Government Budget and the Economy

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Economics Class XII (Introductory Macroeconomics), Chapter 5.

Can a government spend more than it earns?

A household that spends more than it earns for years ends up in trouble. A government can do it year after year, and in a downturn it is often expected to. The budget is the document that shows how, and the three deficit numbers (revenue, fiscal, primary) are the scorecards. CUET loves this chapter because it mixes definitions with small sums: one wrongly sorted item and the whole answer collapses. Learn the sorting rules and the sums become mechanical.

What a budget is

The Constitution (Article 112) requires the government to place before Parliament, for every financial year (1 April to 31 March), a statement of its estimated receipts and expenditure. This Annual Financial Statement is the main budget document. A Finance Bill is presented along with it and gives the details of tax changes proposed for the year.

A budget affects years beyond the one it covers, so the accounts are split in two. The revenue account (revenue budget) records items that relate to the current year only. The capital account (capital budget) records items that change the government's assets and liabilities. Under the Fiscal Responsibility and Budget Management Act (FRBMA), three policy statements accompany the budget: the Medium-term Fiscal Policy Statement (three-year rolling targets), the Fiscal Policy Strategy Statement (priorities and any deviations) and the Macroeconomic Framework Statement (outlook for growth, fiscal balance and external balance).

Three jobs of the budget

Markets alone leave three problems unsolved, and the budget is the government's tool for each.

On the stabilisation function: wages and prices do not fall easily, so employment does not return to its old level on its own after demand drops. The government steps in to raise aggregate demand. When demand exceeds what the economy can produce at high employment, prices rise, and the government uses restrictive measures to cool demand.

Public goods and the free-rider problem

Why can't the market supply a street light or national defence? Because of two features that private goods do not have.

The logic is simple. If you cannot be stopped from using something, you will not volunteer to pay for it. The link between payment and consumption breaks, so no private firm earns anything by producing it. The government must step in.

Providing a public good and producing it are different things. Public provision means it is financed through the budget and used without direct payment. Public production means the government itself produces it. A public good can be provided by the government but produced by a private firm.

Pause and predict: a state pays a private contractor to build and maintain a free public road. Is this public provision, public production, or both?

Check your answer: public provision only. The budget finances it and nobody pays at the point of use. The road is built by a private firm, so it is not public production.

Beyond the textbook. For the exam: public goods are non-rival and non-excludable, so government provides them. In reality: the pure case is rare. A free road is non-excludable, but at rush hour each extra car slows the others down, so it becomes partly rival. Why it matters: real goods sit on a spectrum, and the two-feature test is a clean model, not a complete description of every road or park.

Receipts: where the money comes from

Every receipt is sorted by one question: does it create a liability or reduce an asset? If yes, it is a capital receipt. If no, it is a revenue receipt.

Why borrowing and asset sales are capital receipts. A fresh loan must be repaid with interest, so it creates a liability. Selling shares of a Public Sector Undertaking (PSU disinvestment) means the earnings from that asset disappear in future, so it reduces financial assets. Neither is income the government can count on every year.

Tax revenue is the main revenue receipt.

Non-tax revenue consists of interest receipts on loans given by the Centre, dividends and profits on government investments, fees for services, and cash grants-in-aid from foreign countries and international organisations.

Goods and Services Tax (GST). From 1 July 2017 a single indirect tax on the supply of goods and services replaced a large number of central and state taxes. Before GST, tax was charged on the full value of a product at each stage, including the tax already paid on inputs, so tax piled on tax (cascading). Under GST, tax paid at the previous stage is set off through Input Tax Credit, so effectively only the value added at each stage is taxed. It is a destination-based consumption tax. The standard slabs listed in the chapter are 0%, 3%, 5%, 12%, 18% and 28%, and the GST Council revises rates from time to time.

Worked example: cascading versus value added. A manufacturer sells goods worth ₹100 to a retailer, who adds ₹50 of value and sells onward. The tax rate is 10%. Compare a cascading system (tax on the full value at each stage, with no credit) with a value-added system (credit for tax already paid).

