Highlights of Union Budget 2018-19

The Union Budget of India, also referred to as the Annual financial statement in the Article 112 of the Constitution of India,is the annual budget of the Republic of India. The Government presents it on the first day of February so that it could be materialized before the commencement of new financial year in April. Till 2016 it was presented on the last working day of February by the Finance Minister of India in Parliament. The budget, which is presented by means of the Finance bill and the Appropriation bill has to be passed by both the Houses before it can come into effect from April 1, the start of India's financial year.

An Interim Budget is not the same as a 'Vote on Account'. While a 'Vote on Account' deals only with the expenditure side of the government's budget, an Interim Budget is a complete set of accounts, including both expenditure and receipts. An Interim Budget gives the complete financial statement, very similar to a full Budget. While the law does not debar the Union government from introducing tax changes, normally during an election year, successive governments have avoided making any major changes in income tax laws during an Interim Budget.

12.45 P.M.

Duties

• reduce customs duty. Customs duty on mobile phones and parts of televisions will be increased to 20 per cent. Customs duty on raw cashew will be reduced from 5 per cent to 2.5 per cent.
• change the name of the Central Board of Excise and Customs to the Central Board of Direct Taxes and Customs.
• Mr. Jaitley quotes Swami Vivekananda. "Let new India arise out of peasants' cottage, grasping the plough, out of huts, cobbler and sweeper."
• 
  

12.35 P.M.

Salaried taxpayers

• No changes in personal income tax rates.
• A major portion of the personal income tax collection comes from the salaried class. 1.89 crore returns were filed last year, and ₹1.44 lakh crore was paid as taxes.
• a standard deduction of ₹40,000 for transport and medical reimbursements. Revenue cost of this is ₹8,000 crore.
• Exemption of interest income for deposits in banks and post offices (including TDS) will be increased from ₹10,000 to ₹50,000 for senior citizens.
• All senior citizens will now be able to claim benefit of a deduction of ₹50,000 for medical insurance.
• For critical illnesses, the deduction has been increased to ₹1,00,000.

12.30 P.M.

Taxation

• Growth rate of direct taxes in 2016-17 and 2017-18 have been significant. 12.6% growth was recorded last year, and 18.7% growth till January 2018.
• 85.51 lakh new taxpayers filed their returns. The number of effective taxpayers has increased from 6.47 lakh crore to 8.27 lakh crore. The excess revenue from personal income tax is ₹90,000 crore.
• 100 per cent deduction to farmer-producer companies having ₹100 crore turnover. Corporate tax will be reduced to 25 per cent for companies who have a turnover up to ₹250 crore.
• Estimates of revenue foregone due to this measure is ₹7,000 crore.
• Long term capital gains tax of 10 per cent is proposed for amounts exceeding ₹1 lakh. Health and Education Cess will be increased to four per cent.

12.20 P.M.

Members' salaries

• Emoluments will revised for the President to ₹5 lakh, ₹4lakh for Vice-President and ₹3.5 lakh per month for Governors.
• changes to refix emoluments to MPs with effect from April 1, 2018. The law will provide automatic revision of emoluments every five years indexed to inflation.
• Total revenue expenditure of the government is ₹21.57 lakh crore.
• Fiscal deficit 2013-14 was 4.4 per cent of the GDP. In 2017-18 3.5 per cent of the GDP. Projected fiscal deficit 3.3 per cent of the GDP.

12.10 P.M.

Connectivity and defence

• Niti Aayog will establish programme to direct initiatives to develop artificial intelligence initiatives. Phase 1 of Bharat Net programme has been completed.
• The government will explore use of blockchain technology proactively to boost digital economy. 
• The government will not consider cryptocurrency as legal tender.
•  a unique ID for enterprises too.
• The government will bring out an industry friendly defence policy.
•  taken measures to develop two defence industrial production corridors in the country.

12.10 P.M.

Finance and investment

• The RBI has issued guidelines to nudge corporates to access the bond markets. 
• Corporate bonds rated at BBB are investment grade. 
• The government and concerned regulators will take necessary action. 
• Govt will take reform measures with respect to the stamp duty regime.
• The Commerce Ministry is developing a national logistics portal as a single window program to boost the logistics sector. 
• Disinvestment target of ₹80,000 crore has been set for this year.
• The government will recapitalise public sector banks to help them lend an additional ₹5 lakh crore. 
• United India Insurance, Oriental Insurance and National Insurance will be merged and then listed. 
• Gold monetisation scheme will be revamped to allow people to open hassle-free gold deposit accounts.

11.54 A.M.

Infrastructure and transport

• ₹50 lakh crore is needed to create world class infrastructure in the country. 
• 99 cities have been selected with outlay of ₹2.09 lakh crore under Smart City programme. 
• 10 prominent tourist sites will be developed into iconic ones to boost tourism.
• Railway capex for the year 2018-19 is ₹1.48 lakh crore. 18,000 km of doubling will eliminate capacity constraints.
• India moving towards optimal electrification of railway networks. 
• Work on Eastern and Western dedicated freight corridor is also in progress. 
• Maintenance of track infrastructure is being given special attention.
• Increasing use of technology, fog safe train protection and warning system are other focuses.
•  Redevelopment of 600 major railway stations has been taken up. 
• All stations with more than 25,000 footfalls will have escalators.
•  All trains to be progressively provided with WiFI, CCTV and other state-of-the-art amenities.
• An institute is coming up at Vadodara to train manpower for high-speed railway projects.
• UDAN shall connect 56 unserved airports and 31 unserved helipads in the country. 
• AAI has 124 airports. 
• Govt propose to expand our airport capacity to handle more than one billion trips a year.

