Government Deficit

Government deficit refers to the shortfall between a government’s total expenditures and total revenues in a given fiscal year. It indicates higher spending than earnings, requiring borrowing or monetary adjustments. Persistent deficits can lead to inflation, increased debt, and economic instability if not managed effectively.

Types of Deficits

We can understand the deficit in various ways.

Revenue Deficit:

Revenue deficit refers to the excess of the government’s revenue expenditure (viewing an expected revenue) over revenue receipts;

Revenue deficit = Revenue expenditure (over expected receipts) – Revenue receipts

Since a major part of it is committed expenditure, it can’t be reduced. Often government reduces productive capital expenditure or welfare expenditure.

Capital Deficit

Capital deficit refers to the shortfall in a government’s capital receipts compared to its capital expenditures in a fiscal year. It indicates insufficient funds for asset creation, infrastructure development, or debt repayment, often leading to increased borrowing or disinvestment to bridge the gap and maintain fiscal stability.

Capital deficit =  Capital Disbursement – Capital receipt.

Note: Capital deficit and capital account deficit are different. Capital deficit refers to a shortfall in a government’s capital receipts versus capital expenditure, affecting public finances. Capital account deficit, on the other hand, occurs when a country’s capital outflows exceed capital inflows, impacting foreign exchange reserves and external borrowings.

Conventional deficit:

To see the complete picture, we need to consider all of the government expenditure together. Conventional deficit enables us to see that.

Conventional deficit refers to the gap between a government’s total expenditure and total revenue receipts, excluding borrowings and other liabilities. It is the difference between all non-debt receipts and expenditures together.

Conventional deficit = Total expenditure – Total Revenue Receipts

In other words, what amount of expenditure the government can cover just by its revenue receipts (taxes, fees, fines etc), without any reduction in the capital asset.

It highlights the extent of fiscal imbalance before debt financing. A high conventional deficit indicates excessive government spending over revenue generation, potentially leading to higher debt and inflationary pressures.

Fiscal deficit:

A fiscal deficit is the difference between the government’s total expenditure and total receipts excluding borrowings.

Gross Fiscal Deficit (GFD) = Total expenditure – (Revenue receipts + Non-debt capital receipts)

Non-debt-creating capital receipts are those capital receipts that do not give rise to debt; For example, proceeds from PSU disinvestment. Here the asset is reduced but no debt for the future is created.

Why debt Receipts are removed? Fiscal indicates the amount of new debt that is needed to be raised to finance the deficit. The government can receive money by raising loans from the market. This is a debt receipt. The government does this to finance its deficit. Fiscal Deficit = Expenditure – (Revenue receipts + Non-debt Capital Receipts) = New Debt

Net fiscal deficit:

The lending to the state government should not be counted as an expenditure as it creates an asset for the government. Therefore, sometimes we give importance to the Net Fiscal deficit that excludes such lending.

Net Fiscal Deficit = GFD – lending to state governments.

Who finances this deficit? Budgetary deficits are either financed by increased taxation, borrowing or printing money. Taxation is accounted for in the revenue. Printing money creates liability but the government does not need to pay interest on it and therefore ca Three parties can finance this deficit. Domestic public, Central bank and Foreign entities. Therefore from the finance side, the following equation can be written: GFD = Net borrowing at home + RBI + abroad

Now, some of this debt finances the additional expenditure done by the government on infrastructure, schemes and salaries. But some of this new borrowing goes just to pay interest on the previous debt.

This does not give us a picture of how the government performed this year.

Primary Deficit:

Borrowing on account of current expenditures exceeding revenues is known as the Primary Deficit.

Gross Primary Deficit (GPD) = GFD – interest payments

When we remove the interest payment on the previous debt too, we find the actual deficit made by the government in the current fiscal. If the Primary deficit is high, it means the level of debt of a country is continuously increasing.

