What is a Fiscal Deficit?

And why you should care about it...

In the Union Budget presented in Parliament on 6
th
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. increase the amount of taxes collected by
increasing the tax rates;
2. help stimulate economic growth so that tax
collection automatically increases with it; or
3. print new currency notes to pay back the debt
also called debt monetization.
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.
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)