Fiscal Economics: One Mark Questions, Book Back Answers and Notes

About Fiscal Economics

Medium ~90 min study

A government today does far more than keep law and order. It runs schools and hospitals, builds roads, pays pensions and tries to reduce poverty. All of this needs money, and public finance, also called fiscal economics, studies how the government gets that money and how it spends it.

The main tools are taxation, public expenditure and public borrowing, and the annual budget brings them together. Using them, the government can reduce inequality, control inflation or recession and build infrastructure. In a federal country like India, revenue also has to be shared between the Union and the States, which is where the Finance Commission comes in. The chapter also explains the Goods and Services Tax, which replaced many separate central and state indirect taxes.

From this unit, expect questions on the differences between public and private finance, Adam Smith's canons of taxation, direct versus indirect taxes, the methods of debt redemption, and the formulas for revenue, budget, fiscal and primary deficit. Learn the deficit formulas exactly; they are easy marks if you remember what is subtracted from what.

What you'll learn

• Distinguish between public finance and private finance.
• State Adam Smith's canons of taxation with an example of each.
• Distinguish direct taxes from indirect taxes and explain the main features of GST.
• Explain the causes of growth of public expenditure.
• Describe the methods of redemption of public debt.
• Write the formulas for revenue, budget, fiscal and primary deficit and interpret them.
• Explain the principles of federal finance and the role of the Finance Commission.

Before you start

• National income and GDP from the earlier macroeconomics units.
• The role of the government in the economy.
• Basic ideas of demand, supply and prices.

Fiscal Economics explained

How the Government Raises and Uses Money

Public Finance and Private Finance

Public finance studies the revenue, expenditure, debt, financial administration and fiscal policy of the state. It differs from private finance in one basic way. An individual first looks at income and then decides how much to spend. The government first decides how much it needs to spend to meet society's needs and then finds ways to raise that revenue. The aim of public finance is the greatest social welfare, not private profit.

Public Revenue and Canons of Taxation

Government revenue comes from tax and non-tax sources. A tax is a compulsory payment to the government with no direct return (no quid pro quo) to the taxpayer. Non-tax revenue includes fees, fines, prices of public enterprise goods, and grants. Adam Smith gave four canons of a good tax: equality or ability (pay according to ability), certainty (the amount, time and manner of payment should be clear), convenience (collect at a time and in a way convenient to the payer) and economy (the cost of collection should be low).

Direct and Indirect Taxes

A direct tax is paid by the person on whom it is levied, and the burden cannot be shifted to anyone else. Income tax and corporation tax are examples, and income tax is usually progressive. An indirect tax is levied on goods and services; the seller pays it to the government but passes the burden on to the buyer through higher prices. The Goods and Services Tax, introduced in India on 1 July 2017, is a destination-based indirect tax on the supply of goods and services. It is collected at each stage of the supply chain with credit for tax paid on inputs, and has a dual structure of Central GST and State GST (Integrated GST on inter-state supplies).

Public Expenditure

Public expenditure is spending by the government to meet collective needs. It has grown steadily because of the welfare state idea, population growth, defence needs, urbanisation, rising prices, development planning and social security schemes. Well-planned public spending can create jobs, promote industries and reduce regional inequality by transferring resources to poorer groups and regions.

Public Debt and Its Redemption

When revenue falls short of expenditure, the government borrows from within the country (internal debt) or from abroad (external debt). Debt must be repaid, and the methods of redemption include a sinking fund built up by annual contributions, conversion of high-interest loans into low-interest ones, using budget surpluses, terminal annuities paid in equal yearly instalments, and, in extreme cases, compulsory reduction in the rate of interest or repudiation.

Budget and Deficits

A budget is the government's statement of estimated receipts and expenditure for a financial year. It may be balanced, surplus or deficit. Developing countries often run deficit budgets. The deficits are measured as follows:

• Revenue deficit = revenue expenditure − revenue receipts
• Budget deficit = total expenditure − total receipts
• Fiscal deficit = total expenditure − total receipts excluding borrowings
• Primary deficit = fiscal deficit − interest payments

Federal Finance and the Finance Commission

Federal finance deals with the division of taxing powers and revenue between the Union and the States. Because the States have large responsibilities but limited revenue, there are vertical and horizontal imbalances. The Finance Commission, constituted by the President every five years under Article 280, recommends how the divisible pool of taxes should be shared and the principles for grants-in-aid. The principles of federal finance include autonomy, adequacy, equity, uniformity and administrative efficiency.

Common mistakes to avoid

• Deciding whether a tax is direct or indirect by who hands it to the government. The test is who finally bears the burden: a direct tax cannot be shifted, an indirect tax is passed on to the buyer.
• Applying private finance logic to the government. An individual adjusts spending to income; the government decides spending first and then raises revenue.
• Treating fiscal deficit and primary deficit as the same. Primary deficit = fiscal deficit minus interest payments, so it shows borrowing needed for the current year's spending apart from past debt.
• Describing the Finance Commission as a permanent body. It is constituted by the President every five years (or earlier) under Article 280.
• Writing that GST has one single rate for all goods. GST replaced many taxes with one tax, but it is levied at different rates on different goods and services.

Test yourself on these with the practice test, then check the worked reasoning in the solved MCQs.

Frequently asked questions

How is public finance different from private finance?

The main difference is how income and spending are adjusted. An individual adjusts expenditure to income. The government first decides its expenditure for public needs and then raises revenue to meet it. The government can also borrow on a large scale from its own citizens and create money, which a private person cannot do.

What are the canons of taxation?

Adam Smith gave four canons of taxation. Equality: people should pay according to their ability. Certainty: the amount, time and method of payment should be clear. Convenience: the tax should be collected at a time and in a way convenient to the taxpayer. Economy: the cost of collecting the tax should be as low as possible.

How does GST work?

GST is a destination-based indirect tax on the supply of goods and services, introduced in India on 1 July 2017. Tax is charged at each stage of the supply chain, but each business gets credit for the tax already paid on its inputs, so tax is effectively paid only on value added. The Centre collects CGST, and the state share (SGST) goes to the state where the goods or services are consumed. It replaced many central and state indirect taxes such as excise duty, service tax and VAT.

What are the methods of redemption of public debt?

The main methods are a sinking fund to which a fixed amount is added every year, conversion of high-interest loans into low-interest loans, repayment from a budget surplus, terminal annuities paid in equal yearly instalments, and, in severe crises, compulsory reduction of the interest rate or repudiation of the debt.

What is the difference between fiscal deficit and primary deficit?

Fiscal deficit = total expenditure − total receipts excluding borrowings, so it shows the total amount the government must borrow. Primary deficit = fiscal deficit − interest payments. It shows how much borrowing is needed for the current year's spending, leaving out the burden of interest on past loans.

What does the Finance Commission do?

The Finance Commission is constituted by the President under Article 280 of the Constitution, normally every five years. It recommends how the net proceeds of shareable taxes should be divided between the Union and the States and among the States, and the principles for grants-in-aid to States.

What are the instruments of fiscal policy?

The three instruments are taxation, public expenditure and public debt. During inflation the government raises taxes and cuts spending to reduce demand. During a depression it lowers taxes and increases spending to raise demand and create employment.