Class 12 Economics (Macroeconomics) Chapter 5 Government Budget and the Economy Notes in English

Covers T.R. Jain & V.K. Ohri (2026-27) ch 10. Based on NCERT Introductory Macroeconomics, Chapter 5 (Reprint 2026-27) and the CBSE curriculum 2026-27.

1 Government Budget: Meaning and Its Components

An economy in which there is both a private sector and the government is a mixed economy. The government influences economic life in many ways; this chapter looks only at the functions carried out through the government budget.

1.1 Meaning of the budget

• The budget is for one year, but its impact is felt in the years that follow
• So the budget keeps two accounts: items relating to the current financial year only go into the revenue account (revenue budget); items that concern the assets and liabilities of the government go into the capital account (capital budget)
• A Finance Bill is presented along with the Annual Financial Statement; it details the imposition, abolition, remission, alteration or regulation of the taxes proposed in the budget
• Since Independence, with the Five-Year Plans, the budget is not merely a statement of receipts and expenditure; it has become a significant national policy statement

1.2 Components of the government budget

The book’s Chart 1 (The Components of the Government Budget) shows this classification.

2 Objectives of the Government Budget

The government plays a very important role in increasing the welfare of the people. To do this it intervenes through the budget in three ways: allocation, redistribution and stabilisation. All three operate through the expenditure and receipts of the government.

2.1 Allocation function and public goods

To see why the government must provide public goods, compare them with private goods (clothes, cars, food items). There are two major differences:

Basis	Private goods	Public goods
1. Rivalry	One person’s consumption reduces what is available to others (rival relationship). The chocolate I eat is not available to anyone else	One person’s consumption does not reduce the amount available to others (non-rivalrous). A public park or measures to reduce air pollution benefit everyone
2. Exclusion	Anyone who does not pay can be excluded. No ticket, no movie	There is no feasible way of excluding anyone from the benefits, so they are non-excludable
Examples	Clothes, cars, food items	National defence, roads, government administration, a public park

2.2 Redistribution function

• National income goes either to the private sector (firms and households), called private income, or to the government, called public income
• Out of private income, what finally reaches households is personal income; the amount that can be spent is personal disposable income
• The government affects households’ disposable income by making transfers and collecting taxes

Example: higher income tax rates on the rich (progressive tax) and pensions, scholarships or cheap food grain for the poor. The redistribution objective is sought to be achieved mainly through progressive income taxation (section 3.1).

2.3 Stabilisation function

• The level of employment and prices depends on aggregate demand, which depends on the spending decisions of millions of private agents apart from the government
• If demand is too low, labour and other resources are not fully used; since wages and prices do not fall below a level, employment does not return to its earlier level automatically. The government must raise aggregate demand
• If demand exceeds available output under high employment, inflation may result. The government must use restrictive measures to reduce demand

3 Classification of Receipts

Every receipt falls into one of two classes. The test: does the receipt create a liability for the government (an obligation to repay), or reduce its financial assets? If yes, it is a capital receipt; if neither, it is a revenue receipt.

3.1 Revenue receipts

(a) Tax revenue

Basis	Direct taxes	Indirect taxes
On what	Income of individuals (personal income tax) and profits of firms (corporation tax)	Goods and services
Book’s examples	Personal income tax, corporation tax; wealth tax, gift tax, estate duty (now abolished)	Excise taxes (on goods produced within the country), customs duties (on imports and exports), service tax; now GST

• Paper taxes: wealth tax, gift tax and estate duty never brought in a large amount of revenue, so they are called ‘paper taxes’
• Progressive income taxation: the higher the income, the higher the tax rate. This is how the redistribution objective is pursued
• Firms are taxed on a proportional basis: the tax rate is a particular proportion of profits
• Excise rates: necessities exempted or taxed at low rates; comforts and semi-luxuries moderately taxed; luxuries, tobacco and petroleum products taxed heavily
• GST (Goods and Services Tax) brought a dramatic change in India’s tax system; it covers both goods and services and was implemented by the Centre, 28 states and 7 Union territories from 1 July 2017 (details in section 11)

