Analysing The Concept Of Fiscal Deficit Economics Essay

In contrast to budget deficit, which is nothing more than the difference between the expenditures of the government and the tax revenues that government receives (Galbraith and Darity,1995), the fiscal deficit is the difference between what government spends and what it earns, expressed as a percentage of GDP.

Fiscal deficit holds an important position in macroeconomics theory literature because it has a substantial effect on the indicators of macroeconomic performance of a country like inflation and growth and as a consequence of these imbalances debt financing and debt management.

Feldstein (2004) considered budget deficit analogous to obesity. Just like obesity, it is easy to ignore budget deficits because they do not have immediate effects. In case of obesity there is no immediate concern except the clothing size gets increasing, but in long turn obesity increases the risk of chronic heart attack or diabetes (Feldstein, 2004). Similar to obesity, deficit is also caused by self-indulgent living, that is, governments spending more than its revenues. Another similarity of fiscal deficit with obesity is that severe the problem (obesity/fiscal deficit) more difficult it is to correct it. (Feldstein, 2004). Running fiscal deficits curtails the government’s ability to react to business cycles (global competitiveness report 2009)

Fiscal deficit as a macroeconomic factor

The stability of macroeconomics environment of a country is not only critical for business it is also important for country’s overall competitiveness in global spectrum (Fischer, 1993 global competiveness report)

Fiscal deficit and inflation

Enlargement of fiscal deficit in relation to the overall economy with its associated increase in money supply leads to accelerated inflation.(Ashra et al ,2004). Monetarists argue that inflation is a monetary phenomenon while the Structuralist schools stress focus on structural factors prevalent in a less developed country to explain inflationary processes ( Ashra et al, 2004)

Source: Ashra et al. (2004)

Macroeconomic theory states that persistent fiscal deficits are inflationary (Catao and Terrones, 2005), though empirical research has little success in uncovering this relationship. Sargent and Wallace, 1981 support this theory and add that a government facing persistent deficit has to, sooner or later, finance these deficits with money creation ‘seinorage’ thus producing inflation. Alesina and Drazen,(1991); Cukierman et al. (1992) and Calvo and Vegh,(1999) further added to this theory of fiscal deficit and inflation, especially for developing countries, because these countries are less tax efficient, less politically stable and have limited access to external borrowing all these factors lower the relative cost of seinorage and thus increase dependence on the inflation tax. Monitiel, 1989 and Dornbusch et al. 1990 suggested that fiscal deficits tend to accommodate rather than drive inflations. Blanchard and Fischer, 1989 also suggested that empirical work has had little success in uncovering a strong and statistically significant connection between fiscal deficit and inflation. Later fisher et al 2002 using fixed effects, in a panel of 94 countries, suggested that fiscal deficits are main drivers of high inflations. He further estimated that one percentage point improvement or deterioration in the ratio of fiscal balance to GDP typically leads to a 4.5 percent decline or rise in inflation.

Few studies have been conducted to obtain empirical support for self-perpetuating process of deficit-induced inflation and inflation-induced deficits. Aghelvi 1977 did such study for Indonesia, Aghelvi and khan 1978 for Brazil. Later sarma 1992 followed the Aghlvi khan model and did a similar study for India and came to a similar result. However, Heller (1980) differed from these studies and his research involving a case study of 24 developing countries supported the fact that self-perpetuating dynamic process should not be taken for granted.

Fiscal deficit and inflation (neutrality)

While empirical studies examined the issues of neutrality of money by examining the relationship between real and monetary variables (Lucas 1980, King and Watson 1992, Weber 1994). The studies testing hypothesis of neutrality of money in case of one or more industrialised countries have produced mixed results. While some studies rejected neutrality outright, others rejected long run super neutrality only. The only exception to this neutrality was by Duck (1988) and Moosa (1997), who using seasonal co-integration framework found that money is neutral in the long run in case of India. Ramchandar (1983, 1986), using India’s annual data, found that money cause real income and price level; price level causes real income; and nominal income causes money. Gupta (1984) concluded that in case of India, quality of money is not an exogenous variable, both in nominal money equation or real income statement

