fiscal policy and current account in india

8/6/2019 fiscal policy and current account in india

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Fiscal Policies and Current Accounts

in India

Submitted by:

Group 11Section C

Harsh Agarwal (2010139)

Madhumitha J (2010147)

Pankaj Arora (2010153)

Praveen Trivedi (2010156)

Sneha Hingorani (2010170)

Tirtheshwar Banerjee (2010173)

MACROECONOMICS

END TERM

PAPER

ABSTRACT

This paper examines the relationship between Fiscal policy and the Current account in the Indian

scenario. To highlight the post liberalization period, we have drawn from the data of the last two

decades (1992-2010) and have used multiple regression for our analysis. We have found that

changes in fiscal policy are indeed associated with changes in the current account, but the

relationship is far less than one-for-one. Considering Merchandise and Invisibles as the main

constituents of Current Account, we have analyzed their relationship with Total Tax, Revenue

expenditure and Capital expenditure.


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1 | F i s c a l p o l i c y a n d c u r r e n t a c c o u n t

TABLE OF CONTENTS

Table of Contents .............................................................................................................................................. 1

Fiscal Policy Parameters .................................................................................................................................... 3

1. Taxes ............................... ........................ ................................ ...................... ................................ ............ 3

a) Direct taxes .............................. ......................... ............................... ............................. ...................... .. 3

b) Indirect taxes ............................ ......................... ............................... ............................. ...................... .. 3

2. Expenditure .............................. ........................ ................................ ....................... ............................. ..... 4

a) Revenue expenditure ............................ ................................ ...................... ................................ .......... 4

b) Capital Expenditure ............................ .............................. ...................... ................................ ............... 5

c) Subsidies .............................. ........................ ................................ ...................... ................................ ... 5

Current Accounts .............................................................................................................................................. 6

1. Merchandize Trade Account ........................... ................................ ....................... ................................ .... 6

2. Invisibles Account ............................. ................................ ...................... ................................ ................... 6

a) Services ................................................................................................................................................. 6

b) Investment Income ................................................................................................................................ 6

c) Transfer Payments................................................................................................................................. 7

Theoretical Studies ........................................................................................................................................... 8

1. Direct impact through demand .............................................................................................................. 8

2. Impact through the real exchange rate .................................................................................................. 8

3. Impact on interest rates and country risk premia ........................... ......................... ............................. .. 8

1. Merchandise Account ............................ ............................... ....................... ................................ ............ 11

2. Invisible Account .............................. ................................ ...................... ................................ ................. 12

Conclusion ...................................................................................................................................................... 14

Appendix ........................................................................................................................................................ 15

References ...................................................................................................................................................... 21


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INTRODUCTION

The relationship between fiscal policy and the current account has long attracted interest among

academic economists and policymakers alike, from various angles. For many countries where currentaccount imbalances areespecially large, a relevant question has been to what extent fiscal adjustment

can contribute to resolving external imbalances. Going forward, the implications of fiscal stimulus

first, and fiscal adjustment later, for current account developments will no doubt continue to generate

interest in the context of returning the globaleconomy to strong, sustainable, and balanced growths as

theeffects of the 200809 crises gradually abate. (Abbas, Bouhga-Hagb, Fats, & Mauro, 2010)

This paper analyses the relationship between fiscal policy and the current account in India. We tried to

comeup with some relationships between different parameters of fiscal and current account. The first

surge in Indias economic growth rate came in theearly 1980s, when it increased to above 5% from

the average Hindu growth rate of 3.5% in earlier decades. Unfortunately, this spurt was achieved by

unsustainable fiscal ex pansion financed by domestic credit and external borrowing. Growth

accelerated to 5.8% during the 1980s, but in the second half of the decade, fiscal and current account

deficits widened significantly, causing serious macroeconomic imbalances and culminating in the

balance of payment (BOP) crisis of 1991. These triggered the series ofeconomic reforms that have

been introduced, starting in 1991, to bring about macroeconomic stabilization and implement structural

measures to push up growth. (http://www.adbi.org/working-paper/2010/09)

So in our analysis we have considered data for the last two decades, which reflects the post

liberalization trajectory of the country. Using the statistical technique of multiple regressions, wehave

analyzed the relationship between fiscal policy and the current account.


