In a mixed economy, apart from the private sector, there is the government which plays a very important role. There are three distinct functions that operate through the revenue and expenditure measures of the government budget.

Allocation Function

Certain goods, referred to as public goods (such as national defence, roads, government administration), as distinct from private goods (like clothes, cars, food items), cannot be provided through the market mechanism (transactions between individual consumers and producers) and must be provided by the government.

Distribution Function

Through its tax and expenditure policy, the government attempts to bring about a distribution of income that is considered fair by society. The government affects the personal disposable income of households by making transfer payments and collecting taxes and, therefore, can alter the income distribution.

Stabilization Function

The economy tends to be subject to substantial fluctuations and may suffer from prolonged periods of unemployment or inflation. The overall level of employment and prices in the economy depends upon the level of aggregate demand which is a function of the spending decisions of millions of private economic agents apart from the government. Policy measures are needed to raise aggregate demand. or create restrictive conditions to reduce demand.

Components of Government Budget

There is a constitutional requirement in India to present before the Parliament a statement of estimated receipts and expenditures of the government in respect of every financial year. This Annual Financial Statement constitutes the main budget document. The budget is divided into the revenue budget and capital budget to distinguish between current financial needs and investment in the country’s capital stock.

Revenue Account

The Revenue Budget shows the current receipts of the government and the expenditure that can be met from these receipts. 

Revenue Receipts

Revenue receipts are receipts of the government which are non-redeemable (cannot be reclaimed from the government). They are divided into tax and non-tax revenues.

Tax revenues consist of the proceeds of taxes and other duties levied by the central government. Tax revenues comprise of direct taxes which fall directly on individuals (personal income tax) and firms (corporation tax), and indirect taxes like excise taxes (duties levied on goods produced within the country), customs duties (taxes imposed on goods imported into and exported out of India) and service tax.

Non-tax revenue of the central government mainly consists of interest receipts on account of loans by the central government, dividends and profits on investments made by the government, fees and other receipts for services rendered by the government. Cash grants-in-aid from foreign countries and international organisations are also included.

Revenue Expenditure

Revenue Expenditure is expenditure incurred for purposes other than the creation of physical or financial assets of the central government. It relates to those expenses incurred for the normal functioning of the government departments and various services, interest payments on debt incurred by the government, and grants given to state governments and other parties.

Budget documents classify total expenditure into plan and non-plan expenditure. Plan revenue expenditure relates to central Plans (Five-Year Plans) and central assistance for State and Union Territory plans. Non-plan expenditure covers a vast range of general, economic and social services of the government. The main items of non-plan expenditure are interest payments, defence services, subsidies, salaries and pensions. Interest payments on market loans, external loans and from various reserve funds constitute the single largest component of non-plan revenue expenditure.

Capital Account

The Capital Budget is an account of the assets as well as liabilities of the central government, which takes into consideration changes in capital. It consists of capital receipts and capital expenditure of the government.

Capital Receipts

All those receipts of the government which create liability or reduce financial assets are termed as capital receipts. The main items of capital receipts are loans raised by the government from the public (market borrowings), borrowing by the government from the Reserve Bank and commercial banks and other financial institutions through the sale of treasury bills, loans received from foreign governments and international organisations, and recoveries of loans granted by the central government.

Other items include small savings (Post-Office Savings Accounts, National Savings Certificates, etc), provident funds and net receipts obtained from the sale of shares in Public Sector Undertakings (disinvestment).

Capital Expenditure

These expenditures of the government result in creation of physical or financial assets or reduction in financial liabilities. This includes expenditure on the acquisition of land, building, machinery, equipment, investment in shares, and loans and advances by the central government to state and union territory governments, PSUs and other parties.

Capital expenditure is also categorised as plan and non-plan in the budget documents. Plan capital expenditure relates to central plan and central assistance for state and union territory plans. Non-plan capital expenditure covers various general, social and economic services provided by the government. 

Budget Deficit

When the government spends more than it collects by way of revenue, it incurs a budget deficit.

Revenue Deficit

The revenue deficit refers to the excess of government’s revenue expenditure over revenue receipts. The revenue deficit includes only such transactions that affect the current income and expenditure of the government.

Revenue deficit = Revenue expenditure – Revenue receipts

Fiscal Deficit

Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing.

Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts)

Non-debt creating capital receipts are those receipts which are not borrowings and, therefore, do not give rise to debt.

Fiscal Policy

The government fiscal policy should be used to stabilize the level of output and employment. Through changes in its expenditure and taxes, the government attempts to increase output and income and seeks to stabilize the ups and downs in the economy. In the process, fiscal policy creates a surplus (when total receipts exceed expenditure) or a deficit budget (when total expenditure exceed receipts) rather than a balanced budget (when expenditure equals receipts).

Taxes

Taxes lower disposable income and consumption. For example, if one earns Rs. 1 lakh and has to pay Rs. 10,000 in taxes, the person has the same disposable income as someone who earns Rs. 90,000 but pays no taxes. A cut in taxes increases disposable income at each level of income.

Government Expenditures

When the government purchases are increased, keeping taxes constant, the government runs a deficit.

Debt

Budgetary deficits must be financed by either taxation, borrowing or printing money. If the government continues to borrow year after year, it leads to the accumulation of debt and the government has to pay more and more by way of interest. These interest payments themselves contribute to the debt.

Deficit Reduction

Government deficit can be reduced by an increase in taxes or reduction in expenditure.