(b) Non-tax revenue

• Interest receipts on loans given 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

3.2 Capital receipts

• A loan must be repaid with interest in future, so it creates a liability
• When an asset is sold, the earnings from that asset in future disappear
• So capital receipts can be debt creating (borrowing, such as market loans) or non-debt creating (recovery of loans, disinvestment)

Receipt	Class	Reason
Income tax, corporation tax, GST, customs duty	Revenue (tax)	No liability, no reduction in assets
Interest on government loans, dividends from PSUs, fees	Revenue (non-tax)	No liability, no reduction in assets
Cash grants from abroad	Revenue (non-tax)	Need not be repaid
Market borrowing, borrowing from RBI, external loans	Capital (debt creating)	Creates a liability
Recovery of loans given to states	Capital (non-debt)	Reduces a financial asset (the loan given)
PSU disinvestment	Capital (non-debt)	Reduces a financial asset (shares)

4 Classification of Expenditure

4.1 Revenue expenditure

• Budget documents classify total expenditure into plan and non-plan expenditure (item 7 of Table 5.1)
• Plan revenue expenditure: central Plans (the Five-Year Plans) and central assistance for State and Union Territory plans
• Non-plan expenditure, the more important component of revenue expenditure, covers general, economic and social services; main items: interest payments, defence services, subsidies, salaries and pensions
• Interest payments on market loans, external loans and reserve funds are the single largest component of non-plan revenue expenditure
• Defence expenditure is committed expenditure: given national security concerns, there is little scope for drastic reduction
• A footnote in the book records the case against the plan/non-plan classification: it encouraged starting new schemes while neglecting maintenance of existing capacity, and created the misperception that non-plan expenditure is wasteful, hurting allocations to education and health, where salaries are an important element

Year	2014-15	2015-16	2018-19	2020-21	2022-23 (B.E.)
Subsidies, % of GDP	2.02	1.8	1	3.6	1.2

4.2 Capital expenditure

• Capital expenditure is also categorised as plan and non-plan in the budget documents
• Plan capital expenditure: like its revenue counterpart, the central plan and central assistance for state and union territory plans
• Non-plan capital expenditure: various general, social and economic services provided by the government

Basis	Revenue expenditure	Capital expenditure
Assets	No asset is created	Physical or financial asset is created
Liabilities	No reduction in liabilities	Can reduce liabilities (repaying the principal of a loan)
Nature	Normal, current running of the government; recurring	Investment in nature; adds to future capacity
Examples	Salaries, pensions, interest, subsidies, grants to states, defence services	Roads and buildings, machinery, purchase of shares, loans to states, repayment of loan principal

4.3 Three policy statements with the budget (FRBMA, 2003)

The Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) mandates three policy statements along with the budget:

Statement	What it does
Medium-term Fiscal Policy Statement	Sets a three-year rolling target for specific fiscal indicators; examines whether revenue expenditure can be financed through revenue receipts on a sustainable basis and how productively capital receipts, including market borrowings, are being used
Fiscal Policy Strategy Statement	Sets the government’s priorities in the fiscal area, examining current policies and justifying any deviation in important fiscal measures
Macroeconomic Framework Statement	Assesses the prospects of the economy with respect to the GDP growth rate, the fiscal balance of the central government and the external balance

5 Balanced, Surplus and Deficit Budget

6 Measures of Government Deficit

There are three measures of deficit, and each has its own meaning for the economy. First look at the book’s table, then each measure.

