Learning to live with deficits

Updated: Feb 28 2005, 05:30am hrs
Mythology has it that sage Agastya, in deference to the wishes of his wife, princess Lopamudra, decided to seek wealth from a kingdom that generated surplus revenue. He went to the wealthiest king of his time, but found no surplus in the state account which he could seek from an obliging king. The sage, along with the weathiest king, then visited several other kingdoms but couldnt find a single state where any surplus was left after government expenses had been met. His search for a state generating surplus revenue thus remained futile.

The state of public finances, in essence, has remained the same since the days of the sage Agastya. Only the terminology has changed, becoming more sophisticated with the passage of time. While finance minister P Chidambaram will try to perform the onerous task of bridging the gap between revenue and expenditure, FE takes a Closer Look at the chasm and its various manifestations, like revenue deficit and fiscal deficit :

What is deficit
Deficit is basically the difference between expenditure and receipts. In public finance, it means the government is spending more than what it is earning.

Government expenditure and revenue can be split into capital and revenue. Capital expenditure generally includes those expenses which result in creation of assets. Revenue expenditure is primarly that which does not result in asset creationlike interest payments, salaries, subsidies etc. Eg., expenditure on construction of a flyover will be capital expenditure, while the salary being paid to government officials supervising the construction will be revenue expenditure.

Similarly, on the receipts side, whatever the government receives as taxes is revenue receipts. On the other hand, receipts which are not of a recurring nature, are generally capital receipts. These include domestic and external borrowings, proceeds of disinvestment, recovery of loans given by the Union government etc.

Is deficit financing necessary for a developing country
States often fail to generate tax revenue which is sufficient to take care of the expenses of the state, especially a welfare state.

Deficit financing allows the state to undertake activities which, otherwise, would be beyond the financial capacity of the state. The concept, it may be recalled, was popularised by noted British economist JM Keynes with the aim of pump-priming a depressed economy. The basic intention behind deficit financing is to provide the necessary impetus to economic growth by artifical means.

Unfortunately, the extent to which India has been practising deficit financing has gone way beyond what could possibly have been contemplated by Lord Keynes.

According to the revised estimates for 2003-04, while the Plan expenditure for the year was Rs 1.22 lakh crore, the interest payment on past loans, borrowed to further the ends of deficit financing, was Rs 1.25 lakh crore. It means that India is spending less on development and more on interest payments. This explains the alarming limits to which the concept of deficit financing has been stretched by successive finance ministers.

Why should revenue deficit be eliminated
Tax is the most important source of revenue for a government. All other sources of income are secondary. Traditionally, it has been regarded as a sovereigns legitimate due. The difference between revenue expenditure and revenue receipts is revenue deficit. It means the government is unable to meet its running expenses from recurring sources income.

The Fiscal Responsibility and Budget Management Act, 2003 has laid down the roadmap for a gradual reduction and, subsequently, elimination of revenue deficit by 2008-09. This will entail raising of revenue and, simultaneously, putting a check on expenses relating to subsidies, salary and pension bills, interest payments etc. After all, the government ought to live within its means.

What is the significance of fiscal deficit
The governments first task is to bridge the revenue deficit. Secondly, it must generate the resources for investing in projects and schemes of capital nature. This may include equity contribution to public sector undertakings, loans for public enterprises, and investment in infrastructure sector projects. These investments yield direct as well as indirect dividends. They also facilitate trade and commerce.

The government borrows money to bridge the revenue deficit and fund developmental projects and schemes. The government, as sovereign, borrows at competitive rates from various sources which include the Reserve Bank of India, commercial banks, general public, external borrowings etc.

The total borrowings used to bridge the receiptexpenditure gap is called fiscal deficit. This is measured as a percentage of Gross Domestic Product (GDP) as it may not be appropriate to compare borrowings of different years in absolute terms.