Understand Fiscal Deficit and How it Affects You

September 21 , 2013

Fiscal deficit is one finance jargon you cannot seemingly get away from in times of economic turmoil. Economists and the government worry about it and talk of ways to manage it. Knowing what fiscal deficit is all about, its causes and effects, could give you some sense of direction as media spews the term around. 

What is fiscal deficit?

When a government's spending is more than revenues it is said to be running a fiscal deficit. The opposite is fiscal surplus. Every year the government lays out a roadmap for its expenditures and income for the year, called Union Budget. If it plans to spend more than what it hopes to earn, it is a situation of fiscal deficit. In developing economies like India, fiscal deficit is a regular phenomenon. We run fiscal deficits every year. See historical data of fiscal deficit in India.

Fiscal deficit is different from its counterpart current account deficit. Current account deficit occurs when a country's imports are more than its exports.

Root of fiscal deficit

We said that deficit is the outcome of spending more than what is earned. The bulk of government's revenues come from tax collection, the rest from interest received on its loans, dividends, profits and disinvestment in PSUs.

What does the government spend on? Government expenditures are of two broad types- plan expenditure and non-plan expenditure. Plan expenditure is based on plans discussed by respective states with the central government. Non-plan expenditure goes for interest payment on government's borrowings, defence budget, salary payment, social services (like education, labour welfare), economic services (like census, foreign trade promotion), general services (like police, external affairs, pension, tax collection), loans & grants (to state governments, PSUs and foreign governments) and subsidies (food, petroleum, fertilizers, interest, railways, postal department).

When budgeted expenditures are more than revenues, the government is forced to borrow. It can borrow from domestic markets through bonds or externally from foreign governments or organizations like World Bank. Now, what it borrows it must repay with interest. To finance this interest the government has either to raise revenue or create money by printing it. However, printing money indiscriminately can lead to inflation, so this is hardly a desired solution.

Revenues can be raised in two ways- by increasing tax rates or by stimulating economic growth, which automatically brings in more tax revenue. Raising tax rates- who likes it? In order to stimulate growth often governments have to spend. When government injects money in the economy by buying from private domestic companies it leads to growth of the economy, leaving more money in the hands of consumers and thus increasing demand for goods and services. Thus, there is interplay of factors linking demand and government spending.

Another way to reduce the fiscal deficit gap is to reduce expenditures. Part of this is austerity measures such as cuts in spending on its personnel, which could slightly bring down non-plan expenditure; but this rarely comes into action!

Effects of fiscal deficit

If government has to reduce expenditure to bridge fiscal deficit gap it is bad news for certain sections of the population. Cutting back on useful social and economic schemes can hurt those who rely on them.

Fiscal deficit can also lead to increase in market interest rates if government borrowing from domestic markets is spiked. High interest rate regime makes borrowing expensive for both consumers and businesses.

So, is fiscal deficit bad?

Whether fiscal deficit is good or bad actually depends on why there is a deficit, though having perpetually high deficit levels is not a good sign and most governments would like to avoid it.

If fiscal deficit is largely owing to populist government spending on social programmes not improving productivity, or if the tax machinery is ineffective that a large part of the population gets away without paying taxes then it is a cause of great worry.

Your part here

Taxpaying citizens should be vigilant that their elected government functions in their best interests. We can try to take interest in knowing areas of government spending. Budget announcements can throw light on how the government intends to spend in the year. Doling out goodies without laying conditions to derive economic productivity from beneficiaries would affect general lifestyle and development of society, after all.

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