11.35 A.M.

Health, education and social welfare

• Our government is implementing a comprehensive social security scheme. 
• Govt. have managed to get children to school but quality of education is still a cause for concern.
• Govt. now propose to treat education holistically without segmentation from pre-nursery to Class 12. 
• Govt.will initiate an integrated B-Ed programme for teachers. 
• Govt. propose to move gradually from blackboard to digital board.
• Govt.proposes to launch the Revitalising of Infrastructure and Systems of Education (RISE) by next year. 
• Govt. propose to set up two new full-fledged schools of planning and architecture. 
• 18 new schools of planning and architecture will be set up in the IITs and NITs. 
• Govt. also announces the Prime Minister's fellowship programme to subsidise research.
• The National health Policy 2017 has envisioned health and wellness centres as the foundation of India's healthcare system. 
• Govt. commits ₹1,200 crore for this flagship programme and invites contributions from the private sector.
• Govt. are launching a flagship National Health Protection Scheme to cover 10 crore poor and vulnerable families. 
• Govt. will provide them with upto ₹5 lakh per family per year in secondary and tertiary care institutions. 
•  this scheme will have 50 crore beneficiaries.
• These schemes will generate lakhs of jobs, aprticularly for women, 
• The government is progressing towards universal health coverage.
• Tuberculosis claims more lives every year than any other disease. 
• The government will provide ₹600 crore for nutrititonal support to all TB patients.
• 24 new government medical colleges will be set up by upgrading existing district hospitals in the country. 
• At least one medical college for three parliamentary constituencies.
• The Jivan Bima Yojana has benefited 5.22 crore families. 
• 187 projects have been sanctioned under Namami Gange. 
• All 4,465 Ganga gram villages have been declared open-defecation free. 
• The government has identified 115 aspirational districts and will invest in social services.
• Mass formalisation of MSMEs is taking place following demonetisation and GST. 
• It has created a big database.
•  Online loan sanctioning facility will be revamped to speed up loan giving by banks.
• ₹3 lakh crore is set as target for the Mudra Yojana in FY19. 
• Additonal measures will be taken to boost the growth of venture capital funds and angel investors.
• The government will contribute 12 per cent of wages of new employees for all sectors.
• Women's contribution to PF will be reduced to 8 per cent for the first three years of their employment with no reduction in employer's contribution. 
• The government allocates ₹7,148 crore for the textile sector.

11.15 A.M.

Agriculture and rural economy

• Govt. emphasis is on generating higher income for farmers, and generating productive and gainful employment on farms, and non-farm workers. 
• Govt. want to help the farmers produce more from the same land, at a lesser cost, and get a better price.
•  this year's Budget will focus on strengthening agriculture and the rural economy.
• For better price realisation, farmers need to make decisions based on prices likely to be available in the market.
• APMCs will be linked with ENAM. 
• The government will develop 22,000 Gramin agricultural markets. 
• The cluster-model approach will be adopted for agricultural production. 
• Organic farming with farmer-producer organisations, rural-producer organisation and women self-help groups will be encouraged.
• Minimum Support Price shall be increased by 1.5 times. 
• Operation Green will be launched for agriculture and the Minister allocates ₹500 crore for this.
• The Minister proposes to liberalise export of agricultural products. 
• Govt. agricultural exports have a potential of $100 billion as against reality of $30 billion. 
• Govt. also allocates ₹1,290 crore for development of the bamboo production sector.
• Ujjwala Yojana, the free LPG connection scheme has been expanded to eight crore households.
• The Saubhagya Yojana will be another focus for the government. Six crore toilets have been built already, and in the next year, two crore additional toilets will be constructed.
•  the government will establish a dedicated affordable housing fund.
• Loans to self-help groups will increase to ₹75,000 crore. 
• Govt. allocates ₹5,750 crore to National Livelihood Mission and ₹2,600 crore to the groundwater irrigation scheme.

11.05 A.M.

Finance Minister Arun Jaitley presents the Union Budget. When our government took over India was part of "fragile five," we have successfully reverted it. We are now the fastest growing economy of the world, he says.

Demonetisation has reduced the quantum of cash currency and spurred digitisation of the economy, says Mr. Jaitley.

Indian economy is a $2.5 trillion economy. India is expected to become the fifth largest economy very soon. Indian society, polity and economy have shown remarkable resilience in adjusting to structural reforms. We will grow 7.2-7.5% in the second half of this year. Manufacturing sector is back on the growth path. Exports are expected to grow 15% in 2018. We have taken up programmes to direct the benefits of structural reforms to the poor.

The Minister cites India's improvement in the Ease of Doing Business ranking by 42 places. He mentions the government's schemes for providing free LPG connections and electricity to underprivileged sections. He states that the government has eliminated middlement in the direct benefit transfer programme.

11 A.M.

Lok Sabha proceedings begin. Speaker Sumitra Mahajan is in the Chair. She announces the demise of Lok Sabha member Chintaman Wanga. The House pays silent tribute to the departed MP.

Ms. Mahajan says the Budget will be presented today, despite the usual procedure of the House adjourning for the day to mourn the demise of a sitting member.