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FISCAL POLICY PARAMETERS

1.TAXESTo tax (from the Latin taxo; "I estimate") is to impose a financial charge or otherlevy upon a taxpayer

(an individual orlegalentity) by a state or the functionalequivalent of a state such that failure to pay is

punishable by law.

Taxes are also imposed by many subnationalentities. Taxes consist of direct tax or indirect tax, and

may be paid in money or as its labourequivalent (often but not always unpaid labour). A tax may be

defined as a "pecuniary burden laid upon individuals or property owners to support the government a

payment exacted by legislative authority." A tax "is not a voluntary payment or donation, but anenforced contribution,exacted pursuant to legislative authority" and is "any contribution imposed by

government whether under the name of toll, tribute, tallage, gabel, impost, duty, custom, excise,

subsidy, aid, supply, or other name."

a) Direct taxesIn the general sense, a direct tax is one paid directly to the government by the persons (juristic

or natural) on whom it is imposed (often accompanied by a tax return filed by the taxpayer).

Examples include some income taxes, some corporate taxes, and transfer taxes such as estate(inheritance) tax and gift tax. In this sense, a direct tax is contrasted with an indirect tax or

"collected" tax (such as sales tax or value added tax (VAT)); a "collected" tax is one which is

collected by intermediaries who turn over the proceeds to the government and file the related

tax return. Some commentators have argued that "a direct tax is one that cannot be shifted by

the taxpayer to someoneelse, whereas an indirect tax can be."

b) Indirect taxesThe term indirect taxhas more than one meaning.

In the colloquial sense, an indirect tax (such as sales tax, a specific tax [a tax per unit], value

added tax (VAT), or goods and services tax (GST)) is a tax collected by an intermediary (such

as a retail store) from the person who bears the ultimateeconomic burden of the tax (such as

the customer). The intermediary later files a tax return and forwards the tax proceeds to

government with the return. In this sense, the term indirect tax is contrasted with a direct tax


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which is collected directly by government from the persons (legal or natural) on which it is

imposed.

An indirect tax may increase the price of a good so that consumers are actually paying the tax

by paying more for the products. Examples would be fuel,liquor, and cigarette taxes. An excise

duty on motor cars is paid in the first instance by the manufacturer of the cars; ultimately the

manufacturer transfers the burden of this duty to the buyer of the car in form of a higher price.

Thus, an indirect tax is such which can be shifted or passed on.

2.EXPENDITUREGovernment spending or government expenditure is classified by economists into three main types.

Government acquisition of goods and services for current use to directly satisfy individual or collective

needs of the members of the community is classed as government final consumption expenditure.

Government acquisition of goods and services intended to create future benefits, such as infrastructure

investment or research spending, is classed as government investment (gross fixed capital formation),

which usually is the largest part of the government gross capital formation. Acquisition of goods and

services is made through own production by the government (using the government's labour force,

fixed assets and purchased goods and services for intermediate consumption) or through purchases of

goods and services from market producers. Government expenditures that are not acquisition of goods

and services, and instead just represent transfers of money, such as social security payments, are called

transfer payments. Government spending can be financed by seigniorage, taxes, or government

borrowing.

a)Revenue expenditureRevenue expenditure is the reserve of money used by an establishment to develop or raise

physical assets like equipment, industrial buildings or properties. The operations of an

establishment includeeverything from constructing structures to repairing parts of the building.

Revenueexpenditure is beneficial for the current business year.

