Understanding fiscal and monetary policy
Fiscal policy deals with the taxation and expenditure decisions of the Government.
Monetary policy, deals with the supply of money in the economy and the rate of interest.
These policy approaches are used by economists to drive the broad aspects of the economy. In most modern economies, the government deals with fiscal policy while the central bank is responsible for monetary policy.
Fiscal policy is composed of several parts. These include tax policy, expenditure policy, investment or disinvestment strategies and debt or surplus management. Fiscal policy is an important constituent of the overall economic framework of a country and is therefore intimately linked with its general economic policy strategy.
If a Government receives more than it spends, it has a surplus. If it spends more than it receives it accounts to a deficit. Fiscal deficit is the excess of expenses of a Government over its tax revenues.
Today, The Indian Government has a massive fiscal deficit running into billions of dollars.
What can be done about India’s fiscal deficit?
In order to counter this, the Indian Government can borrow external loans from Foreign Governments or Financial Institutions. It can even print notes in the country. This can offer a temporary relief to any Government. However, the effects of inflation need to be considered here. An excess supply of money in an economy will cause an increase in inflation and leads to less consumer spending. It will also increase interest rates and “crowd out” private investment.
Another option to reduce the fiscal deficit is if the Indian Government draws on its own foreign exchange. It can do so until the balance of payments does not alter much.
Therefore, there is broad agreement that it is not prudent for a government to run an unduly large deficit. A fiscal deficit can cripple an economy and could lead to several borrowings thus leading to a downgrade of the country in the international marketplace.
Taxes can be a crucial factor in regulating India’s fiscal deficit.
The Indian tax system is geared to transfer resources from the private sector to fund the large public sector driven industrialization process and also cover social welfare schemes. Direct taxes are a good source of revenue however Indirect taxes are a larger source of revenue than direct taxes in India.
Is it time for the Indian Government to look at non tax revenues?
Non Tax revenues are things like external borrowings, tapping into forex reserves and the like. Dipping into these sources will increase the supply of money in a country, thereby increasing inflation and interest rates.
In my opinion, The Indian government should introduce taxes on tax free income. Agriculture income is a predominant source of revenue in India. However, none of that revenue comes into the hands of the Indian government as agriculture income is completely tax free as per the Indian Income tax Act. What the government can do is to introduce taxes on agriculture income and increase its tax kitty. This will enable the government to somewhat regulate its fiscal deficit without adversely affecting other factors like inflation and interest rates.