Fiscal Deficit in India: Trends and Concerns – Explained, pointwise

Introduction

The Union Government had estimated the Fiscal Deficit to be INR 16.61 lakh crore for FY2022-23. As of November 2022, the Government’s Fiscal Deficit stood at INR 9.58 lakh crore, which is ~58% of the full-year estimate. The Budget estimate of Fiscal Deficit (INR 16.61 lakh crore) is ~6.4% of India’s GDP. The Fiscal Responsibility and Budget Management (FRBM Act, 2003) prescribes the limit of Fiscal Deficit to be 3% of the GDP. However, successive Governments, since 2003-04, have failed to achieve this target due to multitude of justifiable and unjustifiable reasons. The Act itself has been amended 4 times to change the target dates. While the breach of limit seems reasonable based on certain grounds (like COVID-19 pandemic or global macroeconomic developments), the debate regarding freebies and their impact on Governments’ finances has reignited debate regarding Governments’ obligation to adhere to fiscal prudence and the target of 3% Fiscal Deficit prescribed by the FRBM Act.

What is the meaning of Fiscal Deficit?

Fiscal Deficit is the difference between the total income (Total Revenue Receipts and Non-debt Capital Receipts) and total expenditure of the Government. A situation of Fiscal Deficit arises when the total expenditure of the Government exceeds its income. This Fiscal Deficit is calculated both in absolute terms and also as a percentage of the Gross Domestic Product (GDP) of the country. A recurring high fiscal deficit means that the Government has been spending beyond its means.

The Gross Fiscal Deficit (GFD) is the excess of total expenditure (including loans net of recovery) over revenue receipts (including external grants) and non-debt capital receipts. The Net Fiscal Deficit is the Gross Fiscal Deficit less net lending of the Central Government.

The Parliament had passed the Fiscal Responsibility and Budget Management Act (FRBM Act) in 2003. The Act’s goal is to ensure intergenerational equity in fiscal management, long-run macroeconomic stability, better coordination of fiscal and monetary policy, and transparency in the Government’s fiscal operations. One of the Key Targets of the FRBM Act is to limit the Fiscal Deficit to 3% of GDP. However, the target date of achieving the target has been pushed forward through successive amendments to the Act.

The Fifteenth Finance Commission has suggested that the Union Government should bring down fiscal deficit to 4% of GDP by 2025-26. For State Governments, it has recommended the fiscal deficit limit (as % of GSDP) of: (a) 4% in 2021-22; (b) 3.5% in 2022-23; (c) 3% during 2023-26.

What has been trend of India’s Fiscal Deficit?

For 2022-23, the Government had estimated the Fiscal Deficit to be INR 16.61 lakh crore or 6.4% of the GDP. As of November 2022, the fiscal deficit had touched 58% of the full year budget estimate.

The Fiscal Deficit of the Government had fallen to 2.54% of the GDP in FY2007-08. However, due to the global financial crisis and the consequent fiscal stimulus by the Government to boost growth resulted in fiscal deficit rising to 6.6% of the GDP in FY2009-10 and 5.9% of GDP in FY2011-12.

The deficit had gradually reduced since then, having fallen to 3.44% of the GDP in FY2018-19. However, the COVID-19 pandemic, and the Government’s fiscal package to rescue the economy from lockdowns, resulted in Fiscal Deficit of 9.5% in FY2020-21. It was 6.9% in FY2021-22 and 6.4% in FY2022-23 (estimated).

What are the reasons for high Fiscal Deficit in India?

Revenue Side

Tax-to-GDP Ratio: In India, it is low at around 10-11% of GDP and it has stayed at close to that level for the last 20 years. In contrast, Sweden has ratio of ~26%, the UK and France 25%, South Africa 23%. This means Government collects less revenue causing higher fiscal deficit. This has also lead to lower rate of investment and lower GDP growth.

Narrow Tax Base: An overwhelming majority of Indians do not pay taxes, Indian tax revenues remain largely dependent on indirect tax collections which include all taxes on spending (such as GST). According to Ministry of Finance, only 5.83 crore Income Tax Returns were filed in Assessment Year 2022-23. (~4% of India’s population).

Expenditure Side

High Subsidies: Expenditure on food, fertilisers and petroleum, form the largest share of Government’s expenditure along with interest payments. The expenditure on these items (Food, Fuel, Fertilizers) soared to ~3% of GDP in FY2020-21. For FY2022-23, the subsidy bill on these three heads is expected to be INR 532,446.79 crore: Food (INR 287,179.34 crore), fertiliser (INR 214,511.27 crore) and petroleum (INR 30,756.18 crore).