Common wrong step. Saying GST "removes" the tax on inputs. It does not remove it. The tax is still paid at every stage, but the credit means the total equals the rate times the total value added, here 10% of ₹150 = ₹15.

Expenditure: where the money goes

The same asset test sorts spending. Revenue expenditure does not create physical or financial assets. It covers the running of government departments, interest payments on debt and grants to state governments and others, even if some grants are meant for creating assets. Capital expenditure creates physical or financial assets or reduces financial liabilities: land, buildings, machinery, equipment, shares, and loans and advances by the Centre to states, Union Territories and PSUs.

Budget documents also divide expenditure into plan (the Five-Year Plans and central assistance for state and Union Territory plans) and non-plan (a wide range of general, economic and social services). The main non-plan items are interest payments, defence, subsidies, salaries and pensions. Interest payments are the single largest component of non-plan revenue expenditure. Defence is committed expenditure, with little room for sharp cuts. Subsidies are explicit on items such as exports, interest on loans, food and fertiliser.

Beyond the textbook. For the exam: revenue and capital expenditure are each split into plan and non-plan, as in the chart of budget components. In reality: the Union Budget stopped using the plan and non-plan split from 2017-18 and now presents expenditure as revenue and capital. Why it matters: if a question asks about the components chart, answer from the textbook version. The newer classification does not change how deficits are calculated.

The sorting rules are the most tested skill in this chapter. Use this table as a drill.

Balanced, surplus or deficit

If expenditure equals the revenue collected, the budget is balanced. If tax collection exceeds the required expenditure, it is in surplus. The common situation is that expenditure exceeds revenue, a deficit. A deficit has to be financed, and the most common way is borrowing. The key question is then which deficit measure to use. Each one hides or reveals something different.

The three deficits: what each one tells you

Imagine the budget as a family account. Revenue deficit asks: "Is our monthly income enough for our monthly running costs?" Fiscal deficit asks: "How much must we borrow in total this year?" Primary deficit asks: "If we ignored old loan instalments, how much would we still need to borrow?"

$$\text{Revenue deficit} = \text{Revenue expenditure} - \text{Revenue receipts}$$

$$\text{Gross fiscal deficit} = \text{Total expenditure} - (\text{Revenue receipts} + \text{Non-debt creating capital receipts})$$

$$\text{Gross primary deficit} = \text{Gross fiscal deficit} - \text{Net interest liabilities}$$

Why the fiscal deficit leaves out borrowing. Total expenditure minus every receipt would always be zero once borrowings are counted, because borrowing is exactly what fills the gap. To measure the gap itself, borrowing must be excluded. What stays in the subtraction are revenue receipts and the non-debt capital receipts (recovery of loans and PSU disinvestment). The gap is therefore the total borrowing requirement from all sources.

From the financing side:

$$\text{Gross fiscal deficit} = \text{Net borrowing at home} + \text{Borrowing from RBI} + \text{Borrowing from abroad}$$

Borrowing at home includes small savings schemes and, indirectly, borrowing from commercial banks through the Statutory Liquidity Ratio (SLR). Net interest liabilities are interest payments minus interest receipts on net domestic lending.

The fiscal deficit also breaks into two pieces:

$$\text{Fiscal deficit} = \text{Revenue deficit} + \text{Capital expenditure} - \text{Non-debt creating capital receipts}$$

So the revenue deficit is a part of the fiscal deficit. When a large share of the fiscal deficit comes from the revenue deficit, borrowing is paying for consumption (running costs) rather than investment.

Why a revenue deficit worries economists. It means the government is dissaving: it uses other sectors' savings to meet part of its consumption. It must borrow not only to invest but also to cover running costs, so debt and interest liabilities pile up. Eventually it has to cut spending, and because much revenue expenditure is committed (interest, salaries, defence), the cuts usually fall on capital expenditure or welfare. That means lower growth. The primary deficit removes interest on past debt, so it measures how much current spending exceeds current revenues, which is the imbalance caused by today's decisions.

