Fiscal Deficit

Context: The Centre will rein in the fiscal deficit at the targeted 6.4% of the gross domestic product in the current financial year despite some likely variations in revenues and expenditures from the respective revised estimates.

How will the Fiscal Deficit be reigned?

  • Government is on track to achieve the fiscal deficit target for FY23.
  • Sustained revenue buoyancy over the last 2 years.
  • Increasing average monthly gross GST collections.
  • Modest growth in debt-to-GDP (%) for India will reduce future interest liabilities.
  • Positive growth-interest rate differential keeps Government debt sustainable.

Challenges in Meeting Fiscal Deficit Targets

  • Likely shortfall in tax revenues given the large Budget with several spending and revenue collection heads.
  • Increase in Government’s expenditure: It was increased by Rs 2.42 trillion or 6.14% to Rs 41.87 trillion in the RE from the budget estimate (BE) of Rs 39.44 trillion, to cater to higher revenue expenditure on subsidies, including that on food and fertilisers.

About Fiscal Deficit

  • Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing. 
  • Fiscal deficit arises due to either increase in expenditure or shortfall in revenues. 
  • Fiscal deficit can be financed through borrowing from domestic and foreign sources or by printing money. The borrowing can be either from the central bank of the country, or raising money from capital markets by issuing different instruments like treasury bills and bonds

Implications for the economy:

  • By printing new currency: But printing money in excess of what is justified for the growth of ‘real’ national income will lead to inflationary trends which will be a burden on the people. If deficit financing is maintained at a steady money level, it may not lead to ‘spiral inflation’ but will lead to price rise. The price rise can be minimised by either reducing the scale of deficit financing or imposing price control 
  • Borrowings from domestic sources: It consist of market borrowings, small savings of households, state provident funds and term loans from financial institutions. Financing by borrowing can be unsustainable if the interest rate involved exceeds the growth rate of GDP.
  • Non-productive current expenditure: If the borrowings are high and they are utilised for financing activities which give zero or low returns, the burden of interest payments will be unsustainable. The non-productive current expenditures will give rise to higher revenue deficits 
  • Reducing capital expenditure: If debt service payments form a high proportion of both revenues and expenditures, other activities of the government will suffer. Since expenditures on wages and salaries, defence expenditures, pensions, food subsidies, etc. are all committed expenditures, the main casualty will be capital expenditures in social and infrastructural spheres. 
  • Crowding out private investment: A high fiscal deficit, even if sustainable, will ‘crowd out’ private investment and adversely affect growth. Such impact on growth of GDP will be more direct and severe if the borrowings lead to unproductive public consumption.
  • High interest rates: A continued high level of public borrowing will put pressure on the interest rates. In order to finance the government deficit, the central bank (RBI in India) will have to keep the level of reserves high on deposits in commercial banks. This will necessitate banks to have higher margins on their commercial and lending activities thereby subjecting the rest of the economy to high interest rates.

Implications on macroeconomic stability

  • The effect of fiscal policy on economic growth has for long been a subject of debate in economic theory, empirical research, and economic policymaking. 
  • Rising budget deficit has been considered as one of the main constraints on economic growth in developing economies. 
  • Economists have generally agreed that large and persistent fiscal deficits are inimical to good macroeconomic performance. 
  • As pointed out earlier, such deficits tend to crowd out private investment and increase inflationary potential. 
  • It would also weaken the balance of payments position, make financial sector reforms more difficult and impose a burden of debt on future generations.

Implications on Economy

  • Though the fiscal deficit financed by domestic borrowing will result in increased government investment at the cost of private investment. But government spending will lead to an increase in aggregate demand and expansion of the economy. 
  • As the economy expands, the private sector and businesses will find it profitable to ramp up production to meet the rising consumer demand.
  • JM Keynes, the Cambridge economist, advocated deficit spending by the State during the Great Depression of the 1930s as a means of overcoming depression. He argued that in a period of recession, public spending would stimulate aggregate demand for goods and services and counter unemployment and deflation. The government spending or ‘pump-priming’, as it is referred to, will stimulate private spending, which in turn would lead to economic expansion. This approach was adopted by Franklin Roosevelt, the US President through his ‘New Deal’ programme to overcome the debilitating effects of the depression of 1930’s.
  • After the Second World War, many of the newly independent countries, including India, which embarked on economic development and were faced with paucity of financial resources, resorted to deficit financing to meet developmental needs. 

Need for fiscal prudence

  • The dilemma faced in promoting economic growth and welfare is whether this is best achieved by the government itself, on the Keynesian approach of spending more than what it earns, or by restraining its expenditure to make space for private investment and market forces. 
  • Profligate spending and slippage in fiscal deficit target will end up in high inflation and retarded growth.
  • Against this background, adhering to a policy of fiscal prudence and reducing fiscal deficit assumes importance. 
  • The government must strive to keep the deficit under control so as not to hamper growth. Expenditure ought to be within limits to avoid massive deficits leading to debt financing and the crowding-out effect of private investment. 
  • If deficits become unsustainable, it can lead to higher interest liabilities, and the government may well even have to default.

Counter-cyclical measures

  • In the event of business cycles, with ups and downs affecting the economy, macroeconomic stability will call for a counter-cyclical policy stance, i.e., allow the deficit to go up when growth dips below the desired level, and contain it when growth spikes above the norm.
  • Most advanced economies and several emerging market economies now target structural deficit, which serves as an automatic counter-cyclical stabiliser. The structural deficit is the deficit consistent with sustainable public debt under conditions of normal growth. The actual deficit is allowed to exceed or fall below this target when growth is too low or too high.
  • Maintaining fiscal deficit as targeted is crucial for sustained economic growth. Lower fiscal deficit leads to lower interest rates and higher investment and growth. In exceptional circumstances such as the global financial crisis of 2007-08 which led to the ‘Great Recession, fiscal stimulus may be required to counter recessionary trends even breaching the deficit target.

