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Ask Mint | Why governments run up a fiscal deficit

Ask Mint | Why governments run up a fiscal deficit
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First Published: Mon, Feb 25 2008. 12 33 AM IST

Updated: Mon, Feb 25 2008. 12 33 AM IST
Whenever the dreaded beast of fiscal deficit starts walking, it is time for experts to start talking. Recently, Johnny heard three experts sorting out their differences. “The fiscal beast has lost weight because we have stopped free lunches,” said one expert. “No, it’s looking slim because of regular exercise,” said another. “No, no, it’s looking slim because it is wearing Bermudas,” countered the third expert. “What?” cried the other two. “Oh! Fiscal beast can deceive us by putting on make-up,” added the third expert. Johnny was really clueless. What kind of beast would love to wear Bermudas? Let us find out.
Johnny: Hi Jinny! Whenever the Union Budget is around, many experts start whipping the beast of fiscal deficit. Could you tell me what fiscal deficit is in the first place?
Jinny: Don’t call fiscal deficit a beast. You may unintentionally hurt the sentiments of many who think that deficits are not so bad after all. I will try to give you a neutral view.
The government needs money for its huge expenses. We can broadly divide government expenses into two types: revenue expenses and capital expenses. You can further divide these into planned and non-planned categories, but that may not be very relevant here. The government incurs revenue expenses in running its day-to-day business, whereas capital expenses include all expenses incurred by the government for creating assets. The money spent by the government for paying salary to its staff is revenue expense, and the money spent for constructing a hospital is capital expense.
These expenses ultimately come out of our pockets.
Johnny: That’s why we have to pay taxes, right?
Jinny: Yes, but taxes alone can’t take care of all the government’s expenses. So, there are other sources through which our government earns money. We can broadly divide the sources of government earnings into two categories: tax and non-tax sources. Tax sources include all the direct and indirect taxes, and non-tax sources include revenue receipts and capital receipts. Revenue receipts consist of a variety of things such as dividends received from public sector companies, fees, fines forfeitures, etc., received by the government. Under the category of capital receipts, we keep the money received from the disinvestment of public sector undertakings, recovery of loans, borrowings of the government, etc.
The main difference between revenue receipts and capital receipts is that revenue receipts are recurring in nature, which the government can expect to receive year after year, whereas capital receipts are a kind of one-time income. In your case, the salary you receive is your revenue receipt and the income you receive by selling your home is capital receipt. You might have noticed that the borrowings of the government are also included in capital receipts. This causes confusion. How can borrowed money be treated as part of income?
Actually, it is like covering a crack in the wall with borrowed paper. The government borrows money to cover the crack between its income and expenditure. But, to see the true picture, you need to put aside the borrowed thing first. So if you remove government borrowings from government income, you will see the gap between what the government is spending and what the government is earning. This difference is what we call fiscal deficit. It is expressed as a percentage of gross domestic product.
Johnny: Why does the government need to borrow money when it can print more?
Jinny: The government has two options for covering fiscal deficit: borrowing money from the market or printing more notes. Printing notes looks the easiest option. The government simply hands over its promise, written on a paper, and asks the central bank to hand over the money. But printing more money increases money supply and may cause inflation. It is a kind of invisible tax on your money. It reduces the value of the money you are holding. Borrowing from the market is considered a more decent and less painful way of covering deficits. However, excess borrowing from banks and financial institutions by the government may leave nothing for other borrowers. So, government borrowings have to be managed carefully. But you can’t continue to live on borrowings alone. Each borrowing adds to your already existing liability.
In the long run, cutting the fiscal deficit is the only option. You can do so either by increasing income or decreasing expenditure or simultaneously doing both. Increasing income requires raising taxes and fees, which may not work beyond a point. Stopping all wasteful expenditures is easier said than done. So, till you resolve all this, you may dress up the beast in Bermudas. It will give the beast a tamed look.
What:The difference between total government expenditure and total government income after removing total market borrowings is known as fiscal deficit.
How: The government can reduce its fiscal deficit by increasing its tax and non-tax income and reducing its expenditure.
Why: Reducing deficit is important because high fiscal deficit can lead to financial instability.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Mon, Feb 25 2008. 12 33 AM IST