Union Budget 2018-19 live on Commerce Gurukul

Union Budget 2018-19 live on Commerce Gurukul

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Union Budget

Notes on Definition of Topic of Paper 2 of Commerce UPSC

Contributed by Abu-Bakr-Al-Baghdadi

FISCAL POLICY

INTRODUCTION

• In the previous unit, we have studied the nature of governments’ intervention in markets to provide public goods, remedy externalities, ensure efficient allocation and to enable redistribution of income. We have also looked into how taxes and subsidies influence the incentives for private economic activity. We have been doing this from the microeconomic point of view.
•  From the macroeconomic perspective, the focus is on the aggregate economic activity of governments, say, aggregate expenditure, taxes, transfers and issues of government debts and deficits and their effects on aggregate economic variables such as total output, total employment, inflation, overall economic growth etc . These, in fact, form the subject matter of fiscal policy.
• The significance of fiscal policy as a strategy for achieving certain socio economic objectives was not recognized or widely acknowledged before 1930 due to the faith in the limited role of government advocated by the then prevailing laissez-faire approach. Great Depression and the consequent instabilities made policymakers support a more proactive role for governments in the economy. 
• However, later on, markets started demonstrating an enhanced role in the allocation of goods and services in the economy. In the previous unit, we have seen situations under which markets fail to achieve optimal outcomes and the need for government intervention to combat those market failures. In recent times, especially after being threatened by the global financial crisis and recession, many countries have preferred to have a more active fiscal policy.
• Governments of all countries pursue innumerable policies to accomplish their economic goals such as rapid economic growth, equitable distribution of wealth and income, reduction of poverty, price stability, exchange rate stability, full- employment, balanced regional development etc. Government budget is one among the most powerful instruments of economic policy. The important tools in the budgetary policy could be broadly classified into public revenue including taxation, public expenditure, public debt and finally deficit financing to bridge the gap between public receipts and payments. 
• When all these tools are used for achieving certain goals of economic policy, public finance is transformed into what is called fiscal policy. In other words, through the use of these instruments governments intend to favourably influence the level of economic activity of a country.
• Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and level of growth of aggregate demand, output and employment. It includes any design on the part of the government to change the price level, composition or timing of government expenditure or to alter the burden, structure or frequency of tax payment.
•  In other words, fiscal policy is designed to influence the pattern and level of economic activity in a country. Fiscal policy is in the nature of a demand-side policy. An economy which is producing at full-employment level does not require government action in the form of fiscal policy.

OBJECTIVES OF FISCAL POLICY

The objectives of fiscal policy, like those of other economic policies of the government, are derived from the aspirations and goals of the society. Since nations differ in numerous aspects, the objectives of fiscal policy also may vary from country to country. However, the most common objectives of fiscal policy are:

• Achievement and maintenance of full employment,
• maintenance of price stability,
• acceleration of the rate of economic development, and
• equitable distribution of income and wealth,

The importance as well as order of priority of these objectives may vary from country to country and from time to time. For instance, while stability and equality may be the priorities of developed nations, economic growth, employment and equity may get higher priority in developing countries. Also, these objectives are not always compatible; for instance the objective of achieving equitable distribution of income may conflict with the objective of economic growth and efficiency.

Before we go into the details of fiscal policy, we need to know the difference between discretionary fiscal policy and non-discretionary fiscal policy of automatic stabilizers.

AUTOMATIC STABILIZERS VERSUS DISCRETIONARY FISCAL POLICY

• Non-discretionary fiscal policy or automatic stabilizers are part of the structure of the economy and are ‘built-in’ fiscal mechanisms that operate automatically to reduce the expansions and contractions of the business cycle. Changes in fiscal policy do not always require explicit action by government.
•  In most economies, changes in the level of taxation and level of government spending tend to occur automatically. These are dependent on and are determined by the level of aggregate production and income, such that the instability caused by business cycle is automatically dampened without any need for discretionary policy action.
• Any government programme that automatically tends to reduce fluctuations in GDP is called an automatic stabilizer. Automatic stabilizers have a tendency for increasing GDP when it is falling and reducing GDP when it is rising. In automatic or non discretionary fiscal policy, the tax policy and expenditure pattern are so framed that taxes and government expenditure automatically change with the change in national income.
•  It involves built- in- tax or expenditure mechanism that automatically increases aggregate demand when recession is there and reduces aggregate demand when there is inflation in the economy. Personal income taxes, corporate income taxes and transfer payments (unemployment compensation, welfare benefits) are prominent automatic stabilizers.
• Automatic stabilisation occurs through automatic adjustments in government expenditures and taxes without any deliberate governmental action. These automatic adjustments work towards stimulating aggregate spending during the recessionary phase and reducing aggregate spending during economic expansion. 
• As we know, during recession incomes are reduced; with progressive tax structure, there will be a decline in the proportion of income that is taxed. This would result in lower tax payments as well as some tax refunds. Simultaneously, government expenditures increase due to increased transfer payments like unemployment benefits. 
• These two together provide proportionately more disposable income available for consumption spending to households. In the absence of such automatic responses, household spending would tend to decrease more sharply and the economy would in all probability fall into a deeper recession.
• On the contrary, when an economy expands, employment increases, with progressive system of taxes people have to pay higher taxes as their income rises. This leaves them with lower disposable income and thus causes a decline in their consumption and therefore aggregate demand. Similarly, corporate profits tend to be higher during an expansionary phase attracting higher corporate tax payments.
•  With higher income taxes, firms are left with lower surplus causing a decline in their consumption and investments and thus in the aggregate demand. Again, during expansion unemployment falls, therefore government expenditure by way of transfer payments falls and with lower government expenditure inflation gets controlled to a certain extent. 
• Briefly put, during an expansionary phase, all types of incomes rise and the amount of transfer payments decline resulting in proportionately less disposable income available for consumption expenditure. The built-in stabilisers automatically remove spending from the economy to reduce demand-pull inflationary pressures and further expansionary stimulation.
•  In brief, automatic stabilizers work through limiting the increase in disposable income during an expansionary phase and limiting the decrease in disposable income during the contraction phase of the business cycle. Since automatic stabilizers affect disposable personal income directly, and because changes in disposable personal income are closely linked to changes in consumption, these stabilizers act swiftly to reduce the extent of changes in real GDP.
• However, automatic stabilizers that depend on the level of economic activity alone would not be sufficient to correct instabilities. The government needs to resort to discretionary fiscal policies. 
• Discretionary fiscal policy for stabilization refers to deliberate policy actions on the part of government to change the levels of expenditure, taxes to influence the level of national output, employment and prices. Governments influence the economy by changing the level and types of taxes, the extent and composition of spending, and the quantity and form of borrowing.
• Governments may directly as well as indirectly influence the way resources are used in an economy. We shall now see how this happens by investigating into the fundamental equation of national income accounting that measures the output of an economy, or gross domestic product (GDP), according to expenditures.

