Fiscal Policy and Financial Market Performance

– a Critical Appraisal

Parmeet Singh Sethi

Shaheed Sukhdev College of Business Studies

Index

1. Acknowledgement2. Fiscal Policy

a)What is Fiscal Policy?b) Types of Fiscal Policyc) Importance of Fiscal Policy

3. Financial Marketsa) What are Financial Markets?b) Functions of Financial Markets

4. Basic Conceptsa) Capital Expenditureb) Capital Receiptsc) Revenue Expenditured) Revenue Receiptse) Total Expendituref) Total Receiptsg) Revenue Deficith) Fiscal Deficiti) Direct Taxesj) Indirect Taxes

5. India's Fiscal Policya) India's Fiscal Policy Architecture

6. Fiscal Policy and Financial Markets7. Bibliography

Acknowledgement

I take this opportunity to express my profound gratitude and deep regards to my guide Dr. Kumar Bijoy for his exemplary guidance, monitoring and constant encouragement throughout the course of this project. The blessing, help and guidance given by him time to time shall carry me a long way in the journey of life on which I am about to embark.

I would also like to thank the National Stock Exchange of India for having given me this opportunity to conduct this research and present my findings.

Lastly, I thank my family members and friends for their constant encouragement without which this assignment would not have been possible.

Fiscal Policy

What is Fiscal Policy?

Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.

Fiscal policy is composed of several parts. These include, tax policy, expenditure policy, investment or disinvestment strategies and debt or surplus management. Fiscal policy is an important constituent of the overall economic framework of a country and is therefore intimately linked with its general economic policy strategy.

The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors. These changes can affect the following macroeconomic variables in an economy:

• Aggregate demand and the level of economic activity;• The distribution of income;• The pattern of resource allocation within the government sector and relative to the private sector.

Types of Fiscal Policy

The three main stances of fiscal policy are:

Neutral fiscal policy –It is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

• Expansionary fiscal policy- It involves government spending exceeding tax revenue, and is usually undertaken during recessions.• Contractionary fiscal policy- It occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.

Importance of Fiscal Policy

Fiscal policy feeds into economic trends and influences monetary policy. When the government receives more than it spends, it has a surplus. If the government spends more than it receives it runs a deficit. To meet the additional expenditures, it needs to borrow from domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent amount of money.1 This tends to influence other economic variables. On a broad generalisation, excessive printing of money leads to inflation. If the government borrows too much from abroad it leads to a debt crisis. If it draws down on its foreign exchange reserves, a balance of payments crisis may arise. Excessive domestic borrowing by the government may lead to higher real interest rates and the domestic private sector being unable to access funds resulting in the ‘crowding out’ of private investment. Sometimes a combination of these can occur.The challenge for most developing country governments is to meet infrastructure and social needs while managing the government’s finances in a way that the deficit or the accumulating debt burden is not too great.

Financial Markets

What are Financial Markets?

A Financial Market is a market in which people and entities can trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand.

Financial Markets facilitate:• The raising of capital (in the capital markets)• The transfer of risk (in the derivatives markets)• Price discovery• Global transactions with integration of financial markets• The transfer of liquidity (in the money markets)• International trade (in the currency markets)

Functions of Financial Markets

• Intermediary Functions• Transfer of Resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers.• Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income.• Productive usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production.• Capital Formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country.• Price determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in the economy based on the demand and supply through the mechanism called price discovery process.• Sale Mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets.• Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets.

• Financial Functions• Providing the borrower with funds so as to enable them to carry out their investment plans.• Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures.• Providing liquidity in the market so as to facilitate trading of funds.• it provides liquidity to commercial bank• it facilitate credit creation• it promotes savings• it promotes investment• it facilitates balance economic growth• it improves trading floors

Basic Concepts

Capital ExpenditureAn expenditure is a capital expenditure if it relates to the creation of an asset that is likely to last for a considerable period of time or loan disbursements. Such expenditures are generally not routine in nature.

Capital ReceiptsA capital receipt arises from the liquidation of an asset including the sale of government shares in public sector companies (disinvestments), the return of funds given on loan or the receipt of a loan. Such expenditures are generally not routine in nature.

Revenue ExpenditureRevenue expenditures are fairly regular and generally intended to meet certain routine requirements like salaries, pensions, subsidies, interest payments, etc.

Revenue ReceiptsRevenue receipts represent regular earnings, for instance tax receipts and non-tax receipts such as profits from Public Sector Units.

Total ExpenditureTotal Expenditure is the aggregate to Capital Expenditure and Revenue Expenditure.

Symbolically,

Total Expenditure = Capital Expenditure + Revenue Expenditure

Total ReceiptsTotal Receipts refer to the aggregate of Capital Receipts and Revenue Receipts.

Symbolically,

Total Receipts = Capital Receipts + Revenue Receipts

Revenue DeficitRevenue Deficit indicates the difference between Revenue Expenditures and Revenue Receipts. It is the simplest way to represent and interpret a government's deficit.

Symbolically,

Revenue Deficit = Revenue Expenditure – Revenue Receipts

Fiscal DeficitFiscal Deficit is the difference between Total Expenditure and Total Receipts less Long Term Borrowings.

