MP3-IE-19-02

TOPICS

Fiscal Policy Taxation Monetary Policy in India Financial System Banking

INDIANECONOMY

PART-2

ContentsFiscal Polic1. y: An Overview 5

Fiscal Polic2. y in India 11Annexur1. e: Important Budgetary Terms & Fiscal Concepts ......... 17

Taxation:3. An Overview 21Appendix - 1:1. Direct Taxes ................................................................ 24Appendix - 2:2. Indirect Taxes ............................................................. 26

Principles4. of Taxation 30

Tax Syste5. m in India 35

G6. oods & Services Tax “A Game Changers” 47Introduction 1. ...................................................................................... 47Operational Framework – GST Model 2. ............................................ 49Constitutional Dimension 3. ............................................................... 51Institutional Framework 4. ................................................................. 52“It” In the Implementation of GST5. ................................................. 53Impact of Gst 6. .................................................................................... 53Issues Related to GST 7. ....................................................................... 56Way Forward 8. ..................................................................................... 56

Subsidies 57. 7Rationale of Subsidies 1. ...................................................................... 58Public Distribution System and Subsidies (PDS) 2. .......................... 62Export Promotion through Subsidies 3. ............................................ 65National Food Security Act 4. .............................................................. 68

D8. irect Benefit/Cash Transfer 70

Monetary Policy In India 79. 3Instruments of Monetary Policy 1. .................................................... 75Monetary Policy in Pre-Reform Era (1948-1991) 2. ............................ 77Monetary Policy in Post-Reform Era (Since-1991) 3. ........................ 78Urjit Patel Committee Report on Monetary Policy 4. ...................... 78Monetary Policy Committee and Infl ation Targeting 5. .................. 79

F10. inancial Markets & Instruments 82Money Market 1. ................................................................................... 83Capital Market In India 2. .....................................................................................87

Indian Capital Market Regulatory Framework 3. ............................ 89Primary Market Reforms in India 4. .................................................. 91

Banking 911. 4Central Banking 1. ................................................................................ 94Indian Banking System 2. .................................................................... 95Functions of Commercial Banks 3. ..................................................... 97Challenges Faced by Commercial Banks in India 4. ......................... 98Nationalization of Banks iun India 5. ................................................ 99Banking Reforms in India 6. ................................................................ 99New Bank Licence Criteria 7. ............................................................ 102Small Finance Banks and Payment Banks Criteria 8. .................... 103Non-BAnking Financial Company (NBFC) 9. .................................... 105Terminologies/Concepts Related to Banking in India 10. ............... 106

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CHAPTER 1

The term, fi scal policy, includes the tax and expenditure policies of the government or in alternate words; it means how government receive (raise) money and spends it. Thus, fi scal policy operates through the control of government expenditures and tax receipts. It encompasses two separate but related decisions; public expenditures, and the level and structure of taxes. The amount of public outlay, the incidence and effects of taxation, and the relation between expenditure and revenue exert a signifi cant impact upon the free enterprise economy.Broadly speaking, the taxation policy of the government relates to the programme of revenue generation and resource mobilization, however, over the time the revenue generation in itself has become an important policy instrument to address growth and development. Expenditure policy, on the other hand, deals with the channels by which government resources are pumped into the private economy.Government spending on new goods and services directly adds to aggregate demand in the economy and indirectly increases income through secondary spending, which takes place on account of the multiplier effect.

Multiplier Effect

The fi scal multiplier effect occurs when an increase in government spending into the economy causes a bigger fi nal increase in national income.For example, if the government increases spending by Rs 1 billion, there would be an initial increase in Aggregate Demand of Rs 1bn. However, if this spending eventually causes real GDP to increase by Rs. 2 billion, then the multiplier would have a value of 2.0.Multiplier = Change in Real GDP/Change in government spending Example of How the Multiplier Effect WorksIf the government spent an extra Rs 2 billion on the contractual labour for infrastructure projects, this would cause salaries / wage to increase by Rs 2 billion, therefore National Income will increase by Rs 2 billion.However with this extra income, workers will spend, at least part of it, in other areas of the economy. For example, if they spent 50% of the extra income there would be another Rs 1 billion injected into the economy, e.g., shopkeepers would earn money from increased sales. This extra spending would cause an increase in output, therefore fi rms would employ more workers and pay higher salaries.Therefore, these workers will also increase their spending. This will lead to another injection into the economy, causing higher Real GDP. In other words, if you increase salaries in the NHS, it isn’t just contractual labour, who benefi t from higher incomes. It is also related industries and service industries who see some benefi ts.

