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[Economy] Fiscal Consolidation, Fiscal
Deficit : Meaning, Implications, Explained
Why Vijay Kelkar Committee was formed?
1. Part s of Budget = Revenue + Expendit ure
2. Types of Budget = Def icit /Surplus/Balanced
3. Why print ing more money=Bad idea?
4. When f iscal def icit NOT BAD?
5. When & Why is f iscal def icit BAD?
1. Creat es inf lat ion
2. Black Money
3. Bond Yield increased
4. Crowding out invest ment
5. Twin def icit hypot hesis
6. Current Account Def icit
7. Subsidy Burden = f iscal def icit increased
8. Int erest Payment
9. Vicious circle: Trade t o Fiscal def icit
6. Fiscal Consolidat ion: What is it ?
7. Mock Quest ions
Cont inuing episodes of t echnical incorrect economy.
Set Location: Prime Ministers Office (PMO), New Delhi.
Mohan is busy uploading (un)f unny phot os in his f acebook album and t agging random f riends in
t hem t o get more likes. Vijay Kelkar makes an ent ry in his of f ice.
Kelkar
Sir, t he expert report s suggest t hat f iscal def icit will be around 6 percent f or 2012-13.
This is very dangerous; you need do f iscal consolidat ion immediat ely!
Mohan Ya but what is f iscal def icit and why is it dangerous?
Kelkar What ? youre an economist and yet you dont know what is f iscal def icit ?
Mohan
Well I was an economist . But I didnt maint ain not es and I did not revise t he st andard
ref erence books eit her, so Im unable t o recall t he concept s right now, just like a
no0b player of UPSC.
Kelkar
Well f iscal def icit (FD) = Budget ary Def icit + Market borrowing + ot her liabilit ies of
Government
Mohan Please Explain in English, f rom t he very beginning.
Kelkar
Ok t hen let us st art f rom t he
beginning.Every year, t he Government put s out a plan f or it s income
and expendit ure f or t he coming year. This is, called annual Union Budget and you
need t o get it approved by t he parliament .
Mohan Side quest ion: why do I need t o get it approved by t he parliament ?
Kelkar For t he answer Click ME
Mohan Ok back t o t he t opic
Parts of Budget: Revenue and Expenditure
Kelkar: In every budget , t here is incoming money (Revenue) and out going money (Expendit ure).
Incoming money Out going Money
Incoming money is divided int o t wo part s. Tax and Non Tax
And out going money is divided int o Plan and Non plan Expendit ure.
Incoming Out going
Tax Non Tax Plan Non Plan
Kelkar: We can f urt her ref ine t his classif icat ion int o Revenue/capit al receipt s and Expendit ure.
But let us not complicat e t he mat t er f or t he t ime being.
Mohan: Now What is t his incoming money f rom t ax and non t ax sources?
Kelkar: see t he t able yourself f or t he examples.
Incoming money Out going
Tax Revenue
Non Tax Revenue Plan
Non
Plan
Direct Tax Indirect Tax
1. income t ax
2. Corporat e t ax;
3. Wealt h t ax
4. Capit al gain t ax
(Vodaf one case)
1. cust om
dut y,
2. excise
dut y,
3. service
t ax.
4. VAT
1. Fees Collect ed (Driving license,
RTI, Passport )
2. Fines and Penalt ies (Traf f ic
violat ion et c)
3. Income f rom PSU (e.g. prof it
f rom Airindia (lolz)
4. Gif t s. (discussed in 2
nd
ARC
art icle)
5. Grant s (Foreign Aid f rom UN,
Japan et c)
Mohan: and what is t his out going money? Plan and non-plan?
Kelkar: Out going money = t he area where Government spends t he money (Expendit ure).
Plan-Expendit ure means spending money on t he act ivit ies relat ed t o t he nat ional f ive year plan.
(FYP)
Non-plan Expendit ure, obviously means spending money on act ivit ies t hat are not relat ed wit h
nat ional f ive year plan. Check t he t able f or examples.
Incoming Out going
Tax Revenue
Non Tax Revenue
Plan
Expendit ure
Non Plan
Direct Tax Indirect Tax
1. income t ax
2. Corporat e
t ax;
3. Wealt h t ax
4. Capit al gain
t ax
(Vodaf one
case)
1. cust om
dut y,
2. excise
dut y,
3. service
t ax.