Fiscal deficit and growth

Great degree of attention has been devoted in both theoretical as well as empirical literatures towards possible impact of different fiscal measures on growth (Adam and Bevan, 2005) while theoretical aspect points out the constraint in government budget where change in one aspect needs to be countered by changes elsewhere. Where as, in case of empirical literature it could be said that variations in subset items are growth neutral (gemmel, 2001/ 101 pdf). While Easterly et al. (1994), Miller and Russek (1997) and Kneller et al. (2000) assume that relation between deficit and growth is linear, one notable exception is Giavazzi et al. (2000). Adam and bevan, 2005 work goes in the line of giavazzi and says that while a linear representation tends to fit the data reasonably well for sample of developing countries, it nonetheless masks important and policy-relevant non-linearities, especially at low levels of the fiscal deficit. Particularly in case of low and middle income countries the relation is non-linear.

Fiscal deficit and trade deficit

Fiscal deficit had been linked with trade deficit by certain researchers (Rosensweig and Tallman, 1991 1992) and these two are referred as twin deficits. Milne (1977) in her study of 38 countries found a positive statistical relation between trade deficit and fiscal deficit. Arunro and Ramchandar (1998) further added that current account and fiscal deficits have important policy implications which concern the long term viability of economic progress of a nation. If the basic reason for rising trade deficit is the increasing central government budget deficit then the trade deficit can not be corrected until the government deficits are put in place. However if such a view (role of bedget deficit in trade deficit) is not correct, then reductions in government budget deficit would not resolve the problem of trade deficit ( belongia and stone, 1985). Enders and Lee (1990) and Abell (1990) suggested that there is a casual effect of movement in government deficit on trade deficit. Evan (1989) provided empirical evidence that there is no relation between the two deficits.

Crowding out effect of fiscal deficit

Because of increased government spending often there is reduction in private investment and consumption which is known as crowding out, in economics.

Theoretical economic literature identifies two variants of crowding out, real and financial. The real or direct crowding out occurs when an increase in public investment displaces private capital formation, it does not depend on the mode of financing the fiscal deficit (Blinder and Solow, 1973). The financial crowding out is the phenomenon of partial loss of private capital formation, due to the increase in the interest rates which emanating from the pre-emption of real and financial resources by the government through bond-financing of fiscal deficit (buiter,1990) (wp06)

Economist have empirically tested the real crowding out and found contradictory results. Ramirez (1994), Greene and Villanueva (1990), Aschauer (1989), and Erenburg (1993) found that public investment and private investment have a complimentary relationship, the reason behind analogy among the economists being the fact that, increases in public capital formation stimulate aggregate demand and therefore increase private investment. It was also supported by the fact that higher stock of public capital, in particular infrastructure, increases the return of private investment projects. (wp06)

Contrary to these views Blejer and Khan (1984), Shafik (1992), Parker (1995), Sunderrajan and Takur (1980), Krishnamurty (1985), Kulkarni and Balders (1998), found evidence for crowding out between public and private investment. These set of studies on crowding out argued that public investment might act as a substitute for private investment. (wp06)

How the fiscal deficit is handled

Generally the government handles the debt by borrowing from certain sources. These sources include (i) external financing sources, (ii) the central bank (RBI in case of India) (iii) domestic financial markets (including commercial banks, excluding the central bank) Beckerman, 2000 (multipage)

UK government handles public sector borrowing requirement either by one of the following ways or a combination of all. (1) borrowings from the non- bank private sector like pension funds (2) the bank of England ( central bank of England) (3) borrowing from the banking sector (4) borrowing from abroad (grant, 1994)

Manasan, 2001 came up with new forms of deficit financing. In case of Philippines, budget deficit was financed by following means (1) Arrearages and accounts payable (2) zero coupon bonds (3) securitization (4) partnering with private sector and government owned and controlled corporations. ( pidsdrn01)