The central government's figures (as a percentage of GDP, 2024-25 provisional) show how the pieces fit.

Worked example: deficits from percentage data. Using the table, confirm the fiscal and primary deficit and find what share of the fiscal deficit is the revenue deficit.

Common wrong step. Subtracting all capital receipts, giving $15.0 - (9.2 + 5.8) = 0$. Borrowing of 5.6 is the very thing the deficit measures, so it cannot be subtracted. That 5.6 equals the fiscal deficit, which is a useful check: total borrowings and the fiscal deficit match.

Worked example: a deficit sum in ₹ crore. A government has revenue receipts of ₹4,000 crore and revenue expenditure of ₹5,200 crore (of which interest is ₹900 crore). Capital expenditure is ₹1,300 crore. It recovers loans of ₹100 crore and raises ₹200 crore from disinvestment. Find the three deficits.

Since the fiscal deficit is ₹2,200 crore, borrowings of that amount must close the gap: perhaps ₹1,700 crore at home, ₹100 crore from the RBI and ₹400 crore from abroad.

Common wrong step. Treating the ₹200 crore from disinvestment as a revenue receipt. Revenue receipts would become ₹4,200 crore and the revenue deficit would shrink to ₹1,000 crore, which hides the problem. The fiscal deficit stays ₹2,200 crore either way, because disinvestment sits inside the subtracted bracket in both cases. Misclassifying changes the revenue deficit, not the fiscal deficit.

Pause and predict: expenditure and revenue receipts stay the same, but the government sells PSU shares worth ₹500 crore. What happens to the fiscal deficit and to the revenue deficit?

Check your answer: the fiscal deficit falls by ₹500 crore, because disinvestment is a non-debt creating capital receipt that is subtracted in the formula, so the government needs ₹500 crore less borrowing. The revenue deficit does not change at all, because the sale is a capital receipt and never enters the revenue account. It is still a one-time asset sale, not a lasting source of income.

Fiscal policy and the multiplier

Keynes argued that the government should use its spending and taxes to stabilise output and employment. In doing so it ends up running a surplus or a deficit rather than a balanced budget. The government influences equilibrium income through government purchases (G), which add to aggregate demand directly, and through taxes and transfers, which change disposable income $Y_D$.

With a lump-sum tax $T$ (a fixed amount, not linked to income) and fixed transfers $\overline{TR}$, consumption is $C = \overline{C} + c(Y - T + \overline{TR})$ and aggregate demand is $AD = C + I + G$. Equilibrium is where $Y = AD$, which gives

$$Y^{*} = \dfrac{1}{1-c}\left(\overline{C} - cT + c\,\overline{TR} + I + G\right)$$

A rise in $G$ shifts the AD schedule up by the full change. A tax cut raises disposable income, but only a fraction $c$ of it is spent, so AD shifts up by $c$ times the tax cut. This is why the multipliers differ.

The tax multiplier is always smaller than the spending multiplier by exactly 1 (in absolute value). Here is why with $c = 0.8$ and $\Delta G = 100$. Income rises in rounds, each round being 0.8 of the previous.

A tax change of the same size starts one round later, at $c\,\Delta T$, which is why its total is $100 \times 4 = 400$ rather than 500. Putting the two together, $\Delta Y = \Delta G(1 + c + c^2 + \dots) - \Delta T(c + c^2 + \dots)$. If $\Delta G = \Delta T$, only the first term of the first series survives, and income rises by exactly $\Delta G$.

Worked example: multipliers in numbers. An economy has $C = 60 + 0.75(Y - T)$, $I = 100$, $G = 140$ and lump-sum tax $T = 80$ (no transfers). Find equilibrium income, the effect of $\Delta G = 20$, of $\Delta TR = 20$, and of raising $G$ and $T$ by 20 together.

Common wrong step. Using $\dfrac{1}{1-c}$ for the tax or transfer change, giving 80 in step 5. Transfers (like taxes) reach spending only after households have kept part of the money as saving, so the multiplier is $\dfrac{c}{1-c}$, not $\dfrac{1}{1-c}$.

