Government Budget and the Economy – AHSEC Class 12 Economics Chapter 5 Part – A

“ Introductory Macroeconomics”
Chapter 5: Government Budget and the Economy

Government Budget and the Economy

Concept of the Government Budget:
The Government Budget is a detailed annual financial statement that presents the estimated receipts (income) and estimated expenditures of the government for a particular financial year (in India, from April 1st to March 31st). It is not just an accounting document but a crucial instrument for implementing the government’s fiscal policy and outlining its economic vision.

Components of the Budget:
The government budget is broadly divided into two main parts:

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1. Revenue Budget: This deals with the revenue receipts and revenue expenditure of the government.
   1. Revenue Receipts: These are receipts that neither create a liability nor cause a reduction in the assets of the government. They consist of Tax Revenue (e.g., income tax, corporate tax, GST, customs duty) and Non-Tax Revenue (e.g., interest, profits, fees, fines).
   1. Revenue Expenditure: This is the expenditure that neither creates any asset nor causes a reduction in any liability for the government. It is incurred for the normal functioning of government departments and for providing various services. Examples include salaries, pensions, interest payments, and subsidies.
2. Capital Budget: This deals with the capital receipts and capital expenditure of the government.
   1. Capital Receipts: These are receipts that either create a liability (e.g., borrowings) or reduce financial assets (e.g., recovery of loans, disinvestment).
   1. Capital Expenditure: This is the expenditure that either creates a physical or financial asset (e.g., construction of roads, buildings, purchasing shares) or causes a reduction in liability (e.g., repayment of loans).

Measures of Government Deficit:
When government expenditure exceeds its revenue, it results in a budget deficit. The main types of deficits are:

1. Revenue Deficit: This occurs when revenue expenditure is greater than revenue receipts. It signifies that the government’s own earnings are insufficient to meet its day-to-day operational expenses.
2. Fiscal Deficit: This is the difference between the government’s total expenditure and its total receipts, excluding borrowings. It indicates the total borrowing requirements of the government from all sources.
3. Primary Deficit: This is the fiscal deficit minus interest payments. It indicates the borrowing requirements of the government for meeting expenditures other than interest payments.

Fiscal Policy:
Fiscal policy refers to the use of government revenue collection (taxes) and expenditure to influence a country’s economy. Its primary objectives are to achieve economic stability, reduce income inequality, and promote economic growth. The government can increase aggregate demand by increasing its spending or cutting taxes, and it can reduce aggregate demand by cutting its spending or increasing taxes.

Complete Textual Question Answers (Exercise)

1. Explain why public goods must be provided by the government.
Answer: Public goods have two key characteristics: they are (i) non-rivalrous in consumption, meaning one person’s consumption does not reduce its availability for others, and (ii) non-excludable, meaning it is impossible to prevent anyone from consuming the good. Because of the non-excludable nature, private firms cannot charge a price for them, leading to the free-rider problem where people consume the good without paying. As a result, the private sector has no incentive to supply them. Therefore, essential public goods like national defense, roads, and public administration must be provided by the government.

2. Distinguish between revenue expenditure and capital expenditure.
Answer:

3. ‘The fiscal deficit gives the borrowing requirement of the government’. Elucidate.
Answer: This statement is correct. The fiscal deficit is defined as the excess of the government’s total expenditure over its total receipts, excluding borrowings. This gap represents the amount of money the government needs to borrow to meet its expenses. The government can borrow from various sources, including the central bank (RBI), commercial banks, the public, and foreign entities. Therefore, the magnitude of the fiscal deficit is a direct indicator of the total borrowing requirement of the government for that financial year.

4. Give the relationship between the revenue deficit and the fiscal deficit.
Answer:

• Definition: Revenue Deficit = Revenue Expenditure – Revenue Receipts. Fiscal Deficit = Total Expenditure – Total Receipts (excluding borrowings).
• Relationship: The fiscal deficit is a broader concept than the revenue deficit. The fiscal deficit includes the revenue deficit as well as the part of capital expenditure that is not financed by non-debt creating capital receipts.
• Implication: A high revenue deficit component within the fiscal deficit is a cause for concern, as it implies that the government is borrowing to finance its consumption expenditure rather than for creating productive assets.

