Fiscal deficit management is crucial in the current context of declining household financial savings.
Fiscal Deficit
- About: Fiscal deficit is defined as excess of total expenditure over total receipts excluding borrowings during a fiscal year.
- It reflects the borrowing requirements of the government for financing the expenditure including interest payments.
- Formula:
- Fiscal deficit = Revenue expenditure + capital expenditure – Revenue receipts – capital Receipts excluding borrowings.
- Indicator of Future Liabilities: It is an indicator of the increase in future liabilities of the government on interest payment and loan repayment.
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Fiscal Deficit Target in the Budget 2024-25
- Fiscal Deficit Reduction Goal: The government aims to reduce the fiscal deficit to 4.5% of GDP by 2025-26, down from the budgeted 4.9% for 2024-25.
- This is part of a broader goal to reduce the debt-GDP ratio, which is projected to be 54% in 2025-26.
Debt-GDP Ratio
- About: The debt-GDP ratio measures the government’s total debt compared to the country’s economic output (GDP).
- Formula: Total debt/total GDP
- To lower the debt-GDP ratio, the government needs to reduce its fiscal deficit
- High Debt-GDP Ratio Impact: If the debt-GDP ratio is high, a large portion of the government’s revenue goes towards paying interest on the debt.
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- Long-term Debt Management: From 2026-27 onwards, the government’s goal is to maintain a fiscal deficit that ensures the Central government’s debt follows a declining trend as a percentage of GDP.
- Future Goals: The government aims to keep reducing the debt-GDP ratio after 2025-26 but hasn’t set a specific target or timeline.
- This means it might not meet the previous target of 40% debt-GDP ratio set by the Fiscal Responsibility and Budget Management (FRBM) Act.
Issues with respect to Increasing Fiscal Deficit
Government expenditures exceeding revenue by a high margin can lead to a difficult situation.
- Impact on Inflation: A persistently high fiscal deficit can lead to higher inflation as the government may resort to printing new money to fund its deficit.
- Challenges in Public Debt Management: A high fiscal deficit can hinder the government’s ability to manage its overall public debt effectively.
- The fiscal imbalance results in a significant rise in public debt as the government borrows more to cover the shortfall.
- Risk of Balance of Payments Crisis: The combination of a large deficit and rising debt creates pressure on the country’s foreign reserves, leading to a balance of payments crisis.
- Example: In the 1980s, rising fiscal deficit accompanied by rising government debt led to a difficult balance of payments situation and a high ratio of interest payment to revenue receipts.
- Rising Interest Payments: The ratio of interest payments to revenue receipts surges, limiting the government’s ability to fund other priorities.
- International Comparison: Between 2015-19, the interest payment to revenue receipts ratio averaged 5.5% for Japan, 6.6% for the UK, and 8.5% for the US.
- In contrast, India’s average ratio was much higher at 24% during 2015-16 to 2019-20.
- Increased Borrowing for Development Expenditures: To meet essential developmental expenditures, the government is forced to borrow progressively more, further deepening the fiscal strain.
- Crowding Out of Private Investment: A high fiscal deficit can lead to higher interest rates as the government competes with the private sector for borrowed funds.
- This “crowding out” effect can make borrowing more expensive for businesses, reducing private investment. Lower private investment can stifle economic growth and innovation, ultimately impacting job creation and productivity.
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- Fiscal Responsibility and Budget Management Act (FRBM Act), 2003:
- About: FRBM Act establishes financial discipline to reduce fiscal deficit. It aims to manage fiscal deficit, and maintain macroeconomic stability.
- Key features of the FRBM Act
- Medium Term Fiscal Policy Statement: It lays down the limits on the size of the budget deficits for three years and target for tax and non-tax receipts.
- It sets a target for the Centre’s annual fiscal deficit ratio (FDR) at 3% of gross domestic product (GDP).
- The states had to legislate their own FRBM Acts, limiting a state’s FD to 3% of its own GDP.
- FRBM Review Committee Report (Chairperson: N.K Singh)
- Debt as a Primary Target: The Committee suggested using debt as the primary target for fiscal policy.
- Debt to GDP Ratio: The FRBM Review Committee Report has recommended a debt to GDP ratio of 60% for the general (combined) government by 2023, comprising 40% for the Central Government and 20% for the State Governments.
- Borrowing from RBI: According to the suggestions of the committee, the government must not borrow from the RBI, except when:
- The Centre has to meet a temporary shortfall in receipts.
- RBI subscribes to government securities to finance any deviations.
- RBI purchases government securities from the secondary market.
- Fiscal Council: The Committee proposed to create an autonomous Fiscal Council with a Chairperson and two members appointed by the centre.
- Deviations: The Committee noted that under the FRBM Act, the government can deviate from the targets in case of a national calamity, national security or other exceptional circumstances notified by it.
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Possible Solutions For Maintaining Fiscal Deficit
- Fiscal Consolidation: Implementing fiscal consolidation measures can help reduce the fiscal deficit and stabilize public debt through:
- Spending Cuts: Reducing government expenditures on non-essential programs and services.
- Revenue Increases: Raising taxes or improving the efficiency of tax collection.
- Debt Management: Refinancing or restructuring existing debt to manage interest payments and repayment schedules better.
- Maintaining a Fiscal Deficit of Around 3% of GDP: To support private investment and economic growth, it is important to maintain the fiscal deficit at around 3% of GDP. Exceeding this limit may lead to irresponsible borrowing and financial instability.
- Encouraging Household Savings and Investment: With household savings currently low (5.3% of GDP), efforts should focus on increasing household savings to free up funds for private investment.
- This would allow the government to manage its fiscal deficit without crowding out private investment.
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Importance of Fiscal Consolidation
- Ensuring Sustainable Public Finances: Gradually reducing the fiscal deficit-to-GDP ratio helps maintain economic stability and ensures that public finances remain sustainable.
- It prevents excessive borrowing and debt accumulation, which could jeopardise future economic health.
- Implementing Prudent Fiscal Policies: Effective fiscal management involves expenditure rationalisation, revenue enhancement measures, and subsidy reforms.
- These actions help reduce reliance on borrowing and address fiscal imbalances, fostering a more balanced and sustainable budget.
- Promoting Investor Confidence: A disciplined approach to fiscal management enhances investor confidence.
- Lower fiscal deficits and stable debt levels signal a commitment to fiscal responsibility, making the country more attractive to both domestic and international investors.
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September 7, 2024