4. VAT
1. Fees Collect ed
(Driving license,
RTI, Passport )
2. Fines and
Penalt ies
(Traf f ic violat ion
et c)
3. Income f rom
PSU (e.g. prof it
f rom Airindia
(lolz)
4. Gif t s. (discussed
in 2
nd
ARC
art icle)
5. Grant s (Foreign
Aid f rom UN,
Japan et c)
1. MNGREA
2. Janani
Suraksha
Yojana
3. JNNURM
4. Indira
Awas
Yojana
1. Salary of
judges,
bureaucrat s
and
armymen
2. Buying new
t anks and
missiles
3. Subsidies:
Pet rol,
Kerosene
et c.
4. Light bills of
Government
of f ices.
5. Luxury Travel
bills of
Prat ibha.
Mohan: ok so now what ?
Kelkar: Now we classif y t he budget according t o t he balance bet ween incoming and out going
money.
Types of Budget=Deficit,Surplus,Balanced
When It is called a
out going money > incoming money def icit budget .
out going money < incoming money surplus budget .
out going money = incoming money balanced budget .
In realit y, Government always has def icit budget . Because
as long as t here is Pakist an and China in t he neighborhood, well have t o maint ain a huge army,
keep buying new t anks and missiles.
As long as t here are poor people, well have t o keep running various Government schemes.
Mohan: come t o t he point .
Kelkar: The point is,
When Government spends beyond it s aukaat , it creat es a big pot hole in t he highway.
This pot hole can be called a Revenue def icit , budget def icit , f iscal def icit or primary def icit
according t o t he f ormula you use t o measure t he dept h of t his pot hole.
This pot hole cannot be f illed wit h cement , asphalt or dirt . It can only be f illed wit h cash.
In t he 1980s, Sukhmoy Chrokrobort hy Commit t ee came up wit h t he f iscal def icit f ormula
Fiscal def icit =
1. Budget ary def icit (=t ot al Expendit ure minus t ot al income)
2. + market borrowings (=t hrough Government securit ies (G-Sec)/Bond)
3. + ot her liabilit ies (e.g. pension and provident t o be given in f ut ure)
Mohan: but why should we calculat e t his f iscal def icit ?
Kelkar: This f iscal def icit number t ells you t he dept h of t he hole and gives you t he idea how
much money do you need t o borrow f rom t he sources
wit hin India (int ernal borrowing f rom RBI, Ot her banks et c)
and f rom abroad (ext ernal borrowing- World Bank, IMF et c.)
Bigger t he pot hole, more cash you need t o f ill it up.
Here is some f ood f or t hought . Incoming Out going Breakup f or USA budget 2011. Click on
Image t o Enlarge.
Mohan t hen simply borrow money and f ill up t he pot hole! What is t he problem?
Kelkar
problem is Paisaa Ped pe toh nahi lagtaa (Money doesnt grow on t rees). When
you borrow money, youve t o pay int erest () t o t he part y, every year.To pay t his
int erest in t he f ut ure, youve t hree opt ions.f irst opt ion =Increase t he current t axes
or creat e new t axes.
Mohan Not a good idea sir-ji.
Kelkar
alright , Second opt ion =Creat e policies t o help st imulat e economic growt h so t hat
t ax collect ion aut omat ically increases wit h it , like FDI in aviat ion, power sect or, ret ail,
insurance and so on.
Mohan But t hat s Easier said t han done
Kelkar
Then Third opt ion : Print more currency and use it t o f ill up t he pot hole. This is
called debt monet izat ion.
Mohan Now t his t hird opt ion sounds great
Kelkar
Act ually t hat s t he st upidest of all t hree solut ions. Let me explain wit h t he usual
example.
Why Printing more money= Not good idea?
Suppose, Government orders RBI t o print lot s of cash t o solve povert y.
Then Government launches Rajiv Gandhi Suitcase yojana (RGSY) under which every BPL
f amily is given a suit case cont aining Rs.10 lakh.
What will happen t hen?
Theyll all go and buy lot s of onion,milk,mobile, cars, houses everyt hing.