Table 5.1: Receipts and Expenditures of the Central Government, 2024-25 (P.A.), % of GDP
1. Revenue receipts (a + b)	9.2
(a) Tax revenue (net of states’ share)	7.9
(b) Non-tax revenue	1.4
2. Revenue expenditure, of which	11.8
(a) Interest payments	3.6
(b) Major subsidies	1.4
(c) Defence expenditure	1.0
3. Revenue deficit (2 − 1)	2.6
4. Capital receipts (a + b + c), of which	5.8
(a) Recovery of loans	0.1
(b) Other receipts (mainly PSU disinvestment)	0.1
(c) Borrowings and other liabilities	5.6
5. Capital expenditure	3.2
6. Non-debt receipts [1 + 4(a) + 4(b)]	9.4
7. Total expenditure [2 + 5]	15.0
8. Fiscal deficit [7 − 1 − 4(a) − 4(b)]	5.6
9. Primary deficit [8 − 2(a)]	2.0

Source: Economic Survey 2024-25, Statistical Appendix (as given in the book). Total expenditure is 11.8 + 3.2 = 15.0. The book shows “–” against plan and non-plan expenditure. Tax plus non-tax revenue (7.9 + 1.4) differs slightly from 9.2 because of rounding.

6.1 Revenue deficit

What a revenue deficit means:

6.2 Fiscal deficit

• Net borrowing at home includes borrowing directly from the public through debt instruments (for example, the various small savings schemes) and indirectly from commercial banks through the Statutory Liquidity Ratio (SLR)
• The gross fiscal deficit is a key variable in judging the financial health of the public sector and the stability of the economy
• The relation above shows that the revenue deficit is a part of the fiscal deficit
• In Table 5.1, 9.4 is the total of non-debt receipts (item 6); the non-debt creating capital receipts within it are 0.1 + 0.1 = 0.2
• A large share of revenue deficit in the fiscal deficit shows that a large part of borrowing is being used for consumption rather than investment; the book’s summary says that its growth points to a deterioration in the quality of government expenditure, with lower capital formation

6.3 Primary deficit

6.4 Solved numericals

7 Fiscal Policy and the Multipliers (Not in CBSE 2026-27 syllabus)

This is Box 5.1 of the book. The CBSE 2026-27 curriculum does not list it, but Exercises 5 to 10 are based on it and the UP, Bihar, Rajasthan and MP boards teach from this book. The multiplier of Chapter 4 is extended here to include the government.

7.1 Aggregate demand with the government

• The government affects equilibrium income in two specific ways: government purchases (G) increase aggregate demand, and taxes and transfers change the relation between income (Y) and disposable income (Y_D)
• Lump-sum taxes (T): taxes that do not depend on income; the government makes a constant amount of transfers (T̄R)
• Taxes lower disposable income and consumption: someone who earns ₹1 lakh and pays ₹10,000 in taxes has the same disposable income as someone who earns ₹90,000 and pays no taxes

A lump-sum tax shifts the consumption schedule down in a parallel way, and so the AD curve shifts down in parallel too.

7.2 Changes in government expenditure

• Raise G keeping taxes constant: when G exceeds T, the government runs a deficit
• G is a component of aggregate spending, so the AD schedule shifts up to AD′
• At the initial output, demand exceeds supply, firms expand production, and the new equilibrium is at E′; the multiplier mechanism (Chapter 4) is at work

7.3 Changes in taxes: the tax multiplier

• A tax cut raises disposable income (Y − T) at each level of income
• The AD schedule shifts up, but only by a fraction c of the tax cut (part of the cut is saved)

• The tax multiplier is negative: a tax cut raises consumption and output; a tax increase reduces them
• In absolute value the tax multiplier is smaller than the government spending multiplier: government spending directly affects total spending, while taxes enter only through their effect on disposable income and hence consumption; a tax cut of ΔT raises spending by only cΔT in the first round
• For any value of the MPC, the tax multiplier is always one less in absolute value than the government expenditure multiplier

7.4 Balanced budget multiplier

In Example 5.1, a rise in G of 100 raises output by 500 and a tax rise of 100 reduces income by 400; the net rise is 100, exactly ΔG. Equilibrium income is the final income reached after all the rounds of the multiplier have worked themselves out.

