Themes > Economic Briefs
The Fiscal Deficit
What exactly is the Fiscal Deficit?
The fiscal deficit is the
difference between the government's total expenditure and its total
receipts (excluding borrowing). The elements of the fiscal deficit are (a)
the revenue deficit, which is the difference between the government’s
current (or revenue) expenditure and total current receipts (that is,
excluding borrowing) and (b) capital expenditure. The fiscal deficit can
be financed by borrowing from the Reserve Bank of India (which is also
called deficit financing or money creation) and market borrowing (from the
money market, that is mainly from banks).
Does a Fiscal Deficit Necessarily Lead to Inflation?
No. Two arguments are generally given in order to link a high fiscal deficit to inflation. The first argument is based on the fact that the part of the fiscal deficit which is financed by borrowing from the RBI leads to an increase in the money stock. Some people hold the unsubstantiated belief that a higher money stock automatically leads to inflation since "more money chases the same goods". There are, however, two flaws in this argument. Firstly, it is not the "same goods" which the new money stock chases since output of goods may increase because of the increased fiscal deficit. In an economy with unutilized resources, output is held in check by the lack of demand and a high fiscal deficit may be accompanied by greater demand and greater output. Secondly, the speed with which money "chases" goods is not constant and varies as a result of changes in other economic variables. Hence even if a part of the fiscal deficit translates into a larger money stock, it need not lead to inflation.
The second argument
linking fiscal deficits and inflation is that in an economy in which the
output of some essential commodities cannot be increased, the increase in
demand caused by a larger fiscal deficit will raise prices. There are
several problems with this argument as well. Firstly, this argument is
evidently irrelevant for the Indian economy in 2002 which is in the midst
of an industrial recession and which has abundant supplies of foodgrains
and foreign exchange. Secondly, even if some particular commodities are in
short supply, rationing and similar strategies can check a price increase.
Finally, if the economy is in a state which the proponents of this
argument believe it to be in, that is, with output constrained by supply
rather than demand, then not just fiscal deficits but any way of
increasing demand (such as private investment) is inflationary.
Doesn't a Greater Fiscal Deficit Lead to a Greater Drain on the Exchequer in terms of Interest Outlay?
Yes and no. Certainly, for
a given interest rate a larger fiscal deficit by raising the accumulated
debt of the government raises the interest burden. However, in the
particular case of our economy since liberalization, a large part of the
increasing interest burden is because of the rise in the interest rates in
the post '91 period. This itself is related to the process of
liberalization since the rate of interest has to be kept high in a
liberalized economy to prevent capital outflow. Moreover, a growing
domestic debt is not a problem for a government in the same way in which
growing debt is a problem for a family since the government can always
raise its receipts through taxation and by printing money. Some would say
that printing money would lead to inflation, but as we have shown above,
this is not necessarily the case.
Is it a Good Idea to Reduce Fiscal Deficits Through Disinvestment?
No. The PSUs that the
government has been disinvesting in are the profit making ones. Thus,
while the government earns a lump-sum amount in one year, it loses the
profits that the PSU would have contributed to the exchequer in the
future. Therefore, it is not a good idea even if the objective is to
reduce the fiscal deficit.
Does increased government expenditure necessarily lead to a greater fiscal deficit?
Not necessarily. Suppose
the government spends more on an electricity project for which the
contract is given to a PSU like BHEL. Then the money that the government
spends comes back to it in the form of BHEL's earnings. Similarly, suppose
that the government spends on food-for-work programmes. Then a significant
part of the expenditure allocation would consist of foodgrain from the
Public Distribution System which would account for part of the wages of
workers employed in such schemes. This in turn means that the losses of
the Food Corporation of India (which also includes the cost of holding
stocks) would go down and hence the money would find its way back to the
government. In both cases, the increased expenditure has further
multiplier effects because of the subsequent spending of those whose
incomes go up because of the initial expenditure. The overall rise in
economic activity in turn means that the government’s tax revenues also
increase. Therefore there is no increase in the fiscal deficit in such
What is the Impact of the Government's Policy of Decreasing the Fiscal Deficit?
Logically, there are two
ways in which the fiscal deficit can be reduced — by raising revenues or
by reducing expenditure. However given the character of our State and the
constraints of a liberalized economy, the government has not increased
revenues. In fact, in budget after budget the government has actually
given away tax cuts to the rich. Even when it has tried to raise revenues,
it has been through counterproductive means like disinvestment.
The main impact of the policy of reduced fiscal deficits has therefore been on the government's expenditure. This has had a number of effects. First, government investment in sectors such as agriculture has been cut. Secondly, expenditure on social sectors like education, health and poverty alleviation has been reduced leading to greater hardship for the poor already bearing the brunt of liberalization. Perhaps most importantly, in an economy going through a recession the government is not allowed to play any role in boosting demand.
© MACROSCAN 2002