5. Suppose that for a particular economy, investment is 200, government purchases are 150, net taxes are 100 and consumption is C = 100 + 0.75Y. (a) What is the level of equilibrium income? (b) Calculate the value of the government expenditure multiplier and the tax multiplier. (c) If government expenditure increases by 200, find the change in equilibrium income.
Answer:
(a) Level of equilibrium income:
Given: I = 200, G = 150, T = 100, C = 100 + 0.75Y_D
Equilibrium condition: Y = C + I + G
Y = [100 + 0.75(Y – T)] + I + G
Y = [100 + 0.75(Y – 100)] + 200 + 150
Y = 100 + 0.75Y – 75 + 350
Y = 375 + 0.75Y
Y – 0.75Y = 375
0.25Y = 375
Y = 375 / 0.25 = 1500
The equilibrium level of income is Rs 1500.

(b) Value of multipliers:

• Government Expenditure Multiplier = 1 / (1 – MPC) = 1 / (1 – 0.75) = 1 / 0.25 = 4
• Tax Multiplier = -MPC / (1 – MPC) = -0.75 / (1 – 0.75) = -0.75 / 0.25 = -3

(c) Change in equilibrium income if G increases by 200:
Change in Government Expenditure (ΔG) = 200
Change in Income (ΔY) = Government Expenditure Multiplier × ΔG
ΔY = 4 × 200 = 800
The equilibrium income will increase by Rs 800.

6. Consider an economy described by the following functions: C = 20 + 0.80Y, I = 30, G = 50, TR = 100. (a) Find the equilibrium level of income and the autonomous expenditure multiplier. (b) If government expenditure increases by 30, what is the impact on equilibrium income? (c) If a lump sum tax of 30 is added to finance the increase in government purchases, how will equilibrium income change?
Answer:
(a) Equilibrium income and multiplier:
Autonomous Expenditure (A̅) = C̅ + I + G + cTR = 20 + 30 + 50 + (0.80 × 100) = 100 + 80 = 180
Autonomous Expenditure Multiplier (k) = 1 / (1 – c) = 1 / (1 – 0.80) = 1 / 0.20 = 5
Equilibrium Income (Y) = Multiplier × Autonomous Expenditure = 5 × 180 = 900

(b) Impact on equilibrium income if G increases by 30:
ΔG = 30
Change in Income (ΔY) = Multiplier × ΔG = 5 × 30 = 150
Equilibrium income will increase by 150.

(c) Change in equilibrium income if a lump sum tax of 30 is added:
This is a case of the Balanced Budget Multiplier, where ΔG = ΔT = 30. The value of the balanced budget multiplier is always 1.
Change in Income (ΔY) = Balanced Budget Multiplier × ΔG = 1 × 30 = 30
Equilibrium income will increase by 30.

7. In the above question, what is the effect on output if government transfers and lump-sum taxes go up by 10 per cent?
Answer: Assuming it refers to the initial values in Q6 (TR=100, and a new T=30).

• Increase in TR = 10% of 100 = 10. New TR = 110.
• Increase in T = 10% of 30 = 3. New T = 33.
  The change in income would be: ΔY = (Transfer Multiplier × ΔTR) + (Tax Multiplier × ΔT)
  Transfer Multiplier = c / (1-c) = 0.8 / 0.2 = 4
  Tax Multiplier = -c / (1-c) = -0.8 / 0.2 = -4
  ΔY = (4 × 10) + (-4 × 3) = 40 – 12 = 28.
  Output will increase by 28.

8. We suppose that C = 70 + 0.70YD, I = 90, G = 100, T = 0.10Y. (a) Find the equilibrium income. (b) What are the tax revenues at equilibrium income? Does the government have a balanced budget?
Answer:
(a) Equilibrium income:
Y = C + I + G
Y = 70 + 0.70(Y – T) + 90 + 100
Y = 260 + 0.70(Y – 0.10Y)
Y = 260 + 0.70(0.90Y)
Y = 260 + 0.63Y
Y – 0.63Y = 260
0.37Y = 260
Y = 260 / 0.37 ≈ 702.7

(b) Tax revenues and budget balance:
Tax Revenue (T) = 0.10Y = 0.10 × 702.7 = 70.27
Government Expenditure (G) = 100
Since G > T (100 > 70.27), the government does not have a balanced budget. It has a budget deficit.

9. Suppose the marginal propensity to consume is 0.75 and there is a 20 per cent proportional income tax. Find the change in equilibrium income for the following: (a) government purchases increase by 20 (b) transfers decrease by 20.
Answer:
Given: c = 0.75, t = 0.20
First, calculate the multiplier (k) for this economy:
k = 1 / [1 – c(1-t)] = 1 / [1 – 0.75(1-0.20)] = 1 / [1 – 0.75(0.8)] = 1 / (1 – 0.6) = 1 / 0.4 = 2.5

(a) Government purchases increase by 20:
ΔG = 20
Change in Income (ΔY) = k × ΔG = 2.5 × 20 = 50.
Equilibrium income will increase by 50.

