Fiscal Policy - Objectives and Instruments for UPSC

Objectives and Types of Fiscal Policy

Fiscal policy serves a variety of macroeconomic and socio‑economic purposes. At a broad level, the government uses fiscal instruments to influence aggregate demand and supply and to achieve developmental goals. The key objectives include:

• Promoting economic growth: Public investment in roads, railways, health care, education and digital infrastructure raises productivity and accelerates long‑term growth.
• Ensuring full employment: During downturns, government spending programmes provide employment directly and indirectly by stimulating private sector demand.
• Controlling inflation: In periods of high inflation, fiscal consolidation by reducing spending or increasing taxes can help lower aggregate demand and stabilise prices.
• Reducing inequalities: Progressive taxation, subsidies, social security schemes and other redistribution measures narrow the income and wealth gap.
• Achieving balanced regional development: Targeted expenditure in backward regions addresses geographic disparities and supports inclusive growth.
• Stabilising the external sector: Prudent fiscal management maintains investor confidence, keeps debt sustainable and avoids sharp currency depreciations.

Types of fiscal policy

Depending on the context and goals, fiscal policy can be expansionary, contractionary, neutral or automatic:

• Expansionary fiscal policy: Implemented during recessions, it increases public spending, cuts taxes or both. Programmes like MGNREGS or public works projects inject money into the economy, boosting aggregate demand and employment.
• Contractionary fiscal policy: Used when inflation is high or the economy is overheating. The government may reduce expenditure, postpone new projects or raise taxes to reduce aggregate demand.
• Neutral fiscal policy: Maintains government spending and taxation at levels that do not significantly influence demand. It is pursued when the economy is close to potential output.
• Automatic stabilisers: Certain fiscal instruments, such as progressive taxes and unemployment benefits, adjust automatically with the business cycle. Tax revenue increases when incomes rise and falls when incomes drop, while welfare payments automatically expand during downturns. These stabilisers smoothen economic fluctuations without requiring new policy actions.

In practice, governments often combine elements of these types to respond to specific macroeconomic conditions and policy objectives.

Fiscal Instruments and Tax Systems

Fiscal policy operates through a suite of instruments that raise revenue and allocate resources. Understanding their nature and impact is crucial for aspirants.

Taxation

Taxes are compulsory contributions levied by the government to finance public services and affect private behaviour. They can be categorised as follows:

• Direct taxes: These fall on the income or wealth of individuals and companies. Examples include personal income tax, corporate income tax, capital gains tax and securities transaction tax. They are considered progressive because rates generally rise with the taxpayer’s ability to pay.
• Indirect taxes: Imposed on goods and services, they include the Goods and Services Tax (GST), customs duties and excise duties. Indirect taxes are regressive because they form a larger proportion of expenditure for the poor. However, they are easier to administer and can influence consumption patterns.
• Progressive versus regressive taxes: A tax is progressive if the tax rate increases with the tax base (e.g., higher income taxpayers pay a higher percentage). It is regressive if the tax rate declines as the base increases (e.g., taxes on basic goods which burden the poor more). A proportional tax applies the same rate across all levels.
• Tax reforms: India has undertaken significant tax reforms in the past decade. The introduction of GST in 2017 unified multiple indirect taxes and created a national market. The Finance Bill 2025 proposes to further simplify income tax laws, raising the rebate limit to ₹12 lakh and rationalising tax slabs. Such reforms aim to widen the tax base, reduce litigation and enhance compliance.

Public expenditure

Government spending can be categorised by purpose and nature:

• Revenue expenditure: Recurring expenses for the day‑to‑day functioning of the government and for implementing welfare schemes. It includes salaries, pensions, interest payments, subsidies and grants to states. While necessary, high revenue expenditure can crowd out capital spending if not managed carefully.
• Capital expenditure: Spending that creates durable assets or reduces liabilities. This includes building infrastructure, purchasing equipment, investing in public enterprises and repaying loan principal. Capital expenditure raises the economy’s productive capacity and has significant multiplier effects.
• Plan versus non‑plan expenditure: Though the distinction has been abolished since 2017, historically plan expenditure referred to spending associated with Five‑Year Plans and centrally sponsored schemes, while non‑plan expenditure included routine expenses. The modern classification focuses on capital versus revenue spending for clearer accountability.
• Social sector spending: Outlays on health, education, sanitation, women and child development, and rural development constitute investment in human capital. Schemes like Ayushman Bharat (health insurance), PM‑POSHAN (mid‑day meal), and Jal Jeevan Mission illustrate how fiscal policy addresses social objectives.
• Subsidies and transfer payments: Subsidies lower the price of essential goods such as food, fertilisers and fuel. Direct Benefit Transfer (DBT) programmes like PM‑KISAN and income support under PM Garib Kalyan Yojana deliver cash directly to beneficiaries. Well‑targeted subsidies help reduce poverty and food insecurity, though poorly targeted subsidies can be a fiscal burden.