                                              GDP = C + I + G + NX.

We know that GDP is the value of all final goods and services produced in an economy during a given period of time. The right side of the equation shows the different sources of aggregate spending or demand namely, private consumption (C), private investment (I), government expenditure i.e purchases of goods and services by the government (G), and net exports, (exports minus imports) (NX). It is evident from the equation that governments can influence economic activity (GDP) by controlling G directly and influencing C, I, and NX indirectly, through changes in taxes, transfer payments and expenditure.

INSTRUMENTS OF FISCAL POLICY

• Fiscal policy is a vital component of the general economic framework of a country and is therefore closely connected with its overall economic policy strategy. The ability of fiscal policy to influence output by affecting aggregate demand makes it a potential instrument for stabilization of the economy.
•  The Keynesian school is of the opinion that fiscal policy can have very powerful effects in altering aggregate demand, employment and output in an economy when the economy is operating at less than full employment levels and when there is need to offer stimulus to demand.
•  As such, there is a significant and justifiable role for the government to institute relevant fiscal policy measures. In fact the global financial crisis about the year 2008 has caused fiscal policy to be at centre of the public policy debate.

The tools of fiscal policy are taxes, government expenditure, public debt and the government budget. We shall discuss each of them in the following paragraphs.

Government Expenditure as an Instrument of Fiscal Policy

Public expenditures are income generating and include all types of government expenditure such as capital expenditure on public works, relief expenditures, subsidy payments of various types, transfer payments and other social security benefits. Government expenditure is an important instrument of fiscal policy. It includes governments’ expenditure towards consumption, investment, and transfer payments. Government expenditures include:

1. current expenditures to meet the day to day running of the government,
2. capital expenditures which are in the form of investments made by the government in capital equipments and infrastructure, and
3. transfer payments i.e. government spending which does not contribute to GDP because income is only transferred from one group of people to another without any direct contribution from the receivers.

Government may spend money on performance of its large and ever-growing functions and also for deliberately bringing in stabilization. During a recession, it may initiate a fresh wave of public works, such as construction of roads, irrigation facilities, sanitary works, ports, electrification of new areas etc. 

• Government expenditure involves employment of labour as well as purchase of multitude of goods and services. These expenditures directly generate incomes to labour and suppliers of materials and services. Apart from the direct effect, there is also indirect effect in the form of working of multiplier. The incomes generated are spent on purchase of consumer goods. The extent of spending by people depends on their marginal propensity to consume (MPC).
•  There is generally surplus capacity in consumer goods industries during recession and an increase in demand for various goods leads to expansion in production in those industries as well. Additionally, a programme of public investment will strengthen the general confidence of businessmen and consequently their willingness to invest. Primary employment in public works programmes will induce secondary and tertiary employment, and before long the economy is put on an expansion track.
• A distinction is made between the two concepts of public spending during depression, namely, the concept of ‘pump priming’ and the concept of 'compensatory spending'. Pump priming assumes that when private spending becomes deficient, certain volumes of public spending will help to revive the economy. Compensatory spending is said to be resorted to when the government spending is carried out with the obvious intention to compensate for the deficiency in private investment.
• Public expenditure is also used as a policy instrument to reduce the severity of inflation and to bring down the prices. This is done by reducing government expenditure when there is a fear of inflationary rise in prices. Reduced incomes on account of decreased public spending helps to eliminate excess aggregate demand.

Taxes as an Instrument of Fiscal Policy

• Taxes form the most important source of revenue for governments. Taxation policies are effectively used for establishing stability in an economy.
•  Tax as an instrument of fiscal policy consists of changes in government revenues or in rates of taxes aimed at encouraging or restricting private expenditures on consumption and investment. Taxes determine the size of disposable income in the hands of the general public which in turn determines aggregate demand and possible inflationary and deflationary gaps.
•  The structure of tax rates is varied in the context of the overall economic conditions prevailing in an economy. During recession and depression, the tax policy is framed to encourage private consumption and investment. A general reduction in income taxes leaves higher disposable incomes with people inducing higher consumption. 
• Low corporate taxes increase the prospects of profits for business and promote further investment. The extent of tax reduction and /or increase in government spending required depends on the size of the recessionary gap and the magnitude of the multiplier.
• During inflation, new taxes can be levied and the rates of existing taxes are raised to reduce disposable incomes and to wipe off the surplus purchasing power. However, excessive taxation usually stifles new investments and therefore the government has to be cautious about a policy of tax increase.

Public Debt as an Instrument of Fiscal Policy

• A rational policy of public borrowing and debt repayment is a potent weapon to fight inflation and deflation. Public debt may be internal or external; when the government borrows from its own people in the country, it is called internal debt.
•  On the other hand, when the government borrows from outside sources, the debt is called external debt. Public debt takes two forms namely, market loans and small savings.
• In the case of market loans, the government issues treasury bills and government securities of varying denominations and duration which are traded in debt markets. For financing capital projects, long-term capital bonds are floated and for meeting short-term government expenditure, treasury bills are issued.
• The small savings represent public borrowings, which are not negotiable and are not bought and sold in the market. In India, various types of schemes are introduced for mobilising small savings e.g., National Savings Certificates, National Development Certificates, etc. Borrowing from the public through the sale of bonds and securities curtails the aggregate demand in the economy. Repayments of debt by governments increase the availability of money in the economy and increase aggregate demand.

