Indian Economy, 5th edition (84 page)

First used in the area of public finance in the early 1930s in USA,
13
today the term is being used by the corporate sector, too and such a financial management of a firm might be followed by it as part of its business strategy. Again, a sick firm might need to follow deficit financing route for many years to come as required by the firm to make it come out of the red (i.e., doing away with the losses).

Need of Deficit Financing:
It was in late 1920s that the idea and need of deficit financing was felt. It is when government needs to spend more money than it was expected to earn or generate in a particular period, to go for a desired level of growth and development. Had there been some means to go for more expenditure with less income and receipts, socio-political goals could have been realised as per the aspirations of the public policy! And once the growth had taken place the extra money spent above the income would have been reimbursed or repaid! This was a good /files/04/35/93/f043593/public/government wish which was fulfilled by the evolution of the idea of deficit financing.

It was by early 1930s that the US first tried its hand at deficit financing soon to be followed by the whole Euro-American governments.
14
Through this route the developed world was able to come out of the menace of the Great Depression (1929).
15
The idea became popular around the world by the 1960s. India tried its hand at deficit financing in 1969 and since the 1970s it became a routine phenomenon, till it became wild and illogical, demanding immediate redressal. The fiscal deficits in India did not only peak to unsustainable levels but its composition was also not justified and not based on sound fundamentals of economics. Finally, India headed for a slow but confident process of fiscal reforms that is also known as the process of fiscal consolidation (to be discussed in the coming pages).

Means of Deficit Financing:
Once deficit financing became an established part of public finance around the world, the means of going for it were also evolved by that time. These means, basically are the ways in which the government may utilise the amount of money created as the deficit to sustain its budget for developmental or political needs. These means are given below in order of their suggested and tried preferences.

(i)
External Aids
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are the best money as a means to fulfill a government’s deficit requirements even if it is coming with soft interest. If they are coming without interest nothing could be better.

When India went to borrow from the IMF in the wake of the financial crisis of 1990–91, the body advised India to keep its fiscal deficit to the tune of 4.5 per cent of its GDP and noted it to be sustainable for the economy. What was the rationale behind this data? Basically, in those times with the foreign aids (soft loans either from the
WB
or from the
Aid India
f
orum
) India was able to manage its budget to the tune of 4.5 per cent of its GDP! In 2002, when India’s fiscal deficit was around 6 per cent (5.7 per cent to be precise) the IMF validated it to be sustainable, the reasons were two—first, India was able to show a check on fiscal deficit and secondly, at the same time the forex reserves of the country were suitably higher to neutralise the negative impacts of the higher fiscal deficit than the suggested levels (4.5 per cent)!

External Grants
are even better element in this case (which comes free—neither interest nor any repayments!) but it either did not come to India (since 1975, the year of the first Pokhran testings) or India did not accept it (as happened post-Tsunami, arguing grants/aids coming with a tag/conditions). That is why here this segment has not been discussed as a means to manage deficit.

(ii)
External Borrowings
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are the next best way to manage fiscal deficit with the condition that the external loans are omparatively cheaper and long-term.

t
hough external loans are considered an erosion in the nations sovereign decision making process, this has its own benefit and is considered better than the internal borrowings due to two reasons:

(a)
External borrwing bring in foreign currency/hard currency which gives extra edge to the government spending as by this the government may fulfill its developmental requirements inside the country as well as from outside the country.

(b)
It is prefered over the internal borrowings due to crowding out effect. If the government itself goes on borrowing from the banks of the country, from where will others borrow for investment purposes?

(iii)
Internal Borrowings
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comes as the third preferred route of fiscal deficit management. But going for it in a huge way hampers the investment prospects of the public and the corporate sector. It has the same impact on the expenditure pattern in the economy. Ultimately, economy heads for a double negative impact—lower investment (leading to lower production, lower GDPs and lower per capita income, etc.) and lower demands (by the general public as well as by the corporate world) in the economy—the economy moves either for
stagnation
or for a
slowdown
(one can see them happening in India repeatedly throughout the 1960s, 1970s, 1980s). The situation improved after the mid-1990s.

(iv)
Printing Currency
is the last resort for the government in managing its deficit.
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But it has the biggest handicap that with it the government cannot go for the expenditures which are to be made in the foreign currency. Even if the government is satisfied on this front, printing fresh currencies does have other damaging effects on the economy:

(a)
It increases inflation proportionally. (India regularly went for it since early 1970s and usually had to bear double digit inflations.)

(b)
It brings in regular pressure and obligation on the government for upward revision in wages and salaries of government employees—ultimately increasing the government expenditures necessitating further printing of currency and further inflation—a vicious cycle into which economies entangle themselves.

Now, it remains a matter of choice and availability of the above-given means, and which means a government adopts and in what proportion, for fulfilling its deficit requirement.

Composition of Fiscal Deficit

The
k
eynesian idea of deficit financing, though he advocated it, had a catch in it also which was usually missed by third world economies or intentionally overlooked by them. The catch is related to the question as to why an economy wants to go for fiscal deficit.
a
nd thus it becomes essential to go for an analysis of the composition
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of the fiscal deficit of a government.

Out of the two broad expenditure obligations of a government—revenue expenditure and capital expenditure—the following combinations of expenditure composition are suggested:

(i)
A fiscal deficit with a surplus revenue budget or a zero revenue expenditure is the best composition of fiscal deficit and the most suitable time for deficit financing.

