NCERT Solutions for Class 12 Economics Macroeconomics Chapter 5: Government Budget and the Economy

Chapter at a glance

Concept	Key point
Budget	Annual financial statement of estimated receipts and expenditure of the government (Article 112)
Revenue vs capital	Revenue receipts/expenditure do not create liabilities/assets; capital receipts create liabilities or reduce assets; capital expenditure creates assets or reduces liabilities
Deficits	Revenue deficit = revenue expenditure – revenue receipts; Fiscal deficit = total expenditure – (revenue receipts + non-debt capital receipts); Primary deficit = fiscal deficit – interest payments
Public goods	Non-rivalrous and non-excludable; free-rider problem – must be provided by government
Fiscal policy multipliers	Government expenditure multiplier ; tax multiplier ; transfer multiplier ; balanced budget multiplier = 1
Proportional tax	; multiplier – automatic stabiliser
Debt	Deficits add to debt; Ricardian equivalence; burden on future generations, crowding out
GST	Destination-based, multi-stage tax on value addition with input tax credit; CGST, SGST/UTGST, IGST

Exercises

Answer

Public goods (national defence, roads, street lighting, public parks, law and order) have two features:

1. Non-rivalrous – one person’s consumption does not reduce the amount available to others.
2. Non-excludable – it is not possible (or very costly) to exclude anyone from using them, even if he does not pay.

Because of these features, people can enjoy the benefits without paying – the free-rider problem. Private firms cannot collect payment and therefore will not produce them (or will produce too little). Hence the market fails, and the government must provide public goods, financing them through taxes. (The government need not produce them itself; it may arrange their provision.)

Public goods are non-rivalrous and non-excludable, so people can benefit without paying (free-rider problem); private firms cannot collect payment, so the government must provide them through taxes.

Answer

Revenue expenditure (salaries, interest, subsidies) creates no assets and reduces no liabilities; capital expenditure (buildings, machinery, loans given, debt repayment) creates assets or reduces liabilities.

Answer

Fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts).

Non-debt capital receipts are those that do not create liabilities (recovery of loans, disinvestment proceeds). If the government’s total expenditure exceeds its revenue receipts plus these non-debt receipts, the gap must be met by borrowing (net borrowing at home from RBI/public/banks and from abroad). Hence:

Thus the fiscal deficit shows the total borrowing requirement of the government from all sources. A large fiscal deficit means a rising debt and interest burden in the future.

Fiscal deficit is the excess of total expenditure over revenue receipts and non-debt capital receipts; this gap can be met only by borrowing, so it equals the government’s total borrowing requirement.

Answer

So the fiscal deficit includes the revenue deficit. The revenue deficit is a part of the fiscal deficit. A large share of revenue deficit in the fiscal deficit means that borrowing is used to finance consumption expenditure rather than investment, which is undesirable (it creates debt without creating assets to repay it).

Fiscal deficit = revenue deficit + capital expenditure – non-debt capital receipts; the revenue deficit is part of the fiscal deficit, and a high share of it means borrowing is financing consumption rather than investment.

Answer

Consumption depends on disposable income: with net taxes .

(a) .

(b) Government expenditure multiplier . Tax multiplier .

(c) ; new equilibrium income = 2,300.

1. Y* = 1,500; (b) government expenditure multiplier = 4, tax multiplier = –3; (c) income rises by 800 (to 2,300).

Answer

Consumption is on disposable income (no taxes initially): .

(a) . Autonomous expenditure multiplier .

(b) → income rises to 1,050.

(c) Tax multiplier ; . Net change from (G + 30, T + 30) → equilibrium income = 930 (balanced budget multiplier = 1).

1. Y* = 900, multiplier = 5; (b) income rises by 150 to 1,050; (c) the tax lowers income by 120, so the net rise is 30 (income = 930) – balanced budget multiplier of 1.

Answer

Transfer multiplier ; tax multiplier .

• 10 % increase in transfers: → .

  

  

• 10 % increase in lump-sum taxes: taxes are 30 (from part (c)), so → .

  

  

Comparison: a rise in transfers increases output and a rise in taxes decreases it. Per rupee, their effects are equal in size and opposite in sign (multiplier ±4); here the transfer change is larger in absolute amount (₹ 10 vs ₹ 3), so its effect (+40) is bigger than that of the tax (–12).

A 10 % rise in transfers (₹ 10) raises output by 40; a 10 % rise in lump-sum taxes (₹ 3) lowers it by 12; per rupee the effects are equal and opposite (±4).

Answer

.

(a) .

(b) Tax revenue . Government expenditure = 100 > 70.27, so the government has a budget deficit of 29.73; the budget is not balanced.

1. Y* ≈ 702.7; (b) tax revenue ≈ 70.27, which is less than G = 100, so there is a deficit of ≈ 29.73 – the budget is not balanced.

Answer

With proportional tax, multiplier .

(a) .

(b) Transfer multiplier ; .

1. Income rises by 50; (b) income falls by 37.5.

Answer

• A rise in government expenditure directly increases aggregate demand by the full amount () in the first round, and then by , … Multiplier .

  

  

  

  

• A change in taxes affects aggregate demand only indirectly, through disposable income and consumption. A tax cut of raises disposable income by , but people spend only of it (they save the rest). So the first-round increase in demand is only . Multiplier .

  

  

  

  

  

Since , . E.g. with : G multiplier = 5, tax multiplier = –4.