Any business establishment incurs an appreciable number ofexpenses to steadily maintain its

business operations. There are two broad categories of business expenditure a company can

incur. The first category of business expenditure comprises items incurred for running everyday

operations of theestablishment. The second category ofexpenditure comprises assets bought


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by the company. This results in increased productivity and enhanced efficiency of the

establishment.

b)Capital ExpenditureIt is the fund used by an establishment to produce physical assets like property,equipment orindustrial buildings. Capitalexpenditure is made by theestablishment to consistently maintain

the operational activities.

Comparison: Revenue expenditure and capital expenditure - Capital expenditure results the

increase or acquirement of an asset, whereas revenue expenditure is necessary for the

sustenance ofearning capacity.

c) SubsidiesA subsidy, often viewed as the converse of a tax, is an instrument of fiscal policy. Derived from

the Latin word subsidium, a subsidy literally implies coming to assistance from behind.

However, their beneficial potential is at its best when they are transparent, well targeted, and

suitably designed for practical implementation.

Like indirect taxes, they can alter relative prices and budget constraints and there by affect

decisions concerning production, consumption and allocation of resources. Subsidies in areas

such as education, health and environment at times merit justification on grounds that their

benefits are spread well beyond the immediate recipients, and are shared by the population at

large, present and future. For many other subsidies, however the case is not so clear-cut.

Arising due to extensive governmental participation in a variety ofeconomic activities, there

are many subsidies that shelter inefficiencies or are of doubtful distributional

credentials.(http://www.statisticshell.com)


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CURRENT ACCOUNTS

Current account is one of the two primary components of the balance of payments, the other being the

capitalaccount. The current account is the sum of the merchandize trade account and

services/invisibles account. A deficit on current account means that the countys receipt of foreign

currencies on account of trade and invisibles has been less than its

payments.(http://internationalecon.com/Finance)

1.MERCHANDIZE TRADE ACCOUNTMerchandize Trade Account is a record of all international transactions for goods only in a year.

Goods include physical items like autos, steel, food, clothes, appliances, furniture,etc. The differencebetween total receipts on account ofex ports of goods and total payments on account of imports of

goods is called balance of trade. However, these receipts and payments are not necessarily in

countrys own currency. Besides, receipts and payments on account of trade of goods, some other

receipts and payments also take place between countries. Exports and imports of goods are also called

transactions of visible items or merchandise.

2.INVISIBLES ACCOUNTServices are a part of invisibles. These include shipping, banking, insurance and consultancy services,

foreign travel, investment income, transfer payments etc.

a) ServicesThese services like banking, insurance, shipping and consultancy services etc. are provided by

one country to the other countries. When a country gets such services from other countries, it is

called import of services for which payments in foreign currencies are made. When a country

provides these services to other countries, it is called ex ports of services for which it gets

payments in foreign currencies.

b) InvestmentIncomeA country may receive interests on loans given to other countries. It may also receive dividends

on investments made by its people in other countries. These receipts are also in foreign


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currencies. Similarly payments of interest and dividends on loans and investments by people of

other countries result in outflow of foreign currencies.

c) Transfer PaymentsPeople of a country may receive gifts etc. from their friends and relatives living abroad. These

are called unilateral transfers. Similarly people of a country may be sending gifts to their

relatives and friends. Thus such transfer payments also result in inflow and outflow of foreign

currencies.(http://internationalecon.com/Finance)


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THEORETICAL STUDIES

The major factors through which fiscal policy affects the current account include the following:

1. Direct im

pact thro

ughd

emand

:

The way in which fiscal policy can affect theexternalaccount is through changes in the governments consumption or investment demand for tradable

goods. As Government often accounts for a large part of domestic demand, so that, depending on

the import propensity, shifts in the government import demand function translate into movements

in the trade balance. A fiscalexpansion, whether implemented through a tax reduction or spending

increase, will tend to increase demand (including for imports) and the trade deficit. (Abbas, Bouhga-

Hagb, Fats, & Mauro, 2010)

2. Impact through the real exchange rate:Fiscal policy can also affect the current account byaltering the real exchange rate. Increased government spending on non-tradable (such as the

services or realestate sectors) can lead to appreciation, which in turn can tilt private consumption

toward, and production away from, tradable.(Abbas, Bouhga-Hagb, Fats, & Mauro, 2010)

3. Impact on interest rates and country riskpremia: Fiscal tightening can reduce interestrates, including on external debt, thereby improving the current account balance. At the same time,lower risk can also increase capital inflows, which can boost demand and real appreciation

pressures and eventually worsen the current account (ex pansionary fiscal contractions).