Borrowing and public debt

When expenditure exceeds revenue, the government resorts to borrowing. There are two main categories of public debt:

• Internal debt: Borrowed from domestic sources such as commercial banks, insurance companies, provident funds and the public through instruments like government securities, treasury bills, savings certificates and small savings schemes.
• External debt: Borrowed from foreign governments, multilateral agencies (World Bank, Asian Development Bank), bilateral lenders and commercial markets. External debt exposes the country to exchange rate risks.

Debt servicing (interest and principal payments) absorbs a sizeable portion of revenue receipts. Hence, borrowing must be managed prudently. India’s total public debt (Centre and states) is around 81 % of GDP. The central government intends to reduce its debt to about 50 % of GDP by 2030 through fiscal consolidation and higher growth.

Fiscal rules and institutions

The Fiscal Responsibility and Budget Management (FRBM) Act, enacted in 2003, provides a statutory framework for fiscal discipline. It prescribes numerical targets for fiscal deficit, revenue deficit and debt, and requires the government to present a medium‑term fiscal policy statement. A committee headed by N. K. Singh reviewed the Act in 2017 and recommended adopting a debt‑to‑GDP ratio of 60 % (40 % for the Centre, 20 % for states) by 2023 and setting a medium‑term fiscal deficit target of 2.5 % of GDP. The committee proposed an escape clause allowing deviations up to 0.5 % of GDP in exceptional circumstances.

The Finance Commission, appointed every five years, determines how tax revenues are shared between the Centre and states and recommends grants‑in‑aid. Its role ensures vertical and horizontal equity in fiscal federalism.

Fiscal Multipliers and Crowding Effects

The fiscal multiplier captures the ripple effect of government spending or taxation on total output. When the government spends on infrastructure or cuts taxes, the immediate beneficiaries spend part of the income, which in turn becomes income for others, creating a chain reaction.

Capital versus revenue multipliers

Empirical studies by the National Institute of Public Finance and Policy (NIPFP) find that capital expenditure is a powerful stimulus. With an impact multiplier of around 2.45, every rupee spent on roads, bridges or irrigation can increase GDP by ₹2.45 in the same year. The cumulative multiplier over several years may reach 4.8 as these assets facilitate private investment and boost productivity.

In contrast, revenue expenditure multipliers (including transfer payments and subsidies) hover just below unity (approximately 0.98–0.99). This means that while cash transfers and subsidies are vital for social welfare, they generate less output than capital spending. For this reason, the Union Budget emphasises capital expenditure to achieve higher growth.

Tax multipliers and balanced budget multiplier

Tax cuts stimulate consumption and investment by increasing disposable income. However, the tax multiplier is generally smaller than the spending multiplier because households may save part of their tax savings. The balanced budget multiplier theory posits that if the government increases spending and taxes by the same amount, the positive effect of spending outweighs the negative effect of higher taxes, resulting in a net increase in output equal to the change in spending.

Crowding out and crowding in

Financing large fiscal deficits through borrowing can raise interest rates and crowd out private investment, particularly in economies operating near full capacity. However, when public investment is directed towards productive sectors, it can crowd in private investment by improving infrastructure, reducing transaction costs and opening new markets. Monetary policy conditions also influence the extent of crowding out; accommodative monetary policy can mitigate the impact of larger fiscal deficits.

Fiscal Deficit, Budgets and Recent Trends

The fiscal deficit is the gap between the government’s total expenditure and its total non‑debt receipts. Persistent high deficits can lead to unsustainable debt, higher interest rates and macroeconomic instability. However, moderate deficits can support growth when used for productive investment.

• Budget 2024–25 highlights: The interim Union Budget presented ahead of the general election continued the focus on capital expenditure. Capital outlay was raised by about 11 % to more than ₹11 lakh crore, allocated to roads, railways, renewable energy, agriculture and skilling. The fiscal deficit target was set at about 5 % of GDP, down from over 9 % during the pandemic years. Enhanced spending on PM Awas Yojana, PM Svanidhi Scheme and support for MSMEs demonstrates a pro‑poor focus.
• Budget 2025–26 summary: The full Union Budget for FY 2025–26 projects government expenditure at ₹50.65 lakh crore, a 7.4 % increase over the revised estimate for 2024–25. Tax receipts are expected to rise by 11 % to ₹34.96 lakh crore, partly due to robust GST collections and improved income tax compliance. The fiscal deficit is targeted at 4.4 % of GDP, and the revenue deficit at 1.5 %. Interest payments absorb around 25 % of total expenditure, highlighting the importance of reducing debt.
• GST performance: Since its introduction, GST has stabilised, with monthly collections averaging around ₹1.7 lakh crore in 2025. The GST Council continues to rationalise rates and simplify compliance. As the compensation mechanism ended in 2022, states have adjusted by enhancing their own tax efforts.
• Subsidy reforms: The government is streamlining food, fuel and fertiliser subsidies through direct benefit transfers. The Pradhan Mantri Ujjwala Yojana encourages the use of clean cooking fuel by providing free LPG connections and subsidies. Fertiliser subsidies are being restructured to promote balanced nutrient use and reduce leakages.
• Public debt dynamics: India’s general government debt stood at about 81 % of GDP in mid‑2025. The Centre’s debt is around 57 % of GDP, while states account for the remaining. The government’s medium‑term strategy aims to reduce the debt ratio to about 50 % through fiscal consolidation and strong growth.
• State finances: States’ fiscal positions vary widely. Aggregate state deficits were budgeted at around 3 % of their gross state domestic product in FY 2024–25, with higher outlays on education, health and rural development. Many states rely on market borrowings, and some have set up state development loans.