FISCAL POLICY AN OVERVIEW

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Taxation, on the other hand, operates in reducing the level of Private Spending (on both consumption and investment) by reducing the Disposable Income (income available after paying taxes and social security, such as PF) and the resulting savings in the community. Hence, under the budgetary phenomenon, public expenditure and revenue can be combined in various ways to achieve a desired stimulating or defl ationary effect on aggregate demand.

Objectives of Fiscal Policy

The following are the objectives of fi scal policy: Development by effective Mobilisation of Resources

The principal objective of fi scal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by mobilisation of Financial Resources.The central and the state governments in India have used fi scal policy to mobilise resources. The fi nancial resources can be mobilised by:-

Taxation: Through effective fi scal policies, the government aims to mobilise resources by way of direct taxes as well as indirect taxes because most important source of resource mobilisation in India is taxation.Public Savings: The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises.Private Savings: Through effective fi scal measures such as tax benefi ts, the government can raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by defi cit fi nancing.

Effi cient allocation of Financial Resources The central and state governments have tried to make effi cient allocation of fi nancial resources. These resources are allocated for Development Activities which includes expenditure on railways, infrastructure, etc. While Non-development Activities includes expenditure on defence, interest payments, subsidies, etc.But generally the fi scal policy should ensure that the resources are allocated for generation of goods and services which are socially desirable. Therefore, India’s fi scal policy is designed in such a manner so as to encourage production of desirable goods and discourage those goods which are socially undesirable.

Reduction in inequalities of Income and Wealth Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the upper middle class and the upper class. The government invests a signifi cant proportion of its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor people in society.

Price Stability and Control of Infl ation One of the main objective of fi scal policy is to control infl ation and stabilize price. Therefore, the government always aims to control the infl ation by reducing fi scal defi cits, introducing tax savings schemes, productive use of fi nancial resources, etc.

Employment Generation The government is making every possible effort to increase employment in the country through effective fi scal measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generates more employment. Various rural employment programmes have been undertaken by the Government of India to solve problems in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualifi ed persons in the urban areas.

Balanced Regional Development Another main objective of the fi scal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, fi nance at concessional interest rates, etc.

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Reducing the Defi cit in the Balance of Payment Fiscal policy attempts to encourage more exports by way of fi scal measures like exemption of income tax on export earnings, Exemption of central excise duties and customs, exemption of sales tax and octroi, etc.The foreign exchange is also conserved by providing fi scal benefi ts to import substitute industries, imposing customs duties on imports, etc.The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to export.

Capital Formation The objective of fi scal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly on account of capital defi ciency. In order to increase the rate of capital formation, the fi scal policy must be effi ciently designed to encourage savings and discourage and reduce spending.

Increasing National Income The fi scal policy aims to increase the national income of a country. This is because fi scal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country.

Development of Infrastructure Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fi scal policy measure such as taxation generates revenue to the government. A part of the government’s revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost.

Foreign Exchange Earnings Fiscal policy attempts to encourage more exports by way of fi scal measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc. Foreign exchange provides fi scal benefi ts to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem.

Types of Fiscal Policy

Expansionary fi scal policy It is defi ned as an increase in government expenditures and/or a decrease in taxes that causes the government’s budget defi cit to increase or its budget surplus to decrease. A government can adopt Expansionary fi scal policy on the following basis:

Government needs to borrow from domestic or foreign sources. Print an equivalent amount of money. Draws upon its foreign exchange reserves

But fl ipside of printing is it leads to infl ation. If the government borrows too much from abroad it leads to a debt crisis. If it draws down on its foreign exchange reserves, a balance of payments crisis may arise.

Contractionary fi scal policy It is defi ned as a decrease in government expenditures and/or an increase in taxes that causes the government’s budget defi cit to decrease or its budget surplus to increase.

Neutral Fiscal Policy It is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

Tools of Fiscal Policy

Components of Spending Maintenance (including staff salaries): This component can’t be altered in short-run and hence is hardly a part of policy making, however, in long-run, through VRS and reducing new jobs in public sector or vice versa, this expenditure can be altered.

