It has always been argued amongst economists and policymakers on whether fiscal deficit is good or bad for the economy. Firstly, we all know that the government plays a crucial role in the functioning of the economy as based on the economic cycle they can increase/decrease taxes or spending in certain sectors and or certain sections of the society. Ideally, any government first looks at the monetary policy (RBI) to spur economic growth. However, monetary policy alone is not enough, and therefore the government uses expansionary fiscal policy to promote economic growth.
First, let us understand what fiscal deficit is and how does it affect the economy? And why is it so important?
The government gets its income from tax collection (including corporate tax, GST and income tax), union customs and excise duty, and capital receipts (dividends, disinvestment and borrowings). It then spends on various centrally sponsored schemes, subsidies, defence, social sectors, and pensions. Fiscal deficit arises when a government spends more than its income either by spending more or reducing its income (taxes). Governments across the globe run fiscal deficits as increased spending by the government increases economic activity and boosts aggregate demand.
What is the Ideal Economic Principle?
The ideal economic principle suggests that during recession, the government must run large fiscal deficit to revive growth and during boom period, the government must run surpluses to cover the deficit and reduce public debt. But the latter is never observed in the Indian economy or even across some major economies. This leads to a huge amount of public debt accumulated even in boom periods. If the debt or fiscal deficit is not carefully managed, it can ultimately lead to a default by the government in the long run.
So, how does the government fund deficit?
The government has two options to fund the deficit that is they either borrow from the market or print money (borrow from RBI which has the power to create new money). Both these measures have its repercussion on the economy. First, when the government borrows from the market, it crowds out private investment due to a reduction in capital stock in the economy. Further, higher fiscal deficit increases the demand for money due to higher income and an increase in economic activity. This leads to higher interest rates in the economy. The second option of printing new money has an adverse impact on inflation as the supply of money increases chasing the same goods. Hence, both these options have an adverse impact on inflation and interest rates. Below is the graphical representation of the relationship between fiscal deficit (% to GDP), inflation and interest rates.
Is fiscal deficit only bad?
No, if it had been that bad, most of the major economies would have been crippled. The main motive for the government to run deficits is to promote economic growth and in economic terms, it is called an expansionary policy. No government in the world would opt for a contractionary policy as it would lower economic growth, which does not serve the political motives. Hence, any government must maintain or gradually reduce the fiscal deficit without hampering economic growth. In India as well, the Fiscal Responsibility Budget Management (FRBM) Act, 2003 requires the government to reduce the fiscal deficit gradually however the government has time and again missed the targets.
Therefore, in conclusion, the harsh truth remains that none of the government can run fiscal surplus as a big entity like the government spending less would impact growth adversely. Hence, maintaining or gradually reducing the deficit would be an appropriate strategy for any government. For India, fiscal deficit around 3% is manageable but anything beyond 3.5-3.7% could be detrimental to India’s economy and sovereign rating.
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