Government spending raises demand by its full amount in the first round, but a tax change alters demand only through consumption, by c times the change (part is saved); so |tax multiplier| = c/(1 – c) < 1/(1 – c).

Answer

• Deficit is a flow – the excess of government expenditure over receipts in a year.
• Debt is a stock – the total accumulated borrowings of the government at a point of time.

When the government runs a deficit, it borrows to finance it, which adds to the stock of debt. Each year’s deficit increases debt; a surplus would reduce it:

Higher debt leads to higher interest payments (revenue expenditure), which in turn raise future deficits – a possible debt trap.

Deficit is a flow (excess of expenditure over receipts in a year) and debt a stock; each year’s deficit is financed by borrowing, adding to the accumulated debt, which raises future interest payments and deficits.

Answer

Arguments that it imposes a burden

1. Burden on future generations – debt must be repaid with interest through future taxes, reducing future disposable income.
2. Crowding out – government borrowing absorbs savings that could have gone to private investment, raising interest rates and lowering future capital stock and growth.
3. Interest burden – a large share of revenue goes to interest payments, leaving less for development.
4. Inflation – if financed by borrowing from RBI (money creation).
5. External debt – repayment requires transfer of resources abroad.

Arguments that it may not

1. Internal debt – “we owe it to ourselves”; it is a transfer from taxpayers to bondholders within the country.
2. Ricardian equivalence – people anticipate future taxes and save more, so the effect on demand is neutral.
3. If borrowing finances productive investment (infrastructure), it raises future income and pays for itself.

Conclusion: public debt is a burden when used for consumption, when it crowds out private investment or is external; it is less of a burden if used productively.

It can be a burden – future taxes, crowding out of private investment, rising interest payments, inflation and external repayment – though internal debt is partly a transfer, Ricardian equivalence may neutralise it, and productive use can make it self-financing.

Answer

Not necessarily.

• A fiscal deficit raises aggregate demand (through higher spending or lower taxes). If the economy is at full employment (output cannot rise), the extra demand leads to higher prices – inflation. Also, if the deficit is financed by borrowing from the RBI (monetisation), money supply increases, which may be inflationary.
• But if there are unemployed resources and output is below capacity, higher demand raises output and employment rather than prices.
• If the deficit finances investment that raises productive capacity, it may even reduce inflation in the long run.

So whether fiscal deficits are inflationary depends on the level of resource utilisation, the method of financing and the use of the funds.

Not necessarily – deficits are inflationary when the economy is near full employment or they are monetised, but with unused capacity they mainly raise output, and if used for investment they expand supply.

Answer

Deficit reduction is needed to control debt, interest burden, crowding out and inflation. Methods:

1. Increasing revenue – broadening the tax base, better tax compliance (GST, digitisation), reducing tax evasion; raising non-tax revenue.
2. Reducing expenditure – cutting wasteful and non-productive spending; better targeting of subsidies (DBT); efficient government administration.
3. Disinvestment – sale of government shares in PSUs (a non-debt capital receipt).
4. Fiscal rules – the FRBM Act, 2003 set targets to reduce fiscal and revenue deficits.

Issues/cautions

• Cutting capital expenditure (infrastructure, health, education) to reduce deficits harms long-term growth.
• Disinvestment is a one-time receipt; selling profitable PSUs may lose future income.
• Reducing deficits during a recession may deepen the slowdown (lower aggregate demand).

So deficit reduction should focus on raising revenue efficiently and cutting unproductive expenditure, while protecting productive investment.

Deficits can be reduced by raising tax and non-tax revenue, cutting unproductive expenditure and subsidies, disinvestment and fiscal rules (FRBM); but cutting productive capital spending or tightening in a recession can harm growth, so reduction should be well-designed.

Answer

GST (Goods and Services Tax) is a comprehensive, destination-based, multi-stage indirect tax levied on the supply of goods and services, introduced on 1 July 2017 (101st Constitutional Amendment). It is a tax on value addition at each stage, with input tax credit for tax paid at earlier stages. It replaced many central and state taxes (excise duty, service tax, VAT, entry tax, octroi, luxury tax, etc.).

Better than the old system

1. Removes cascading (tax on tax) through input tax credit.
2. One nation, one tax – uniform laws, procedures and rates across the country; a common national market.
3. Simpler compliance – online registration, returns and payments (GST portal).
4. Lower cost of production and logistics; more competitive Indian goods.
5. Wider tax base and more transparency; less tax evasion.
6. Expected growth in GDP and easier inter-state movement (no check-posts).

Categories

• CGST – Central GST on intra-state supply.
• SGST/UTGST – State/Union Territory GST on intra-state supply.
• IGST – Integrated GST on inter-state supply and imports (collected by the Centre and shared).

(Rates: 0 %, 5 %, 12 %, 18 %, 28 %, plus special rates; petroleum products and alcohol are outside GST for now.)

GST is a destination-based, multi-stage tax on value addition with input tax credit; it removes cascading, creates a common national market with uniform rates, simplifies compliance and widens the tax base; its categories are CGST, SGST/UTGST and IGST.

Topic checklist

• ☒ Public goods and components of budget (Q 1, 2)
• ☒ Deficits and their relationship (Q 3, 4, 11)
• ☒ Fiscal policy multipliers (Q 5–10)
• ☒ Public debt, inflation and deficit reduction (Q 12–14)
• ☒ GST (Q 15)

Total questions answered: 15 of 15