Net Primary Deficit

The net fiscal deficit is the gross fiscal deficit less the net lending and grants given by the Central Government to the states and UTs. The net primary deficit denotes net fiscal deficit minus net interest payments.

Net Primary Deficit = GPD – Net Interest Payments

Government Debt:

Government debt refers to the total borrowings of a government from domestic and external sources to finance budget deficits. It includes internal debt (bonds, treasury bills, market loans) and external debt (foreign loans, multilateral institutions).

Concepts of debt and deficit are closely related. A deficit is a flow that adds to the stock of debt.

Is Debt good?

There are several perspectives on the appropriate amount of government debt:

Debt is Bad

• Government debt as a ‘burden‘: When we take debt, we are essentially transferring the burden of repayment to future generations. When the government increases spending by borrowing today, which will be repaid by taxes tomorrow.
• Issues of financing debt: There is a limited amount of money supply in the economy. Either the government can borrow it or the private player.
• Decreased private Borrowing: If the government issues bonds; corporate bond sales would decrease; some private borrowers would get crowded out of the financial markets;
• Taxation and ‘printing money’ both reduce future consumption
• It is inflationary: Uncontrolled government spending can create inflation for the economy.

Essential for Growth

But, for governments, debt is essential for a better Economy if it is used in the right way:

• If government deficits succeed in their goal of raising production, there will be more income and therefore more savings. Thus government and industry can borrow more.
• If government invests in infrastructure future generations would be better off.

Therefore, we can easily say that debt is a necessary evil for the government.

There is an interesting theory, the Ricardian Equivalence, that questions the positive impact of raising government debt.

Ricardian Equivalence

Ricardian Equivalence is an economic theory proposed by David Ricardo and later expanded by Robert Barro. It suggests that government borrowing and taxation have the same effect on the economy because rational consumers anticipate that increased government debt today will lead to higher future taxes. When the government finances spending through borrowing instead of immediate taxation, individuals expect future tax increases to repay the debt. As a result, they save more instead of increasing their current consumption, neutralizing the stimulative effect of deficit spending. This implies that government deficits do not impact total demand, interest rates, or GDP growth, as consumers adjust their behaviour accordingly. Criticism: Assumes perfect rationality, which may not hold true in real-world economies. Ignores individual constraints, as not all individuals can save for future tax hikes. Practically, we can ignore this outlook.

The government takes these debts using government securities.

Government Securities (G-Sec):

Government Security (G-Sec) are tradeable instruments issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation.

Such securities are either short-term or Long-term:

Short-term Government Borrowing

The short term borrowing is either done through the treasury bill or through the Cash Management bills (CMB)

Treasury bills (T-bills):

The treasury bills are government debt securities, with original maturities of less than 1 year: These are money market instruments issued by the GoI and are presently issued in three tenors, namely, 91-day, 182-day and 364-day.

• These are zero coupon securities and pay no interest.
• They are issued at a discount and redeemed at the face value at maturity.

Cash Management Bills (CMBs – 2010):

To meet temporary mismatches in the cash flow of the government Cash Management Bills are issued. They have the generic character of T-bills but are issued for maturities <91 days.

Long term:

Long-term debt instruments are usually called Government bonds or dated securities with an original maturity of greater than 1yr.

They carry a fixed or floating coupon (interest rate) which is paid on the face value, on a half-yearly basis. Generally, the tenor of dated securities ranges from 5 years to 40 years.

Dated Government securities are long-term securities and carry a fixed or floating coupon (interest rate) which is paid on the face value, payable at fixed periods (usually half-yearly). They are issued at face value. For example, Gold bonds under the SGB scheme.

Bonds are of two types:

Fixed Rate Bonds – These are bonds on which the coupon rate is fixed for the entire life of the bond. Most Government bonds are issued as fixed-rate bonds. Floating Rate Bonds – Floating Rate Bonds are securities that do not have a fixed coupon rate. The coupon is re-set at pre-announced intervals as the benchmark rate changes.