Budget as an Instrument of Fiscal Policy

• Government’s budget is widely used as a policy tool to stimulate or contract aggregate demand as required. The budget is simply a statement of revenues earned from taxes and other sources and expenditures made by a nation’s government in a year.
•  The net effect of a budget on aggregate demand depends on the government’s budget balance. A government’s budget can either be balanced, surplus or deficit. A balanced budget results when expenditures in a year equal its revenues for that year. Such a budget will have no net effect on aggregate demand since the leakages from the system in the form of taxes collected are equal to the injections in the form of expenditures made. 
• A budget surplus that occurs when the government collects more than what it spends, though sounds like a highly attractive one, has in fact a negative net effect on aggregate demand since leakages exceed injections. A budget deficit wherein the government expenditure in a year is greater than the tax revenue it collects has a positive net effect on aggregate demand since total injections exceed leakages from the government sector.
• While a budget surplus reduces national debt, a budget deficit will add to the national debt. A nation’s debt is the difference between its total past deficits and its total past surpluses. If a government has borrowed money over the years to finance its deficits and has not paid it back through accumulated surpluses, then it is said to be in debt. Deliberate changes to the composition of revenue and expenditure components of the budget are extensively used to change macro economic variables such as level of economic growth, inflation, unemployment and external stability. 
• For instance, a budget surplus reduces government debt, increases savings and reduces interest rates. Higher levels of domestic savings decrease international borrowings and lessen the current account deficit.

GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE

GOVERNMENT INTERVENTION IN THE CASE OF DEMERIT GOODS

• Demerit goods are goods which are believed to be socially undesirable. Examples of demerit goods are cigarettes, alcohol, intoxicating drugs etc. The consumption of demerit goods imposes significant negative externalities on the society as a whole and therefore the private costs incurred by individual consumers are less than the social costs experienced by the society. 
• The production and consumption of demerit goods are likely to be more than optimal under free markets. The price that consumers pay for a packet of cigarettes is market determined and does not account for the social costs that arise due to externalities.
•  In other words, the marginal social cost will exceed the market price and overproduction and over- consumption will occur, causing misallocation of society's scarce resources. (Refer Figure 2.2.1 in unit 2). 
• However, it should be kept in mind that all goods with negative externalities are not essentially demerit goods; e.g. Production of steel causes pollution, but steel is not a socially undesirable good.

The generally held argument is that consumers overvalue demerit goods because of imperfect information and they are not the best judges of welfare with respect to such goods. The government should therefore intervene in the marketplace to discourage their production and consumption. How do governments correct market failure resulting from demerit goods?

• At the extreme, government may enforce complete ban on a demerit good.
• e.g. Intoxicating drugs. In such cases, the possession, trading or consumption of the good is made illegal.
• Through persuasion which is mainly intended to be achieved by negative advertising campaigns which emphasize the dangers associated with consumption of demerit goods.
• Through legislations that prohibit the advertising or promotion of demerit goods in whatsoever manner.
• Strict regulations of the market for the good may be put in place so as to limit access to the good, especially by vulnerable groups such as children and adolescents.
• Regulatory controls in the form of spatial restrictions e.g. smoking in public places, sale of tobacco to be away from schools, and time restrictions under which sale at particular times during the day is banned.

Imposing unusually high taxes on producing or purchasing the good making them very costly and unaffordable to many is perhaps the most commonly used method for reducing the consumption of a demerit good. 

• For example, the GST Council has bracketed four items namely, high end cars, pan masala, aerated drinks and tobacco products into demerit goods category and therefore these would be taxed (with a cess being added on to the basic tax) at much higher rates than the top GST slab of 28 per cent.
• However, there are various limitations for government to succeed in producing the desired optimal effects in the case of demerit goods. There are many practical difficulties in imposing taxes.
•  In order to impose a tax which is equivalent to the marginal external cost, the governments need to know the exact value of the marginal external cost and then ascribe accurate monetary value to those negative externalities. In practice, this is extremely difficult to do.

The government can fix a minimum price below which the demerit good should not be exchanged. The effect of such minimum price fixation above equilibrium price is shown in the figure below:

Figure 2.3.5

Outcomes of Minimum Price for a Demerit Good

• Free market equates marginal private cost with marginal private benefit (point B) and produces an output of a demerit good Q at which marginal social benefit (MSB) is much less than marginal private benefit (MPB).
•  At this level of output, there is a divergence (BC) between marginal private benefit (MPB) and marginal social benefit (MSB). The shaded area represents loss of social welfare. If the government determined minimum price is P1, demand contracts and the quantity of alcohol consumed would be reduced to Q1. At Q1level of output, marginal social benefit (MSB) is equal to marginal social cost (MSC) and the quantity of alcohol consumed is optimal from the society’s point of view.
• The demand for demerit goods such as, cigarettes and alcohol is often highly inelastic, so that any increase in price resulting from additional taxation causes a less than proportionate decrease in demand. Also, sellers can always shift the taxes to consumers without losing customers.
• The effect of stringent regulation such as total ban is seldom realized in the form of complete elimination of the demerit good; conversely such goods are secretly driven underground and traded in a hidden market.

GOVERNMENT INTERVENTION IN THE CASE OF PUBLIC GOODS

• We have seen in the previous unit that public goods which are non excludable is highly prone to free rider problem and therefore markets are unlikely to get established. Direct provision of a public good by government can help overcome free-rider problem which leads to market failure. The non-rival nature of consumption provides a strong argument for the government rather than the market to provide and pay for public goods.
•  In the case of such pure public goods where entry fees cannot be charged, direct provision by governments through the use of general government tax revenues is the only option.
• Excludable public goods can be provided by government and the same can be financed through entry fees. A very commonly followed method is to grant licenses to private firms to build a public good facility.
•  Under this method, the goods are provided to the public on payment of an entry fee. In such cases, the government regulates the level of the entry fee chargeable from the public and keeps strict watch on the functioning of the licensee to guarantee equitable distribution of welfare.
• Certain goods are produced and consumed as public goods and services despite the fact that they can be produced or consumed as private goods. This is because, left to the markets and profit motives, these may prove dangerous to the society. Examples are scientific approval of drugs, production of strategic products such as atomic energy, provision of security at airports etc.