(b) Transfers decrease by 20:
ΔTR = -20
The transfer payment multiplier is c / [1 – c(1-t)] = 0.75 / 0.4 = 1.875
Change in Income (ΔY) = Transfer Multiplier × ΔTR = 1.875 × (-20) = -37.5.
Equilibrium income will decrease by 37.5.

10. Explain why the tax multiplier is smaller in absolute value than the government expenditure multiplier.
Answer: The government expenditure multiplier is larger because government spending (G) is a direct component of aggregate demand (AD). A change in G causes a one-for-one initial change in AD. In contrast, a change in taxes (T) affects AD indirectly. A tax cut, for instance, first increases disposable income (YD). Households then spend only a fraction of this additional income (the MPC fraction). Because the initial impact on spending is smaller for a tax change than for a government spending change, the overall multiplier effect is also smaller in absolute value.

11. Explain the relation between government deficit and government debt.
Answer: Government deficit is a flow concept, representing the shortfall of revenue compared to expenditure in a single year. Government debt is a stock concept, representing the total accumulated borrowings of the government over many years. The relationship is that the annual government deficit adds to the total stock of government debt. Debt is the accumulation of past deficits.

12. Does public debt impose a burden? Explain.
Answer: Yes, public debt imposes a burden.

• Future Burden: The government must pay interest on its debt and eventually repay the principal. This requires raising future taxes or cutting future spending, which imposes a burden on future generations.
• Crowding Out: When the government borrows heavily from the market, it competes with private borrowers for funds. This can drive up interest rates and “crowd out” private investment, leading to slower long-term economic growth.
• Foreign Debt: If the debt is owed to foreigners, the repayment of interest and principal involves a transfer of resources out of the country.

13. Are fiscal deficits inflationary?
Answer: Yes, fiscal deficits can be inflationary. When the government finances its deficit by borrowing from the central bank (a process called deficit financing or monetisation of the deficit), it leads to an increase in the money supply. If the economy’s output cannot increase at the same rate, this excess money supply will chase the same amount of goods, leading to a rise in the general price level, which is inflation.

14. Discuss the issue of deficit reduction.
Answer: Deficit reduction can be achieved through two main approaches:

1. Expenditure Reduction: The government can cut its spending. However, cutting productive expenditure (like on infrastructure) or social welfare expenditure (like on health and education) can harm economic growth and social well-being.
2. Revenue Increase: The government can increase its revenue by increasing tax rates or expanding the tax base (bringing more people and activities under the tax net). It can also improve its non-tax revenue, for instance, through the disinvestment of inefficient public sector enterprises. A balanced approach that focuses on cutting wasteful expenditure and increasing revenue efficiently is generally considered the best strategy.

15. What is Goods and Services Tax (GST)? How is it more effective than the old tax system? Discuss its types.
Answer: GST is a comprehensive, destination-based indirect tax levied on the supply of goods and services. It is a value-added tax, meaning tax is levied on the value added at each stage of production.
Effectiveness: It is more effective than the old system because it has eliminated the cascading effect (tax on tax) of the previous regime. Under GST, producers get a credit for the taxes they have paid on their inputs (Input Tax Credit), which prevents the tax from becoming part of the cost at each stage. This reduces the final price for consumers.
Types: In India, GST has a dual structure:

• CGST (Central GST): Levied and collected by the Central Government.
• SGST (State GST): Levied and collected by the State Governments.
• IGST (Integrated GST): Levied on inter-state supplies of goods and services. It is collected by the Centre and then apportioned to the destination state.

Previous Years’ AHSEC Question Answers (2015-2025)

Long Questions:

1. Question: What is fiscal policy? Write its two objectives. (AHSEC 2025)
Answer: Fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to influence a country’s economy.
Two Objectives:

1. Economic Growth: To promote economic growth by making public investments in infrastructure and creating an environment conducive to private investment.
2. Equitable Distribution of Income: To reduce income inequality through progressive taxation (taxing the rich more) and spending on social welfare schemes for the poor.

