What is Fiscal Deficit and why it is so important?

The fiscal deficit is one of the most frequently used terms in the economy and in the finance budget. So, in this article, we will discuss the significance of the fiscal deficit.

What is the Fiscal Deficit?

The fiscal deficit is the difference between the total revenue and total expenditure of the government.  Therefore, it indicates the borrowings require by the government.

image of fiscal deficit

What causes the Fiscal Deficit?

The fiscal deficit arises when a government’s total expenditures exceed the revenue that it generates, excluding the money from borrowings.

Therefore, the fiscal deficit shows how much the government is spending more than the earning.

So, fiscal deficit upside means increment in government spending.

The major element of fiscal deficits:

  1. Revenue deficit
  2. Capital expenditure increment

Revenue Deficit

The difference between the government’s budget revenue and actual net revenue. 

Indicates the government’s earnings are not adequate to running its departments and other provided services.

So, if the government spends more than the earnings, they have to restore by the external borrowings. In this way, the revenue deficit results from the borrowings.

As a result, the government can take the following actions to manage the situation of deficit

  1. Through the borrowings or by selling assets.
  2. By increasing the tax rate.
  3. Reducing unnecessary expenditures.

Capital Expenditure

Capital expense or capital expenditure or CAPEX is the capital that spends to buy, maintain for improvement of long-term assets (buildings, land, vehicles, and equipment) to improve the efficiency or capacity.

Therefore, whenever capital expenditure increases that become a crucial reason for the fiscal deficit. 

Difference between Revenue Expenditure and Capital Expenditure

Revenue ExpenditureCapital Expenditure
1. It occurs due to the running of government departments and maintenance.1. It occurs due to the acquisition of capital assets.
2. This is a short period of expenditure.2. This is generally long period expenditure.
3. This is the recurring expenditure. 3. This is non-recurring type expenditure.
4. Revenue Expenditure does not result in the creation of assets.4. Capital Expenditure results in the creation of assets.

Other important causes of the Fiscal Deficit

  1. Amount of interest burden due to both domestic and foreign loans.
  2. Poor political interference in the public sector and corruption of management.
  3. Excessive government borrowing due to internal and external debt.
  4. Increase in subsidies by government creates a fiscal imbalance.
  5. Non-tax compliance.
  6. Wasteful expenditure of the government that results from inflationary pressure in the economy.

Fiscal Deficit in India

India recorded a fiscal deficit equal to 3.53 percent of the country’s Gross Domestic Product (GDP) in 2017.

Fiscal Deficit of India

Imgae Source :tradingeconomics.com

Fiscal Expenditure in India increased to 18320.33 INR Billion in December from 16132.08 INR Billion in November in the year 2018.

Fiscal Expenditure of India

Imgae Source :tradingeconomics.com

How far Fiscal Deficit is desirable for the Indian economy?

Consequently, there are a lot of commitments of investment for the government in a growing economy like India. They have to create infrastructure, accelerate industrialization, and provide social expenditure and any more.

So, the fiscal deficit can be justified as the expenditures due to finance activities leading to the creation of a national asset.

But, a high fiscal deficit is harmful to the financial health of any nation. It has incurred year after year cumulatively and creates an immense debt for the government.

Therefore, here are some points on how it is bad for the economy.

  1. Crowding out effect

    A large fiscal deficit means the government has to borrow heavily. So, the demand for loans will soar up in the market. It causes an increment in the tax rate. Due to the high tax rate, private firms do not invest in the new project and new emplacement.

    Therefore, private investment falls. That creates an adverse impact on employment generation and income. This situation is called Crowding out effect. So, a high magnitude of the crowding out effect even lead to lesser income in the economy.

  2. Inflation

    The fiscal deficit creates inflation because of the demand impact of the high level of expenditure by the government.

  3. Trade Deficit

    Due to the high fiscal deficit, the government has to borrow more and more from the market. It may even have to borrow from foreign investments. As a result, foreign funds start flowing into the country with high interest.

    In this way, foreign firms and institutions exchange their currency with the Indian rupee. As a result, the demand of Indian rupee goes up, and it appreciates.

