Government Budget and the Economy

Public goods (like national defense, roads, street lights) have two key features: Non-rivalry (one person’s consumption doesn’t reduce availability for others) and Non-excludability (it is difficult to stop non-payers from using them).

Due to these features, the private market fails to provide them because of the “Free Rider Problem”—people will use the good without paying for it, making it unprofitable for private firms. Therefore, the government must provide these goods and finance them through taxes.

Basis	Revenue Expenditure	Capital Expenditure
Asset/Liability Status	It does not create assets nor reduce liabilities.	It creates assets (e.g., roads) or reduces liabilities (e.g., loan repayment).
Nature	Recurring and routine (e.g., Salaries, Pensions, Interest).	Non-recurring and irregular (e.g., Building a dam).
Purpose	To maintain normal functioning of government.	To create future benefits or reduce debt burden.

Fiscal Deficit is defined as the excess of Total Expenditure over Total Receipts (excluding borrowings). Mathematically:

$$Fiscal Deficit = Total Expenditure – (Revenue Receipts + Non-debt Creating Capital Receipts)$$

Since the government must cover this gap to balance its books, it borrows money. Therefore, the Fiscal Deficit is numerically equivalent to the Total Borrowing Requirements of the government from all sources (RBI, public, or abroad) to finance its expenditures.

Revenue Deficit is a part of the Fiscal Deficit.

• Revenue Deficit = Revenue Expenditure – Revenue Receipts. (Indicates dis-savings).
• Fiscal Deficit = Revenue Deficit + (Capital Expenditure – Non-debt Capital Receipts).

A large share of Revenue Deficit in the Fiscal Deficit indicates that a large part of borrowing is being used just to meet consumption needs (salaries, interest) rather than for investment.

Given: $I = 200$, $G = 150$, Net Taxes $(NT) = 100$, $C = 100 + 0.75Y$ (where $Y$ is disposable income $Y – NT$).

(a) Equilibrium Income ($Y$):

Equation	$Y = C + I + G$
Substitute C	$Y = 100 + 0.75(Y – 100) + 200 + 150$
Expand	$Y = 100 + 0.75Y – 75 + 350$
Simplify	$Y – 0.75Y = 375$
Solve for Y	$0.25Y = 375 \Rightarrow Y = 1500$

(b) Multipliers:

MPC ($c$) = 0.75

• Govt. Expenditure Multiplier ($\frac{1}{1-c}$): $\frac{1}{1-0.75} = \frac{1}{0.25} = \mathbf{4}$
• Tax Multiplier ($\frac{-c}{1-c}$): $\frac{-0.75}{0.25} = \mathbf{-3}$

(c) Effect of Increase in G by 200:

$\Delta Y = \Delta G \times \text{Multiplier} = 200 \times 4 = 800$

Given: $Y_d = Y + TR$ (Assuming T=0 initially). So $C = 20 + 0.8(Y + 100) = 20 + 0.8Y + 80 = 100 + 0.8Y$.

(a) Equilibrium Income & Multiplier:

$Y = C + I + G \Rightarrow Y = (100 + 0.8Y) + 30 + 50$

$Y – 0.8Y = 180 \Rightarrow 0.2Y = 180 \Rightarrow \mathbf{Y = 900}$

Autonomous Expenditure Multiplier: $\frac{1}{1-c} = \frac{1}{0.2} = \mathbf{5}$

(b) Increase in G by 30:

$\Delta Y = \Delta G \times 5 = 30 \times 5 = \mathbf{150}$

(c) Lump-sum Tax (T) of 30 added:

The Tax Multiplier is $\frac{-c}{1-c} = \frac{-0.8}{0.2} = -4$.

$\Delta Y_{Tax} = \Delta T \times (-4) = 30 \times (-4) = -120$.

Total Change = $\Delta Y_G + \Delta Y_T = 150 – 120 = \mathbf{30}$.

(This illustrates the Balanced Budget Multiplier of 1).

Base Values: $TR = 100$. (From Q6, no base tax was given, so we compare purely on multiplier mechanics or assume T from 6c).

Multipliers:

• Transfer Multiplier = $\frac{c}{1-c} = \frac{0.8}{0.2} = \mathbf{4}$
• Tax Multiplier = $\frac{-c}{1-c} = \frac{-0.8}{0.2} = \mathbf{-4}$

Effect:

• 10% Increase in TR: $\Delta TR = 10$. $\Delta Y = 10 \times 4 = \mathbf{40}$ (Income Increases).
• 10% Increase in T: Assuming a base T, the multiplier is -4. An increase in Taxes decreases income by the same magnitude for equivalent amounts.