2. Question: How can financial deficits be reduced? Explain briefly. (AHSEC 2025)
Answer: Financial (Fiscal) deficits can be reduced through:

• Increasing Revenue: The government can increase its revenue by widening the tax base, increasing tax rates on certain items, and improving tax compliance to reduce tax evasion.
• Reducing Expenditure: The government can cut down on non-productive expenditures like subsidies, administrative costs, and other non-essential spending.
• Disinvestment: Selling the shares of Public Sector Undertakings (PSUs) to the private sector can generate revenue and reduce the deficit.

3. Question: Show the relationship between Revenue Deficit and Fiscal Deficit. (AHSEC 2024)
Answer: There is a direct relationship between Revenue Deficit and Fiscal Deficit. The fiscal deficit is always greater than or equal to the revenue deficit.

• Revenue Deficit = Revenue Expenditure – Revenue Receipts. It shows that the government’s current income is insufficient to meet its current expenditure.
• Fiscal Deficit = Total Expenditure – Total Receipts (excluding borrowings). It indicates the total borrowing needs of the government.
  The relationship can be expressed as: Fiscal Deficit = Revenue Deficit + (Capital Expenditure – Non-debt creating Capital Receipts). A high revenue deficit component in the fiscal deficit is considered unhealthy as it implies borrowing for consumption purposes.

4. Question: Write any two objectives of the government budget. (AHSEC 2023)
Answer: Two objectives of the government budget are:

1. Reallocation of Resources: To allocate resources in line with social and economic priorities through taxes and subsidies.
2. Economic Stability: To maintain stability by controlling inflation and fighting recession through appropriate fiscal measures.

5. Question: What is Primary Deficit? (AHSEC 2022)
Answer: The primary deficit is the fiscal deficit of the current year minus the interest payments on previous borrowings. It shows the borrowing requirement of the government, exclusive of interest payments. It indicates how much of the government’s borrowings are going to finance expenses other than interest payments.
Formula: Primary Deficit = Fiscal Deficit – Interest Payments.

6. Question: Differentiate between Revenue Receipts and Capital Receipts. (AHSEC 2020)
Answer:

• Revenue Receipts: These receipts do not create any liability or cause a reduction in the assets of the government. They are regular and recurring in nature. Examples: Tax revenue, fines.
• Capital Receipts: These receipts either create a liability for the government or cause a reduction in its assets. They are non-recurring. Examples: Borrowings, proceeds from disinvestment.

7. What are the objectives of a government budget? (AHSEC 2015, 2017, 2019)
Answer: The main objectives of a government budget are:

• Reallocation of Resources: To reallocate resources in line with social and economic priorities through taxes, subsidies, and direct public expenditure.
• Reducing Inequalities in Income and Wealth: To reduce the gap between the rich and the poor by imposing higher taxes on the rich and spending more on welfare schemes for the poor.
• Economic Stability: To control fluctuations in the economy, such as inflation and recession, through its fiscal policy tools.
• Management of Public Enterprises: To provide financial support and manage public sector undertakings.
• Economic Growth: To promote the rate of economic growth by undertaking public investment in infrastructure and creating a conducive environment for private investment.

8. Distinguish between Revenue Receipts and Capital Receipts. (AHSEC 2016, 2018, 2022)
Answer:

Short Questions:

1. What is a revenue deficit? (AHSEC 2015, 2019)
Answer: When a government’s total revenue expenditure exceeds its total revenue receipts, the shortfall is called a revenue deficit.

2. Give an example of a direct tax. (AHSEC 2016, 2020)
Answer: Income Tax.

3. Write the formula for fiscal deficit. (AHSEC 2017)
Answer: Fiscal Deficit = Total Expenditure – (Revenue Receipts + Non-debt Creating Capital Receipts).

4. What is an indirect tax? (AHSEC 2018, 2023)
Answer: A tax whose burden can be shifted to another person. For example, Goods and Services Tax (GST).

5. What is a government budget? (AHSEC 2022)
Answer: It is an annual statement of the estimated receipts and expenditures of the government for a financial year.

6. What is a primary deficit?
Answer: It is the fiscal deficit minus interest payments.

7. What is a balanced budget?
Answer: A budget in which the government’s estimated total receipts are equal to its estimated total expenditure.