India’s Record in Managing Fiscal Deficit

  • Since the early years of planning in the 1950s, the Government of India adopted deficit financing as a means to mobilise resources necessary for the five-year plans as the levels of outlays were of such an order which could not be met only by taxation and borrowing from the public or external aid.
  • Also, in the early phase of planning, the private sector was not in a position to provide the necessary investment for industrialisation. Hence the government had to undertake investment in the public sector to develop the core sector of basic and heavy industries. This necessitated resorting to deficit financing.

Economic growth and Fiscal Deficit

  • Prudent fiscal management requires that revenue receipts not only meet revenue expenditures, but also generate surplus to finance the Plan and other capital and development outlays. 
  • But all through the 1980’s, the government revenues fell short of expenditure. The fiscal imbalance persisted and worsened during the 1980’s, and the gross fiscal deficit surged to 8% by the end of the decade. 
  • Another disturbing trend was that almost throughout the 1980s, non-development expenditure increased faster than development outlays which meant that long-term development of the country received less priority. The persistent fiscal imbalances accentuated inflationary pressures. 
  • These and the critical foreign exchange position towards the end of 1980s and the early 1990’s  forced India to launch radical reform measures. 
  • With determined effort at fiscal consolidation, the central government brought down the combined deficit of the Centre and the states by the mid-1990s.
  • But later, instances such as hikes in salaries of government employees at both the Centre and the states, increase in subsidies, and payments to farmers towards debt relief made the government’s task of adhering to fiscal deficit targets challenging. 

The FRBM Act and Fiscal prudence

  • An important step towards ensuring fiscal prudence was the enactment of the Fiscal Responsibility and Budget Management Act in 2003 which mandates the Central Government to ensure equity in fiscal management and long term macro-economic stability. 
  • The Act streamlined the Budget presentation process and helped to enforce fiscal discipline.
  • There was a view that instead of fixed fiscal deficit targets, it would be better to have a fiscal deficit ‘range’ as the target which would give necessary policy space to the government to deal with unforeseen and dynamic situations such as natural calamities or volatile global economic conditions which would have adverse repercussions on the economy.
  • Committee on FRBM Act: Therefore, in 2016, an Expert Committee, headed by N.K. Singh was set up to review the implementation of the Act. The Committee made the following important recommendations:
    • Public debt to GDP ratio should act as the medium-term anchor for fiscal policy. Combined debt-to-GDP ratio of the centre and states should be brought down to 60% by 2023 (40%- Centre, 20%- States).
    • Fiscal deficit as the operating target. Fiscal deficit should be reduced from 3.5% (2017) to 2.5% by 2023. This will help achieve the public debt target of 40% for the centre by 2023.
    • Formation of Fiscal Council to do fiscal analysis round the year, advise the government on any corrective action needed and advise if conditions exist Justify triggering the ‘escape clauses’ for deviating from the fiscal deficit target.
    • Escape Clause to accommodate counter cyclical issues: Flexibility in fiscal deficit target (0.5%) to deal with economic instabilities.

Fiscal deficit: The real picture 

  • A key concern is that the fiscal deficit numbers, put out by the government, do not present the true picture of public finances. Though the deficit has been brought down over the years, the government’s off-budget borrowings have increased manifold.
  • There is a problem with budget data because the central government overstates the receipts and understates the expenditures figures. The government borrows funds using off-budget’ methods which enable it to finance capital and revenue expenditures while seemingly adhering to deficit targets.
  • For instance, fertiliser subsidies are cleared through special banking arrangements;  irrigation schemes are financed through borrowings by NABARD and power projects through Power Finance Corporation. 
  • Further, instead of paying the food subsidy bill during the current year, the central government carries it over to the following year which creates future liabilities and also adds to interest payment liabilities This leaves the fiscal deficit figures cited in Union budgets questionable.
  • These aspects have been pointed out by the Comptroller and Auditor General (CAG) also. 


  • Some experts suggest that during a prolonged slowdown in the economy, there is a need for a public expenditure-led booster to revive demand even if it means breaching the fiscal deficit target.
  • While the need for stimulating growth is paramount, there is a limit to which fiscal deficit may be stretched. The consequences of breaching the deficit target could be severe and it may last over a long period. It will also take longer to bring the debt-GDP ratio to the prescribed limit. 
  • The longer also will be the period during which interest payments claim an unduly large portion of revenue receipt In view of these considerations, it would be prudent to adhere to the path of fiscal discipline and fiscal deficit targets, save in exceptional situations of economic slowdown or recession requiring stimulus, or to meet other unforeseen contingency as pointed out by the Committee on FRBM Act. 

UPSC Mains PYQ 2013:

What are the reasons for introduction of Fiscal responsibility and Budget Management (FRBM) Act, 2003? Discuss critically its salient features and their effectiveness.

UPSC Prelims PYQ 2016:

There has been a persistent deficit budget year after year. Which action/actions of the following can be taken by the Government to reduce the deficit?

    1. Reducing revenue expenditure

    1. Introducing new welfare schemes

    1. Rationalising subsidies

    1. Reducing import duty

Select the correct answer using the code given below.

(a) 1 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2, 3 and 4

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