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Understanding The Concept of Fiscal Deficit

3 Mins 13 Apr 2023 0 COMMENT

A government finances its schemes and developmental activities through taxes and other revenues. When the revenue falls short to meet the government expenditures, a deficit occurs. Thus, the difference between the income and expenditure of a government in a financial year is known as a fiscal deficit. As a result, the government has to resort to borrowings for its seamless working.

What are the components of fiscal deficit?

The fiscal deficit has two components which are discussed below:

Government’s income

Tax and non-tax revenue are the two major sources of government income. Tax revenues of the government include:

  • Goods and Service Tax (GST) and taxes from Union Territories
  • Corporation tax
  • Income tax
  • Custom duties
  • Union excise duties

Non-tax revenues of the government include:

  • Dividends and profits
  • Interest receipts
  • External grants
  • Other non-tax revenue

Government’s expenditure

Capital and revenue expenditure are the main components of the government’s expenditure. The capital expenditure includes the following:

  • Expenditure on land acquisition, building, equipment, machinery, etc.
  • Investments made by the government
  • Repayment of liabilities

Revenue expenditure includes:

  • Interest payments
  • Salaries and pensions
  • Subsidies, etc.

Calculation of fiscal deficit

The fiscal deficit is calculated with the help of evaluating the income and expenditure of the government in a financial year. The formula of calculation is as follows:

Fiscal deficit = Total expenditure – Total revenue (excluding government borrowings)

Usually a fiscal deficit is measured as a percentage of the country’s gross domestic product.

How is the fiscal deficit met?

When the government spends more than it generates revenues, it has to borrow funds to meet its expenditure. Thus, the government resort to borrowings from multiple sources, such as the RBI, public sector banks, overseas market, capital markets, the public, etc.

However, the government can reduce the fiscal deficit gap with the help of the following measures:

  • Reducing expenditure on subsidies
  • Reducing non-plan expenditures
  • Broadening the tax base
  • Checking tax evasion
  • Reducing corruption
  • Levy of more direct taxes, etc.

Fiscal deficit target

The Fiscal Responsibility and Budget Management Act (FRBM) requires the government to bring down the fiscal deficit to below 4.5% of the GDP by 2025-26. It also allows the government to deviate from the target by 0.5 percentage points in times of war, national calamities, etc.

Is fiscal deficit good for the economy?

Usually, countries face fiscal deficits as a common phenomenon. A certain percentage of fiscal deficit is considered good for the economy if the government is spending more on infrastructures, such as roads, ports, railways, etc. and other developmental activities. In India, a fiscal deficit of less than 4 per cent is considered healthy for the economy.

However, a high fiscal deficit has disadvantages too. A high government borrowing to close the fiscal deficit gap may lead to a high debt to GDP ratio, inflation, and currency devaluation. A high fiscal deficit also impacts the credit ratings of an economy which may affect the interest rates of borrowings.

Impact of fiscal deficit on India’s growth

How fiscal deficit impacts the Indian economy is a debated issue. According to many economists, a fiscal deficit positively impacts the country’s economic growth. However, it is important to closely analyse the quality of the government’s expenditure. A fiscal deficit used for productive expenditure leads to a boost in production and employment, which results in the growth of the economy.

However, if the government’s fiscal deficit is due to a shortfall in revenue, it may hamper the country’s growth. It is because the government will borrow to bridge the revenue deficit and not for the creation of assets.

Key takeaway

As consumers, voters, and investors, you must understand the fiscal deficit concept and why it is happening. In a recession, the deficit might be due to increased government spending to address unemployment, support businesses, etc. However, a fiscal deficit in a healthy economy might be due to mismanagement of expenses, poor taxation, and corruption hampering the government finances. It is to be noted that a fiscal deficit is an inevitable part of the budget, but the government must spend on productive assets and minimise wasteful expenditure to address the fiscal deficit issue.

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