The causes and consequences of rising government deficit had received attention in both, developed countries and less developed countries( Blanchard, 1985; buiter and patel, 1992) .Recordance equivalence (RE) theorem had been widely discussed in context of funding government deficit (Barro,1987; Seater 1993) RE theorem states that whether the budget debt is financed by debt issue or tax increase, it is inconsequential; such an equivalence arises because today’s deficit financing acts as tommorow’s tax liabilities (Ghatak and Ghatak, 1996, new 10)

Sustainability of fiscal policy

To analyse the sustainability of fiscal policy two approaches have been used (Uctum and Wickens, 2000 1) testing the stationarity of debt or deficit 2) other studies look at the co-integration relationship linking the primary deficit, outstanding debt and interest payment for us. Hamilton and Flavin (1986) rejected the non stationarity of constant dollar undiscounted US debt under the assumption of constant real rates. Smith and Zin (1988) found the same results for Canada. Blanchard et al (1990), using sustainability indicator found that most OECD countries have sustainable policies in the medium term using the same approach. Roubino (1995) found that most OECD countries have unsustainable policies.

European stability and growth pact has made two important implications for fiscal policy. First it puts limit 3% of GDP as the maximum budget deficit and secondly it imposes fines on those counties who have excess to this percentage (Hallet and Mcadam, 2003). The idea behind these implications is that random shock or cyclical movement should not take deficit beyond 3% except in exceptional circumstances (Eichengreen, 1997)

Fiscal deficits are regarded as the main causes of inflation, balance of payment crisis and poor investment performance and growth in developing countries (Naastepad, 2003). Consequently programmes are run in these countries to counter the problem of fiscal deficit. Experiences have shown that such programmes aiming to reduce fiscal deficit usually fail to restore price stability and reduce current account deficit in short run (Taylor,1990; Corbo and Fischer 1995; Rodrick 1995). Gupta (1992) further added that there is considerable uncertainty regarding the relations between fiscal policy and macroeconomics performance.

Fiscal deficit and India

India has faced both current account deficits and budget deficits since 1960s. economists have considered these twin deficit problems as two unrelated problems (Parikh and Rao, 2006). Virmani (2001) was among first to argue that because of roles of invisibles in India’s balance of payment, the methods of financing budget deficit have implications for current account deficits. Similar conclusion was reached by Cerra and Saxena (2002). Anuro and Ramchander (1998), using granger casuality test found out that unlike many developed countries causations in India seem to runs from current account deficit to fiscal deficit

India’s inflation depend on both domestic supply and world inflation (Minford and walters, 1989).

India has one of the highest overall national fiscal deficits in the world (Buiter and patel, 2006) (new11)

It is not just the advanced economies which faced the heat of fiscal deficit; during the global recession developing economies too suffered from this and as a result India’s fiscal deficit jumped from 3.3% in 2007-08 to 6.8% in year 2010. This figure is highest for India in last sixteen years ( verma, 2009, Euroweek, (3))

The Fiscal Reforms and Budget Management Act (FRBMA) enacted in 2003, is an important institutional mechanism formed to ensure fiscal prudence and support for macroeconomic balance. According to the Rules framed under the Act, the target was to eliminate revenue by 31 March 2009, and fiscal deficit to be reduced to no more than 3% of estimated GDP by March 2009 (11th five year plan growth vol. 1, 2008)

The major factors that have added to the growth of fiscal deficit in India and many other developing nations are subsidies, public transfers and interest payments (Roy and Tisdell, 1998)

In Indian context, many economist have expressed their concern over the building governments deficit and mounting debt. Solvency condition seems to be violated in Indian case and there are chances that with existing trend the public sector may become bankrupt in finite times (Buiter and Patel, 1992, 1995; Jha, 1999)(new 4)

Many studies have tested sustainability of public debt in Indian context. Buiter and Patel (1992) tested sustainability of debt of various public sector ( centre state government and public sector units ) and found that Indian public debt was unsustainable. Rajaraman and Mukhopadhay (2000) performed the test for stationarity on aggregate public debt series of the central and state government (period 1952-19980 and found that debt- GDP ratio is on unsustainable path. Contrary to these studies, Goyal et al. (2004), from the series of tests conducted on central state and combined finances, found that while the finances of both the central and the state are unsustainable individually, the combined finances are sustainable when structural break is taken into account.

