Fiscal Deficit And Revenue Deficit

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By moderator July 29, 2019 15:14

A budget talks about Fiscal and revenue deficits when the receipts are less than expenditure. This not only reduces the government capacity to spend but also affects the socio-economic development of the country.

Fiscal Deficit

In layman terms, if the Government spends more than it earns we have a situation which is called fiscal deficit. Fiscal deficit measures the indebtedness of the government and throws light on the extent to which the government exceeds its means. Thus it is the sum of budgetary deficit together with the government’s market borrowings and liabilities undertaken. To explain from a different perspective the government expenditure is financed partly from the receipts and for the balance, the government may be required to borrow or incur dis-savings. This portion of government expenditure which is financed by borrowings and drawing down of cash balances is referred to as the fiscal deficit

The size of a country’s fiscal deficit would depend upon the objectives that the economy sets to achieve by undertaking the deficit. Thus for a meaningful comparison country’s fiscal deficit is usually communicated as a percentage of its gross domestic product (GDP).

Fiscal Deficit = Total Expenditure – Total Receipts other than Borrowings

By expanding the term Total Expenditure as Revenue Expenditure and Capital Expenditure and Total Receipts as Revenue and Capital Receipts, we can rewrite the above formula as:

Fiscal Deficit = (Revenue Expenditure + Capital Expenditure) – (Revenue Receipts + Capital Receipts other than borrowings)

Now by rearranging the terms:

Fiscal Deficit = (Revenue Expenditure – Revenue Receipts) + Capital Expenditure – (Recoveries of loans + other Receipts)

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003, was brought into force on July 5, 2004. FRBM Act gave a medium-term target for balancing current revenues and expenditures and set overall limits to the fiscal deficit at 3% of GDP to be achieved according to a phased deficit reduction roadmap. The FRBM Act enhanced budgetary transparency by requiring the government to place before the Parliament on an annual basis reports related to its economic assessments, taxation and expenditure strategy and three-year rolling targets for the revenue and fiscal balance. It also required quarterly progress reviews to be placed in Parliament. At present for the financial year 2018-19, the fiscal deficit is 3.39% of GDP.

Issues with the high fiscal deficit:

  1. The Crowding Out Effect: Over time, heavy borrowings by the Government (creating a huge demand for loanable funds) push the interest rates in the economy to a new high. The interest rates in the central bank, in turn, dictate the borrowing rates implemented by the commercial banks. As a result, borrowings become very costly for private investors.

  2. Threat on Debt Sustainability: A high fiscal deficit increases the cost of borrowing for the country increasing the yields on Government bonds; which has an adverse impact on the debt sustainability of the country in two ways: the country’s creditworthiness and capability becomes an issue of contention in foreign capital markets (further increasing the cost of debt); and, because of the high cost of capital (high yields on government bonds), the country finds itself in a debt trap by having to borrow additional funds for payment of the huge interest component.

  3. Growing Interest Burden Reduces Discretionary Public Expenditure: A high fiscal deficit increases the cost of borrowing for the country increasing the yields on Government bonds. The heavy burden of interest expenses eat into the Government funds, leading to declined availability of funds for public works and developmental expenditure. Hence the social and economic development of the country suffers tremendously.

  4. High Inflation at full Employment Level:  A high fiscal deficit is financed by borrowing from the Central Bank can lead to high inflation, especially if the economy is operating at full employment capacity. Reason being that borrowing from RBI increases the money stock and increased supply of money chasing the same goods leads to an increase in price levels and hence inflationary pressures on the economy.

  5. Fiscal Deficit Spills over into the External Sector Triggering BoP Stress: Due to high fiscal deficit, capital inflows of the country fall short of the financing requirements, resulting in significant depletion of the foreign exchange reserves; which poses a spillover effect on the Balance of Payment situation

  6. Sentiments of Foreign Investor are Negatively Impacted: A high fiscal deficit put makes the country’s BoP spill into the red, giving out a message of a poor credit standing to the international investor. Because of negative sentiments in the market, the businesses and Government find increasing difficulties in raising capital from the foreign markets, further increasing the gravity of deficit.

Revenue Deficit

The shortfall between the total revenue received to the total revenue expenditure is revenue deficit.

Revenue deficit = Total revenue expenditure – Total revenue receipts

Under the new framework of the Fiscal Responsibility and Budget Management (FRBM) Act, ‘Revenue Deficit’ and ‘Effective Revenue Deficit’ have been removed as targeted fiscal indicators of measuring fiscal health of the economy. 

Issues with revenue deficit:

  1. It looks like the government is unable to even run the revenue expenditure without borrowing. This reduces the confidence of investors on the government.

  2. High revenue deficit will go co-terminus with a fiscal deficit which will affect capital assets and hence obstructing the economic growth.

  3. “Effective revenue deficit” that is the revenue expenditure( grants and loans to the states) used to create capital assets is also put under the broad heading of revenue deficit which misleads the people on capital assets creation.

A fiscal deficit co-terminus with a revenue deficit is to have frowned as it implies that at least some part of the borrowing is to finance current consumption, something a government ought prudently to avoid, at least for long. Therefore, unless the revenue deficit is kept explicitly in the picture, we cannot deduce the soundness of economic management from a mere reduction in the fiscal deficit.

Way forward:

The government has appointed NK Singh committee to review FRBM and contain the Fiscal and revenue deficit.

  1. Bring down the fiscal deficit to 2.5% of GDP and revenue deficit to 0.8% of GDP by 2023.

  2. The panel recommended to target the stock variable of the deficit, that is, Debt to GDP ratio. IT recommended that the ration should be maintained at 60% with 40% from the central government and the remaining 20% of all the state governments combined.

  3. Trigger an “escape clause” to increase the deficit as a countercyclical measure. This can be triggered only when the growth deviates from 3% of last year.

  4. Create an independent fiscal council so that it can review the fiscal target that was decided in the budget.

  5. The revenue deficit needs to be reduced to 0% of GDP according to the FRBM, hence swift measures need to be taken such as increasing the efficiency in working of government and reduce unnecessary spending.

A new Act is needed because the existing FRBMA has proved ineffective. It was suspended with impunity in 2009, for several years, during which the fiscal deficit went out of control. There was also non-transparency which allowed the deficit to be seriously understated. The lesson is not that fiscal rules are useless, but that the old Act was flawed, and we need something better.

Sources:

  1. https://www.thehindu.com/opinion/lead/governing-india-through-fiscal-math/article28739557.ece

  2. Fiscal deficit and its trends in India( Sonika Gupta et al.)

 

moderator
By moderator July 29, 2019 15:14