations to
the President as to:
The distribution between the Union and States of the net
proceeds of taxes which are to be or may be divided
between the States of the respective shares of such
proceeds;
The principles which should govern the grants-in-aid of the
revenues of the State in need of such assistance out of the
Consolidated Fund of India; and Any other matters referred
to the Commission by the President in the interest of sound
finance.
The recommendation of the Commission, together with an
explanatory memorandum as to the action taken thereon,
are laid before each House of Parliament.

The Finance Commission

The Finance Commission is constituted by the
President under article 280 of the Constitution,
mainly to give its recommendations on
distribution of tax revenues between the Union
and the States and amongst the States
themselves. Two distinctive features of the
Commissions work involve redressing the
vertical imbalances between the taxation powers
and expenditure responsibilities of the centre
and the States respectively and equalization of
all public services across the States.

What are the functions of the

Finance Commission?

It is the duty of the Commission to make

recommendations to the President as to
the distribution between the Union and the
States of the net proceeds of taxes which are
to be, or may be, divided between them and
the allocation between the States of the
respective shares of such proceeds;
the principles which should govern the
grants-in-aid of the revenues of the States
out of the Consolidated Fund of India;

What are the functions of the

Finance Commission?

the measures needed to augment the Consolidated Fund

of a State to supplement the resources of the Panchayats
in the State on the basis of the recommendations made
by the Finance Commission of the State;
the measures needed to augment the Consolidated Fund
of a State to supplement the resources of the
Municipalities in the State on the basis of the
recommendations made by the Finance Commission of
the State;
any other matter referred to the Commission by the
President in the interests of sound finance.
The Commission determines its procedure and have such
powers in the performance of their functions as
Parliament may by law confer on them.

Who appoints the Finance Commission

and what are the qualifications for
Members?

The Finance Commission is appointed by the President under

Article 280 of the Constitution. As per the provisions contained
in the Finance Commission [Miscellaneous Provisions] Act, 1951
andThe Finance Commission (Salaries & Allowances)
Rules, 1951,the Chairman of the Commission is selected from
among persons who have had experience in public affairs, and
the four other members are selected from among persons who

(a) are, or have been, or are qualified to be appointed as Judges

of a High Court; or
(b) have special knowledge of the finances and accounts of
Government; or
(c) have had wide experience in financial matters and in
administration; or
(d) have special knowledge of economics

How are the recommendations of

Finance Commission implemented?

The recommendations of the Finance Commission

are implemented as under:Those to be implemented by an order of the
President:
The recommendations relating to distribution of
Union Taxes and Duties and Grants-in-aid fall in this
category.
Those to be implemented by executive orders:
The recommendations in respect of sharing of Profit
Petroleum, Debt Relief, Mode of Central Assistance,
etc. are implemented by executive orders.

What is the composition of the

Fourteenth Finance Commission?

The Fourteenth Finance Commission has been set up

under the Chairmanship of Dr. Y.V.Reddy [Former
Governor Reserve Bank of India]. Other Members of
the Commission are Ms. Sushma Nath [ Former Union
Finance Secretary ], Dr. M.Govinda Rao [ Director,
National Institute for Public Finance and Policy, New
Delhi ), Dr. Sudipto Mundle, Former Acting Chairman,
National Statistical Commission. Prof Abhijit Sen
(Member, Planning Commission) is the part-time
Member of the Fourteenth Finance Commission. Shri
Shri Ajay Narayan Jha is the Secretary, Fourteenth
Finance Commission.

What is the tenure of the

Fourteenth Finance Commission?

The Finance Commission is required to give its

report by 31st October, 2014. Its recommendations
will cover the five year period commencing from 1st
April, 2015.

IMPORTANCE OF THE BUDGET

There is no other Government measure that affects

the whole economy as the Budget. No wonder all
sections of the people await the annual Budget
with mixed feelings-anxiety, fear and hope. The
Endeavour of the Finance Minister is to present a
Budget which gives maximum support to forces
that can move the country forward on the path of
growth with stability and social justice. The Budget
should set the stage for the achievement of
economic and social goals.
The importance of functional finance and pump
priming are recognised all over the world.

IMPORTANCE OF THE BUDGET

In India, today, about a half of the GDP is channeled

into the Government sector by the Union, State and UT
Budgets and disbursed by the Union, State and UT
Governments under various development and nondevelopment heads. These indicate the development
and distributive importance and implications of the
Budgetary operations.
There has been a steep increase in the Government
expenditures, both in absolute and relative terms. The
total budgetary expenditures (of the Centre, States and
Union Territories) are about 50 per cent of the GDP
today. The Central Government expenditures alone
account for over one-fourth of the GDP today.

Economic Stabilization
There are two forms of fiscal policy
responses to instability in an
economy: Automatic stabilizers
Discretionary fiscal policy

Automatic Stabilizers
An

automatic stabilizer is an expenditure programme

or tax law that automatically increases expenditures
(or decreases taxes) when an economy enters a
recession and automatically decreases expenditures
(or increases taxes) when an economy enters a period
of inflation.
As is clear from this definition, automatic stabilizers
refer to the built-in responses that are generated in the
system without any deliberate action on the part of the
government, to correct instability and thus restore
economic stability in the economy. Such stabilizers are
also known as built-in stabilizers. The two main
automatic stabilizers that are generally discussed in
economic literature are
1.
changes in tax revenues, and

1. Changes in Tax
Revenues.
As

the Gross National Product (GNP) of a country

rises, some people who did not have taxable income
before become taxable while many tax payers are
shifted into higher tax brackets. Thus tax revenues
increase with an increases in GNP. This is of course
the direction in which tax should move as the
national income increase. Conversely, when the GNP
falls, some tax payers find their incomes dropping
below the taxable level on the one hand, while many
tax payers fall into lower tax brackets. Thus tax
revenues are reduced as GNP falls. Hence, the tax
revenues again move in the direction required for
stabilization.

2. Unemployment Compensation
and Welfare Payments
In

many
developed
countries
of
the
West
unemployment compensation is paid to workers who
are laid off. During recession, as more people become
unemployed, unemployment compensation paid by the
government
to
the
unemployed
automatically
increases. This means that consumption expenditures,
an important component of aggregate demand, will not
fall as far as they otherwise would. During period of
boom as business activity expands the number of
unemployed people falls and, correspondingly, the
unemployment compensation falls. Thus increase in
spending is curbed and this is just what we want to see
happen. This shows that unemployment compensation
has an automatic stabilizing effect on the economy.
Various welfare programmes also have the same effect

Discretionary Fiscal Policy

Discretionary

fiscal policy implies deliberate changes

undertaken by the government of a country in the tax
rates and planned outlays in an effort to stabilize the
economy. As is clear from this definition, it is the
discretionary fiscal policy that is the fiscal policy
'proper' as it entails definite and conscious actions
initiated by the government of a country to alter tax
rates and its own expenditures. However, two
comments are in order on this conventional definition
of discretionary fiscal policy :

Cont
First,

on the revenue side, tax rates (or taxation) is

not the sole tool in the hands of the government
authorities. Two other important tools that have
assumed considerable importance over time are (i)
public borrowing, and (ii) forced saving (also known as
deficit financing).
Second, the definition given above is from the point of
view of the developed countries where the prime issue
is economic stabilization.
However, in the case of the developing countries, the
main issue is economic development. Therefore,
viewed from the perspective of the developing
countries, discretionary fiscal policy would imply
deliberate policy actions undertaken by the
government on public revenue -and public expenditure