PRICE INTERVENTION : NON MARKET PRICING

• Price controls are put in place by governments to influence the outcomes of a market. Very often, there is strong political demand for governments to intervene in markets for various goods and services on grounds of fairness and equity. 
• Price intervention generally takes the form of price controls which are legal restrictions on price. Price controls may take the form of either a price floor (a minimum price buyers are required to pay) or a price ceiling (a maximum price sellers are allowed to charge for a good or service). Fixing of minimum wages and rent controls are examples of such market intervention.
• Government usually intervenes in many primary markets which are subject to extreme as well as unpredictable fluctuations in price.
•  For example in India, in the case of many crops the government has initiated the Minimum Support Price (MSP) programme as well as procurement by government agencies at the set support prices. The objective is to guarantee steady and assured incomes to farmers. In case the market price falls below the MSP, then the guaranteed MSP will prevail. The following diagram will illustrate the effects of a price floor. 
• Nevertheless, mere announcement of higher support prices for commodities, which are not effectively backed up by procurement arrangement, does not serve the purpose of remunerative levels of prices for producers.

Figure 2.3.6

Market Outcome of Minimum Support Price

When price floors are set above market clearing price, suppliers are encouraged to over-supply and there would be an excess of supply over demand. At price `150/ which is much above the market determined equilibrium price of ` 75/, the market demand is only Q1, but the market supply is Q2.

When prices of certain essential commodities rise excessively, government may resort to controls in the form of price ceilings (also called maximum price) for making a resource or commodity available to all at reasonable prices. For example: maximum prices of food grains and essential items are set by government during times of scarcity. A price ceiling which is set below the prevailing market clearing price will generate excess demand over supply. As can be seen in the following figure, the price ceiling of ` 75/ which is below the market determined price of  ` 150/leads to generation of excess demand over supply equal to Q1-Q2.

Figure 2.3.7

Market Outcome of Price Ceiling

With the objective of ensuring stability in prices and distribution, governments often intervene in grain markets through building and maintenance of buffer stocks. It involves purchases from the market during good harvest and releasing stocks during periods when production is below average.

GOVERNMENT INTERVENTION FOR CORRECTING INFORMATION FAILURE

• For combating the problem of market failure due to information problems and considering the importance of information in making rational choices, the following interventions are resorted to:
• Government makes it mandatory to have accurate labeling and content disclosures by producers. For example: SEBI requires that accurate information be provided to prospective buyers of new stocks.
• Public dissemination of information to improve knowledge and subsidizing of initiatives in that direction.
• Regulation of advertising and setting of advertising standards to make advertising more responsible, informative and less persuasive.

GOVERNMENT INTERVENTION FOR EQUITABLE DISTRIBUTION

• One of the most important activities of the government is to redistribute incomes so that there is equity and fairness in the society. Equity can be brought about by redistribution of endowments with which the economic agents enter the market.
•  Some common policy interventions include: progressive income tax, targeted budgetary allocations, unemployment compensation, transfer payments, subsidies, social security schemes, job reservations, land reforms, gender sensitive budgeting etc.

 Government also intervenes to combat black economy and market distortions associated with a parallel black economy. Government intervention in a market that reduces efficiency while increasing equity is often justified because equity is greatly appreciated by society.

The discussion above is far from being comprehensive; yet it points toward the numerous ways in which governments intervene in the markets. However, we cannot be sure whether the government interventions would be effective or whether it would make the functioning of the economy less efficient. Government failures where government intervention in the economy to correct a market failure creates inefficiency and leads to a misallocation of scarce resources occur very often. Government failure occurs when:

•  intervention is ineffective causing wastage of resources expended for the intervention.
• intervention  produces fresh and more serious problems

There are costs and benefits associated with any Government intervention in a market, and it is important that policy makers consider all of the costs and benefits of a policy intervention.

GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE

Introduction:

• In the previous unit, we have seen that under a variety of circumstances the market and the price system fail to achieve productive and allocative efficiency in an economy. As such, it should be construed that the existence of a free market does not altogether eliminate the need for government and that government intervention is essential for the efficient functioning of markets.
•  The focus of this unit will be the intervention mechanisms which governments adopt to ensure greater welfare to the society and the probable outcomes of such market interventions. 
• Government plays a vital role in creating the basic framework within which fair and open competitive markets can exist. It is indispensable that government establishes the ‘rule of law’, and in this process, creates and protects property rights, ensures that contracts are upheld and sets up necessary institutions for proper functioning of markets.
•  For achieving this, an appropriately framed competition and consumer law framework that regulates the activities of firms and individuals in their market exchanges should be in place.

We have seen in the previous unit that the major reasons for market failure are market power, externalities, public goods, and incomplete information. Before we go into the details of government intervention, we shall try to have a quick glimpse of the forms of government intervention.

