Articles

Fiscal deficit and ways to reduce it

By: Vasu Garg

Fiscal deficit stands out as a typical but risky gamble amongst the endless economic instruments used by governments and central banks around the world to manage policies and
affect markets.

Usually, taxes (direct and indirect) are the only source of income for the government. Consequently, a government is said to run a fiscal deficit whenever its spending (payments to government employees, infrastructural projects (roads, railway lines, airports etc.) exceeds its revenues. Up till the Great Depression, governments worldwide preferred to follow a fiscal
surplus. However, as demand for jobs and economic growth increased, fiscal deficits became the norm.
The basic idea behind this thinking was that when the government spends a lot of money, it basically creating jobs for its people. This would lead to less joblessness. This is especially important for politicians, as they can use this as a strategy for swaying public opinion and getting re-elected. Moreover, since greater number of people would be employed, more people will pay taxes. Consequently, revenue for the government will increase. This revenue can then justify spending a larger sum on various endeavours such as infrastructural projects and various government programs that initially enabled the higher income collection. Consequently, the loop will repeat itself.
In the short term, government seeks to borrow money from the open market by selling government bonds to cover the gap between its revenues and expenses (government borrows money at a specific interest rate and agrees to pay back the money at a given timeline). Anyone, including individuals, corporations, foreign governments and even the central bank, can buy these government bonds. The problem, however, arises when governments around the world misuse this process and mismanage their budgets.
Since it is not feasible to repay all the previous debts from a particular fiscal year’s revenue, governments issue new bonds to meet their debt from the previous bonds. In the meantime, fiscal deficit continues to rise. In general, such practices can be detrimental in the long term. If the government is unable to raise high revenue while sustaining a high fiscal deficit, investors’ trust in the government’s bonds declines. This, in turn, leads to a higher interest rate on consequent government issued bonds. If the cycle continues, the government faces the possibility of defaulting on its
loans. Such an event can lead to a breakdown of the global economy and panic among the people. The Greek Debt Crisis is a perfect case of what happens when the fiscal deficit hits an insurmountable amount. Ten years after the crisis, the Greek economy is three-fourth of its previous size and the unemployment rate is at 18.08% (2019).
To prevent fiscal deficit from going out of course, a number of measures can be taken by the governments:

• Decreased government spending can provide cushion against high fiscal deficit, provided it is supplemented with high economic growth. For instance, despite cutting government spending by over 20% in 1990’s, Canada was able to stably reduce their fiscal deficit. The primary reason for this was their high economic growth rate.

• Increasing tax rates is another measure that can reduce fiscal deficit. However, its impact may vary depending on the timing of the policy. Tax increases at a time of recession would significantly reduce spending by public. When citizens spend less, eventually the government would earn less revenue. Higher direct taxes (revenue taxes) may also be counterproductive to lawmakers seeking to be re-elected. As such,
strategic tax rises would be made by indirect taxes on specific products and services (tobacco, luxury goods, restaurants, etc.) that would not result in a negative public reaction.

• Strong economic growth is likely the best way to reduce the fiscal deficit without any adverse side effects for governments. Significant economic development takes place as government spending goes beyond paying debts and wages of workers to build infrastructural projects. The fiscal deficit in this case will build a conventional Keynesian multiplier impact by making wise investments in infrastructure and education. Low fiscal deficit, however, can have dangerous implications in the form of untameable inflation. Governments must therefore take initiatives that foster economic growth.

• A substantial reduction in spending on major subsidies such as food, fertilizers, exports, electricity to curb public (developing) spending. For example, in India, the government spends more than 2.5 lakh crores on large subsidies to food, fertilizers, promotion of central government exports etc.
• Another useful method to curb public spending is to reduce interest rates on outstanding debt. Throughout India, for example, interest payments account for 40 per cent of spending on the central government revenue account. Instead, the funds raised from disinvestment in the public sector should be used to withdraw a portion of the old public debt, rather than to finance new spending. Simple reduction of public debt would in turn decrease the cost of interest payments.
• Governments’ budget support for public sector enterprises should be reduced aside from infrastructure projects. Instead, these companies should be asked to raise their funds through the market or from banks.
• Strict actions to combat corruption within the system should be taken. In the case of Greece Debt Crisis, income undeclared was one of the major factors for the debt crisis.
• Public Sector Undertakings (PSUs) that do not perform and make money should be discontinued or sold off. Under private ownership, many of these companies are likely to thrive. In this way, job losses will be reduced and their products and services maximized production, quality and productivity.
In a nutshell, it becomes clear that fiscal deficit is necessary weapon in the arsenal of any modern-day government. However, strong management is essential if it is to be used correctly.

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