What is fiscal deficit and why should you care?

What is fiscal deficit?

If you are an economics freak or someone who happens to follow the Budget speech by the finance minister every year, you would have come across the term ‘fiscal deficit.’

See, the central government spends massive amounts of money on infrastructure, defence, pensions, public welfare and social schemes, etc. and, almost every time these expenditures exceed the government’s incomes from sources like taxes, dividends, etc.

So, the shortfall a government incurs when it spends more than it has earned is called fiscal deficit.

Why is fiscal deficit important?

Okay, first of all, the government has broadly 2 choices to cover the fiscal deficit — either borrow money or print more currency.

Printing currency sounds like a good option, I mean why take debt in the first place. But we have seen enough cases in history (Zimbabwe, Weimar Germany, Venezuela) where printing money recklessly led to hyperinflation.

So most governments resort to borrowing money from the capital markets by issuing bonds or from the central bank.

Therefore, fiscal deficit is a key indicator of a government’s financial health.

Consistently high fiscal deficit over prolonged periods implies increased borrowing and can lead to economic challenges.

However, high fiscal deficits are not always bad and may indicate that the government is spending money on infrastructure development.

How is fiscal deficit calculated?

Fiscal deficit is calculated by subtracting the total income from the total expenditure of the government in a particular financial year.

It is either expressed in absolute terms or as a percentage of the GDP.

For example, if the GDP of a country is ₹100 lakh crores, and the difference between total income and expenditure is ₹10 lakh crores, the fiscal deficit will be 10%.

Fiscal deficit of the Indian economy

The honourable finance minister Nirmala Sitharaman during her Interim Budget 2024 speech, revised the fiscal deficit for 2023-24 (FY24) to 5.8% of GDP from the previous estimate of 5.9%.

The FM also announced the fiscal deficit target for 2024-25 (FY25) at 5.1% of the GDP (gross domestic product) and said that the government is on path to reduce the fiscal deficit to below 4.5% of the GDP by 2025-26 (FY26).

  1. Definition: A fiscal deficit occurs when a government’s total expenditures exceed its total revenue within a specific period, typically a fiscal year.
  • Explanation: When a government spends more money than it earns through taxes and other sources of revenue, it must finance the shortfall by borrowing money. This borrowing contributes to the fiscal deficit.
  1. Importance of Monitoring:
  • Economic Stability: A high fiscal deficit can signal economic instability, as it indicates that a government is relying heavily on borrowing to fund its operations.
  • Impact on Interest Rates: Large deficits may lead to higher borrowing costs for the government, which can translate into higher interest rates for businesses and consumers.
  • Government Spending: Excessive deficits may result in reduced government spending on essential services such as healthcare, education, and infrastructure.
  • Inflationary Pressures: Financing deficits through borrowing can increase the money supply, potentially leading to inflationary pressures in the economy.
  • Debt Burden: Persistent deficits can contribute to a growing national debt burden, which may require future generations to bear the costs through higher taxes or reduced public services.
  1. Factors Contributing to Fiscal Deficits:
  • Economic Downturns: During periods of economic recession or slowdown, governments often experience a decline in tax revenues while still needing to maintain spending levels, leading to larger deficits.
  • Government Policies: Fiscal deficits can also result from deliberate policy choices, such as implementing tax cuts or increasing spending on stimulus measures to boost economic growth.
  • Unforeseen Events: Natural disasters, geopolitical tensions, or other unexpected events can strain government finances by necessitating emergency spending or causing revenue shortfalls.
  1. Monitoring and Mitigation Strategies:
  • Budgetary Discipline: Governments can mitigate fiscal deficits by adopting prudent fiscal policies, such as maintaining balanced budgets or implementing fiscal rules to limit deficit spending.
  • Revenue Enhancement: Increasing tax revenues through measures like closing loopholes, broadening the tax base, or implementing new taxes can help reduce deficits.
  • Expenditure Rationalization: Governments can also reduce deficits by prioritizing spending on essential services, implementing efficiency measures, and cutting wasteful expenditures.
  • Debt Management: Effective debt management strategies, such as refinancing existing debt at lower interest rates or extending maturities, can help alleviate the burden of fiscal deficits.

In summary, monitoring fiscal deficits is crucial for assessing a government’s financial health and ensuring economic stability. By understanding the causes and implications of deficits, policymakers and citizens can work together to implement responsible fiscal policies and safeguard the long-term prosperity of their countries.

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A fiscal deficit occurs when a government’s expenditures exceed its revenues. It’s important because persistent deficits can lead to higher debt, increased borrowing costs, and potential economic instability.