Why is fiscal consolidation so important?

Why is fiscal consolidation so important?

Subject: Economy

Section: Fiscal Policy

Why in the news?

Recently Union Finance Minister Nirmala Sitharaman announced during her Budget speech that the Centre would reduce its fiscal deficit to 5.1% of gross domestic product (GDP) in 2024-25.

What is the fiscal deficit?

• Definition: 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. 
• Fiscal surplus: 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.
• Difference Between debt and deficit: 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.
• GDP percentage: 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.
  • In other words, 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 the government fund its fiscal deficit?

• Borrowing Mechanism:
  • Government borrows money from the bond market to fund its fiscal deficit.
  • Lenders, including private entities and central banks, compete by purchasing government-issued bonds.
• Central Bank’s Role:
  • Central banks like RBI are significant players in the credit market.
  • RBI may indirectly purchase government bonds in the secondary market from private lenders, creating fresh money through open market operations.
• Money Supply Impact:
  • RBI’s bond purchases can increase money supply, leading to potential inflation in the broader economy over time.
• Risk-Free Nature:
  • Government bonds are generally considered risk-free as the central bank can create fresh currency under extreme scenarios to repay lenders.
  • Governments find it relatively easy to borrow money from the market.
• Interest Rate Challenges:
  • Government faces challenges not in borrowing itself but in the interest rates it offers.
  • Worsening government finances lead to decreased demand for bonds, prompting the government to offer higher interest rates, increasing borrowing costs.
• Monetary Policy Influence:
  • Central bank lending rates, which were near zero pre-pandemic, have risen post-pandemic.
  • Higher central bank rates make it more expensive for governments to borrow, influencing the Centre’s efforts to reduce fiscal deficit.

Why does the fiscal deficit matter?

• Inflation Impact: A high fiscal deficit is directly linked to inflation, as the government may resort to using freshly issued money to cover the deficit. This can contribute to higher inflation rates.
• Pandemic Scenario: The fiscal deficit surged to 9.17% of GDP during the pandemic but has since improved and is expected to drop to 5.8% now.
• Market Perception: The fiscal deficit serves as an indicator of the government’s fiscal discipline. A lower fiscal deficit can enhance ratings for Indian government bonds, signalling responsible financial management.
• Borrowing Confidence: Funding more spending through tax revenues and borrowing less builds confidence among lenders, reducing the government’s borrowing costs.
• Debt Management: A high fiscal deficit can impact the government’s ability to manage overall public debt. The International Monetary Fund warned of potential risks, projecting India’s public debt to exceed 100% of GDP in the medium term, though the government contested this assessment.
• International Bond Market: Lowering the fiscal deficit may facilitate the government’s efforts to tap into the international bond market, making it easier to sell bonds overseas and access more affordable credit.

What lies ahead?

• Fiscal Deficit Target (2024-25):
  • The Centre aims to reduce the fiscal deficit to 5.1% of GDP.
  • Despite plans for increased capital expenditure and program spending.
• Revenue Source:
  • Majority of funding for spending plans come from tax collections.
  • Expects a significant 11.5% rise in tax collections for 2024-25.
• Expenditure Changes:
  • Planned reduction in fertiliser subsidy from ₹1.88 lakh crore (2023-24) to ₹1.64 lakh crore (2024-25).
  • Projected decrease in food subsidy from ₹2.12 lakh crore (2023-24) to ₹2.05 lakh crore (2024-25).
• Economic Growth Concerns:
  • Raising tax rates to boost collections may negatively impact economic growth.
  • Taxes can act as a dampener on overall economic activity.
• Fiscal Deficit Target Challenges:
  • Ambitious fiscal deficit targets may face challenges.
  • Uncertainty as government projections may not align with actual outcomes.

Fiscal Responsibility and Budget Management (FRBM) Act

• The FRBM Act, 2003, intends to bring transparency and accountability in the conduct of the fiscal and monetary actions of the government.
• The central government agreed to the following fiscal indicators and targets, subsequent to the enactment of the FRBMA
• Revenue deficit to be eliminated by the 31st of March 2009. A minimum annual reduction of 0.5% of GDP.
• Fiscal Deficit to be brought down to at least 3% of GDP by 31st of March 2008. A minimum annual reduction – 0.3% of GDP.
• The FRBM Act made it mandatory for the government to place the following along with the Union Budget documents in Parliament annually:
  • Medium Term Fiscal Policy Statement
  • Macroeconomic Framework Statement
  • Fiscal Policy Strategy Statement
• The FRBM Act proposed that revenue deficit, fiscal deficit, tax revenue and the total outstanding liabilities be projected as a percentage of gross domestic product (GDP) in the medium-term fiscal policy statement.
• Several years have passed since the FRBM Act was enacted, but the Government of India has not been able to achieve targets set under it. The Act has been amended several times.
• In 2013, the government introduced a change and introduced the concept of effective revenue deficit.
• This implies that effective revenue deficit would be equal to revenue deficit minus grants to states for the creation of capital assets.
• In 2016, a committee under N K Singh was set up to suggest changes to the Act.