Importance of Fiscal Consolidation

What’s in today’s article?

• Why in news?
• What is Fiscal deficit?
• How does government fund its fiscal deficit?
• Challenges in raising the funds through bonds
• Why does the fiscal deficit matter?
• What lies ahead?

Why in news?

• Union Finance Minister announced during her Budget speech that the Centre would reduce its fiscal deficit to 5.1% of gross domestic product (GDP) in 2024-25. 
• She further added that the fiscal deficit would be pared to below 4.5% of GDP by 2025-26.

What is Fiscal Deficit?

• About
  • 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.
• Statistics for 2024-25
  • In 2024-25, the government’s tax receipts are expected to be ₹26.02 lakh crore while its total revenue is estimated to be ₹30.8 lakh crore. 
    • Taxes are the most important source of revenue for any government.
• The Union government’s total expenditure, on the other hand, is estimated to be ₹47.66 lakh crore.
• Focus on keeping the fiscal deficit under control rather than on generating a 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.
  • This is because a controlled deficit policy is said to be expansionary.
  • In such policy the government spends more on budget items such as infrastructure.
  • Such policies are typically used to boost productivity and the economy.
• Fiscal deficit is not 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.

How does Government fund its Fiscal Deficit?

• Money from bond market
  • In order to fund its fiscal deficit, the government mainly borrows money from the bond market.
    • In this market, lenders compete to lend to the government by purchasing bonds issued by the government.
• In 2024-25, the Centre is expected to borrow a gross amount of ₹14.13 lakh crore from the market, which is lower than its borrowing goal for 2023-24.
• Role of RBI
  • Reserve Bank of India (RBI) is also a major player in the credit market, although it may not always directly purchase government bonds. 
    • The RBI may still purchase government bonds in the secondary market, from private lenders who have already purchased bonds from the government. 
    • So, when a government borrows from the bond market, it not only borrows from private lenders but also indirectly from the central bank. 
  • The RBI purchases these bonds through what are called ‘open market operations’ by creating fresh money.
  • This in turn can lead to higher money supply and also higher prices in the wider economy over time.

Challenges in raising the funds through bonds

• Rate of borrowing
  • Government bonds are generally considered to be risk-free as the government can — under the worst-case scenario — get help from the central bank, which can create fresh currency to pay off the lenders. 
  • So, governments generally do not find it hard to borrow money from the market. 
  • The bigger problem is the rate at which they are able to borrow the money. 
  • As a government’s finances worsen, demand for the government’s bonds begins to drop forcing the government to offer to pay a higher interest rate to lenders, and leading to higher borrowing costs for the government.
• Role of monetary policy
  • Monetary policy also plays a crucial role in how much it costs governments to borrow money from the market. 
  • Central bank lending rates which were near zero in many countries before the pandemic have risen sharply in the aftermath of the pandemic. 
  • This makes it more expensive for governments to borrow money and could be one reason why the Centre is keen to bring down its fiscal deficit.

Why does the fiscal deficit matter?

• Relationship between fiscal deficit and inflation
  • There is a strong direct relationship between the government’s fiscal deficit and inflation in the country. 
  • When a country’s government runs a persistently high fiscal deficit, this can eventually lead to higher inflation as the government will be forced to use fresh money issued by the central bank to fund its fiscal deficit. 
  • The fiscal deficit recently reached a high of 9.17% of GDP during the pandemic and has since improved significantly and is projected to drop to 5.8% now.
• Indicator of fiscal discipline maintained by the government
  • The fiscal deficit also signals to the market the degree of fiscal discipline maintained by the government. 
  • A lower fiscal deficit may thus help improve the ratings assigned to the Indian government’s bonds. 
  • When the government is able to fund more of its spending through tax revenues and borrow less, this gives more confidence to lenders and drives down the government’s borrowing cost.
• Ability of the government to manage its overall public debt
  • A high fiscal deficit can also adversely affect the ability of the government to manage its overall public debt. 
  • In December, the International Monetary Fund warned that India’s public debt could rise to more than 100% of GDP in the medium term due to risks.
    • Although, the Centre disagreed with the assessment. 
  • It is also worth noting that the Centre has been keen on tapping the international bond market. 
  • A lower fiscal deficit may help the government to more easily sell its bonds overseas and access cheaper credit.

What lies ahead?

• The Centre plans to bring down its fiscal deficit in 2024-25 to 5.1% of GDP despite having plans to boost capital expenditure and to spend on other programmes. 
• So, most of the revenue to fund such spending will have to come from tax collections. 
  • The Centre expects tax collections to rise by 11.5% in 2024-25. 
  • It has also projected a cut in expenditure on fertilizer subsidy, from ₹1.88 lakh crore in 2023-24 to ₹1.64 lakh crore in 2024-25. 
  • The amount spent on food subsidy is also projected to drop from ₹2.12 lakh crore in 2023-24, to ₹2.05 lakh crore in 2024-25.

Q1) What is national debt?

National debt is the sum of a country's annual budget deficits, minus any surpluses. A deficit happens when the government spends more than it brings in. To finance this deficit, the government borrows money by selling debt obligations to investors. 

Q2) What is Gross domestic product (GDP)?

Gross domestic product (GDP) is the standard measure of the value added created through the production of goods and services in a country during a certain period.

Source: Why is fiscal consolidation so important? | Explained