8. Give an example of revenue expenditure.
Answer: Payment of salaries to government employees.

9. Give an example of capital receipt.
Answer: Borrowings by the government from the market.

10. What is the full form of GST?
Answer: Goods and Services Tax.

Additional Most Important Question Answers

A. Very Short Answer Questions (1 Mark)

1. Question: What is a government budget?
   Answer: A government budget is an annual statement of the estimated receipts and expenditures of the government for a financial year.
2. Question: Write the formula for Revenue Deficit.
   Answer: Revenue Deficit = Revenue Expenditure – Revenue Receipts.
3. Question: Give an example of a direct tax.
   Answer: Income Tax.
4. Question: Give an example of an indirect tax.
   Answer: Goods and Services Tax (GST).
5. Question: Give an example of capital expenditure.
   Answer: Construction of a bridge.
6. Question: What does fiscal deficit indicate?
   Answer: It indicates the total borrowing requirement of the government.
7. Question: What is the value of the balanced budget multiplier?
   Answer: One (1).
8. Question: Mention one source of revenue receipts.
   Answer: Tax revenue.
9. Question: Give an example of non-tax revenue.
   Answer: Fines.
10. Question: In which year was the FRBM Act enacted?
    Answer: In 2003.
11. Question: What is the duration of the financial year in India?
    Answer: From April 1st to March 31st.
12. Question: Which deficit indicates the total borrowing requirement of the government?
    Answer: Fiscal Deficit.
13. Question: Who formulates the fiscal policy?
    Answer: The government of the country (specifically, the Ministry of Finance).
14. Question: Why does the government provide subsidies?
    Answer: For the welfare of the public and to encourage certain sectors of the economy.
15. Question: What type of tax is Corporate Tax?
    Answer: It is a direct tax.
16. Question: If the government expenditure multiplier is 5, what does it mean?
    Answer: It means that a Rs 1 increase in government expenditure will lead to a Rs 5 increase in the equilibrium income.
17. Question: What is meant by Deficit Financing?
    Answer: Financing the budget deficit by borrowing from the central bank or by printing new currency.
18. Question: When was GST implemented in India?
    Answer: July 1, 2017.
19. Question: What is Disinvestment?
    Answer: The act of the government selling its share in Public Sector Enterprises (PSEs).
20. Question: What is a key implication of a revenue deficit?
    Answer: It shows that the government is unable to meet its current expenditure from its current income and is dissaving (borrowing to finance consumption).

B. Short Answer Questions (2/3 Marks)

1. Question: Differentiate between revenue expenditure and capital expenditure.
   Answer:
   1. Revenue Expenditure: This expenditure does not create any asset or reduce any liability for the government. It is recurring in nature and is meant for the normal functioning of the government. Example: Salaries, pensions.
   1. Capital Expenditure: This expenditure either creates an asset or reduces a liability for the government. It is non-recurring and adds to the economy’s productive capacity. Example: Construction of roads, repayment of loans.
2. Question: What is the relationship between fiscal deficit and primary deficit?
   Answer: Fiscal deficit represents the total borrowing requirement of the government. Primary deficit is the fiscal deficit minus the interest payments on previous loans.
   Relationship: Primary Deficit = Fiscal Deficit – Interest Payments.
   A zero primary deficit implies that the government is borrowing only to make interest payments on its past debts.
3. Question: Write two main objectives of the government budget.
   Answer: Two main objectives of the government budget are:
   1. Reallocation of Resources: The government uses taxes and subsidies to allocate resources towards socially productive sectors and discourage the production of harmful goods.
   1. Reducing Income Inequalities: The government aims to reduce the gap between the rich and the poor by imposing higher taxes on the wealthy and spending on welfare schemes for the poor.
4. Question: What are the two characteristics of public goods?
   Answer: The two main characteristics of public goods are:
   1. Non-rivalrous: The consumption of the good by one individual does not reduce its availability for others. Example: A public park.
   1. Non-excludable: It is not possible to exclude anyone from enjoying the benefits of the good. Example: National defence.

C. Long Answer Questions (5/6 Marks)

1. Question: Show the components of the government budget with the help of a chart.
   Answer: The components of the government budget can be shown as follows:

• Question: What is fiscal policy? How does it work to achieve economic stability?Answer: Fiscal policy refers to the government’s policy regarding its expenditure, taxation, and borrowing to achieve specific economic objectives like growth and stability. Achieving Economic Stability:
  • During Inflation: When there is excess aggregate demand in the economy, the government can control it by decreasing government spending and increasing taxes. This reduces the disposable income of the people, curbing demand and controlling prices.
  • During Recession: When there is deficient aggregate demand, the government can boost it by increasing government spending (e.g., on infrastructure) and decreasing taxes. This leaves more money in the hands of the public, which encourages consumption and investment, thereby reviving the economy.
    In this way, fiscal policy acts as a tool to counteract the business cycles of boom and bust, thus maintaining economic stability.