Conversely, fiscalexpansions that are deemed unsustainable can generate capital flight and force

a rapid external account adjustment.

The relative strength of these mechanisms, and thus the net impact of fiscal policy on the current

account, is determined by model assumptions. In practice, it will depend of country characteristics. For

example, in a smallemerging market, the current account impact of a fiscal consolidation may well be

adverse if the capital inflow response to a declining risk premium outweighs any direct demand

contraction effects. In a largeeconomy, a fiscalexpansion may induce a private sector response that

often combines a real depreciation (effected, possibly, by firms reducing mark-ups to try and gain

market share) and rising consumption demand, so that the impact on the trade balance is difficult to

predict.


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ANALYSIS

We used the data from last 20 years of different parameters involved in fiscal policy and net current

balance and use multiplelinear regression methodology

Theequation to calculate Net Current Account is as:-

NCA = -68444.6 + -1.066 Td+ 0.90 Ti + -0.419 Rex + 0.853 Cex + 0.700 S

Here

NCA Net Current Account

Td - Direct Tax

Ti - Indirect tax

Rex - Revenue Expenditure

Cex - Capital Expenditure

S - Subsidy

But when welook up at correlation between different independent variables, we found that Revenue-expenditure (Rex) and subsidy(S); and indirect (Ti) and direct taxes (Td)arehighly correlated. In such

case there will beerror in distinguishing the independent effect ofeach variable.

Figure No.1

Also wehave observed that subsidy is not significant variable in estimating the net current account (as

p=.525 >> .05).


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Figure No.2

Hence we ignored the subsidy variable and used total tax variable combining direct and indirect

variable.

Improvedequation

NCA = -12573.3 -.074T + 0.212 Rex+ 1.292 Cex

HereT TotalTax

Figure No.3


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We found that Total tax variable is lesser significant variable in determining Net capital account.

Now we studied the impact of fiscal policy variables on major ingredients (Merchandise and Invisible

account) of net current balance.

1.MERCHANDISEACCOUNTIn the case of Merchandise as a dependent variable, wehave the following independent variables:-

i) Capital Expenditure.ii) Revenue Expenditure.iii) TotalTax.

TheR-square value of this analysis comes out to be 96.2%. This means that the change in Dependent

variable (which is Total Merchandise in this case) can be determined by the independent variable to an

extent of 96.2%


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Figure No.4

Equation is

MA = 32160-.481 T - 0.264 Rex+ 1.579 Cex

Here

MA Merchandise Account

The findings from the analysis are that Total Tax and capital expenditure are most critical in

determining theTotal Merchandise value. Moreover, following conclusions can be drawn:-

IfTotal tax increases by 1%, then total merchandise value decreases by 0.481%.

IfRevenue Expenditure increases by 1%, then total merchandise decreases by 0.264%.

If Capitalexpenditure increases by 1%, then total merchandise increases by 1.579%.

2.INVISIBLE ACCOUNTIn the case of Invisible output as a dependent variable, wehave the following independent variables:-

i. Capital Expenditure.ii. Revenue Expenditure.iii. TotalTax.

The R-square value of this analysis comes out to be 98.3%. This means that the change in total

Invisible account can be determined by the independent variable to an extent of 98.3%.

The findings from the analysis are that TotalTax is the most critical in determining theTotal Invisible

Output. However we can also take Capitalexpenditure into consideration as it has 76% accuracy.