7.5 Proportional taxes

• A more realistic assumption: the government collects a constant fraction t of income as taxes, T = tY
• Consumption function: $C = \bar{C} + c(Y – tY + \overline{TR}) = \bar{C} + c(1-t)Y + c\,\overline{TR}$
• Proportional taxes lower consumption at each level of income and also lower the slope of the consumption function: the MPC out of income falls from c to c(1 − t)
• So the new AD schedule is flatter (Figure 4)

A cut in the tax rate works like a rise in the propensity to consume: AD swings up to AD′, demand exceeds output at the initial income, and the new higher income is Y′.

7.6 Automatic stabilisers and discretionary fiscal policy

• The private sector has built-in stabilisers too: corporations maintain their dividends in the face of a change in income in the short run, and households try to maintain their previous living standards
• Built-in stabilisers reduce only part of the fluctuation; the rest must be taken care of by deliberate policy

7.7 Changes in transfers

• If the government raises transfers T̄R instead of purchases, autonomous spending rises only by cΔT̄R
• Part of any increase in transfers is saved, so output rises by less than with an equal rise in G

8 Government Debt (Not in CBSE 2026-27 syllabus)

• Budgetary deficits must be financed by taxation, borrowing or printing money; governments have mostly relied on borrowing, giving rise to government debt
• Deficits are a flow which add to the stock of debt
• Borrowing year after year accumulates debt, more interest must be paid, and the interest payments themselves add to the debt

8.1 Is government debt a burden?

What is true of one small trader’s debt may not be true of the government’s debt: the ‘whole’ must be dealt with differently from the ‘part’, because the government can raise resources through taxation and printing money.

Arguments that debt is a burden	Arguments that it is not
The government borrows today by issuing bonds and may repay some twenty years later by raising taxes on the young who have just entered the workforce; their disposable income and consumption fall, so national savings fall	Ricardian equivalence: forward-looking consumers see that borrowing today means higher taxes later; caring for their children, they save more now, fully offsetting government dissaving, so national savings do not change
Government borrowing reduces the savings available to the private sector; if this reduces capital formation and growth, debt is a ‘burden’ on future generations	‘Debt does not matter because we owe it to ourselves’: resources move between generations, but purchasing power stays within the nation
Debt owed to foreigners is a burden, since goods must be sent abroad to match the interest payments	If the government invests in infrastructure and the return is greater than the rate of interest, future generations may be better off; the debt could be paid off by the growth in output

The traditional argument is that when the government cuts taxes and runs a deficit, consumers spend more of their after-tax income; they may be short-sighted, or may expect the future taxes to fall on future generations. The book’s conclusion (Summary 6): public debt is burdensome if it reduces future growth in output.

8.2 Other perspectives on deficits and debt

• Are deficits inflationary? The criticism: higher spending or tax cuts raise aggregate demand; if firms cannot produce more at ongoing prices, prices rise. But if there are unutilised resources, output is held back by lack of demand; a high fiscal deficit then brings higher demand and greater output, and need not be inflationary
• Crowding out: if the government borrows by issuing bonds, these compete with corporate bonds for the available savings; some private borrowers get ‘crowded out’ of financial markets. But the flow of savings is fixed only if income cannot rise; if deficits raise production, income and saving both rise, and both government and industry can borrow more
• The growth in debt should be judged by the growth of the economy as a whole (see the infrastructure argument in the table above)

9 Deficit Reduction (Not in CBSE 2026-27 syllabus)

• A Planning Commission study (Programme Evaluation Organisation) estimated that to transfer Re 1 to the poor, the government spends ₹3.65 as food subsidy; the book takes this as showing that cash transfers would increase welfare
• Many countries with huge deficits put in place self-imposed limits on expenditure (in India, the FRBMA)
• A larger deficit does not always mean a more expansionary policy: in a recession GDP falls and firms and households pay less tax, so the deficit rises in a recession and falls in a boom even with no change in policy

10 Fiscal Responsibility and Budget Management Act, 2003 (Not in CBSE 2026-27 syllabus)

In a multi-party parliamentary system, electoral concerns play an important role in expenditure policy. A legal provision applicable to all governments, present and future, is argued to be effective in keeping deficits under control.

