Why is fiscal consolidation so important? (GS Paper 2, Polity and Constitution)
Why in news?
- Union Finance Minister announced during her Budget speech that the Centre would reduce its fiscal deficit to 5.1% of gross domestic product (GDP) in 2024-25. She further added that the fiscal deficit would be pared to below 4.5% of GDP by 2025-26.
- The FM’s projections surprised most analysts who expected the government’s fiscal deficit target would be slightly higher, at about 5.3% or 5.4% of GDP. The government’s revised estimates also lowered the fiscal deficit projection for 2023-24 to 5.8% of GDP.
What is fiscal deficit?
- Fiscal deficit refers to the shortfall in a government’s revenue when compared to its expenditure. When a government’s expenditure exceeds its revenues, the government will have to borrow money or sell assets to fund the deficit. Taxes are the most important source of revenue for any government.
- In 2024-25, the government’s tax receipts are expected to be ₹26.02 lakh crore while its total revenue is estimated to be ₹30.8 lakh crore. The Union government’s total expenditure is estimated to be ₹47.66 lakh crore.
- When a government runs a fiscal surplus, on the other hand, its revenues exceed expenditure. It is, however, quite rare for governments to run a surplus. Most governments today focus on keeping the fiscal deficit under control rather than on generating a fiscal surplus or on balancing the budget.
Fiscal deficit vs. national debt:
- The fiscal deficit should not be confused with the national debt. The national debt is the total amount of money that the government of a country owes its lenders at a particular point in time.
- The national debt is usually the amount of debt that a government has accumulated over many years of running fiscal deficits and borrowing to bridge the deficits.
- The fiscal deficit is generally expressed as a percentage of a country’s GDP since it is believed that the figure shows how easily the government will be able to pay its lenders.
- The higher a government’s fiscal deficit as a share of GDP, the less likely its lenders will be paid back without trouble. Countries with larger economies can run higher fiscal deficits (in terms of absolute numbers of money).
How does government fund its fiscal deficit?
- In order to fund its fiscal deficit, the government mainly borrows money from the bond market where lenders compete to lend to the government by purchasing bonds issued by the government.
- In 2024-25, the Centre is expected to borrow a gross amount of ₹14.13 lakh crore from the market, which is lower than its borrowing goal for 2023-24, as it expects to fund its spending in 2024-25 through higher GST collections. Economists were expecting that the Centre would set a borrowing target of about ₹15.6 lakh crore for 2024-25.
- The central banks such as the Reserve Bank of India (RBI) are also major players in the credit market, although they may not always directly purchase government bonds. The RBI may still purchase government bonds in the secondary market, from private lenders who have already purchased bonds from the government.
- So, when a government borrows from the bond market, it not only borrows from private lenders but also indirectly from the central bank. The RBI purchases these bonds through what are called ‘open market operations’ by creating fresh money, which in turn can lead to higher money supply and also higher prices in the wider economy over time.
- Government bonds are generally considered to be risk-free as the government can —get help from the central bank, which can create fresh currency to pay off the lenders. So governments generally do not find it hard to borrow money from the market.
- Monetary policy also plays a crucial role in how much it costs governments to borrow money from the market.
Why does the fiscal deficit matter?
- There is a strong direct relationship between the government’s fiscal deficit and inflation in the country.
- When a country’s government runs a persistently high fiscal deficit, this can eventually lead to higher inflation as the government will be forced to use fresh money issued by the central bank to fund its fiscal deficit.
- The fiscal deficit recently reached a high of 9.17% of GDP during the pandemic and has since improved significantly and is projected to drop to 5.8% now.
- The fiscal deficit also signals to the market the degree of fiscal discipline maintained by the government. A lower fiscal deficit may thus help improve the ratings assigned to the Indian government’s bonds.
- When the government is able to fund more of its spending through tax revenues and borrow less, this gives more confidence to lenders and drives down the government’s borrowing cost.
- A high fiscal deficit can also adversely affect the ability of the government to manage its overall public debt. In December, the International Monetary Fund warned that India’s public debt could rise to more than 100% of GDP in the medium term due to risks although the Centre disagreed with the assessment.
What lies ahead?
- The Centre plans to bring down its fiscal deficit in 2024-25 to 5.1% of GDP despite having plans to boost capital expenditure and to spend on other programmes. So, most of the revenue to fund such spending will have to come from tax collections.
- The Centre expects tax collections to rise by 11.5% in 2024-25. It has also projected a cut in expenditure on fertilizer subsidy, from ₹1.88 lakh crore in 2023-24 to ₹1.64 lakh crore in 2024-25.
- The amount spent on food subsidy is also projected to drop from ₹2.12 lakh crore in 2023-24, to ₹2.05 lakh crore in 2024-25.
- Trying to balance the budget primarily through raising tax rates to increase tax collections, however, could come at the cost of economic growth since taxes can act as a dampener on economic activity. There is no guarantee, however, that the government will be able to meet its fiscal deficit target, which is seen as ambitious by many, as its projections may turn out to be wrong.
