The Fiscal Deficit
The fiscal deficit is the
difference between the government's total expenditure and its total receipts
(excluding borrowing). The elements of the fiscal deficit are (a) the revenue
deficit, which is the difference between the government’s current (or revenue)
expenditure and total current receipts (that is, excluding borrowing) and (b)
capital expenditure. The fiscal deficit can be financed by borrowing from the
Reserve Bank of India (which is also called deficit financing or money
creation) and market borrowing (from the money market, that is mainly from
banks).
Thus we can infer that we need an
objective fiscal policy to manage the same. Before moving on with the Fiscal
Deficit lets’ understand fiscal policy and how it impacts fiscal deficit and growth.
Stances of fiscal policy
The three main stances of fiscal
policy are:
Neutral fiscal policy is usually
undertaken when an economy is in equilibrium. Government spending is fully
funded by tax revenue and overall the budget outcome has a neutral effect on
the level of economic activity.
Expansionary fiscal policy
involves government spending exceeding tax revenue, and is usually undertaken
during recessions.
Contractionary fiscal policy
occurs when government spending is lower than tax revenue, and is usually
undertaken to pay down government debt.
However, these definitions can be
misleading because, even with no changes in spending or tax laws at all, cyclic
fluctuations of the economy cause cyclic fluctuations of tax revenues and of
some types of government spending, altering the deficit situation; these are
not considered to be policy changes. Therefore, for purposes of the above
definitions, "government spending" and "tax revenue" are
normally replaced by "cyclically adjusted government spending" and
"cyclically adjusted tax revenue". Thus, for example, a government
budget that is balanced over the course of the business cycle is considered to
represent a neutral fiscal policy stance.
Methods of funding
Governments spend money on a wide
variety of things, from the military and police to services like education and
healthcare, as well as transfer payments such as welfare benefits. This
expenditure can be funded in a number of different ways:
- Taxation
- Seigniorage, the benefit from printing money
- Borrowing money from the population or from abroad
- Consumption of fiscal reserves
- Sale of fixed assets (e.g., land)
- Borrowing
A fiscal deficit is often funded
by issuing bonds, like treasury bills or consols and gilt-edged securities.
These pay interest, either for a fixed period or indefinitely. If the interest
and capital requirements are too large, a nation may default on its debts,
usually to foreign creditors. Public debt or borrowing : it refers to the
government borrowing from the public.
Consuming prior surpluses
A fiscal surplus is often saved
for future use, and may be invested in either local currency or any financial
instrument that may be traded later once resources are needed; notice,
additional debt is not needed. For this to happen, the marginal propensity to
save needs to be strictly positive.
Economic effects of fiscal policy
Governments use fiscal policy to
influence the level of aggregate demand in the economy, in an effort to achieve
economic objectives of price stability, full employment, and economic growth.
Keynesian economics suggests that increasing government spending and decreasing
tax rates are the best ways to stimulate aggregate demand, and decreasing
spending & increasing taxes after the economic boom begins. Keynesians
argue this method be used in times of recession or low economic activity as an
essential tool for building the framework for strong economic growth and
working towards full employment. In theory, the resulting deficits would be
paid for by an expanded economy during the boom that would follow; this was the
reasoning behind the New Deal.
Governments can use a budget
surplus to do two things: to slow the pace of strong economic growth, and to
stabilize prices when inflation is too high. Keynesian theory posits that
removing spending from the economy will reduce levels of aggregate demand and
contract the economy, thus stabilizing prices.
Economists debate the
effectiveness of fiscal stimulus. The argument mostly centers on crowding out,
whether government borrowing leads to higher interest rates that may offset the
stimulative impact of spending. When the government runs a budget deficit,
funds will need to come from public borrowing (the issue of government bonds),
overseas borrowing, or monetizing the debt. When governments fund a deficit
with the issuing of government bonds, interest rates can increase across the
market, because government borrowing creates higher demand for credit in the
financial markets. This causes a lower aggregate demand for goods and services,
contrary to the objective of a fiscal stimulus. Neoclassical economists
generally emphasize crowding out while Keynesians argue that fiscal policy can
still be effective especially in a liquidity trap where, they argue, crowding
out is minimal.