    Therefore, Indian exportation becomes expensive, and imports become cheaper. This results in lower exports and higher imports. In this way, the situation leads to a higher trade deficit. Thus, a high Fiscal Deficit may lead to a very high trade deficit for the country.

  4. Intergenerational Equity

    Due to the high borrowing year by year, the future interest payment becomes a tremendous concern for the government. Similarly, it adds to the burden on the future generation.

    Read more: Intergenerational Equity

    So, the expenditure and borrowing in the current generation become a debt is paid back by the future generation. In this way, the fiscal deficit violates the principle of intergenerational equity in the economy.

  5. Effect on Crude Oil price

    We all know that India is one of the largest importers of crude oil. We borrowed crude oil is from overseas markets.

    Therefore, the INR/USD plays a major role in the economy. So, when the domestic currency, the INR depreciates against the USD, fuel prices will increase automatically. So, the depreciating currency, become one of the significant factors of the increase in petrol price.

    Now, the accelerating fiscal deficit is one of the reasons for a currency crisis in the country. Not only petrol price but the price of diesel, LPG and kerosene also has the striking impact of high fiscal deficit.

    So, we can consider that the fiscal deficit and crude oil costs are indirectly linked and an essential part for the economy.

What is Fiscal Deficit impact on the GDP?

GDP or Gross domestic product is the monetary value of all finished goods & services produced within its geographical boundary in a year or specific time period. It reflects the cost of living and the inflation rates of the countries. So, using GDP rates, we can compare the differences in living standards between nations.

So, GDP depends on the following elements:

  1. All private consumption
  2. Government spending
  3. Amount of capital investment
  4. Value of net exports

So, the fiscal deficit in terms of GDP is an expression which indicates the debt portfolio of a nation.

The fiscal deficit has an indirect impact on GDP. Seems like, if GDP is Rs 100 and there fiscal deficit is Rs. 10 then this is stated that the fiscal deficit is 10% of GDP. Now, if the fiscal deficit reduces to Rs. 7, then that is said that 7% of GDP.

Let’s have some discussion that how fiscal deficit can affect GDP.

  1. Tax Revenue

    High fiscal deficit means high tax rate. So, Government earns more revenue that helps GDP growth.

  2. Treasury Bonds

    At high fiscal deficit Government takes loans from the citizen in the form of treasury bonds. So, in this way the government depriving the citizen of spending he but they spend it on several projects.

  3. Loans from the Bank

    Another way to manage fiscal deficit is taking loans from the Central Bank through Balance Sheet Expansion. Therefore, the money supply in the country increases and results from a higher GDP. In contrast, it also introduces inflation in the economy at a time.

  4. Foreign Loans

    Similarly, taking loans from external sources the government can manage fiscal deficit. It helps in the GDP growth. But the resulting burden of payable tax in the high rate that becomes the liabilities of the country. That also causes inflation.

Therefore, here fiscal deficit only indicates that the government has to borrow less to finance its planned expenditure. Consequently, a comfortable deficit number can help any government to stop tightening its belt and assists in growth.

India’s GDP Annual Growth Rate

The Indian economy advanced to 7.1 in the third quarter of 2018. This is well below 8.2 percent in the previous period and market expectations of 7.4 percent.

So, this is the lowest growth rate in the last three quarters. Due to, a slowdown in consumer spending, high oil prices, and a weaker rupee.

image of GDP rate India
India’s GDP Growth Rate

Image Source:tradingeconomics.com

Bottom Line

So, it is difficult to conclude whether the fiscal deficit is good or bad for any nation.

Certainly, some economists claimed it is crucial for the economic growth of a country. For the reason, that only domestic savings and internal revenue are not enough for economic growth. A deficit is usually financed through borrowing from either the central bank of the country or raising money from capital markets by issuing different instruments like treasury bills and bonds.

In contrast, others argue that an enormous fiscal deficit may lead to an increase in the tax rate and a decrease in savings.

The furthermore huge fiscal deficit has a crucial impact on the business confidence that further affects investments. Therefore, delay in fiscal adjustment does not reflect well on the government’s economic management abilities.

Therefore, we can conclude that some number of fiscal deficit is good for economic growth. But in a condition that the borrowed money is used for productive purposes and the rate of return from that investment is higher than the interest rate paid.

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