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Figure No.5

Equation is

IA = -44733.9 +.407 T + 0.052 Rex 0.287 Cex

Here IA Invisible Account

Moreover, following conclusions can be drawn:-

i) IfTotal tax increases by 1%, then total invisible output increases by 0.407%.ii) IfRevenue Expenditure increases by 1%, then total invisible accountincreases by 0.052%.iii) If Capitalexpenditure increases by 1%, then total invisible account decreases by 0.287%.


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APPENDIX

Exhibit 1: data from last 20 years of different parameters involved in fiscal policy and net current balance

TAX EXPENSE NET CURRENT ACCOUNT

YearDirect

Taxes

Indirect

Taxes

Tax

Revenues

Revenue

Expenditu

re

Capital Subsidy

Total

ExpMerchan

diseInvisibl

esServices

Transfe

rsIncome

990-91 14267 73297 87564 73516 31782 12158 105298 -16933 -433 1761 4539 -6733 -

991-92 19047 83627 102674 82292 29122 12253 111414 -6494 4259 3133 10522 -9396 -

992-93 22485 92007 114492 92702 29916 10824 122618 -17239 4475 2698 12280 -10503 -

993-94 25310 96407 121718 108169 33684 11605 141853 -12723 9089 1677 17670 -10258 -

994-95 33868 112418 146286 122112 38627 11854 160739 -28419 17836 1883 26726 -10773 -

995-96 41476 131264 172741 139861 38414 12666 178275 -38061 18415 -702 29833 -10716 -

996-97 47179 150126 197305 158933 42074 15499 201007 -52561 36279 2621 45425 -11767 -

997-98 54626 159746 214371 180335 51718 18540 232053 -57805 36922 4943 45183 -13204 -2

998-99 57253 172727 229980 216461 62878 23593 279340 -55478 38689 9114 44542 -14967 -

999-00 70937 200607 271544 249078 48975 24487 298053 -77359 57028 17670 54789 -15431 -2

000-01 80755 220218 300973 277839 47753 26838 325592 -56737 45139 7905 59967 -22733 -

001-02 82506 226441 308947 301468 60842 31210 362310 -54955 71381 15889 75560 -20068 1

002-03 100799 252101 352900 338713 74535 43533 413248 -51697 82357 17644 81403 -16690 3

003-04 125186 282912 408097 362074 109129 44323 471203 -63386 127369 46381 101696 -20708 6

004-05 156146 329229 485375 384329 113923 45957 498252 -151765 139591 68831 93135 -22375 -

005-06 195412 381184 576596 439761 66362 47520 506123 -229664 185927 102611 109432 -26116 -4

006-07 267771 456252 724023 514609 68778 57125 583387 -279962 235579 133064 135749 -33234 -4

007-08 355607 521889 877496 594433 118238 70926 712671 -367664 304185 156244 168452 -20511 -

008-09 393125 576723 969848 793798 90158 129708 883956 -543158 411544 228309 204338 -21103 -1

009-10 423683 602777 1026460 906355 115192 131025 1021547 -555659 374901 162525 247365 -34989 -1


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Exhibit-2: Tax and current account

-800000

-600000

-400000

-200000

0

200000

400000

600000

800000

1000000

1200000

0 5 10 15 20 25

Direct Taxes

Indirect Taxes

Tax Revenues

Merchandise

Invisibles

Services

Transfers

Income

Current AccountYEARS

o


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Exhibit-3: Government Expenditure and current account

-800000

-600000

-400000

-200000

0

200000

400000

600000

800000

1000000

1200000

0 5 10 15 20 25

RevenueExpenditureCapital

Subsidy

Total

Exp

Merchandise

Invisibles

Services

Transfers

Income

Years -->

mo

n

n

h

u

a


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Exhibit-4: Fiscal deficit and Current Account

-800000

-600000

-400000

-200000

0

200000

400000

600000

0 5 10 15 20 25

Fiscal deficit

Merchandise

Invisibles

Services

Transfers

Income

Current Account

o

n

n

u

YEARS


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Exhibit 5: Indian government expenditure

