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Fiscal deficit and its implications

2020 FEB 21

Mains   > Economic Development   >   Indian Economy and issues   >   Fiscal deficit

WHY IN NEWS?

The Union Budget presented in last July expected the fiscal deficit to be 3.3 per cent of the GDP for the current financial year (FY20). But the Finance Minister while presenting the budget recently, has estimated the fiscal deficit to be at 3.8% for FY20 (2019-20) and the deficit to be at 3.5% in FY21       (2020-21).

Types of deficit

  • Budget deficit =   total expenditure – total receipts
  • Revenue deficit = revenue expenditure – revenue receipts
  • Fiscal Deficit = total expenditure – total receipts except borrowings
  • Primary Deficit = Fiscal deficit- interest payments
  • Effective revenue Deficit-= Revenue Deficit – grants for the creation of capital assets
  • Monetized Fiscal Deficit = that part of the fiscal deficit covered by borrowing from the RBI.

FISCAL DEFICIT – TAKEAWAYS FROM THE BUDGET:

  • FM had set a fiscal deficit target of 3.3 per cent for the current financial year during her budget presentation in July. But the government failed to meet its tax collection targets. Matters turned worse as persistent economic slowdown forced the government to announce tax cuts and other sops.
  • Fiscal Deficit is considered the most important marker of a government’s financial health.
  • Finance Minister cited Section 4 (2) of the Fiscal Responsibility and Budget Management (FRBM) Act that provides for a trigger mechanism for a deviation from the estimated fiscal deficit on account of structural reforms in the economy with unanticipated fiscal implications.
  • According to the data released by the CAG the government’s fiscal deficit touched 132.4% of the full-year target at December-end mainly due to slower pace of revenue collections.
  • Fiscal marksmanship refers to the accuracy of the government’s forecast of fiscal parameters such as revenues, expenditures and deficits etc. In other words, if the difference between what the government projected as the likely fiscal deficit in the Budget and the actual figures a year later is large, then it reflects poor fiscal marksmanship.
  • The government was expecting the fiscal deficit to be 3.3% but the actual figure presented is 3.8% according to the recent budget.
  • The Budget numbers is very crucial as the central purpose of publicly disclosing the Budget or the annual financial statement in a democracy and seeking approval from the legislature is to make the policymaking and governance transparent and participatory.
  • Budget numbers are forecasts and estimates is unlikely to tally exactly with the actual numbers a year later, but there is underlying belief that when the government states a figure it is based on genuine calculations.
  • However, if these fiscal forecasts turn out to be way off the mark repeatedly it will undermine the credibility of the Budget numbers and indeed the Budget presentation itself.

IMPLICATIONS OF HIGH FISCAL DEFICIT:

  • In the economy, there is a limited pool of investible savings. These savings are used by financial institutions like banks to lend to private businesses (both big and small) and the governments (Centre and state).
  • The significance of fiscal deficit is that if this ratio is too high, it implies that there is a lesser amount of money left in the market for private entrepreneurs and businesses to borrow. Lesser amount of this money in turn leads to higher rates of interest charged on such lending.
  • So, in simple terms, a higher fiscal deficit means higher borrowing by the government which in turn mean higher interest rates in the economy.
  • Debt Trap – Fiscal deficit indicates the total borrowing requirements of the government. Borrowings not only involve repayment of principal amount, but also require payment of interests. Interest payments increase the revenue expenditure, which leads to revenue deficit. It creates a vicious circle of fiscal deficit and revenue deficit, wherein government takes more loans to repay the earlier loans. As a result, country is caught in a debt trap.
  • Inflation - Government mainly borrows from Central Bank to meet its fiscal deficit. And when the bank print money to finance the government, it can increase the money supply in the economy and create inflationary pressure.
  • Foreign dependence – if the government tries to finance its deficit from external borrowings, it can make the country dependent on foreign countries and financial institutions.
  • Hampers future growth - Borrowings increase the financial burden for future generations. It adversely affects the future growth and development prospects of the country.
  • Affect investments – A very high fiscal deficit might reduce the sovereign credit rating of the country, which will make it difficult to raise funds abroad and attract investments to India.

ANALYSIS:

  • A big reason for India’s precarious fiscal position has been its struggles with tax collection. The tax-GDP ratio for centre and states combined was 17.1% for India in 2018-19, lower than the bigger economies such as China, Brazil and Russia.
  • One major reason for this has been its narrow tax base. Since an overwhelming majority of Indians do not pay taxes, Indian tax revenues remain largely dependent on indirect tax collections which include all taxes on spending (such as GST). These indirect taxes account for over two-thirds of total tax revenue in India, the largest such proportion among the 10 Emerging Market Economies.
  • Over half of the government’s expenditure in India goes towards subsidies and other programmes. India also spends a substantial amount on interest payments, about 6% of total government spending went towards interest payments.
  • Higher proportion of interest payments are a direct outcome of the debt levels accumulated by the Indian government. India’s debt-to-GDP ratio at 69%.
  • Ahead of Budget 2020, a common demand from economists and analysts was for greater spending to reignite the economy. Such stimulus was not possible due to the lack of resources. India’s deteriorating fiscal position made any large injection into the economy difficult.
  • The government is optimistic about reducing the fiscal deficit in FY21, but the government’s revenues are unlikely to grow close to the Budget’s expectation. As a result, either the fiscal deficit will overshoot from the budgeted number or the expenditure numbers will be much lower than promised.
  • Economists and analysts argue that the actual fiscal deficit figures might be higher, that’s because some of the government’s expenditure is funded by the so-called “off-budget” items. As a result, while this extra expenditure did not figure in the official calculations, it did mean that the true fiscal deficit or borrowing by the public sector was higher than the level presented in the Budget.
  • There is no set universal level of fiscal deficit that is considered good. Typically, for a developing economy where private enterprises may be weak and governments may be in a better state to invest, fiscal deficit could be higher than in a developed economy.
  • In developing economies, governments also have to invest in both social and physical infrastructure upfront without having adequate avenues for raising revenues.
  • Government can finance the deficit mainly by two ways:
    • Borrowings - Fiscal deficit can be met by borrowings from the internal sources (public, commercial banks etc.) or the external sources (foreign governments, international organisations etc.). it has the risk of perpetuating deficit by falling into dept trap.
    • Deficit financing - Government may borrow from RBI against its securities to meet the fiscal deficit. RBI issues new currency for this purpose. This process is known as deficit financing. It has the risk of inflationary pressures.
  • Other ways to reduce the deficit include:
    • Increased emphasis on tax-based revenues
    • Appropriate measures to reduce tax evasion.
    • Disinvestment should be done where assets are not being used effectively
    • Reduction in subsidies by the government will also help reduce the deficit.
    • A broadened tax base may also help in reducing the government deficit
    • Avoiding ‘unplanned expenditure’
  • Instead of focusing more on subsides and other sops same expenditure can be channelized to building irrigation facilities, roads, warehouses and other infrastructure which would eventually help the economy to build a durable basis.
  • Also, the government should not bombard the economy with any new reforms, as individuals and enterprises are taking a back foot in spending and investments due to the measures like demonetization and implementation of GST which were arguably implemented in a haste.

Practice Question

Q. What do you understand by fiscal deficit? Examine the implications a high fiscal deficit can have on the economy.