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Rediff.com  » Business » Fiscal deficit, what's that?

Fiscal deficit, what's that?

By Shankar Acharya
November 30, 2006 12:15 IST
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As we bask in the glow of a fourth consecutive year of 8 per cent growth, we seem to have forgotten one of the perennial bugbears of the 1990s, the dreaded "fiscal deficit".

Most economists accorded an important role to the high fiscal deficits of the late 1980s in causing the economic crisis of 1991. We spent much of the first half of the nineties decade striving, with partial success, to reduce the fiscal deficit. The second half was spent struggling, unsuccessfully, to contain the fiscal deficit from ballooning in the wake of the Fifth Pay Commission decisions.

Several years of effort yielded the Fiscal Responsibility and Budget Management Act of 2003 (notified in 2004) at the central government level and many states have followed with similar laws (nudged along by some crucial conditionalities in the Twelfth Finance Commission's recommendations for debt relief).

But today, "the fiscal deficit" is a guaranteed conversation killer. Is that really justified? Have matters improved so much? Or has our dynamic economy matured beyond such mundane "accountant's concerns"?

Well, let's start with a few numbers. As the table shows, there was a significant improvement in the consolidated (Centre and states) fiscal deficit from an 8.9 per cent of GDP average in 1988-91 (it was an even higher 9.4 per cent in 1990/91) down to 6.5 per cent in 1995/6.

Then, as the Fifth Pay Commission decisions took hold and the tax revenue effort weakened, the overall deficit climbed back up to nearly 10 per cent of GDP by 2001/2. Subsequently, helped by fiscal responsibility laws and better revenue performance, the deficit has been brought down to 7.5 per cent of GDP in the two most recent years.

So, in the last fifteen years, approximately spanning three five-year-plan periods, there has been a cycle in the fiscal deficit: down from a high level, then back up even higher and then down again.

It is interesting to note the inverse correlation between the fall-rise-fall of the fiscal deficit and the growth performance of the Indian economy during this period: strong growth of 6.7 per cent in the Eighth Plan (1992-97) when the deficit was shrinking; some deceleration in the Ninth Plan (1997-2002) when the deficit was widening; and resurgent growth in the Tenth Plan (2002-7) with the fiscal deficit again reducing.

This inverse correlation is not wholly accidental. There may be some causality at work, operating through the usual transmission mechanisms of credit availability, real interest rates, savings and investment. (I don't wish to suggest that the variation in fiscal deficit levels is the sole factor explaining changes in GDP growth outcomes; obviously, other factors were also at work.)

The numbers do suggest that the reduction in the fiscal deficit in the first half of the 1990s helped to accommodate the upsurge in private corporate savings and investment of the period, just as the subsequent widening of the fiscal and revenue deficits in the latter half of the decade contributed to a significant drop in aggregate savings and investment, especially in public savings.

The latest rebound in gross investment (to 30 per cent of GDP by 2004/5) has been greatly helped by the 4 percentage point positive swing in public savings, largely attributable to the substantial drop in public dissavings brought about by the large reduction in the consolidated revenue deficit (from 7 per cent in 2001/2 to 3.7 per cent in 2004/5).

To me, the lesson in these numbers is fairly clear: fiscal (and revenue) deficits matter. We forget this at our peril. It is also a trifle disquieting to note that, after the latest round of fiscal consolidation, our fiscal position is still somewhat weaker than it was a decade ago.

Today's (2005/6) fiscal deficit of 7.5 per cent of GDP is a little higher than the 6.5 in 1995/6. Actually, the gap is perhaps 0.6 per cent greater once we adjust upwards the fiscal deficit in 2005/6 by the Rs 17,000 crores (Rs 170 billion) of oil bonds issued off-budget in 2005/6, as we should. (By the way, an 8 per cent fiscal deficit makes us one of the highest deficit countries in the world.)

Furthermore, the government debt to GDP ratio at 83 per cent in March 2006 is a good deal worse than the 63 per cent in March 1996. The vulnerability to increases in interest rates is obvious.

What's the fiscal outlook for the future? Mixed, at best. On the positive side are the recently enacted fiscal responsibility laws at the central and state levels. But we know from the central government's example in 2005/6 that such legislated trajectories can be "paused" when the government finds the restraints too inconvenient.

Nor does it help to have the Planning Commission and Left parties advocating further "pauses" in the Eleventh Plan. The other positive feature of the fiscal outlook is the buoyancy in state government revenue associated with the switch to VAT systems of sales taxation in the last couple of years.

This could yield further returns as organised retail trade gathers steam. So could the implementation of a well-designed system for national Goods and Services Tax as recommended by the Kelkar Task Force in 2004, which was announced for implementation in this year's Budget speech. But the target date was put disappointingly distant (April 2010) and there are not many signs of serious preparatory work.

On the negative side, there are at least three major threats to fiscal consolidation in the medium term.

First, the tax exemptions built into the Special Economic Zones scheme are unduly generous and could seriously erode the revenue base in the medium term. Second, the populist programmes (such as the national rural employment guarantee scheme) of the UPA government pose serious budgetary headaches for the future.

Perhaps most important is the possible fallout from the Sixth Pay Commission, which is expected to present its report in late 2008. If it is similar to the consequences of the predecessor commission, then we are in for a very rough ride on the fiscal front.

The bottom line is that if we don't take the fiscal deficit seriously (as we patently don't today), then it could easily widen and harm our future growth and development. It's done it beforeĀ….it can do so again.

The author is Honorary Professor at ICRIER and former Chief Economic Adviser to Government of India. The views expressed are personal
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