Symbolically,

Fiscal Deficit = Total Expenditure - (Total Receipts – Long Term Borrowings)

Fiscal Deficit is a more comprehensive indicator of a government's budget as it gives a more holistic view of the government‟s funding situation since it gives the difference between all receipts and expenditures other than loans taken to meet such expenditures.

Direct TaxesDirect taxes are taxes which are charged upon and collected directly from the person or organisation that ultimately pays the tax. Taxes on personal and corporate incomes, personal wealth and professions are direct taxes.

Indirect TaxesAn indirect tax is a tax collected by an intermediary from the person who bears the ultimate economic burden of the tax. Taxes such as sales tax, a specific tax, value added tax, or goods and services tax are indirect taxes.

India's Fiscal Policy

India's Fiscal Policy Architecture

The Indian Constitution provides the overarching framework for the country's fiscal policy. India has a federal form of government with taxing powers and spending responsibilities being divided between the central and the state governments according to the Constitution. There is also a third tier of government at the local level.

Since the taxing abilities of the states are not necessarily commensurate with their spending responsibilities, some of the central government's revenues need to be assigned to the state governments. To provide the basis for this assignment and give medium term guidance on fiscal matters, the Constitution provides for the formation of a Finance Commission (FC) every five years. Based on the report of the FC the central taxes are devolved to the state governments. The Constitution also provides that for every financial year, the government shall place before the legislature a statement of its proposed taxing and spending provisions for legislative debate and approval. This is referred to as the Budget. The central and the state governments each have their own budgets.

The central government is responsible for issues that usually concern the country as a whole like national defence, foreign policy, railways, national highways, shipping, airways, post and telegraphs, foreign trade and banking. The state governments are responsible for other items including, law and order, agriculture, fisheries, water supply and irrigation, and public health. There is now increasing devolution of some powers to local governments at the city, town and village levels.

The taxing powers of the central government encompass taxes on income (except agricultural income), excise on goods produced (other than alcohol), customs duties, and inter-state sale of goods. The state governments are vested with the power to tax agricultural income, land and buildings, sale of goods (other than inter-state), and excise on alcohol.

Besides the annual budgetary process, India follows a system of five- year plans for ensuring long-term economic objectives. This process is steered by the Planning Commission for which there is no specific provision in the Constitution. The main fiscal impact of the planning process is the division of expenditures into plan and non-plan components.

The plan components relate to items dealing with long-term socio- economic goals as determined by the ongoing plan process. They often relate to specific schemes and projects. These are usually routed through central ministries to state governments for achieving certain desired objectives. These funds are generally in addition to the assignment of central taxes as determined by the Finance Commissions. In some cases, the state governments also contribute their own funds to the schemes.

Non-plan expenditures broadly relate to routine expenditures of the government for administration, salaries, and the like.

Fiscal Policy and Financial Markets

Theoretically, fiscal policy actions play a significant role in the determination of asset prices. For example, increases in taxes, with government spending unchanged, would lower expected asset returns, or prices as they discourage investors from investing in the stock market. Also, increases in government borrowing raise the short-term interest rate which, in turn, lower the discounted cash flow value from an asset and thus signals a reduction in stock market activity. In the latter case, if high interest rates threaten to choke off future economic activity, then the RBI might step in to reverse this undesirable situation.

In general, from the investors’ perspective large budgetary deficits adversely impact stock and bond prices because they increase interest rates. That is because the government, being a large borrower, soaks up large amounts of funds that otherwise would have been available for the private sector, and thus drives up interest rates The increase in interest rates, in turn, will reduce business capital spending and ultimately undermine real economicactivity. These events will affect the financial markets by reducing asset prices and household wealth, further raising the cost of borrowing and reducing business spending. Ultimately, higher interest rates and weaker economic activity may further deteriorate the fiscal imbalance potentially triggering another round of such negative effects reinforcing thus the vicious circle.

Large future deficits entail additional risks to the economy which include a loss in investor confidence and adverse effects on the exchange rate. Specifically, a loss in investor confidence would cause a shift of portfolios away from home-currency assets into foreign-currency assets, thereby placing a downward pressure on the domestic currency, and an upward pressure on the interest rate, which would limit the ability of the country to finance its liabilities and increase the country’s exposure to exchange rate fluctuations. This situation, in turn, could undermine capital spending and ignite a drop in asset prices which would further restrain real economic activity.

The effects of money growth on stock returns can be approached from two theoretical perspectives, namely the efficient market approach (Cooper and Rozeff, 1974) and the (general equilibrium) portfolio approach. The first approach simply argues that all past information incorporated in the money supply data is reflected in current stock returns and so money supply changes should have no impact on stock returns (except, perhaps, a contemporaneous effect). The second perspective suggests that investors attempt to hold an equilibrium position among all assets, including money and equities. An exogenous shock that increases the money supply would temporarily disturb this equilibrium until investors substitute money for other assets (including stocks). So, equities respond to monetary disturbance with a lag (and that lag could, theoretically, be linked to an interest-rate effect, a corporate-earnings effect, a risk-premium effect and so on .

Bibliography

www. nse india.com en.wikipedia.orgwww.investopedia.comfinmin.nic.inwww.nagauniv.org.inwww.unigoa.ac.inwww.rbi.org.inTimes of IndiaThe Market OracleMoneycontrol.comBusiness Today Economic Times