GOVERNMENT INTERVENTION TO MINIMIZE MARKET POWER

• As we are aware, market power—exercised either by sellers or buyers— is an important factor that contributes to inefficiency because it results in higher prices than competitive prices. In addition, market power also tends to restrict output and leads to deadweight loss. Because of the social costs imposed by monopoly, governments intervene by establishing rules and regulations designed to promote competition and prohibit actions that are likely to restrain competition. These legislations differ from country to country. 
• For example, in India, we have the Competition Act, 2002(as amended by the Competition (Amendment) Act, 2007) to promote and sustain competition in markets. The Antitrust laws in the US and the Competition Act, 1998 of UK etc are designed to promote competitive economy by prohibiting actions that are likely to restrain competition. Such legislations generally aim at prohibiting contracts, combinations and collusions among producers or traders which are in restraint of trade and other anticompetitive actions such as predatory pricing.
•  On the contrary, some of the regulatory responses of government to incentive failure tend to create and protect monopoly positions of firms that have developed unique innovations. For example, patent and copyright laws grant exclusive rights of products or processes to provide incentives for invention and innovation. 
• Policy options for limiting market power also include price regulation in the form of setting maximum prices that firms can charge. Price regulation is most often used for natural monopolies that can produce the entire output of the market at a cost that is lower than what it would be if there were several firms. If a firm is a natural monopoly, it is more efficient to permit it serve the entire market rather than have several firms who compete each other. 
• Examples of such natural monopoly are electricity, gas and water supplies. In some cases, the government‘s regulatory agency determines an acceptable price, so as to ensure a competitive or fair rate of return. This practice is called rate-of-return regulation. Another approach to regulation is setting price-caps based on the firm’s variable costs, past prices, and possible inflation and productivity growth. 

GOVERNMENT INTERVENTION TO CORRECT EXTERNALITIES

• As you may easily recall, freely functioning markets produce externalities because producers and consumers need to consider only their private costs and benefits and not the costs imposed on or benefits accrued to others. Governments have numerous methods to reduce the effects of negative externalities and to promote positive externalities.
•  We shall first examine how government regulation can deal with the inefficiencies that arise from negative externalities. Since the most commonly referred negative externality is pollution, we shall take it as an exemplar in the following discussion. 

Government initiatives towards negative externalities may be classified as:

1. Direct controls that openly regulate the actions of those involved in generating negative externalities, and 
2. Market-based policies that would provide economic incentives so that the self- interest of the market participants would achieve the socially optimal solution. 

• Direct controls prohibit specific activities that explicitly create negative externalities or require that the negative externality be limited to a certain level, for instance limiting emissions. Production, use and sale of many commodities and services are prohibited in our country.
•  Smoking is completely banned in many public places. Stringent rules are in place in respect of tobacco advertising, packaging and labeling etc.
• Governments may pass laws to alleviate the effects of negative externalities. Government stipulated environmental standards are rules that protect the environment by specifying actions by producers and consumers.
•  For example, India has enacted the Environment (Protection) Act, 1986. The government may, through legislation, fix emissions standard which is a legal limit on how much pollutant a firm can emit. The set standard ensures that the firm produces efficiently. If the firm exceeds the limit, it can invite monetary penalties or/and criminal liabilities. The firms have to install pollution-abatement mechanisms to ensure adherence to the emission standards. 
• This means additional expenditure to the firm leading to rise in the firm’s average cost. New firms will find it profitable to enter the industry only if the price of the product is greater than the average cost of production plus abatement expenditure. 
• Another method is to charge an emissions fee which is levied on each unit of a firm’s emissions. The firms can minimize costs and enhance their profitability by reducing emissions. Governments may also form special bodies/ boards to specifically address the problem: for instance the Ministry of Environment & Forest, the Pollution Control Board of India and the State Pollution Control Boards. 
• The market-based approaches–environmental taxes and cap-and-trade – operate through price mechanism to create an incentive for change.
•  In other words, they rely on economic incentives to accomplish environmental goals at lesser costs. The market based approaches focus on generation of a market price for pollution. This is achieved by: 

1. Setting the price directly through a pollution tax 
2. Setting the price indirectly through the establishment of a cap-and-trade system. 

• The key to internalizing an externality (both external costs and benefits) is to ensure that those who create the externalities include them while making decisions. One method of ensuring internalization of negative externalities is imposing pollution taxes. The size of the tax depends on the amount of pollution a firm produces.
•  These taxes are named Pigouvian taxes after A.C. Pigou who argued that an externality cannot be alleviated by contractual negotiation between the affected parties and therefore taxation should be resorted to. These taxes, by ‘making the polluter pay’, seek to internalize external costs into the price of a product or activity. 
• More precisely, the tax is placed on the externality itself (the amount of pollution emissions) rather than on output (say, amount of steel). For each unit of pollution, the polluter must choose either to pay the tax or to reduce pollution through any means at its disposal. Tax increases the private cost of production or consumption as the case may be, and would decrease the quantity demanded and therefore the output of the good which creates negative externality. The proceeds from the tax, some argue, can be specifically earmarked for projects that protect or enhance environment. 

The following figure illustrates the market outcomes of pollution tax.

Market Outcomes of Pollution Tax 

• When negative production externalities exist, marginal social cost is greater than marginal private cost. The free market outcome would be to produce a socially non optimal output level Q at the level of equality between marginal private cost and marginal private benefit. (Since externalities are not taken into account, marginal private benefit would be contemplated as marginal social benefit). 
• When externalities are present, the welfare loss to the society or dead weight loss would be the shaded area ABC. The tax imposed by government (equivalent to the vertical distance AA1) would shift the cost curve up by the amount of tax, prices will rise to P1 and a new equilibrium is established at point B, where the marginal social cost is equal to marginal social benefit. Output level Q1 is socially optimal and eliminates the whole of welfare loss on account of overproduction. 

However, there are problems in administering an efficient pollution tax.