Proportional taxes and automatic stabilisers. More realistically, tax is a fixed fraction $t$ of income, $T = tY$. Disposable income is $Y(1-t)$, so households spend only $c(1-t)$ of each extra rupee of income. The AD schedule is flatter, and the multiplier shrinks.

$$\dfrac{\Delta Y}{\Delta A} = \dfrac{1}{1 - c(1-t)}$$

Worked example: why proportional tax is a shock absorber. With $C = 50 + 0.8Y_D$, $I = 70$, $G = 80$, no transfers and $T = 0.25Y$, find equilibrium income and tax revenue. Then investment falls by 20. Compare with a lump-sum system.

The same shock cuts income by 50 instead of 100. Nobody had to change a policy. Tax collection simply fell with income, so disposable income and spending dropped less. That is an automatic stabiliser. Welfare transfers work the same way: they rise in a slump and fall in a boom. Deliberately changing $G$ or $T$ to offset a shock, for example raising $G$ when investment falls, is discretionary fiscal policy. Built-in stabilisers dampen only part of the fluctuation. The rest needs deliberate policy.

Common wrong step. Saying the budget deficit shows the stance of policy. In step 5 the surplus shrank with no change in policy. A recession cuts tax revenue and widens the deficit, and a boom narrows it. A bigger deficit does not always mean a more expansionary policy.

Debt: deficits pile up

Deficits are a flow; debt is the stock they add to. Budget deficits must be financed by taxation, borrowing or printing money, and governments rely mostly on borrowing. Continued borrowing means ever-larger interest payments, and those interest payments themselves add to the debt.

Is debt a burden? The textbook gives these views side by side.

Beyond the textbook. For the exam: Ricardian equivalence says consumers save more when the government borrows, so deficits do not raise national demand. In reality: most studies find that households respond only partly. Some cannot borrow against future income, and others do not look decades ahead. Why it matters: the idea is a useful benchmark, not a law. It explains why the effect of a deficit depends on how people expect to be taxed later.

Are deficits inflationary? The textbook gives both sides. Higher spending or lower taxes raises aggregate demand, and if firms cannot produce more at current prices, prices rise. But if resources lie idle and output is held back by lack of demand, higher demand raises output instead, and a high deficit need not be inflationary.

Crowding out. When the government borrows by issuing bonds, they compete with corporate bonds for the same pool of savings. Private borrowers get "crowded out", so private investment can fall. But the pool of savings is not fixed. If deficits raise production, income and saving rise too, and both government and industry can borrow more.

Pause and predict: an economy saves ₹100 in total and the government borrows ₹40, leaving ₹60 for firms. Does this prove ₹40 of private investment was lost?

Check your answer: no. That holds only if total savings stay at ₹100. If the borrowed ₹40 is spent in a way that raises output and income, savings rise, and firms may still be able to raise ₹60 or more. Crowding out is a possibility, not a certainty.

Cutting the deficit and the FRBMA

A deficit can be reduced by raising taxes or cutting expenditure. India has tried to raise tax revenue with greater reliance on direct taxes, since indirect taxes are regressive. It has also raised receipts through the sale of shares in PSUs. The main thrust has been towards expenditure reduction, through better planning and administration of programmes, or by changing the scope of what government does. Cutting vital areas such as agriculture, education, health and poverty alleviation would adversely affect the economy.

The Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) binds governments to deficit targets so that electoral pressure does not push deficits up.

The Act applies to the central government, and 26 states have enacted their own fiscal responsibility laws. Some fear welfare spending may be squeezed to meet the targets.

Exam traps

Formula sheet

60-second revision

Where this chapter connects

• Previous: Determination of Income and Employment builds the multiplier and the AD framework that this chapter extends with $G$ and taxes.
• Related: National Income Accounting explains private income, personal income and disposable income, which the redistribution function changes.
• Related: Money and Banking covers the RBI and the SLR, which appear in how deficits are financed.
• Next: Open Economy Macroeconomics adds foreign borrowing, trade and exchange rates to the picture.