……..… India is a federal country and has twenty eight states and 7 union territories. The state government have independent executive, legislative and judicial wings and this fact makes sustainability of public finance an important issue (Goyal et al, 2004) ( pdf 9)

The legitimate size of a sustainable fiscal deficit is debatable but it is beyond doubt that India’s fiscal deficit is too high, and unless it is handled properly by reducing it in an orderly and enduring way it will jeopardize both the broader reform process and ability of the government to meet prioritized infrastructure and other social expenses (Shirazi and Zagha, 1994) (11 pdf)

Fiscal decentralization

Fiscal decentralization occurs through devolution of responsibilities for public spending and revenue collection from central to local government (Neypati, 2010,new 8). Fiscal decentralization is considered to be a feature of economic reform programme because of certain points 1) since local governments have better local information decentralization of spending increases efficiency and therefore better chances are there of it matching with the preferences of citizens (Samuelson, 1954; Oates, 1972, 1993); (2) fiscal decentralisation increases accountability and transparency of public goods (De Mello 2000a) (3) tax payers are more comfortable with accountable local governments ( Wasylenko, 1987) with all these factors it appears that fiscal decentralization can become an important tool to reduce debt. But contrary to this Neypati, 2004 and king and Maa 2001, both found negative relation between fiscal decentralization and inflation (one of the characteristics of fiscal deficit). Jin and Zou (2002) demonstrated that expenditure decentralisation increases the size of government aggregate but revenue decentralization has the opposite effect. De Mello (2000b) did research on number of countries and found that fiscal decentralization helps in reduction of government debt, especially in low income countries. Zang (2006) and Bouton et al. (2008) said that without a proper central redistribution system fiscal decentralisation may give rise to a more unequal income redistribution if revenue bases vary across regions. Tanzi (2000) adds that effectiveness of fiscal decentralisation depends upon factors such as size of country, extent of privatization in economy, local government’s ability to raise revenue, transparency and local administration effectiveness.

Democracy and fiscal deficit

Divided governments and alternating governments are the two main factors of a political system that generate myopic and inefficient policies ( Person and Tabelliniu, 2000). Political competition assures that the current ruling party can loose in the next upcoming election, this modifies the planning of government. The incumbent government knows this fact and thus can induce an excessive expenditure because future costs are not completely internalized. The incumbent government strategically misbalances its count to improve its probability of re-election (Alsina and Tabellini, 1990) (5.pdf)

Almost 150 years before the great depression, budget deficits were only limited to times of war and recession. Budget surpluses were common in all other periods and the budget surpluses use to reduce the national debt that had accumulated during the time of recession and wars. (Buchanan and Wagner, 1977) (bbfratc, Wagner and Tollison)

In democracy a political bias exists in favour of deficit finance. (Buchanan and Wagner, 1977). Politicians at periodic bases face test of their incumbency. The budgetary policies can enhance or retard the likelihood of their remaining in office. Generally tax reductions and increase in expenditure strengthen a politician’s base of support contrary to this If the politician increases tax and reduction in expenditure this will tend to weaken his base. It is noticed that politicians use budgetary policy to strengthen their electoral base but in turn increase state expenditure and reduce taxes (bbfratc, Wagner and Tollison), which harms the fiscal stability and give rise to deficit. (Buchannan and Wagner, 1977) are of the view that balanced budget which has mix of deficit budget and budget surplus is better for macroeconomic stability of any country.

Tax reforms and fiscal deficit

To achieve fiscal consolidation tax reformation is critical. The reform in tax system is also important to minimize distortions in the economy and to create stable and predictable environment for the markets to function (Rao, 2005). Ahmad and stern (1991) are of the view that in many developing countries tax policy is directed towards the correctness of fiscal imbalances. Bird (1993) observed tax reforms in many countries and said that “fiscal crisis has been proven to be mother of tax reform” ( 14.pdf)