Economy

The Fiscal Deficit Discourse Explained

The Annual Budget session of the Indian Parliament is a widely followed event for the polity as well as the economy. Every citizen is a stakeholder and therefore, a major section of the population shows keen interest in observing the discussions and announcements made. The popular discourses in the country, including those dominating the media houses, revolve considerably around the Budget. In the process, one often comes across technical terms whose meanings one might be unaware of, or might have a limited understanding of. Fiscal Deficit is one such recurrently used term whose implications a layman might not know fully. However, since we often engage in trying to analyse the policies of the government, this article attempts to offer a comprehensive explanation of the concept.

What does ‘fiscal deficit’ mean?

A fiscal deficit means that the government’s expenditure has exceeded its revenue in a fiscal year. This imbalance is also called current accounts deficit or budget deficit. Now, from our common understanding of budgeting our household expenditures, we realise that this is a condition that can disturb the financial stability of any concerned entity if not dealt with effectively. Particularly with the gigantic numbers involved in an entire nation’s budget, we know the consequences of inefficiency will be grave. Therefore, we move to the next question very naturally.

How is a fiscal deficit managed/financed?

Fiscal deficits of the government are financed primarily through borrowings, either domestic or external. This involves a sale of government securities such as Treasury Bonds to private individuals, business firms or foreign governments, who lend money to the government, expecting a future return. Sometimes governments also finance their deficits through the aid of the Central Bank of the country. In India, for instance, the Reserve Bank of India is known as the ‘Lender of Last Resort’ to the government. The RBI can liquidate the assets of the country and issue new currency in order to lend money to the government.

Implications

Economists around the world have been divided on their analysis of fiscal deficits. There is widespread disagreement with regard to the impact that deficits have on a country’s economy. British economist John Keynes, in his study of macroeconomics, explains that large deficits in governmental expenditure drive the economy forward and maintain a healthy circulation of money and commodities in the market. Government bonds and securities are believed to be very safe investments, and therefore, investors are generally keen on purchasing them. Since this instigates a competitive vibe amongst other private companies selling shares in the market, they also tend to offer better interest rates to the investors. This is a frequently used mechanism in the government’s monetary policy which ensures that the aggregate demand in the market remains high. In fact, deficits are also central in a government’s attempt to push the economy out of recessionary trends. Noble laureate Paul Krugman reiterates this understanding in his theory, claiming that USA’s recovery from the Great Recession of 2007-09 was sluggish owing to the Congress’s unwillingness to incur large deficits for boosting the economy.

An alternative understanding comes from the critiques of fiscal deficits, who broadly harp on the following points: One of the central problems in the creation of budget deficits is that the cash flow in the market increases and the incomes of certain sections of the population rise. Consequently, the aggregate demand in the market rises disproportionately with regard to the aggregate supply, and there is the creation of inflationary pressures in the economy. A similar consequence occurs when the RBI issues new currency on the request of the government. The increased money in the hands of the people pushes the demand curve upward.

The second and the graver problem is with regard to the burden that loans create on the government just like on any individual who has taken a loan. Often, governments are compelled to borrow money at high rates of interest. Recurring deficits and borrowings year after year result in an accumulation of interest payable to the lenders. New commitments and expenditures in the following fiscal year often prevent the government from paying back the loans quickly, and the amount keeps getting piled up. After a certain period, the government might get so burdened by the dues that a financial crisis could be generated where the government might need to take yet another loan that would entirely be spent on making interest payments for previous loans; a phenomenon that is termed ‘debt trap’ in economic terms. Even if as acute a consequence as this is not reached, accumulated debts certainly reduce the actually disposable part in the budget presented by the government. This adversely affects the general state of the country as allotments to sectors like health, education, etc. get comprised for the payment of interests.

Critics agree that sometimes deficit spending does provide a boost to the financial sector. However, this is usually a short-run impact. In fact, one can not take for granted that each time a deficit is incurred, the economy will necessarily get boosted. The impact on the economy is dependent on the nature of the deficit and expenditure. While investments in infrastructure building and setting up new industries and institutes shall contribute positively, a reduction in the revenue generation due to increased tax evasion or tax cuts and subsidies shall not reap any real benefit for the macroeconomic health of the country.

Fiscal deficit trends in India

Most contemporary economies have deficits in their budget. Likewise, India’s budget also shows a deficit each financial year. The approach in India has, however, been inclined towards a balanced budget policy. In the pre-liberalisation era, the budget had large current account deficits owing to India’s heavy reliance on imports of oil and petroleum. The Gulf War further worsened the situation as oil prices sky-rocketed and foreign investors withdrew from the market. The foreign exchange reserves of the country had depleted to catastrophic levels. It was in this backdrop that PM Narasimha Rao decided to lead the country onto the path of economic liberalisation, popularly known today as the ‘New Economic Policy’ of 1991. In the preceding year (1990-91), India’s fiscal deficit was 7.61 percent of the GDP. Around two decades later, the Fiscal Responsibility and Budget Management Act (2003) was passed by the Indian Parliament with the objective of reducing fiscal deficit in the forthcoming budgets, institutionalising fiscal discipline and making the overall management of public funds more efficient. An attempt was made at reducing the deficit following this Act, and in a persistent fall in the graph, the deficit in 2007-08 was 2.54 percent. The following two years again brought in a low phase for the economy, with the fiscal deficit soaring up to 5.99 and 6.46 percent. A gradual decrease was observable thereafter.

The Narendra Modi government has been continuously emphasising on the need to reduce fiscal deficit and has been successful to some extent. In the year 2018-19, the government achieved a 3.39 percent, lower than the estimated 3.4 as per revised estimates. We have also noted that the government has provided a projected fiscal deficit of 3.3 percent in the recent Budget. Given the ambitious projects and tall promises made by the PM as he was sworn in for a second term, it would indeed be interesting to watch how this target would be met in the midst of the construction of roads, establishment of a bullet train system, among other projects, and simultaneously also allowing for tax reductions for both corporates and individuals.

Foreign Borrowings and loans from the World Bank are a common phenomenon in the developing countries, and the trend in India has not been very different. For innumerable large-scale development projects (construction of dams, for instance), the World Bank has approved of being a stakeholder. While this is extremely crucial to facilitate growth in the country, we are now aware of the long-term economic implications that borrowings and deficits have on the economy.

 



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