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Loan payments: This again is a component, which can’t be touched in short-run, however, governments in long-run can reduce these payments or eliminate them by running the budget surplus. Subsidies: This component is a major part of policy as it can be altered in short-run, but unfortunately, subsidies as policy instrument, have been abused in India. These are used by politicians as poll promise and political instruments to gain more popular support. Ideally only meritorious subsidies shall be in operation and all the wasteful subsidies must be phased out, for example, fertilizer subsidy and power subsidy benefi ts the large farm holder and capitalist farmers instead of the needy ones. Similarly, the recent example of Aam Aadmi Party manifesto is a good example, how subsidies should not be used. In place of these, subsides for health programs, renewable energy, public transport shall be encouraged to ensure good health and sustainable growth. Welfare schemes: These are one of the policy options that once introduced can’t be removed due to their populist nature. Similarly, in most of the cases these are necessary too and important instrument of social welfare and economic growth. However, it is the implementation part, which is key, as these schemes generally suffer from poor implementation and massive corruptions and loopholes. Thus, despite being meritorious expenditure in nature, these at time appears as waste.Wasteful expenses: Needless to say these are the expenditures that must be curbed with immediate effect; however, no government in world has neither shown the intention to curb them, though there are efforts to reduce them from time to time under public pressure. For example, full page government advertisements in newspaper to generate favorable public opinion.

Components of Earning Tax single: Single most important source of government revenue is also a very important policy measure as elaborated in the policy combinations above. Borrowing: Borrowing is a necessary source of funds, though not a desirable one. Particularly, in developing countries, as tax/GDP ratio is low due to less per capita income. However, it becomes an important part of monetary policy as well due to its impact on interest rates and credit creation and thus, overall money supply. Proceeds from sale/lease of assets: This is a both a one-time and regular source of income. For example, lending government buildings for private use, or other assets such as telecom spectrum or lease of a mine block for certain years, is a regular source of income, whereas sale of PSUs is a onetime income. These however, are good sources of revenue, as they provide government more room to spend without increasing taxes.Profi ts from PSU: Profi ts from PSUs can also be a potential source of revenue, however, since most of PSUs are generating losses, Indian government usually ends up subsidizing them. At times PSUs are deliberately kept in losses to keep prices low and ensure wider outreach for social welfare, example, PSU banks in pre-reform era and post-offi ces. Similarly, at other times, they are in losses due to ineffi ciency and wasteful expenditure. Most striking case in India, is of ministerial corruption to keep PSUs in loss deliberately to benefi t private sector, for example, CAG report says that, Indian Airlines was deliberately kept in losses by avoiding fl ights on profi table routes to benefi t private airlines during UPA government’s rule. Similarly, in previous NDA government, BSNL was deliberately pushed into loss, by increasing tariffs to provide competitive edge to a newly launched company by one of the biggest business conglomerate in India.

Role of Fiscal Policy in Developing Countries

The fi scal policy in developing countries should be conducive to rapid economic development. In a poor country, fi scal policy can no longer remain a compensatory fi scal policy. It has a tough role to play in a developing economy and has to face the problem of growth-cum-stability.The main goal of fi scal policy in a newly developing economy is the promotion of the highest possible rate of capital formation. Underdeveloped countries are encompassed by vicious circle of poverty on account of capital defi ciency; in order to break this vicious circle, a balanced growth is needed. It needs accelerated rate of capital formation.Since private capital is generally shy in these countries, the government has to fi ll up the lacuna. A mounting public expenditure is also required in building social overhead capital. To accelerate the rate of capital formation, the fi scal policy has to be designed to raise the level of aggregate savings and to reduce the actual and potential consumption of the people.Another objective of fi scal policy, in a poor country is to divert existing resources from unproductive to productive and socially more desirable uses. Hence, fi scal policy must be blended with planning for development.

