What is a Fiscal Deficit?

And why you should care about it...

In the Union Budget presented in Parliament on 6th July this year, Finance Minister Pranab Mukherjee announced that ..the fiscal deficit as a percentage of GDP is projected at 6.8% compared to 2.5% in BE 2008-09 and 6.2% as per provisional accounts 2008-09. This level of deficit is a matter of concern and Government will address this issue in right earnest. We've all heard about it and we've all read articles that worry about a large fiscal deficit, whether in India or in the United States. But the question is, what is the problem with a big fiscal deficit? Indeed, what is it to begin with? Every year, the Government puts out a plan for it's income and expenditure for the coming year. This is, of course, the annual Union Budget. A budget is said to have a fiscal deficit when the Government's expenditure exceeds it's income. When this happens, the Government needs additional funds. Now there are two ways for the Government to arrange these funds. The first is, of course, to borrow. The Government can borrow either from the citizens themselves or from other countries or organisations like the World Bank or the IMF. The money borrowed by a nation's Government is called public debt. As on any other debt, the Government promises to pay a certain rate of interest. To pay this interest in the future, the Government has three options: 1. 2. increase the amount of taxes collected by increasing the tax rates; help stimulate economic growth so that tax collection automatically increases with it; or print new currency notes to pay back the debt also called debt monetization.

Now suppose that to repay some of it's debt, the Government decides to print some new currency notes. Say the Government prints new notes worth Rs. 10 lacs. This means the amount of money available to spend increases from Rs. 1 crore to Rs. 1.1 crores. Since the amount of wheat produced hasn't increased, each tonne of wheat now costs Rs. 1,100, a 10% increase! (1.1 crores paid for ten thousand quintals = Rs. 1,100 per quintal). So we have just seen that the effect of debt monetization is inflation, which acts like an invisible tax on all the people of a country. So does that mean that fiscal deficits are evil? Well, not necessarily. If the money that the Government had borrowed was used to increase the amount of wheat production, then the inflation could have been avoided. To see how, we assume that the Government used the borrowed money to improve the irrigation facilities in the country. Also suppose that this programme led to an increase in wheat production from 10,000 quintals to 11,000 quintals. In that case, even with an increase of money to 1.1 crores, the cost of wheat would remain steady at Rs. 1,000 per quintal. Thus we'd have economic growth and also avoid inflation. Everybody would be better off. Clearly then, it was a good thing that the Government borrowed money to implement this programme. It is thus clear that a fiscal deficit is not necessarily a bad thing. However, a large and persistent fiscal deficit can be an indication of several worrying signs in the economy. It can mean that the Government is spending money on unproductive programmes which do not increase economic productivity. It can also mean that the tax collection machinery is not effective so that a significant proportion of people get away without paying their due taxes. In any case, a large fiscal deficit significantly increases the chances of inflation in the economy which is an invisible tax on every citizen. In extreme conditions, inflation can give way to hyper-inflation that can completely destroy a country. In milder forms, high inflation and a large fiscal deficit lead to a weaker national currency (imports become expensive) and reduce the credit-worthiness of the country. As citizens, therefore, we must not only pay attention to the fiscal deficit, we must also try and understand the different areas of Government spending. Is the Government borrowing money to spend on programmes that lead to increased economic productivity or is it spending on unproductive programmes. Remember, even directly giving money (or amenities) to sections of people, without creating conditions for them to be more economically productive is dangerous because of the reasons seen above. Vigilant, always! Parijat Garg (parijat@governindia.org)

3.

We can all agree that the first option is not desirable. That leaves the second and third options. While the second option sounds like the best one, it is easier said than done. We will see presently why the third option is dangerous and can act like an unfair and invisible tax on the people of a country. To do so, we will begin with a very simple model of a national economy. Suppose that there is only one commodity that everyone needs to buy in order to live a good life say wheat. Also, assume that our country produces ten thousand quintals of wheat every year. There are a total of twenty-five thousand people in the country who spend Rs. 400 each per year to buy wheat. Thus total amount of money spent to buy wheat is Rs. 1 crore. Since this Rs. 1 crore is spent to purchase ten thousand quintals of wheat, the cost of wheat is Rs. 1,000 per quintal.