Prelims Capsule

Public Finance/ Fiscal Policy – Part 2

Public Finance/ Fiscal Policy 

In this series we started with the –

This post we shall discuss- Deficits, Concept of Fiscal Consolidation, FRBM Act and related reforms.

What is a ‘Deficit’?

  • Simply said, if I had Rs 9 and I wanted a pen worth Rs 10. I am on a deficit of Re. 1. A deficit is the amount by which a resource falls short of a mark, mostly used to describe a difference between cash inflows and outflows. Deficit is synonymous with shortfall or loss.
  • The term deficit is generally prefixed by another term to refer to a specific situation like income deficit, budget deficit or trade deficit.
  • We can simply use Budget Deficit to define the financial situation wherein the government’s expenditures are more than its revenues.
  • But since Budget itself has so many components we can’t simply explain all policy implications just by budget deficit using excess of public expenditure over public revenue

For the point of view of exam there are 5 types of deficits that are important for us to learn.Each type of deficit has a unique policy relevance to help us improve the outcomes and there is no single measure which may be universally preferred over all others for all time to come.

Revenue Deficit

  • Budget is divided into Revenue Account and Capital Accounts as discussed in the previous post, if there is a shortfall on the revenue account. Such a deficit is called the Revenue deficit i.e., the excess of expenditure on revenue account over the receipts on revenue account measures revenue deficit.
  • Revenue deficit = Total Revenue expenditure – Total Revenue receipts
  • Revenue deficit means the government is using the savings of other sectors of the economy to finance a part of the consumption expenditure of the government.
  • Revenue deficit signifies that government’s own earning is insufficient to meet normal functioning of government departments and provision of services. Revenue deficit results in borrowing
  • The aim of the fiscal policy should always be to ensure surplus in the revenue budget so that the government also contributes to raising the rate of saving in the economy.
  • Currently, the revenue deficit is envisaged to reduce from 2.1 percent of GDP in 2016-17 to 1.9 percent of GDP in 2017-18.

Policy Implications

  • A high revenue deficit warns the government either to curtail its expenditure or increase its tax and non-tax receipts. Thus, main remedies are:
    1. Government should raise rate of taxes especially on rich people and any new taxes where possible
    2. Government should try to reduce its expenditure and avoid unnecessary expenditure. (Austerity Measures) Having a minimum government.
Additional Information:

·         Remember we had said in the previous post as Note that Union Grantsto states are treated as revenue expenditure, even though some of the grants may be used for creation of assets while the loans to the States are Capital. Since such grants are included as revenue expenditure, we don’t get a clear picture of Revenue deficit. Therefore we have a measure called “Effective Revenue Deficit” – which isthe difference between revenue deficit and grants for creation of capital assets.

·         Effective Revenue deficit is a new term introduced in the Union Budget 2011-12.

·         Grants for creation of capital assets, as a concept, was introduced in the FRBM Act through the amendment in 2012.

·         However, the 14th Finance Commission observed that the artificial carving out of the revenue account deficit into effective revenue deficit to bring out that portion of grants which is intended to create capital asset at the recipient level leads to an accounting problem and raises the moral hazard issue of creative budgeting. The Commission recommend that the Union Government should consider making an amendment to the FRBM Act to omit the definition of effective revenue deficit from 1 April 2015.

·         But Government hasn’t done away with it. The Effective revenue deficit is estimated at 0.7 per cent, in contrast to the FRBM Act that has called for eliminating it by 2017-18.



Capital Deficit

  • The excess of capital expenditure over capital receipts measures the capital deficit.
  • Capital Deficit = Expenditure on Capital Account – Capital Receipts
  • Capital Expenditure include: Central Plan and Assistance for States and Union Territories, defence expenditure on Capital account, loans to public enterprises, States and Union Territory Governments, foreign governments and others;
  • The items of capital receipts include recoveries of loans extended by the centre itself, but only net receipts of loans raised by it.

Note: Receipts on account of sale of 91 days treasury bills and drawing down of cash balances do not form a part of capital receipts. However, net receipts on account of sale of 182 days and 364 days treasury bills and sales proceeds of government assets are included in capital receipts.

Fiscal Deficit

  • The difference between total expenditure (along with loans net of repayments) and revenue receipts plus certain non-debt capital receipts is called Fiscal Deficit.
  • Fiscal Deficit = Total Expenditure – (Revenue Receipts + Non-debt Capital Receipts)
  • Non debt creating capital receipts are those which do not give rise to debt, as the name itself suggests. For instance, loan recovery and proceeds from disinvestment in the PSUs
  • Fiscal deficit indicates the total borrowing requirements of the government from all sources. This may also be called Gross Fiscal Deficit (GFD).
  • It measures that portion of government expenditure which is financed by borrowing and drawing down of cash balances.

Note: Revenue deficit is a part of fiscal deficit. It can also be expressed as

  • Fiscal Deficit = revenue deficit + Capital expenditure – Non debt creating capital receipts).
  • Fiscal Deficit = Total Expenditure – Total Receipts Excluding Borrowings

From these equations: The fiscal deficit can occur even if the revenue deficit is not there if the following conditions prevail:

  • Revenue budget is balanced, but the capital budget is in deficit.
  • Revenue budget is in the surplus, and the capital budget is in deficit, and the deficit is more than the surplus.

