scorecardresearchHere's all you need to know about Fiscal Deficit
Union finance minister Nirmala Sitharaman at Parliament for the presentation of the Union Budget. (PTI)

Here's all you need to know about Fiscal Deficit

Updated: 30 May 2022, 08:11 AM IST

When the government spends more than its total income, such a situation is called a fiscal deficit. As governments borrow more to finance fiscal deficits and acquire more debt, the majority of their revenue will shift to interest payments and less to capital spending, thereby harming the economy.

When we build a budget, we are creating a strategy for how we will spend our money in the future. This strategy helps us decide what to buy and where to spend our money, we will rank the most crucial items in the budget.

We are not the only ones who prepare budgets; governments also do so. They forecast the amount of income and expenses for the coming fiscal year.

The financial year in India is between 1st April to 31st March every year. The government prepares its budget for this period. Once the preparation is completed, they will present this every year on the 1st of February.

The budget document shows the government's expected revenues (income tax, corporate tax, import tax) and projected expenses (defence, healthcare, education, welfare program).

When the government spends more than its total income, such a situation is called a fiscal deficit.

This number was closely monitored by economists, investors, and corporations during budget season, as it will determine interest rates, inflation, and even the health of the economy.

It is calculated that the fiscal deficit = government’s total expenditure (capital and revenue expenditure)- total income received by the government (revenue receipt + recovery of loans + other receipts).

To finance the fiscal deficit, governments usually borrow money from different sources, like through issuing bonds, divestments, or borrowing from other nations.

The biggest buyers of government debt are banks and insurance companies. Banks invest in government securities as a part of their statutory liquidity ratio.

Fiscal Policy

Fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy.

Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorised that government changes in the levels of taxation and government spending influence aggregate demand and the level of economic activity.

He developed this theory in the 1930s during the Great Depression. when the free-market approach to economic management becomes unworkable.

This theory is in favour of an expansionary fiscal policy. Its primary tools are government infrastructure spending, unemployment compensation, and education. The downside of overdoing Keynesian programmes is that it boosts inflation.

Importance of FRBM Act in Budget

In the year 2000, the Budgetary Responsibility and Budget Management (FRBM) Bill was introduced in Parliament to provide legal support for fiscal restraint. It was enacted in 2003 and establishes targets for the government to meet in order to minimise fiscal deficits. It also improves openness in the government's fiscal activities. Another goal was to provide a more equitable allocation of India's debt over time.

The initial deadline to reach the 3% target was 2007-08, but it has been extended several times over the years. In 2018, the deadline was again extended to 2020-21.

In May 2016, the government set up a committee under NK Singh to review the FRBM Act. The government believed the targets were too rigid. The committee recommended that the government should target a fiscal deficit of 3 per cent of the GDP in the years up to March 31, 2020; cut it to 2.8 per cent in 2020–21; to 2.5 per cent by 2023.

However, the COVID-19 pandemic led to a shortfall in revenue and an additional burden in terms of the expansion of welfare measures.

The target was reduced to 3.5 per cent in the FY21 Budget, as permitted by the FRBM Act. To divert from the budgetary consolidation road map, the Centre invoked the escape clause. The option allows the government to increase the deficit by 0.5 percentage points in times of national emergencies, such as wars or natural disasters.

Because of higher expenditure and lower revenues on account of COVID-19, the number in FY21 came in at 9.3% of the GDP. For FY 22-23, the Centre estimated a fiscal deficit of 6.4%. It aims to reduce it to 4.5 per cent by FY26.

Additionally, the act was expected to give necessary flexibility to the Reserve Bank of India to manage inflation in India.

Why is a manageable budgetary deficit required?

As governments borrow more to finance fiscal deficits and acquire more debt, the majority of their revenue will shift to interest payments and less to capital spending, thereby harming the economy.

Furthermore, when the government borrows, it competes with everyone else in the economy who wants to borrow from the limited pool of accessible funds (Corporates). Interest rates will rise as a result of this rivalry, while private investment will fall. This is known as "crowding out."

Moreover, the fiscal deficit could result in cost-push inflation. High-interest rates raise production costs, which are then passed on to customers, resulting in higher pricing.

At a broader level, an increase in government borrowing raises the risk of rating agencies further downgrading India's credit rating.

When credit rating agencies downgrade their ratings, creditors become anxious about the borrower's capacity to repay the obligation. When this happens, creditors want higher interest rates to compensate for the increased risk. This increases the deficit year after year.

Higher borrowings

On May 21, the government cut excise duty on petrol by a steep 8 per litre and that on diesel by 6 per litre to give relief to consumers from high fuel prices that have also pushed inflation.

The excise duty cut will translate into a reduction of 9.5 a litre on petrol and 7 a litre in diesel after taking into account its impact on other levies.

The move will have a revenue implication of around 1 trillion for the government, she said.

The government also stated that the Centre will provide a subsidy of 200 per gas cylinder (up to 12 cylinders) to over 90 million Pradhan Mantri Ujjwala Yojana beneficiaries. This will have a revenue implication of around 6,100 crore a year.

On the other hand, the government also announced an additional fertiliser subsidy of 1.10 lakh crore to further cushion farmers from the price rise.

The entire loss due to the excise duty cuts and increased payouts on fertilizers, the waived import tax on coking coal, and cooking gas for the poor will raise the government's borrowings.

In the Union Budget of 2022–2023, the government unveiled a massive borrowing plan. The government announced a gross borrowing of 14.1 trillion and net borrowing of 11.6 trillion, both of which were significantly higher than market estimates and beyond the FRBM target level.

Experts said the latest moves will likely increase fiscal concerns and raise doubts about the government's meeting its deficit target of 6.4 per cent of GDP for 2022-23.

According to Barclays, India's fiscal deficit may overshoot by 6.9 per cent of GDP this fiscal year. it also said that these measures mean the overall fiscal deficit will likely exceed budgetary estimates by at least 2 lakh crore, Financial Express reported. 

To conclude, A fiscal deficit will boost a sluggish economy. Money spent on the creation of productive assets creates investment and job opportunities. But too much deficit spending will turn into debt. Each year's deficit adds to the debt. As the debt grows, the interest on debt must be paid each year. This increases spending while not providing any benefits, and secondly, higher debt levels can make it more difficult to raise funds.

Ministry wise budget allocation
Ministry wise budget allocation
First Published: 30 May 2022, 08:11 AM IST