What is Government Deficit?
Budget deficit refers to a situation when budget expenditures of the government are greater than the budget receipts. A deficit is an amount by which the expenditures in a budget exceed the income.
A government deficit is the amount of money in the set budget by which the government expenditure exceeds the government income amount.
This deficit provides an indication of the financial health of the economy.
To reduce the deficit of the gap between the expenditures and income, the government may cut back on certain expenditures and also increase revenue-generating activities.
Effects of Budget Deficit
- Crowding out Effect
- Increased Debt
- Higher Interest Rates
- Higher Interest Payments
- Short-term Economic Growth
1. Crowding Out Effect
Budget deficits generally come with a high level of debt as governments struggle to bring in enough money to cover expenditures.
What this does is attract investment in government bonds and other forms of denominated debt.
However, this takes investment and loans away from private institutions and towards the government instead.
So in turn, it makes it more difficult for small and medium companies to access the same level of credit that they may obtain otherwise.
2. Increased Debt
One effect of a budget deficit is increased debt. When the government spends more than it receives, it must pay for such expenses.
Unless it has accumulated funds from the previous year’s surpluses, it must be funded through Debt. Governments borrow money by issuing bonds to private investors.
In the UK, these are known as gilts, and in the US, they are known as Treasury Bonds. By issuing these, the government borrows money from the private sector, insurance, Banks, households, and Overseas investors.
3. Higher Interest Rates
As the government borrows more, it takes more cash away from the private sector. for example, at a rate of 1 %, only 100 people may be willing to lend money to the government.
If the government wants to raise more money, it has to attract more people willing to lend. It does this by increasing the interest they are willing to pay.
For example, by increasing the rate to 2% there maybe twice as many people willing to lend to the government.
4. Higher Interest Payments
When the government runs a budget deficit, it must borrow money. It must also pay interest on these debts.
In the same way, we pay interest on our mortgages, the government pays interest on its Debt.
5. Short-term Economic Growth
When governments run budget deficits, they may stimulate aggregate demand. They may do so during a recession in order to boost the economy.
For instance, when a recession hits, demand declines as people lose jobs and have less money to spend.
The government may look to step in and create artificial demand in order to prevent a deep economic downturn.
With reference to the budget of the Government of India, there are three important types of budget deficit.
- Revenue Deficit
- Fiscal Deficit
- Primary Deficit
1. Revenue Deficit
Revenue deficit is related to revenue expenditure and revenue receipts of the government. This does not include items of capital receipts and capital expenditure. Thus, revenue deficit is the excess of revenue expenditure over revenue receipts.
Revenue Deficit = Revenue expenditure – Revenue receipts
RD = RE- RR
What do you do when your annual expenditure exceeds your annual income? The following options are 1. Plan a cut in expenditure, 2. Raise funds through borrowing, 3. Raise funds by selling assets like a house.
The government is also placed in a similar situation when it faces the problem of revenue deficit.
Example: The Government in India has cut its expenditure on subsidies by restricting the supply of subsidized LPG cylinders to 9 per family during a year.
This might cause hardship to people with low income. Second, the government resorts to borrowing 1. from the general public, 2. from the RBI, 3.from the rest of the world.
2. Fiscal Deficit
Fiscal deficit is estimated accounting for all receipts and expenditures of the government. Fiscal deficit is the excess of total expenditure over total receipts. It is estimated as under:
Fiscal Deficit = Total expenditure – Total receipts other than borrowings
A fiscal deficit is an estimate of borrowings by the government. A greater fiscal deficit implies greater borrowings by the government. It has the following implications:
1. Inflationary Spiral: Borrowing from RBI is often linked to an inflationary spiral in the economy. This is how it happens: Borrowing from RBI increases the money supply in the economy. An increase in money supply leads to an increase in the general price level. A persistent increase in the general price level leads to an inflationary spiral.
2. National Debt: Fiscal deficit leads to National debt. It is a burden on future generations. Future generations inherit a laggard economy. It is an economy where GDP growth remains low because a significant percentage of national income is used up to pay past debts.
3. Erosion of Government Credibility: High fiscal deficit erodes the credibility of the government in the domestic as well as international money market.
The credit rating of the government is lowered. Global investors start withdrawing their investment from the domestic economy. Demand for the domestic currency starts declining.
The exchange rate starts rising. Imports become expensive. Government expenses on imports start peaking up. We start importing inflation along with the import of goods and services.
Domestic investment starts shrinking. The government is left with no options but to open up domestic markets for foreign investors.
When foreign investment increases the domestic economy may take a kick start but not without surrendering its control to the nonresidents.
3. Primary Deficit
Primary deficit is the difference between fiscal deficit and interest payment. It is estimated as under:
Primary Deficit = Fiscal deficit – Interest payment
The distinction between fiscal deficit and primary deficit becomes essential. It is like this: fiscal deficit shows borrowings by the government for purpose of
1. Funding the current year deficit: the excess of current year expenditure over current year revenue and
2. Payment of interest on the accumulated National debt.
Primary deficit, on the other hand, shows government borrowing exclusively for purpose of funding the current year deficit. It does not include borrowing for the payment of interest on the accumulated National Debt.
Implications of primary deficit are similar to those of fiscal Debt. The only difference is that the primary deficit does not carry the load of interest payments on account of the past loans. Primary deficit just indicates borrowings when:
Current year expenditure > Current year revenue