These trends highlight the balancing act of supporting growth while ensuring fiscal prudence. Continued tax reforms, improved compliance, rationalisation of subsidies and prioritisation of capital expenditure are essential to maintain momentum.

Fiscal Federalism and Role of Finance Commissions

India’s Constitution assigns specific powers to the Union and state governments. The Centre collects customs duties, corporation tax and part of income tax, while states levy taxes on property, vehicles and state excise. The goods and services tax is shared by both levels and decided by the GST Council. Fiscal federalism ensures that resources are allocated fairly and that states have the autonomy and capacity to deliver public services.

• Vertical devolution: The Finance Commission recommends how the divisible pool of central taxes should be shared with states. The 15th Finance Commission set the states’ share at 41 % for 2021–26, factoring in the impact of the GST compensation cess. This helps states finance their expenditure responsibilities.
• Horizontal devolution: The Commission also decides how the share among states is divided. Criteria include population, area, demographic performance, income distance and forest cover. This ensures that poorer states with lower tax capacity receive more resources.
• Grants‑in‑aid: In addition to tax devolution, the Commission recommends grants for specific purposes such as disaster management, infrastructure development, nutrition, health and performance incentives. These grants encourage states to adopt reforms and invest in key sectors.
• Centre–state relations: Cooperative federalism is crucial for successful fiscal policy. The GST Council, comprising central and state finance ministers, decides GST rates and exemptions by consensus, demonstrating collaboration. Centrally sponsored schemes involve cost‑sharing between the Centre and states; they address national priorities while allowing states flexibility to implement programmes locally.
• Challenges: Differences in fiscal capacity, political priorities and administrative capability create tension between levels of government. Some states argue for greater flexibility in using funds and oppose conditionalities attached to grants. Balancing fiscal autonomy with national standards is an ongoing challenge.

A well‑designed intergovernmental fiscal framework promotes equitable growth and efficient public service delivery.

Fiscal Policy vs. Monetary Policy

Monetary and fiscal policies are complementary tools for managing the economy. While fiscal policy is concerned with taxation and spending decisions taken by the government, monetary policy is conducted by the Reserve Bank of India (RBI) to control money supply and interest rates. The following table summarises their key differences:

Coordination between fiscal and monetary authorities is essential. During the pandemic, the RBI maintained accommodative monetary policy while the government provided fiscal stimulus. In normal times, monetary tightening may accompany fiscal expansion to keep inflation in check.

Quick Facts

UPSC Notes: Prelims and Mains

Prelims pointers

• Fiscal policy: Use of government taxation, expenditure and borrowing to influence the economy.
• Deficit measures: Fiscal deficit = Total expenditure – Total non‑debt receipts; Revenue deficit = Revenue expenditure – Revenue receipts; Primary deficit = Fiscal deficit – Interest payments; Effective revenue deficit = Revenue deficit – Grants for creation of capital assets.
• Types of taxes: Direct (income tax, corporate tax, wealth tax) vs. indirect (GST, customs, excise). Progressive, proportional and regressive tax structures.
• Expenditure classification: Revenue vs. capital expenditure; capital expenditure creates assets or reduces liabilities.
• FRBM Act: Provides a statutory framework for fiscal discipline; sets targets for deficits; includes escape clauses for unforeseen circumstances.
• Finance Commission: Constitutional body that recommends distribution of tax revenue between the Centre and states and among states.
• Goods and Services Tax Council: Constitutional body to decide GST rates, exemptions and administration; ensures cooperation between Centre and states.
• Fiscal multipliers: Impact of fiscal spending on national income; capital expenditure has higher multipliers than revenue spending.
• Budget terminology: Vote on account (authorization of expenditure until the full budget is passed), charged vs. voted expenditure, appropriation bill, finance bill.