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An important aim of fi scal policy in a developing economy is to create an equitable distribution of income and wealth in the society. Here, however, a diffi culty arises. The aims of rapid growth and attainment of equality in income are two paradoxical goals because growth needs more savings and equitable distribution causes reduction of aggregate savings as the propensity to save by the richer section is always high and that of the poor income group low.As such, if high economic growth is the objective, the question arises as to what extent inequalities should be reduced. Of course, many a time, under the goal of socialism, the government unduly resorts to reduction of inequalities at the cost of growth which may lead to the distribution of poverty rather than prosperity. A reconciliation of these two contradictory goals of growth and reduction of inequalities can defi nitely bring forth better results.Furthermore, fi scal policy in a poor country has an additional role of protecting the economy from high infl ation domestically and unhealthy developments abroad. Though infl ation to some extent is inevitable in the process of growth, fi scal measures must be designed to curb infl ationary forces. Relative price stability constitutes an important objective.The approach to fi scal policy in an economy which is developing must be aggregative as well as segmental. The former may lead to overall economic expansion and reduce the general pressure of unemployment; but due to the existence of bottlenecks though general price stability may be maintained, sectoral price rise may inevitably be found.These sectoral imbalances are to be corrected by appropriate segmental fi scal measures which would remove frictions and immobility’s turn demands into proper directions, seek to eliminate bottlenecks and other obstacles to growth.For less developed countries such as India the following main objectives of fi scal policy may be restated as:

To increase the rate of investment and capital formation, so as to accelerate the rate of economic growth. To increase the rate of savings and discourage actual and potential consumption. To diversify the fl ow of investments and spendings from unproductive uses to socially most desirable channels.To check sectoral imbalances. To reduce widespread inequalities of income and wealth. To improve the standard of living of the masses by providing social goods on a large scale.

For the purpose of development, not only an expansionary budget but a defi cit is desirable too in a developing country. The government expenditure on developmental planning projects must be increased.It may be fi nanced even by means of defi cit fi nancing. Defi cit fi nancing, here, refers to the creation of new money by printing additional notes by the government or by borrowing from the central bank which ultimately means creation of additional money supply. However, the government must use the technique of defi cit fi nancing cautiously. An excessive dose of defi cit fi nancing may lead to infl ation which may endanger economic growth.Public borrowing also is an important means of getting resources for development of the public sector. External loans are useful to some extent when the country has to import machines, capital goods, etc., from a foreign country and the country has a scarcity of foreign exchange.Anyway the effectiveness of fi scal measures in promoting development in a poor country depends on the incentives administered to the strategic points in the productive set up by virtue of the consequences of taxation and public spending.It must be noted that fi scal policy in a developing economy has to operate within a framework infl uenced by social, cultural and political conditions and institutions, which may inhibit the formulation and implementation of good economic policies.Further, fi scal policy in a poor country may be used to reduce inequalities in income and wealth distribution by means of taxes and government expenditure. Taxation has to be progressive and government spending must be welfare-oriented.In short, for promoting economic growth, the fi scal policy must be fi rst formulated in such a way that it will increase the rate of volume of investment in the public and private sectors. The tax policies must discourage unproductive and speculative investment. Second, fi scal policy must mobilise more and more resources for capital formation. Hence, taxation must be used to curb excessive consumption. Third, it must encourage an infl ow of foreign capital.Fiscal policy, however, cannot be effective when there are loopholes in the taxation laws and the tax administration is corrupt so that there is large-scale tax evasion. Again, if the government is extravagant

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in spending on non-developmental items, then a technique such as defi cit fi nancing may prove to be infl ationary. Again, market imperfections, bottlenecks, shortages of raw materials, and lack of entrepreneurial skills, do not allow fi scal policy to be effective.A high population growth, and an orthodox society also come in the way of development and without a coordinated, sound, physical plan and its proper implementation, fi scal policy cannot be very effective in reaching its goal of rapid economic development with stability.Nonetheless, of all economic policies, fi scal policy today assumes unique importance in realising general economic goals, depending on the size of the fi scal measures adopted and their timing. The exact change effected in the national economy will depend on the form and the magnitude of public revenue, especially, the rates and structure of taxation and the mode of public spending by the government.Further, when prices are rising, government has to adopt a surplus budget at an appropriate time in order to avoid secular infl ation. But, there is practical diffi culty in knowing the changing conditions or appearance of price stability; hence it is very diffi cult to forecast perfect timing.Political and administrative delays tend to aggravate the problem and the desired effect of fi scal programme may not be realised. Sometimes, even if the fi scal action is taken at a right time, in quantitative or qualitative terms, it may not be adequate or appropriate.Quite often, trade union activities come in the way of operating fi scal measures. The workers may resent certain taxation measures or may demand high wages during infl ation, and when the government is forced to raise the wage level on account of demand-pull infl ation, cost-push infl ation may also emerge to make the situation worse.

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