=Demand of product will increase, but t he supply will remain almost t he same as earlier.
So, t here will be one cust omer of f ering Rs.400 per kilo of onion, t hen anot her guy would of f er
Rs.500 per kilo of onion=inf lat ion =not good.
On t he ot her hand, Suppose your boss pays you 10 lakh per year, but t hat means he def init ely
ext ract s work wort h more t han 10 lakhs f rom you and sells some goods/services t o a t hird
client . That s why giving you 10 lakhs doesnt increase inf lat ion. (because some ot her client is
buying t he services you had produced).
but giving 10 lakh t o a poor wit hout making him economically product ive = increases inf lat ion.
Hence print ing money t o solve problems= not good idea.
Here is anot her example: Suppose t hat t here is only one commodit y t hat everyone
needs t o buy in order t o live a good lif e say wheat .
Also, assume t hat our count ry produces 10,000 quint als of wheat every year.
There are a t ot al of 25,000 people in t he count ry who spend Rs. 400 each per year t o
buy wheat .
Since t his Rs. 1 crore is spent t o purchase t en t housand quint als of wheat , t he cost of
wheat is Rs. 1,000 per quint al.
Now suppose t hat t o repay some of it s debt , t he Government decides t o print some new
currency not es. Say t he Government print s new not es wort h Rs. 10 lacs.
This means t he amount of money available t o spend increases f rom Rs. 1 crore t o Rs.
1.1 crores.
Since t he amount of wheat produced hasnt increased, each t onne of wheat now
cost s Rs. 1,100, a 10% increase! (1.1 crores paid for ten thousand quintals = Rs.
1,100 per quintal).
So we have just seen t hat t he ef f ect of debt monet izat ion is inf lat ion.
Inf lat ion act s like an invisible t ax on all t he people of a count ry. (recall t he f irst opt ion
increasing t ax was not a good opt ion.)
Mohan : Does t hat mean f iscal def icit =bad?
Kelkar: not always bad. It depends on t he sit uat ion.
When fiscal deficit = NOT BAD?
If t he money t hat t he Government had borrowed was used t o increase t he amount of
wheat product ion, t hen t he inf lat ion could have been avoided. (for example borrowing
money to create new canal or irrigation project)
If Such irrigat ion project led t o an increase in wheat product ion f rom 10,000 quint als t o
11,000 quint als.
In t hat case, even wit h an increase of money t o 1.1 crores, t he cost of wheat would
remain st eady at Rs. 1,000 per quint al.
Thus wed have economic growt h and also avoid inf lat ion
Clearly t hen, it was a good t hing t hat t he Government borrowed money t o implement
t his program.
Thus, f iscal def icit is not necessarily a bad t hing, always.
When and why is fiscal deficit= BAD?
Creates inflation
A large and persist ent f iscal def icit =somet hing is wrong in t he economy.
It can mean t hat t he Government is spending money on unproduct ive programmes which
do not increase economic product ivit y. (For example MNREGA, most of t he money is
eat en midway by t he Sarpanch and Local of f icers.) =Bad
Now t hese rich Sarpanch and Local of f icers buy more gold, land and cars= demand
increased but ot her normal people dont have t hat much money = inf lat ion. (demand pull
t ype).
Black Money
Fiscal def icit = crudely speaking when incoming money is less and out going money is more.
So, incoming money is less = t ax collect ion machinery is not ef f ect ive = perhaps lot of
people are evading t he t axes = black money =inf lat ion (demand pull t ype) = Very bad.
In ext reme condit ions, inf lat ion can give way t o hyperinf lat ion t hat can complet ely
dest roy a count ry. =very bad.
Bond Yield increased
From Eurozone Greece Exit art icle, You already know what is bond yield. If not click me
When Government keeps borrowing and borrowing t o f ill up t he f iscal def icit pot hole, t hen
bond yield will increase = not good because more and more of t axpayers money (i.e.
Government s incoming money) will go in repaying t hat bond int erest rat e rat her t han going
int o educat ion or healt hcare.
Crowding out investment
We already saw t hat , Fiscal def icit pot hole can only be f illed wit h cash. This cash has t o be
borrowed f rom RBI, ot her banks, FII et c. who buy t he Government bonds.