Some classical and neoclassical
economists argue that crowding out completely negates any fiscal stimulus; this
is known as the Treasury View, which Keynesian economics
rejects. The Treasury View refers to the theoretical positions of classical
economists in the British Treasury, who opposed Keynes' call in the 1930s for
fiscal stimulus. The same general argument has been repeated by some
neoclassical economists up to the present.
In the classical view, the
expansionary fiscal policy also decreases net exports, which has a mitigating
effect on national output and income. When government borrowing increases
interest rates it attracts foreign capital from foreign investors. This is
because, all other things being equal, the bonds issued from a country
executing expansionary fiscal policy now offer a higher rate of return. In
other words, companies wanting to finance projects must compete with their
government for capital so they offer higher rates of return. To purchase bonds
originating from a certain country, foreign investors must obtain that country's
currency. Therefore, when foreign capital flows into the country undergoing
fiscal expansion, demand for that country's currency increases. The increased
demand causes that country's currency to appreciate. Once the currency
appreciates, goods originating from that country now cost more to foreigners
than they did before and foreign goods now cost less than they did before.
Consequently, exports decrease and imports increase.
Other possible problems with
fiscal stimulus include the time lag between the implementation of the policy
and detectable effects in the economy, and inflationary effects driven by
increased demand. In theory, fiscal stimulus does not cause inflation when it
uses resources that would have otherwise been idle. For instance, if a fiscal
stimulus employs a worker who otherwise would have been unemployed, there is no
inflationary effect; however, if the stimulus employs a worker who otherwise
would have had a job, the stimulus is increasing labor demand while labor
supply remains fixed, leading to wage inflation and therefore price inflation.
Fiscal straitjacket
The concept of a fiscal
straitjacket is a general economic principle that suggests strict constraints
on government spending and public sector borrowing, to limit or regulate the
budget deficit over a time period. The term probably originated from the
definition of straitjacket (anything that severely confines, constricts, or
hinders). Various states in the United
States have various forms of self-imposed fiscal straitjackets.
Does a Fiscal Deficit Necessarily
Lead to Inflation?
No. Two arguments are generally
given in order to link a high fiscal deficit to inflation. The first argument
is based on the fact that the part of the fiscal deficit which is financed by
borrowing from the RBI leads to an increase in the money stock. Some people
hold the unsubstantiated belief that a higher money stock automatically leads
to inflation since "more money chases the same goods". There are,
however, two flaws in this argument. Firstly, it is not the "same
goods" which the new money stock chases since output of goods may increase
because of the increased fiscal deficit. In an economy with unutilized
resources, output is held in check by the lack of demand and a high fiscal
deficit may be accompanied by greater demand and greater output. Secondly, the
speed with which money "chases" goods is not constant and varies as a
result of changes in other economic variables. Hence even if a part of the
fiscal deficit translates into a larger money stock, it need not lead to
inflation.
The second argument linking
fiscal deficits and inflation is that in an economy in which the output of some
essential commodities cannot be increased, the increase in demand caused by a
larger fiscal deficit will raise prices. There are several problems with this
argument as well. Firstly, this argument is evidently irrelevant for the Indian
economy in 2002 which is in the midst of an industrial recession and which has
abundant supplies of foodgrains and foreign exchange. Secondly, even if some
particular commodities are in short supply, rationing and similar strategies
can check a price increase. Finally, if the economy is in a state which the
proponents of this argument believe it to be in, that is, with output
constrained by supply rather than demand, then not just fiscal deficits but any
way of increasing demand (such as private investment) is inflationary.
India's Fiscal and Growth position
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