Mains insights

• Analyse the trade‑off between fiscal stimulus and debt sustainability. Discuss how large deficits in crisis periods can support growth but must be balanced with consolidation once the economy recovers to avoid debt spirals.
• Discuss the effectiveness of direct benefit transfers (DBT). Explain how technology (Aadhaar, JAM trinity) has improved targeting and reduced leakages, while also noting challenges such as digital literacy and banking access.
• Evaluate the impact of GST on cooperative federalism. Assess the role of the GST Council in resolving disputes and the challenges faced by states after the end of the compensation period.
• Compare India’s fiscal multipliers to those of other countries. Explain how factors like openness to trade, financial market depth and labour market conditions influence the size of multipliers.
• Examine the role of public sector enterprises and disinvestment. Discuss how strategic disinvestment can reduce fiscal burdens and promote efficiency, and the need to balance revenue maximisation with long‑term national interests.
• Assess the implications of demographic trends. With a young population, India needs to invest heavily in education, health and skill development. Fiscal policy must plan for rising pension and healthcare costs as the population ages.

UPSC Previous Year Questions

Fiscal policy features regularly in UPSC examinations. The following examples illustrate the kinds of questions asked:

1. Prelims 2016: Which one of the following is likely to have a high multiplier effect on the economy?
   1. Direct cash transfer to poor households
   2. Reduction in personal income tax rates
   3. Increase in capital expenditure on infrastructure projects
   4. Waiver of farm loans

   Answer: Increase in capital expenditure on infrastructure projects has the highest multiplier.

2. Prelims 2018: The term Fiscal Responsibility and Budget Management (FRBM) refers to:

   Answer: Legislation aiming to ensure prudent fiscal management by setting targets for deficits and debt.

3. Prelims 2021: Consider the following statements about the Finance Commission:
   1. It recommends how the revenue from GST is shared between the Centre and states.
   2. Its recommendations are binding on the government.

   Which of the statements given above is/are correct?
   Answer: Neither statement is correct – the Finance Commission does not decide GST revenue sharing (the GST Council does), and its recommendations are advisory.

4. Mains 2020 (GS III): Examine the role of public expenditure in promoting inclusive growth in India. Discuss how the government should balance social sector spending with capital investments.
5. Mains 2023: “Fiscal federalism in India is evolving toward greater cooperation and competition.” Discuss with reference to Finance Commission recommendations and GST reforms.

Practice MCQs

1. Which of the following is an example of a direct tax?
   1. Goods and Services Tax (GST)
   2. Customs duty on imported cars
   3. Income tax on salaries
   4. Excise duty on tobacco
2. The primary deficit is defined as:
   1. Fiscal deficit minus revenue deficit
   2. Fiscal deficit minus interest payments
   3. Revenue deficit minus grants for capital assets
   4. Total expenditure minus total receipts
3. Which constitutional body determines how central tax revenue is shared with states?
   1. Planning Commission
   2. Finance Commission
   3. GST Council
   4. Central Board of Direct Taxes
4. Which of the following would be classified as capital expenditure of the government?
   1. Granting of scholarships to students
   2. Payment of salaries to teachers
   3. Construction of a new highway
   4. Subsidy on kerosene
5. The balanced budget multiplier suggests that if the government increases expenditure and taxes by the same amount, national income will:
   1. Decrease
   2. Remain unchanged
   3. Increase by the amount of the change in expenditure
   4. Increase by more than the change in expenditure

Answer Key

1. Answer: (c)
2. Answer: (b)
3. Answer: (b)
4. Answer: (c)
5. Answer: (c)

Frequently Asked Questions

Why is fiscal discipline important?

Fiscal discipline prevents excessive borrowing, keeps interest rates moderate and ensures that future generations are not burdened with unsustainable debt. Prudent fiscal policy also maintains investor confidence and macroeconomic stability.

How is the fiscal deficit financed?

The fiscal deficit is financed by borrowing from domestic markets through government securities, treasury bills and small savings schemes, and from external sources such as multilateral agencies and foreign investors. The central bank may also monetise deficits in exceptional situations, though this risks inflation.

What is counter‑cyclical fiscal policy?

Counter‑cyclical fiscal policy involves increasing government spending or cutting taxes during economic downturns and reducing spending or raising taxes during booms. This helps smooth out the business cycle, supporting growth in bad times and curbing inflation in good times.

How do grants differ from loans?

Grants are transfers from the Centre to states or from international agencies that do not need to be repaid. They are provided for specific purposes or to correct fiscal imbalances. Loans, on the other hand, must be repaid with interest and increase the debt burden.

What is zero‑based budgeting?

Zero‑based budgeting is a budgeting approach where every expenditure item must be justified afresh each year, starting from zero. It aims to eliminate wasteful spending and ensure that resources are allocated based on priorities and cost–benefit analysis rather than historical trends.