Off-budget Financing: Economists and analysts argue that the actual fiscal deficit figures might be even higher because some of the government’s expenditure is funded by the so-called “off-budget” items. (The off-budget borrowings are loans that government does not take directly, but public institutions borrow after the Government’s order). This extra expenditure does not figure in the official calculations. This means that the true fiscal deficit is higher than the level presented in the Budget.

Debt-to-GDP Ratio: India’s debt ratio is projected to be 84% of its GDP by the end of 2022, which is higher than many emerging economies. Due to this there is increase in interest payment. Interest payment of the government has increased to 3.1% of the GDP to INR 7.31 lakh crore in 2021-22.

Others

Poor Bond Market: In the developed economies, the Bond Markets are mature and developed. The Bond Markets judge the sustainability of the borrowing of a Central/State/Local Government and demand higher interest rates when public finance is on an unsustainable path. Such a system is healthy as fiscal responsibility is rewarded by cheaper debt financing (i.e., Government can borrow at lower interest rates) and vice versa. Poorly developed bond markets in India lack the ability to act like this check-and-balance. When the government needs to borrow, it forces financial firms (like banks) to lend to it.

What are the reasons for non-adherence to the FRBM Act?

Escape Clause: The term ‘Escape Clause’ refers to the circumstance in which the Central Government can deviate from fiscal deficit targets. The FRBM Act has defined three conditions upon which the escape clause can be invoked: (a) Over-riding considerations of national security, acts of war, and calamities of national proportion and collapse of agriculture severely affecting farm output and incomes; (b) Far-reaching structural reforms in the economy with unanticipated fiscal implications; (c) A sharp decline in real output growth of at least 3 percentage points below the average for the previous four quarters. Because of this clause, the goal posts for fiscal targets have been moved multiple times over the course of the past two decades.

Amendments to FRBM Act: Amendments to the FRBM Act are permissible through money bills, which include Finance Bills. This makes it easier to amend the Act and shift the target dates e.g., the date of eliminating Revenue Deficit was gradually shifted through amendments in 2004, 2012, 2015 and 2018.

Effectiveness of Fiscal Responsibility Framework:  In the US, the Government shuts down when the Budget negotiation is not able to fit within the debt ceiling. In Germany, the ‘Federal Debt Brake‘ is in the Constitution, and there would be a shutdown of government payments if it were violated. Such overarching clause is missing in the FRBM Act.

What are the harmful impacts of high Fiscal Deficit?

Crowding-out: Due to high fiscal deficit, the Government borrows from financial institutions. This reduces the financing available to private sector. This reduces private investments, slowing down the economic growth rate.

Higher Interest Rates: Higher borrowing by Government reduces the financing available in the market (demand exceeds supply). This raises interest rates.

Inflation: To cover its fiscal deficit, the Government also borrows from the Central Bank. When the Central Bank prints money to finance the government, the economy’s money supply expands, causing inflationary pressures.

Debt Trap: Persistent fiscal deficit and dependence of borrowing may lead to accumulation of debt. As the debt rises, the interest payments on cumulative debt rise, putting further pressure on Government finance. Ultimately it may create a vicious cycle with the Government entangled in a debt trap where it has to borrow more money to just repay existing debt and interest payments.

External Dependence: Financing Fiscal Deficit through borrowings from abroad may force the Government to borrow from abroad. This creates dependence on foreign financial institutions and Governments. There is also risk of ballooning of debt in the event of domestic currency depreciation.

What steps can be taken to address Fiscal Deficit?

First, The Government should focus on rationalizing the subsidies. The tendency to grant ‘freebies’ should be kept in check. The subsidies can be made more targeted. Checking leakages and diversions can also help in rationalizing the spending.

Second, The Government should also improve the tax system. Tax-to-GDP ratio must be improved by ensuring better compliance (~4% pay Income Tax). In addition, introduction of Wealth Tax and raising the rate of Property Tax can reduce the asymmetry with respect to Direct and Indirect Taxes. Laws regarding tax evasion must be made more robust and implementation strengthened.

Third, The Government can also enhance revenues through monetization of assets especially idle assets like land lying vacant with Government entities.

Fourth, The Government should adhere to the recommendations regarding fiscal consolidation given by the 15th Finance Commission.

Fifth, The amendments to the FRBM Act regarding shifting of target dates should be debated in the Parliament. The Government should adhere to the Act and the costs of deviation from the provisions of the Act should be increased.

Conclusion

The Government had to enhance its spending during the pandemic. Breach from fiscal consolidation targets is justified in such circumstances. However, even during the normal times, the fiscal deficit has never been below 3% since 2007-08. As normalcy returns post COVID-19 pandemic, the Government must focus on fiscal consolidation and bringing down the Fiscal Deficit to more sustainable level at the earliest.

Syllabus: GS III, Indian Economy

Source: Indian Express, The Times of India, The Times of India, Business Standard