(ii)
The deficit requirements for lower revenue expenditures and higher capital expenditures are the next best situation for deficit financing, provided revenue deficit is eliminated soon.

(iii)
The last could be the situation when major part of deficit financing is to fulfill revenue expenditures and a minor part to go for capital expenditures. The total money of the deficit might go to fulfil revenue expenditure, which could be the worst form of it.

Basically, there should be a judicious mix of plan and non-plan expenditure as well as revenue and capital expenditures in India.
l
esser non-plan expenditure or higher plan-expenditure are better reasons behind deficit financing in India (though India has a typical feature of capital expenditure which makes this combination of deficit financing not a suggested form—discussed ahead).

Third world economies (including India) though went for higher and higher fiscal deficits and deficit financing, they either did not address or failed to address the composition of deficit favourable towards capital and non-revenue expenditures.

Fiscal Policy

The real meaning, significance and impact of fiscal policy emerged in the wake of the Great Depression and the Second World War. Fiscal policy has been
defined
as ‘the policy of the government with regard to the level of government purchases, the level of transfers, and the tax structure’—probably the best and the most acclaimed definition among experts.
21
Later, the impact of fiscal policy on macro-economy was beautifully analysed.
22
As the policy has a deep impact on the overall performance, of the economy, fiscal policy is also
defined
as the policy which handles public expenditure and tax to direct and stimulate the level of economic activity (numerically denoted by the Gross Domestic Product).
23
It was J. M. Keynes, the
first
economist who developed a theory linking fiscal policy and economic performance.
24

Fiscal policy is also
defined
as ‘changes in government expenditures and taxes that are designed to achieve macroeconomic policy goals’
25
(such as growth, employment, investment, etc.). Therefore, we say that ‘fiscal policy denotes the use of taxes and government expenditures’.
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How the taxes and the government expenditures influence the overall economy, has been explained in a brief discussion here.
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Let us first discuss the
taxes
and their impact on the economy:

(i)
Taxes have a direct bearing on people’s income affecting their levels of disposable incomes, purchase of goods and services, consumption and ultimately their standard of living;

(ii)
Taxes directly affect the savings of individuals, families and the firms which affect investment in the economy—as investment affects the output (GDP) thereby influencing the per capita income;

(iii)
Taxes affect the prices of goods and services as factor cost (production cost) is affected thereby affecting incentives and behaviour of the economic activities, etc.

Government expenditures
affect/influence the economy in two ways:

(i)
there are some expenditure on government purchases of goods and services, for example construction of roads, railways, ports, foodgrains, etc in the goods category and salary payments to government employees in the services category; and

(ii)
there are some expenditure due to government’s income support, to the poor, unemployed and old-age people (known as government
transfer payments
).

Deficit Financing in India

India was declared to be a planned economy right after Independence. As development responsibilities of the government were very high, there was a need of huge funds in rupee as well as in foreign currency forms. India faced continuous crises in managing the required fund to support its
f
ive Year Plans—neither foreign funds came nor internal resources could be mobilised in sufficient amount. (Due to lower tax collections, weaker banks that too privately owned, and negligible saving rate, etc.)
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By the late 1960s, the government headed for deficit financing and the 1970s onwards, India started going for higher and higher fiscal deficits and became more and more dependent on increased deficit financing with every fresh year.
w
e may classify dificit financing in India into three phases.

The First Phase (1947–1970)

This phase had no concept of deficit financing and the deficits were shown as Budgetary Deficits. Major aspects of this phase were—

(i)
Trying to borrow from inside and outside the economy but unable to meet the target.

(ii)
In the 1950s, a serious attempt was made to increase tax collections and check revenue expenditures to be ultimately able to emerge as a surplus revenue budget economy. But huge cost was paid in the form of tax evasion, rise in corruption, stagnating standard of life and a neglected social sector.

(iii)
Taking recourse to heavy borrowings from the RBI and finally nationalisation of banks so that their money could be used by the government to support the plans. This not only increased the interest burden of the governments but also ruptured the whole financial system in coming years—banks did not remain commercial entities and became part of the government’s political statement.

(iv)
Establishing giant PSUs with higher revenue expenditures (salaries) which increased the revenue expenditures of the future governments when the pensions and the PFs needed to be serviced.

(v)
Unable to go for the required level of investment even after taking recourse to all the above given means.

The Second Phase (1970–1991)

This is considered the period of deficit financing, follow up of unsound fundamentals of economics and finally culminating in severe financial crisis by the year 1990–91. Major highlights of this phase may be summed up as follows
—

(i)
t
his phase saw the nationalisation policy and simultaneous revival of an increased emphasis on expansion of the PSU (two points should be noted here specially—
first
, many of the South East Asian economies have, officially declared their acceptance of capitalism and privatisation.
Secondly
, China had declared that investment in the government-controlled companies are a loss of money at this time).

(ii)
Upcoming PSUs increased the total expenditure of the government’s revenue as well as capital.

(iii)
Existing PSUs were taking their own due from the economy—the illogical employment creation excessively increased the burden of salaries, pensions and PF; many of them had started fetching huge losses by this time; as the public sector does not have profit as its primary goal; there was a lack of profit and loss analysis; as the PSUs had no connection between their need of labour force and the existing labour force. Ultimately the responsibility of profit or loss did not remain the onus of the officers, thus making them centres of intentional losses and an institutionalised centre of corruption; etc.