All you wanted to know about fiscal deficit

KR Srivats | Updated on November 16, 2020

The Centre announcing another round of stimulus measures has set off a heated debate on whether the government ought to worry about the fiscal deficit hitting double digits this year, or forget about this number and focus on reviving the economy instead. But what is the fiscal deficit and why does it matter so much?

What is it?

Fiscal deficit is the gap between total expenditure and total income of the government. Unlike households, governments usually possess the ability to live beyond their means by either borrowing or printing money. The fiscal deficit can arise either due to revenue expenses overshooting income or increase in capital expenditure. The fiscal deficit matters because it indicates the extent by which government spending exceeds its income and the total borrowings needed by it to fill this gap. The government experiences a fiscal deficit when it spends more money than it takes in from taxes and other revenues. This gap between income and spending is then closed by government borrowings, which increase the national debt. A fiscal deficit is usually calculated and expressed as a percentage of a country’s Gross Domestic Product (GDP).

Why is it important?

Countries run deficits to give a boost to a sluggish economy by putting more money in the hands of people who can then buy and invest more. However, long-term deficits can be detrimental to economic growth and stability. There are differing views on the use of fiscal deficits. Some economists and policy analysts pitch for higher fiscal deficits to boost aggregate demand. A counter cyclical fiscal policy, as advocated by John Maynard Keynes, could be useful during periods of economic strife. Here, the government undertakes deficit spending to make up for the decline in investment and boost consumer spending to stabilise aggregate demand. When economic conditions improve, the spending is retracted shrinking the deficit.

But some argue that when the government goes on a borrowing binge, this crowds out private borrowers like companies, manipulates interest rates and reduces net exports. This could then lead to either higher taxes, higher inflation or both. Politicians like to rely on fiscal deficits to expand popular initiatives such as welfare programs or public works, without having to raise taxes or cut spending elsewhere in the Budget. In this context, fiscal deficits encourage rent seeking and politically motivated appropriations. Many businesses support fiscal deficits if it means receiving public benefits. Ultimately, voters too seem to think fiscal deficit is a good idea.

Why should I care?

Untrammelled deficits can lead to runaway inflation which hurts our quality of life. Money printing to fund deficits can devalue paper money. A significantly high fiscal deficit could also derail macro stability leading to delays in investment decisions by businesses, which affects hiring.

Any political skirmish on government debt, like the one seen in 2011 in US, could unnerve markets and diminish investor confidence. In the long term, a high level of debt is associated with slower growth. Huge deficits are seen in a largely negative light by international rating agencies and economy watchers. High borrowings could distort interest rates in the economy and prop up non-competitive firms. Persistent deficits increase government debt and take away a large portion of its revenues towards interest payouts, leaving a large burden of dues for future generations to service. The high borrowings that Indian government is now resorting to, to fund its Atmanirbhar Bharat package should be cause for worry as it will raise the deficit and national debt.

The bottomline

Modern monetary theorists may welcome deficits but living beyond one’s means may not end well.

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Published on November 16, 2020

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