So, t hat much money (Credit /loan) is not available f or ot her needy businessman.
t hus f iscal def icit Crowds out invest ment f rom privat e sect or. Now t hat needy businessman
will have t o borrow money at higher int erest f rom anot her part y (this is how fiscal deficit
increases interest rates)= input cost of product increased = he will increase t he MRP of his
product or service t o maint ain t he same prof it margin = inf lat ion. (cost -push t ype)
Twin deficit hypothesis
This hypot hesis says t hat as t he f iscal def icit of t he count ry goes up it s t rade def icit (i.e.
t he dif f erence bet ween export s and import s) also goes up.
Hence, when a government of a count ry spends more t han what it earns, t he count ry
also ends up import ing more t han export ing.
In India, t he t rade def icit st ory is basically about oil and gold t wo commodit ies t hat t he
count ry does not produce much but import s a hell of a lot .
Current Account Deficit (CAD)
When India import s more t han it export s = leads t o Current Account Def icit . (we already
discussed it earlier, click ME)
CAD is anot her pot hole but it can be f illed only wit h f oreign currency (most ly dollars!)
This increases t he demand of dollars in Forex Market = rupee weakens against dollar=
price of pet rol will increase= again inf lat ion= bad.
Subsidy Burden = fiscal deficit increased
t he government of India does not pass on a major part of t he increase in t he price of oil
t o t he end consumer and t hus subsidises diesel, LPG and kerosene .
So oil companies sell at a loss, and t he government compensat es t hese companies f or
t he loss (by giving t hem bonds).
This increases government expendit ure, which, in t urn, increases t he f iscal def icit .
Interest Payment
In t his f inancial year alone (2012-13), t he government will pay more t han 4 lakh crore just as
int erest payment on debt t aken earlier! = more imbalance bet ween incoming and out going
money.
The vicious circle: Trade to Fiscal deficit
Thus, in Indias case, a great er t rade def icit also leads t o a great er f iscal def icit . So t he causalit y
in Indias case is bot h ways.
A high f iscal def icit leads t o higher t rade def icit .
And high t rade def icit leads t o higher f iscal def icit .
And t his, in t urn, also leads t o a weaker rupee, which, in t urn, pushes up t he cost of oil in
rupee t erms leading t o a higher f iscal def icit .
Now in t he opening lines, Kelkar said Fiscal def icit would be around 6%. What does t hat mean?
There are t wo ways t o express Fiscal Def icit .
1. Absolut e Value: Rs. 521,980 crores on March 31, 2012 .
2. Percent age: 5.9% of GDP.
In newspapers and economic discussions, t he Fiscal is usually expressed in second f orm
(percent age).
You might t hink 5 or 6% is such a t rivial amount , why Kelkar is so worried?
Well, t o underst and t he gravit y of t he sit uat ion, youve t o compare t he percent age wit h
ot her percent ages.
1. Around 3.8% of Indias GDP goes in Educat ion. (2012)
2. Around 6% of Indias GDP goes in Fiscal Def icit . (2012)
3. Greeces Fiscal def icit was more t han 10% of it s GDP and look how much t rouble it is
f acing. (recall Eurozone Art icle)
Theref ore, we must not only pay at t ent ion t o t he f iscal def icit , we must also t ry and
underst and t he dif f erent areas of Government spending.
Is t he Government borrowing money t o spend on programmes t hat lead t o increased
economic product ivit y or is it spending on unproduct ive programs?
Remember, even direct ly giving money (or amenit ies) t o BPL, wit hout making t hem more
economically product ive = dangerous because of t he various reasons seen above.
Fiscal Consolidation: What is it?
Mohan
ok so f ar I underst ood
1. What is f iscal def icit .
2. Why and when f iscal def icit is bad.
But what is t his f iscal consolidat ion?
Kelkar
Fiscal consolidat ion means doing everyt hing t o f ix t he f iscal def icit problem in it s
root and prevent ing heavy f iscal def icit s sit uat ion f rom occurring in f ut ure.
Mohan But How can we do t hat ?
