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Fiscal deficit: Too much air.... - Views on News from Equitymaster
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  • Apr 5, 2005

    Fiscal deficit: Too much air....

    Among most discussions that concentrate around the factors that are impacting the development of the Indian economy in a major way, the one regarding the 'ever-increasing' fiscal deficit takes prominence. Be it a student of economics, or an economist himself, everyone seems to be concerned about the way our governments (both at the Centre and the states) are spending beyond their resources. In this write-up, this is the topic of our analysis.

    What is fiscal deficit?
    Simply put, fiscal deficit is the difference between the government's total expenditure and its total receipts (excluding borrowings). In other words, it is the amount that the government borrows to meet its expenditure that couldn't be met by only its receipts. There have been opinions about how growing fiscal deficit is a concerning factor in the development of economies globally. However, one fails to understand that, specifically for developing economies (like India), governments' expenditure is bound to overshoot its receipts for the simple reason that these economies have to spend their way to grow. While slowdown in receipts (like tax revenues) is a concerning factor, as economies move ahead towards greater development and income levels rise, government receipts also rise in terms of growing tax and non-tax revenues.

    It is important to take note that there is a difference in the levels of spending over revenues that developed economies do relative to the developing ones. Developed nations (like the US, the UK and Japan) witnessed declining fiscal deficit figures in the closing years of the last decade. However, owing to the slowdown that engulfed global economies, especially hurting the prospects of the developed ones, these countries (the developed ones) saw their revenues decline (or there was a forced decline like the tax-cuts in the US). This was, particularly, the reason for their declining rising deficits, rather that the fact that it happened due to increased expenditure.

    On the other hand, in case of the developing nations (like India and China), deficit has continuously been on a rise. The need to expend on development efforts like infrastructure building, primary education, rural development and interest payments on debt are the major reasons why developing nations have high levels of expenditure relative to their revenues. However, the concern arises when a major portion of the total expenditure goes away in debt servicing, i.e. payment of interest on government debt. This is because of the fact that this is non-developmental and usually takes away a major chunk of the total receipts of the government.

    The largest chunk of the Central government's total expenditure goes as revenue expenditure (like salaries to government employees). And the next largest chunk goes away in non-plan expenses (like subsidies, defense and interest payments). Here, the concerning part is the large amounts expended on subsidies and interest payments. While subsidies are required for development of, say, the agriculture sector, how these are allocated is concerning for the Indian economy.

    Deficits and inflation...
    One of the biggest arguments against deficits is that it props up inflation in the economy. The reason given for this is - government's borrowings to meet its expenditure lead to a rise in the money stock in the economy. This is said to have an inflationary effect as few goods are chased by more money. However, if this had been the case, then the inflation levels in India would have been rising by leaps and bounds. In fact, this has not been the case. This is because as government spending increases, output levels in the economy also rise, thus 'few goods' are not few anymore! Also, as deficit result into increased utilisation of resources by putting people to employment, thus giving them a greater spending power. This, in turn, increases the overall demand in the economy.

    This argument of increasing inflation due to rising deficits seems also irrelevant in India's case (as is evident in the last few years), as India has abundant resources in forms of stocks of food grains and rising foreign exchange reserves. Therefore, any inflationary effect can be checked (albeit partly). In case of food grains, these can be rationed to check inflation. And in case of rising foreign exchange reserves, the Reserve Bank of India (RBI) can sterilize these to suck out increased liquidity from the markets, thus keeping a check on rising prices (or inflation).

    The concern, but not really...
    Despite all these myths about the negative affects of rising fiscal deficits, one real concern in case of India is that we have not been able to push our real GDP growth to a new trajectory. However, one must keep in mind the fact that the GDP growth rate in India is highly dependent on the growth of the agriculture sector (see chart above). Decline in agricultural activity has dragged down the overall GDP growth because the share of non-food items in rural expenditure has been increasing. And consequently, compression of rural income in years of poor agricultural performance has delayed effects on aggregate demand. The graphs above depict both the situation - compressed GDP growth despite rising deficits, and the effect of agriculture on real GDP growth. Though we as a country have to learn to live within our means, politicians do not seem to understand that!



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