Comparison: Transfers increase income, Taxes decrease income. The magnitude of the change depends on the base amount.

(a) Equilibrium Income:

$Y_d = Y – 0.10Y = 0.90Y$

$C = 70 + 0.7(0.9Y) = 70 + 0.63Y$

$Y = C + I + G = (70 + 0.63Y) + 90 + 100$

$Y = 260 + 0.63Y \Rightarrow 0.37Y = 260$

$Y = \frac{260}{0.37} \approx \mathbf{702.7}$

(b) Budget Balance:

Tax Revenue ($T$) = $0.10 \times 702.7 = \mathbf{70.27}$

Govt Spending ($G$) = 100

Budget = $T – G = 70.27 – 100 = -29.73$ (Deficit)

Result: No, the government does not have a balanced budget.

Step 1: Calculate Multiplier with Proportional Tax

$$K = \frac{1}{1 – c(1-t)} = \frac{1}{1 – 0.75(1-0.2)} = \frac{1}{1 – 0.75(0.8)}$$

$$K = \frac{1}{1 – 0.6} = \frac{1}{0.4} = \mathbf{2.5}$$

(a) Govt Purchases increase by 20:

$\Delta Y = 20 \times 2.5 = \mathbf{50}$

(b) Transfers decrease by 20:

Transfer Multiplier in proportional tax model = $\frac{c}{1 – c(1-t)} = \frac{0.75}{0.4} = \mathbf{1.875}$

$\Delta Y = (-20) \times 1.875 = \mathbf{-37.5}$

Reason:

• Government Expenditure ($G$): A change in $G$ affects Aggregate Demand directly and fully (e.g., Govt buys $100 goods $\rightarrow$ $100 direct demand).
• Taxes ($T$): A change in Taxes affects Aggregate Demand indirectly via Disposable Income. If Taxes decrease by $100, Disposable Income rises by $100. However, people will save a part of this (based on MPS) and only spend the rest (MPC). Thus, the initial change in spending is less than the change in tax.

Mathematically: Multiplier ($G$) > Multiplier ($T$) because $1 > c$ (MPC).

Flow vs. Stock Concept:

• Government Deficit is a flow variable. It represents the shortfall of revenue compared to expenditure in a single financial year. It tells us how much the government needs to borrow this year.
• Government Debt is a stock variable. It is the accumulation of all past deficits. It represents the total amount the government owes at a specific point in time.

Relationship: High annual deficits lead to a rapidly growing national debt.

Yes, public debt can impose a burden if not managed well:

1. Future Taxes: To repay debt and interest, the government may have to raise taxes in the future, reducing disposable income of future generations.
2. Crowding Out: High government borrowing reduces the funds available for the private sector and drives up interest rates, hurting private investment.
3. Unproductive Spending: If debt is used for consumption rather than creating productive assets (infrastructure), it becomes a deadweight burden without generating income to repay it.

Ideally: Fiscal deficits increase Aggregate Demand. If the economy is at full employment, this excess demand pushes up prices, causing inflation.

However: If the economy has unused resources (recession), deficit spending can increase output without causing inflation. Also, if the deficit is financed by borrowing from the public (not printing money), it may not be inflationary.

Governments can reduce deficits by two main methods:

1. Increasing Taxes: Raising direct or indirect taxes. However, this may reduce disposable income and slow down economic growth (and can be politically difficult).
2. Reducing Expenditure: Cutting spending on subsidies, administration, or welfare schemes. This effectively lowers the deficit but can hurt the poor and reduce essential public services.

Best Approach: A mix of better tax compliance (widening the base) and rationalizing subsidies (targeting only the needy) is preferred over drastic cuts or hikes.

GST (Goods and Services Tax): It is a comprehensive, multi-stage, destination-based indirect tax that replaced many indirect taxes in India (like Excise, VAT, Service Tax). It follows the motto “One Nation, One Tax”.

Comparison: It is better than the old system because it eliminates the Cascading Effect (tax on tax). It simplifies compliance through a unified online portal and ensures a seamless flow of credit.

Categories:

• CGST: Central GST (collected by Central Govt on intra-state sales).
• SGST: State GST (collected by State Govt on intra-state sales).
• IGST: Integrated GST (collected by Centre on inter-state sales).