Kelkar Just t ry t o reduce t he out going money and increase t he incoming money. (Look at
that plan-non plan table again.)That means
1. Cut down subsidies.
2. St op leakages in subsidies.
3. Ref orm t he t ax st ruct ure (implement GST).
4. Improve t he perf ormance of PSUs.
5. Recover blackmoney
6. st op minist ers f rom using Business class airt icket s and ot her wast ef ul
Government expendit ures. (= t ake aust erit y measures)
+ Policy ref orms such as FDI (t o creat e environment conduct ive f or economy = t hat
will aut omat ically increase product ivit y and t ax collect ion. Recall t he second opt ion.)
Mohan
hmm t hat it self sounds like a problem. I t hink I should make anot her Commit t ee (so
that I dont have to implement its recommendations). Let me check my phonebook f or
ret ired judges.
Kelkar
Sir t his is t he mat t er of economy not railway accident s. It requires an expert on
economy.
Mohan Then make a Commit t ee headed by Mont ek Singh
Kelkar
but Media wont like his recommendat ions. (Everyone who earns more than Rs.20 is
not a BPL and he should pay 10% income tax.)
Mohan Then make a Commit t ee headed by some columnist f rom The H*****!
Kelkar
But Madam-ji wouldnt like his recommendat ions. (hand over Finance Ministry to Fidel
Castro)
Mohan Then whom should I appoint ?
Kelkar The expert is sit t ing in f ront of you.
Mohan
Alright , t omorrow morning you got o t he f inance Minist er along wit h your class
10,12,college marksheet s, ext ra-curricular act ivit y cert if icat es and job experience
cert if icat es (if any) and get t he appoint ment let t er f rom him.
Kelkar
What ???
I served as t he f inance Secret ary of India (despit e not being an IAS).
I served as an execut ive direct or in IMF.
Hell I even served as t he chairman of 13
th
Finance Commission of India!
and now youre asking the Vijay Kelkar t o submit his class 10-12 marksheet s and
ext ra curricular act ivit y cert if icat es?
Mohan Chillx. I was joking. You may go now. If I need any more help, Ill give you a miss call.
Kelkar PM and miss-call? Anot her joke?
Mohan
No, Im serious! Miss call= Government expendit ure on phone bills reduced= f iscal
consolidat ion.
Kelkar Whaat an idea sir-ji.
Then Vijay Kelkar set out f or a journey t o prepare a roadmap f or f iscal consolidat ion.
In Sept ember 2012, He submit t ed his report t o t he Government .
Well see t he recommendat ions of Kelkar Commit t ee in f ut ure art icle. (To Be
cont inued.)
Mock Questions
Which of t he f ollowing st at ement s are correct ?
1. Salaries paid t o Const it ut ional bodies is an example of Planned Expendit ure
2. Fiscal def icit is always higher t han budget ary def icit .
3. Fiscal def icit cannot be f inanced t hrough ext ernal borrowing.
4. Kelkar Commit t ee was creat ed t o suggest t he roadmap f or implement at ion of Direct Tax
Code.
5. High and persist ent Fiscal Def icit is a sign of healt hy and growing economy.
6. To achieve Fiscal consolidat ion, Government should increase t he non-plan expendit ure.
7. Fiscal consolidat ion means t he st eps t aken by Government t o increase it s shareholding in
PSUs.
8. Vijay Kelkar is t he chairman of 14t h Finance Commission.
Descriptive 15 marks (150 words)
1. What is f iscal def icit . What re t he salient f eat ures of FRBM Act ?
2. Major recommendat ions of Kelkar Commit t ee on Fiscal consolidat ion.
All of my art icles on Economy are Archived on t his link: mrunal.org/economy
Ref
1. Wheat example f rom Parijat Gargs art icle on governindia.org
2. Kelkars Charact er is port rayed according t o his bio on
ht t p://www.redif f .com/business/1998/sep/11kelkar.ht m
3. US budget f rom www.sankey-diagrams.com
4. Twin def icit et c f rom ht t p://www.dnaindia.com/money/column_of -def icit s-f alling-rupee-
good-economics-and-mindless-aust erit y_1690732
5. Educat ion GDP ht t p://www.sunpost .in/2012/05/17/india-spends-3-85-gdp-on-educat ion/
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Sept ember 30t h, 2012 | Cat egory: Economy