• Pollution taxes are difficult to determine and administer because it is difficult to discover the right level of taxation that would ensure that the private cost plus taxes will exactly equate with the social cost. If the demand for the good is inelastic, the tax may only have an insignificant effect in reducing demand. 
• The method of taxing the polluters has many limitations because it involves the use of complex and costly administrative procedures for monitoring the polluters. 
• This method does not provide any genuine solutions to the problem. It only establishes an incentive system for use of methods which are less polluting. 
• In the case of goods which have inelastic demand, producers will be able to easily shift the tax burden in the form of higher product prices. This will have an inflationary effect and may reduce consumer welfare. 
• Pollution taxes also have potential negative consequences on employment and investments because high pollution taxes in one country may encourage producers to shift their production facilities to those countries with lower taxes. 
• The second approach to establishing prices is tradable emissions permits (also known as cap-and-trade). These are marketable licenses to emit limited quantities of pollutants and can be bought and sold by polluters. Under this method, each firm has permits specifying the number of units of emissions that the firm is allowed to generate.
•  A firm that generates emissions above what is allowed by the permit is penalized with substantial monetary sanctions. These permits are transferable, and therefore different pollution levels are possible across the regulated entities. Permits are allocated among firms, with the total number of permits so chosen as to achieve the desired maximum level of emissions. By allocating fewer permits than the free pollution level, the regulatory agency creates a shortage of permits which then leads to a positive price for permits.
•  This establishes a price for pollution, just as in the tax case. The high polluters have to buy more permits, which increases their costs, and makes them less competitive and less profitable. The low polluters receive extra revenue from selling their surplus permits, which makes them more competitive and more profitable.
•  Therefore, firms will have an incentive not to pollute. India is experimenting with cap-and-trade in the form of Perform, Achieve & Trade (PAT) scheme and carbon tax in the form of a cess on coal. 

The advantages claimed for tradable permits are:

• The system allows flexibility and reward efficiency 
• It is administratively cheap and simple to implement and ensures that pollution is minimised in the most cost-effective way 
• It also provides strong incentives for innovation. 

Consumers may benefit if the extra profits made by low pollution firms are passed on to them in the form of lower prices. 

The main argument in opposition to the employment of tradable emission permits is that they do not in reality stop firms from polluting the environment; they only provide an incentive to them to do so. Moreover, if firms have monopoly power of some degree along with a relatively inelastic demand for its product, the extra cost incurred for procuring additional permits so as to further pollute the atmosphere, could easily be compensated by charging higher prices to consumers.

The two interventions mentioned above i.e. pemits and taxes make use of market forces to encourage consumers and producers to take externalities into account when planning their consumption and production. In other words, the polluters are forced to consider pollution as a private cost.

• We shall now look into the case of positive externalities. As we are aware, subsidies involve government paying part of the cost to the firms in order to promote the production of goods having positive externalities.
•  This is in fact a market-based policy as subsidies to producers would lower their cost of production. What would be the outcome of government intervention through subsidy? A subsidy on a good which has substantial positive externalities would reduce its cost and consequently price, shift the supply curve to the right and increase its output. A higher output that would equate marginal social benefit and marginal social cost is socially optimal 

The effect of a subsidy is shown in the following figure.
                            Effect of Subsidy on Output

• A Pigouvian subsidy equal to the benefit of externality (S=E) is granted by government to the producer. The output level post subsidy is Q* which equates marginal social benefit with marginal social cost. This is socially optimum level of output. 
• In the case of products and services whose externalities are vastly positive and pervasive, government enters the market directly as an entrepreneur to produce and provide them.
•  For example, fundamental research to protect the futuristic technology interest of the society is, in most cases, funded by government as the market may not be willing to provide them. Governments also engage in direct production of environmental quality.
•  Examples are: aforestation, reforestation, protection of water bodies, treatment of sewage and cleaning of toxic waste sites. 

GOVERNMENT INTERVENTION IN THE CASE OF MERIT GOODS

• Merit goods are goods which are deemed to be socially desirable and therefore the government deems that its consumption should be encouraged. Substantial positive externalities are involved in the consumption of merit goods. Left to the market, only private benefits and private costs would be reflected in the price paid by consumers.
•  This means, compared to what is socially desirable, people would consume inadequate quantities. Examples of merit goods include education, health care, welfare services, housing, fire protection, waste management, public libraries, museum and public parks. 
• In contrast to pure public goods, merit goods are rival, excludable, limited in supply, rejectable by those unwilling to pay, and involve positive marginal cost for supplying to extra users. Merit goods can be provided through the market, but are likely to be under-produced and under-consumed through the market mechanism so that social welfare will not be maximized. The following diagram will show the market outcome for merit goods. 

In the absence of government intervention, the output of the merit good would be Q where the marginal private cost (MPC) is equal to marginal private benefit (MPB). The welfare loss to the society due to under production and under consumption is the shaded area (ABC). On account of considerable positive externalities, the optimal output is Q* at which marginal social (MSC) cost is equal to marginal social benefit (MSB). This is a strong case for government intervention in the case of merit goods.

The additional reasons for government provision of merit goods are:

• Information failure is widely prevalent with merit goods and therefore individuals may not act in their best interest because of imperfect information. 
• Equity considerations demand that merit goods such as health and education should be provided free on the basis of need rather than on the basis of individual’s ability to pay. 
• There is a lot of uncertainty as to the need for merit goods E.g. health care. Due to uncertainty about the nature and timing of healthcare required in future, individuals may be unable to plan their expenditure and save for their future medical requirements. The market is unlikely to provide the optimal quantity of health care when consumers actually need it, because they may be short of the necessary finances to pay the market price. 
• The possible government responses to under-provision of merit goods are regulation, subsidies, direct government provision and a combination of government provision and market provision. Regulation determines how a private activity may be conducted. For example, the way in which education is to be imparted is government regulated. Governments can prohibit some type of goods and activities, set standards and issue mandates making others oblige.
•  For example, government may make it compulsory to avail insurance protection. Compulsory immunization may be insisted upon as it helps not only the individual but also the society at large. Government could also use legislation to enforce the consumption of a good which generates positive externalities. E.g. use of helmets, seat belts etc. 
• The Right of Children to Free and Compulsory Education Act, 2009 which mandates free and compulsory education for every child of the age of six to fourteen years is another example. A variety of regulatory mechanisms may also be set up by government to enhance consumption of merit goods and to ensure their quality. 

When governments provide merit goods, it may give rise to large economies of scale and productive efficiency apart from generating substantial positive externalities and overcoming the problems mentioned above.