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Tag Archives | Fiscal deficit

Primer on deficits

Today’s budgetary deficits are tomorrow’s taxes. Therefore, it is important to understand what deficit means, and how India has performed on this metric over the past few years. This post provides a primer on this topic.

Budgetary deficit occurs when the expenditures[1] are more than receipts (This is true for homes and nations).There are three types of deficits

  • Revenue Deficit
  • Fiscal Deficit
  • Primary Deficit

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Revenue deficit is defined as the difference between total revenue expenditure and total revenue receipts. The revenue deficit signals how much the government is spending when compared to its earnings to perform its day-to-day activities(like paying salaries etc.)

Revenue receipts are those government receipts which neither reduce assets nor create future liabilities. These are proceeds from taxes, interest and dividend from government investment, cess, and other receipts for services rendered by the government. Revenue expenditure includes those expenditures that neither creates assets nor reduces liabilities. These are expenditures on salaries of government employees, subsidies, grants (to state government and other entities), interest payments and pensions. These expenditures are short term and recurring in nature and mostly meant to ensure the daily functioning of the government.

Given this, revenue deficit shows how much the government is borrowing to finance its daily functioning. In the past few years, eliminating the revenue deficit has been the priority for both the Union and State governments. The Fiscal Responsibility and Budget Management Act, 2003 recommended elimination of revenue deficit by 2009.

Revenue deficit = Total revenue expenditure – Total revenue receipts

Fiscal Deficit is defined as the difference between total expenditure and total receipts (excluding borrowings) ie., any loans received as money are not counted as receipts.. Therefore fiscal deficit actually represents the amount of borrowing that the government must make to meet its expenses(this is the reason why the fiscal deficit is the most discussed number and a keenly observed number during the budget and by commentators.

Fiscal Deficit = Total expenditure – Total receipts(excluding borrowings)

Primary deficit is defined as the difference between fiscal deficit and interest payments ie., if the primary deficit is zero then, the governments borrowings will be used just to meet its previous borrowings. If the primary deficit is positive and significant, it feeds back into the interest payments in the following years, as fresh debt is created, for which interest has to be paid.

Primary deficit = Fiscal deficit – interest payments

 

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[1] There are two types of expenditures: Revenue expenditure and Capital Expenditure. Revenue expenditure is a cost that is charged to expense as soon as the cost is incurred.

Varun Ramachandra and Anupam Manur are Policy Analysts at Takshashila Institution. Varun tweets at @_quale and Anupam tweets at @anupammanur

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A Fiscal Lesson for Monetary Policy

Is it wise to entrust monetary policy to the central government, when it has consistently failed to achieve its fiscal and revenue deficit targets?

The Finance Ministry has put up the revised draft of the Indian Financial Code (IFC) on its website and has invited comments from the general public. Its many drastic proposals have invited much outrage from economists with the main target being the structure of the monetary policy committee. Earlier this year, the Reserve Bank of India and the Finance Mininistry came to an agreement to form a monetary policy committee (MPC) and also agreed on adopting inflation targeting. The draft IFC goes on to expound the structure and functions of the MPC:

Part XI “Reserve Bank”, Chapter 64 – Objectives and Functions of the Reserve Bank; Clause 256:

  1. The Reserve Bank must constitute a Monetary Policy Committee to determine by majority vote the Policy Rate required to achieve the inflation target.
  2. The Monetary Policy Committee will comprise –
    • (a) the Reserve Bank Chairperson as its chairperson;
    • (b) one executive member of the Reserve Bank Board nominated by the Reserve Bank Board;
    • (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and
    • (d) four persons appointed by the Central Government.

Thus, the MPC will consist of seven people, the majority of which (four) will be from the central government. Since it is stipulated that the interest rate will be set by the MPC on the basis of a majority vote, the government will get a greater say in the determining of monetary policy than the RBI. Further, the chairperson of the MPC (the RBI chairperson) does not get a veto vote. This is essentially the heart of the heated debate on the transfer of control of monetary policy from the RBI to the central government.

Why is this a bad thing?   

The issue boils down to whether the government can be trusted to keep the long term interests of the economy in mind while making monetary policy decisions. The trends in fiscal policy can point towards the answer. As Anantha Nageshwaran points out, “the Indian economy is inflation prone and fiscal populism, is its biggest contributor. From loan waivers to corporate give-aways, fiscal policy primes the pump needlessly on many occasions for non-economic considerations.”

It is difficult to trust a central government (irrespective of which party in power) which has failed to adhere to its own rules regarding fiscal policy. The government passed the Fiscal Responsibility and Budget Management Act (FRBMA) in 2003 with the intention of reining in the ballooning fiscal and revenue deficits. It planned to reduce fiscal deficit to 3% of GDP and eliminate revenue deficits by 2008, though this deadline was later extended to 2009 without any opposition. However, by 2009 the revenue and fiscal deficits were as high as 4.7 and 6.2 per cent of GDP respectively.  From 2009 to 2012, the FRBMA targets were never met as can be seen in Figure 1.

The events after 2012 are even more disturbing. The budget speech of 2012-13 contained amendments to the FRBMA which diluted targets and extended deadlines. The amendments extended the deadline to reduce the fiscal deficit to 3% to 2017 and increased the targeted revenue deficit to 2% instead of 0% (to be achieved by 2015). May, 2013 witnessed further dilutions and extensions of the targets.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

There are multiple reasons for the central government’s failure to adhere to its own targets. However, the essential problem lies with the inherent short term growth bias of the central government as these posts have elaborated. Political considerations like re-election make the central government more than willing to consistently spend more than it earns despite the risks of higher future inflation and increased interest rates.

This begs the question as to how the central government can be entrusted with conducting monetary policy when such a task requires a long term perspective. “There is thus plenty of reason in the Indian context for the central bank to remain in a perpetual vigilant and adversarial mode. It provides the vital check and balance”, as Anantha Nageswaran elaborates. Thus, if the IFC is insistent on setting up an MPC, it should revisit the composition of members and should tilt the balance away from the political central government and towards the RBI.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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