Policy implications of Fiscal Deficit

  1. Debt Trap:
  • The fiscal deficit could be financed only through borrowings and with more and more borrowings the debt obligations increases.
  • The government has to repay the loan amount along with the interest which results into the increase in the revenue expenditure and as a result, the revenue deficit increases. Thus, this compels the government to resort to the external borrowings.
  1. Wasteful Expenditure + Inflation:
  • The deficit often leads to the wasteful expenditure of the government that ultimately results in the inflationary pressures in the economy.
  • As government borrows from RBI which meets this demand by printing of more currency notes (called deficit financing), it results in circulation of more money. This may cause inflationary pressure in the economy.
  1. Affects Sustainability of the growth:
  • Borrowing is in fact financial burden on future generation to pay loan and interest amount which retards growth of economy

The servicing of this debt has become a serious problem. Public debt in India is mostly subscribed to by commercial banks and financial institutions. A judicious macro-management of the economy requires a progressive reduction in the fiscal deficit and revenue deficit of the government.

Note 1: For 2017-18, the Budget has pegged the fiscal deficit at 3.2 per cent of the GDP. The FRBM Act mandates that the fiscal deficit should be lowered to 3 per cent in the next financial year

Note 2: A little reflection on the explanation will show that fiscal deficit is actually equal to borrowings. Thus, fiscal deficit gives the borrowing requirement of the government.

Fiscal Deficit Financing

  1. Borrowing within the country:

Fiscal deficit can be met by borrowing from domestic sources, e.g., public and commercial banks. It also includes tapping of money deposits in provident fund and small saving schems. Borrowing from public to deal with deficit is considered better than deficit financing because it does not increase the money supply which is regarded as the main cause of rising prices.

  1. Borrowing from external sources: Borrowing from outside India that is from sources like multilateral institutions such as IMF, World Bank, BRICS Bank, AIIB, ADB or the foreign banks.
  2. Borrowing from RBI

Government issues treasury bills which RBI buys in return for cash from the government. This cash is created by RBI by printing new currency notes against government securities. Thus, it is an easy way to raise funds but it carries with it adverse effects also. Its implication is that money supply increases in the economy creating inflationary trends and other ills that result from deficit financing. Therefore, this way of the fiscal deficit financing is avoided.

Fiscal Consolidation

The policies adopted by the Governments (national and sub-national levels) to reduce their deficits and decrease the accumulation of debt are together called Fiscal Consolidation.

The path adopted for fiscal consolidation in India is enumerated in the Fiscal Responsibility and Budget Management (FRBM) Act, 2003.

FRBM Act, 2003

  • According to FRBM, the government should eliminate revenue deficit and reduce fiscal deficit to 3% (medium term) of the GDP.
  • FRBM Act provides a legal institutional framework for fiscal consolidation. It is now mandatory for the Central government to take measures to reduce fiscal deficit, to eliminate revenue deficit and to generate revenue surplus in the subsequent years.
  • The Act binds not only the present government but also the future Government to adhere to the path of fiscal consolidation. The Government can move away from the path of fiscal consolidation only in case of natural calamity, national security and other exceptional grounds which Central Government may specify.
  • Further, the Act prohibits borrowing by the government from the Reserve Bank of India, thereby, making monetary policy independent of fiscal policy. The Act bans the purchase of primary issues of the Central Government securities by the RBI after 2006, preventing monetization of government deficit.
  • The Act also requires the government to lay before the parliament three policy statements in each financial year namely Medium Term Fiscal Policy Statement; Fiscal Policy Strategy Statement and Macroeconomic Framework Policy Statement.
  • To impart fiscal discipline at the state level, the Twelfth Finance Commission gave incentives to states through conditional debt restructuring and interest rate relief for introducing Fiscal Responsibility Legislations (FRLs). All the states have implemented their own FRLs.

Other Measures

  • Improved tax revenue realization: For this, increasing efficiency of tax administration by reducing tax avoidance, eliminating tax evasion, enhancing tax compliance etc. are to be made.
  • Enhancing tax GDP ratio by widening the tax base and minimizing tax concessions and exemptions also improves tax revenues.
  • Better targeting of government subsidies and extending Direct Benefit Transfer scheme for more subsidies.
  • Introduction of GST, even the Demonetization could be considered as a move for Fiscal consolidation which increases the tax base and tax revenues and helps in reducing the fiscal deficit.
  • The introduction measures for speedy disposal mechanism to reduce tax arrears. Tax
  • Rationalization tax treaties to minimize tax evasion and avoidance through tax havens by renegotiating the DTAA Agreements.

Why is Fiscal Consolidation important?

  • Fiscal consolidation efforts are considered by the sovereign-rating agencies as it an indicator of the country’s seriousness commitment towards servicing the debt it raises.
  • Even though an economy grows well, and its other indicators, such as external sector strength, it does not get a good rating only on the ground of poor efforts at fiscal consolidation.

Primary Deficit

  • Primary deficit is fiscal deficit minus interest payments on previous borrowings
  • Primary deficit = Fiscal deficit – Interest payments
  • It shows how much government borrowing is going to meet expenses other than Interest payments.
  • A zero primary deficit means that government has to resort to borrowing only to make interest payments that is fiscal deficit is equal to interest payment. Then government is not adding to the existing loan.
  • Primary Deficit also helps the governments convey the measures being taken by the current government to the electorate over previous governments’ bad performance.

Monetised Deficit

  • The Monetised Deficit is the amount RBI helps the central government in its borrowing programme.
  • The monetized deficit results in the increase in the net holdings of treasury bills by the RBI and also the RBI contribution towards the government’s market borrowings increases. With the issue of more money to the government, the money supply in the economy increases, as a result of which the inflationary pressure prevails. Hence, we can say that monetised deficits are the part of a fiscal deficit that leads to the inflation in the economy.
  • Thus, it can be concluded that monetised deficit occurs when the government takes a monetary support from the RBI to finance its debt obligations and try to reduce its unnecessary expenditures.


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