Year Revenue of which Capital Loans Capital of which Total

expenditure Defence Interest Subsidies expenditure and outlay Defence expenditure

expenditure payments advances expenditure

(7+8) (2+6)

1982-83 18742 4494 3938 2262 12049 7384 4665 527 30791

1983-84 22251 5189 4795 2902 13283 8053 5230 642 35534

1984-85 27691 6324 5974 4038 15941 9194 6747 737 43632

1985-86 33924 7021 7512 4796 18742 11087 7655 967 52666

1986-87 40860 9179 9246 5451 22056 12797 9259 1298 62916

1987-88 46174 8861 11251 5980 22087 12793 9294 3107 68261

1988-89 54106 9558 14278 7732 25005 14750 10255 3783 79111

1989-90 64210 10194 17757 10474 28698 16890 11808 4222 92908

1990-91 73516 10874 21498 12158 31782 19652 12130 4552 105298

1991-92 82292 11442 26596 12253 29122 17723 11399 4905 111414

1992-93 92702 12109 31075 10824 29916 16297 13619 5473 122618

1993-94 108169 14978 36741 11605 33684 20454 13230 6867 141853

1994-95 122112 16426 44060 11854 38627 23736 14891 6819 160739

1995-96 139861 18841 50045 12666 38414 24316 14099 8015 178275

1996-97 158933 20997 59478 15499 42074 27878 14196 8508 201007

1997-98 180335 26174 65637 18540 51718 34193 17526 9104 232053

1998-99 216461 29861 77882 23593 62878 44037 18841 10036 279340

1999-00 249078 35216 90249 24487 48975 24938 24037 11855 2980532000-01 277839 37238 99314 26838 47753 23008 24745 12384 325592

2001-02 301468 38059 107460 31210 60842 34284 26558 16207 362310

2002-03 338713 40709 117804 43533 74535 * 31668 29101 14953 413248

2003-04 362074 43203 124088 44323 109129 * 28768 34150 16863 471203

2004-05 384329 43862 126934 45957 113923 * 28910 52338 31994 498252

2005-06 439761 48211 132630 47520 66362 11337 55025 32338 506123

2006-07RE

506767 51542 146192 53463 74870 9706 65164 34458 581637

2007-08BE

557900 54078 158995 54330 82621@ 7498 75123@ 41922 640521@

(http://www.rbi.org.in/scripts/AnnualPublications.aspx)


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Exhibit 6: Indian Current Account data

(http://www.rbi.org.in/scripts/AnnualPublications.aspx)


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REFERENCES

(n.d.). Retrieved november 10, 2010, from http://www.statisticshell.com:

http://www.statisticshell.com/multireg.pdf

Abbas, S. A., Bouhga-Hagb, J., Fats, A., & Mauro, P. (2010, may 30). Fiscal Policy and the Current

Account. www.imf.org/external/pubs/ft/wp/2010/wp10121.pdf.

Abbas, S. A., & Bouhga-Hagb, J. (2010, may 30). www.imf.org/external/pubs/ft/wp/2010. Retrieved

october 10, 2010, from www.imf.org:

http://www.imf.org/external/pubs/ft/wp/2010/wp10121.pdf

http://internationalecon.com/Finance. (n.d.). Retrieved november 5, 2010, from

http://internationalecon.com: http://internationalecon.com/Finance/Fch5/F5-5.php

http://www.adbi.org/working-paper/2010/09. (n.d.). Retrieved november 10, 2010, from

http://www.adbi.org: http://www.adbi.org/working-

paper/2010/09/17/4075.fiscal.policy.issues.india.after.gfc/

http://www.rbi.org.in/scripts/AnnualPublications.aspx. (n.d.). Retrieved november 1, 2010, from

http://www.rbi.org.in/: http://www.rbi.org.in/scripts/AnnualPublications.aspx?head=Handbook

of Statistics on Indian Economy

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