 

Bond Yield

The Government generally raises debt using Fixed Coupon Rate Bonds. These are Government bonds that pay fixed interest (coupon) annually or semi-annually. Let’s understand this with the help of a 10-year bond yield, which acts as a benchmark (also known as the benchmark 10-year bond yield)10-year Bond YieldA 10-year Government of India bond is a long-term debt instrument that pays a periodic interest (coupon) for 10 years and the principal amount at maturity. Suppose the government issues a ₹1,000 bond with a 7% annual coupon rate, meaning the investor receives ₹70 per year for 10 years. However, bonds can be priced higher or lower than ₹1000 as per the market demand. Let’s understand with the help of an example.Yields at different Market prices of Bond The term yield refers to the earnings a bond can make in relation to the investment made by an investor to buy it. It is possible that an investor buys the ₹1,000 face value bond at ₹1,100 bond. The yield would then decrease to 6.36% (70/1100 × 100), making it less attractive for the new buyers. Conversely, if the bond price falls to ₹900, the fixed ₹70 coupon now offers a higher yield of 7.78% (70/900 × 100), making it more attractive to investors. Thus, Bond yields follow an inverse relationship with bond prices. The higher the prices lesser the earnings (yield), and vice versa. Factors affecting the bond Yield This movement is influenced by factors like: Inflation: Higher inflation increases bond yields as investors demand higher returns to offset reduced purchasing power. RBI’s monetary policy: If the RBI raises interest rates, bond prices fall, leading to higher yields, and lower interest rates push prices up and reduce yields. Market demand: The higher the demand, the higher the bond price, and lower the yield. The 10-year bond yield is a key economic indicator, reflecting investor confidence, interest rate expectations, and inflation trends. It influences borrowing costs for businesses, home loan rates, and overall economic stability in India.

Fiscal Activism

Fiscal activism refers to proactive government intervention using taxation, public spending, and deficits to stabilize the economy, promote growth, and address recessions or unemployment, often following Keynesian economic principles.

The Positive impact of this fiscal activism:

• Consumption boom: This would infuse money into the economy, indirectly putting the money in the pockets of the people which then be spent, boosting the consumption boom in the short run.
• Expenditure on infrastructure: The government plans to spend most of its excess budgeted allocation as capital expenditure for making highways and railways.
• Boosting Private investment: The government is using its own budgetary allocation to attract private investment into its ambitious National Infrastructure Pipeline.
• Economic revival: This would in turn lead to an economic revival after a small technical depression in the economy due to the pandemic.
• Recapitalization of banks: The government would use a part of this access expenditure to recapitalize the banks that are affected by the NPA crisis, which recently an RBI report indicated, is bound to happen.
• Support to several stressed sectors: The government is liberalizing the import duty structures to make the import of raw materials cheaper for several stressed sectors.
• Boosting incomes of the poor: Further, it has increased its allocation to ambitious schemes like MGNREGA, and Agriculture.
• Improving City infrastructure: The government can increase its focus on infrastructure and schemes like introducing Mass public transit systems to Tier 2 and 3 cities etc, boosting economic activity.

The negative impact of fiscal activism:

• Higher inflation for a longer period can lead to a situation like stagflation, a situation when jobs are few and inflation is too high. Such a situation can be quite brutal for the common folks and can create depression-like situations.
• Higher cost of capital in the long run: Higher borrowing from the market would push out the private sector from the credit market and would reduce private investment in the longer run.
• Higher taxes: The government plans to control the fiscal easing by increasing the buoyancy of tax revenue through improved compliance, and secondly, by increasing receipts from the monetisation of assets, including Public Sector Enterprises and land.
• Violation of fiscal discipline: It breaches the statutory requirement mandated by the FRBM Act, 2003.

Thus, Fiscal discipline is necessary while financing a deficit. Deficit, just as too much of anything, can be bad.

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