#	Main features of the FRBMA
1	Reduce the fiscal deficit to not more than 3% of GDP and eliminate the revenue deficit by March 31, 2009, then build up an adequate revenue surplus
2	Reduce the fiscal deficit by 0.3% of GDP each year and the revenue deficit by 0.5%; if tax revenue falls short, cut expenditure
3	Actual deficits may exceed targets only on grounds of national security, natural calamity or other exceptional grounds the central government specifies
4	The central government shall not borrow from the RBI except by way of advances to meet temporary excess of cash disbursements over cash receipts
5	The RBI must not subscribe to primary issues of central government securities from 2006-07
6	Measures for greater transparency in fiscal operations
7	Three statements laid before both Houses with the Annual Financial Statement (section 4.3)
8	Quarterly review of trends in receipts and expenditure placed before both Houses

• The Act applies to the central government; 26 states have enacted their own fiscal responsibility laws
• Concern: welfare expenditure may be reduced to meet the targets
• FRBM Review Committee: given the task of keeping the 2003 framework while revamping it for India’s changed situation and future growth path

11 Goods and Services Tax (GST): One Nation, One Tax, One Market

This is Box 5.3 of the book; Exercise 15 is based on it. The CBSE 2026-27 curriculum lists the “concept of GST” with Indian Economic Development, Chapter 3.

Central taxes subsumed in GST	State taxes subsumed in GST
Central Excise Duty, Service Tax, Central Sales Tax, cesses like KKC and SBC	VAT/Sales Tax, Entry Tax, Luxury Tax, Octroi, Entertainment Tax, Taxes on Advertisements, Taxes on Lottery/Betting/Gambling, State cesses on goods

• Kept out: five petroleum products are out of GST for the time being; State governments continue to levy VAT on alcoholic liquor for human consumption; tobacco attracts both GST and Central Excise Duty
• Categories (rates): the book gives 6 standard rates: 0%, 3%, 5%, 12%, 18% and 28%
• Constitutional basis: the 101st Constitution Amendment Act received the President’s assent on 8 September 2016; it introduced Article 246A, empowering Parliament and the State Legislatures to make laws on GST; then the CGST, UTGST and SGST Acts were enacted
• Benefits: fewer taxes; free movement of goods and services and a common market; lower cost of business and of cascading; Indian products more competitive at home and abroad; GDP expected to rise by about 2%; registration, returns and payments online at www.gst.gov.in; wider tax base, more transparency, less human interface between taxpayer and government, greater ease of doing business

12 Key Formulas

Measure	Formula
Revenue deficit	Revenue expenditure − Revenue receipts
Fiscal deficit	Total expenditure − (Revenue receipts + Non-debt creating capital receipts) = total borrowing
Fiscal deficit (relation)	Revenue deficit + Capital expenditure − Non-debt creating capital receipts
Primary deficit	Fiscal deficit − Net interest liabilities
Government expenditure multiplier	1 ÷ (1 − c)
Tax multiplier	−c ÷ (1 − c)
Transfer multiplier	c ÷ (1 − c); with proportional tax c ÷ [1 − c(1 − t)]
Balanced budget multiplier	1
Multiplier with proportional taxes	1 ÷ [1 − c(1 − t)]

13 Differences the Exam Asks For

Basis	Revenue receipts	Capital receipts
Liability	None (non-redeemable)	May create one (borrowing)
Assets	No reduction	May reduce them (disinvestment, recovery of loans)
Examples	Taxes, interest receipts, dividends, fees, grants	Borrowing, recovery of loans, disinvestment

Basis	Revenue deficit	Fiscal deficit
Formula	Revenue expenditure − Revenue receipts	Total expenditure − (Revenue receipts + Non-debt capital receipts)
Shows	Borrowing for consumption, government dissaving	Total borrowing requirement from all sources
Relation	The revenue deficit is a part of the fiscal deficit

Basis	Automatic stabiliser	Discretionary fiscal policy
Works	Automatically, with no decision	Through deliberate government action
Examples	Proportional income tax, welfare transfers	Raising G when investment falls
Limit	Removes only part of the fluctuation	Needed for the rest