Now a days fiscal deficit is regarded as one of the most important concept of the public finance. With the downgrading of the credit rating of the United States, once again debate has started about the safe levels of fiscal deficit. In India, government had passed the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, to bring down the fiscal deficit below 3 percent of GDP and eliminating the revenue deficit by 2008. In India, 3 percent fiscal deficit is considered safe as it doesn’t produce burden on the rate of interest, interest payments of the Government and doesn’t crowd out the private sector due to lack of funds in the economy.
Crowding out is a situation where due to excessive borrowing of the government, private sector is unable to generate funds from the market and hence its growth is stalled.
What is Fiscal Deficit
Basically fiscal deficit is the excess of public expenditure over revenue receipts and non-debt creating capital receipts. Thus fiscal deficit includes excess of total expenditure plus borrowings over public revenue i.e.
Fiscal Deficit = Budgetary Deficit + Borrowings
Borrowings includes the markets borrowings as well as the borrowings from the R.B.I. where latter tantamount to the printing of new currency. This printing of new money is inflationary in nature.
ILL-effects of Fiscal Deficit
Though the FRBM Act 2003 had stipulated the centre and the state government to keep the fiscal deficit below 3 percent of the GDP per annum but since 2008, they are unable to keep it under safe limits of 3 percent. Debt waiver for farmers, bail out packages by the government during 2007-09 financial crisis, tax reduction on the petroleum products to curb inflationary pressures, increasing subsidy in food, fertilizer, fuel etc were the main reasons behind the rising fiscal deficit beyond the safe limits. Further due to lack of private sector participation during crisis period, government spending increased manifold thereby putting extra pressure on the fiscal deficit.
The fiscal deficit plays a crucial role in the macro-management of the economy. The high fiscal deficit means higher interest payments in the forthcoming years. Higher interest payments means more expenditure for which government had to borrow more to meet the rising public expenditure and again more borrowings means higher interest payments. If the spiral continues, government can fall into a debt trap which means that government had to borrow to repay its loans. In such a scenario, government must either increase its tax revenue or curtail the expenditure and if it fails to do any of it, there lies the danger of default as is happening in the PIGS (Portugal, Iceland, Greece and Spain). In the extreme cases, public and investors lost the confidence in the ability of the Government to repay the loans and the government is unable to raise the funds from the market and default becomes imminent. This results in loss of employment, erosion of public confidence, minimal private sector participation, high rate of inflation and overall economic instability. The situation in Greece is something like this only and its economy is at the brink of collapse and proper measures are expedient. In most cases, economic instability translates into the political instability as happened in Mexico, Argentina (2002), India (1989-1992) etc. The roots of most recent Jasmine revolution in the Middle East countries like Egypt, Tunisia can also be found in economic crisis.
once Government resort to high level of market borrowings, there is upward pressure on the rate of interest. High rate of interest is a major hindrance for new investment, particularly the private investment as less funds are available in the market for private sector borrowing and thus interest rate is pushed upward and private sector is crowded out resulting in low output, high unemployment, and high rate of inflation – a recipe of stagflation (an anomalous situation where inflation and unemployment coexist). When high level of unemployment, inflation and low productivity cripples the economy for long time, it results in wide economic inequality- both vertical as well as horizontal. These inequalities were most important causes of the recent revolution found in Middle East countries. Thus we can see that it is very much expedient that fiscal deficit doesn’t cross the safe limits and even if it crosses, it must be brought back as soon as possible.
Advantages of Fiscal Deficit
If fiscal deficit is maintained at reasonable level with occasional breaches, it is very helpful in the effective manipulation of the economy. For instance, during a downturn in the economy, when private sector is not coming forward to invest due to lack of demand, public expenditure may infuse the necessary demand. Further government borrowing may not let interest rates fall too much, which may lead to the situation of liquidity trap. Liquidity trap is the situation where interest rates are too low and further lowering of the rate of interest doesn’t have any impact on the investment. It is because this reason, Keynes realized importance of fiscal deficit as a tool of fiscal policy over monetary policy. He found fiscal policy more effective than monetary policy in maintaining the full employment equilibrium (Though monetary economists like Milton Friedman think opposite). Full employment equilibrium is a situation where economy grows through self-sustainable process where all the resources (human as well as physical) of economy are fully utilized.
Fiscal policy refers to the use of taxation, public borrowings and public expenditure as a tool of stabilization, growth and development of the economy while monetary policy is the policy adopted by monetary authority to achieve similar objectives through control of financial institutions, sale and purchase of monetary assets, maintenance of interest rate structure.
Another positive attribute of fiscal deficit lies in the reasons of its rise. If fiscal deficit rises due to high level of revenue deficit, the indeed it is a dangerous sign but if it increases on account of increased spending on bail out packages as did Unites States during the financial crisis, then it is not that bad. If US would have allowed Goldman Sachs and Citi Bank to fail, as it did in the case of Lehman Brothers, then situation would have been much worse then what was seen during the crisis.
In the case of developing country like India, if fiscal deficit is increasing due to rise in capital expenditure on social and economic infrastructure like roads, power, ports, land development, health, education etc, then it must be treated as investment which will increase the productivity, output, income and employment later.
Further in a country where farmer suicides are taking place unabatedly, debt waiver may not be economically correct but ethically correct and occasional rise in the fiscal deficit due to such events must not be frowned upon.
Thus we can see that fiscal deficit is the most important tool to bring stability in the economy with a high level of income and employment provided that two important conditions are met-
•The contribution of revenue deficit in the fiscal deficit should be as far as possible zero.
•The component of short term debt in the total debt must be minimum as the short term debt is usually found to bear high rate of interest and used for non-investment purposes.
For such topics of Basic understanding on the subject matter which will keep you motivated to crack CAT 2011 along with various other MBA entrance tests. This would also be useful for extempore speaking , GD. Please keep on visiting www.mbarendezvous.com
Portal with Management by objective approach.