Fiscal Consolidation Road Map

[Economy] Fiscal Consolidation, Fiscal Deficit : Meaning, Implications, Explained Why Vijay Kelkar Committee was formed? 1. Parts of Budget= Revenue + Expenditure 2. Types of Budget= Deficit/Surplus/Balanced 3. Why printing more money=Bad idea? 4. When fiscal deficit NOT BAD? 5. When & Why is fiscal deficit BAD? 1. Creates inflation 2. Black Money 3. Bond Yield increased 4. Crowding out investment 5. Twin deficit hypothesis 6. Current Account Deficit 7. Subsidy Burden = fiscal deficit increased 8. Interest Payment 9. Vicious circle: Trade to Fiscal deficit 6. Fiscal Consolidation: What is it? 7. Mock Questions
Continuing episodes of technical incorrect economy.
Set Location: Prime Minister’s Office (PMO), New Delhi.
Mohan is busy uploading (un)funny photos in his facebook album and tagging random friends in them to get more “likes”. Vijay Kelkar makes an entry in his office. Kelkar | Sir, the expert reports suggest that fiscal deficit will be around 6 percent for 2012-13. This is very dangerous; you need do fiscal consolidation immediately! | Mohan | Ya but what is fiscal deficit and why is it dangerous? | Kelkar | What? you’re an economist and yet you don’t know what is fiscal deficit? | Mohan | Well I was an economist. But I didn’t maintain notes and I did not revise the standard reference books either, so I’m unable to recall the concepts right now, just like a no0b player of UPSC. | Kelkar | Well fiscal deficit (FD) = Budgetary Deficit + Market borrowing + other liabilities of Government | Mohan | Please Explain in English, from the very beginning. | Kelkar | Ok then let us start from the beginning.Every year, the Government puts out a plan for its income and expenditure for the coming year. This is, called annual Union Budget and you need to get it approved by the parliament. | Mohan | Side question: why do I need to get it approved by the parliament? | Kelkar | For the answer Click ME | Mohan | Ok back to the topic | | |
Parts of Budget: Revenue and Expenditure
Kelkar: In every budget, there is incoming money (Revenue) and out going money (Expenditure). Incoming money | Outgoing Money |
Incoming money is divided into two parts. Tax and Non Tax
And outgoing money is divided into Plan and Non plan Expenditure. Incoming | Outgoing | Tax | Non Tax | Plan | Non Plan | | | | |
Kelkar: We can further refine this classification into Revenue/capital receipts and Expenditure.
But let us not complicate the matter for the time being.
Mohan: Now What is this incoming money from tax and non tax sources?
Kelkar: see the table yourself for the examples. Incoming money | Outgoing | Tax Revenue | Non Tax Revenue | Plan | Non Plan | Direct Tax | Indirect Tax | | | | 1. income tax 2. Corporate tax; 3. Wealth tax 4. Capital gain tax (Vodafone case) | 1. custom duty, 2. excise duty, 3. service tax. 4. VAT | 1. Fees Collected (Driving license, RTI, Passport) 2. Fines and Penalties (Traffic violation etc) 3. Income from PSU (e.g. profit from Airindia (lolz) 4. Gifts. (discussed in 2nd ARC article) 5. Grants (Foreign Aid from UN, Japan etc) | | |
Mohan: and what is this outgoing money? Plan and non-plan?
Kelkar: Outgoing money = the area where Government spends the money (Expenditure).
Plan-Expenditure means spending money on the activities related to the national five year plan. (FYP)
Non-plan Expenditure, obviously means spending money on activities that are not related with national five year plan. Check the table for examples. Incoming | Outgoing | Tax Revenue | Non Tax Revenue | Plan Expenditure | Non Plan | Direct Tax | Indirect Tax | | | | 1. income tax 2. Corporate tax; 3. Wealth tax 4. Capital gain tax (Vodafone case) | 1. custom duty, 2. excise duty, 3. service tax. 4. VAT | 1. Fees Collected (Driving license, RTI, Passport) 2. Fines and Penalties (Traffic violation etc) 3. Income from PSU (e.g. profit from Airindia (lolz) 4. Gifts. (discussed in 2nd ARC article) 5. Grants (Foreign Aid from UN, Japan etc) | 1. MNGREA 2. Janani Suraksha Yojana 3. JNNURM 4. Indira Awas Yojana | 1. Salary of judges, bureaucrats and armymen 2. Buying new tanks and missiles 3. Subsidies: Petrol, Kerosene etc. 4. Light bills of Government offices. 5. Luxury Travel bills of Pratibha. |
Mohan: ok so now what?
Kelkar: Now we classify the budget according to the balance between incoming and outgoing money.
Types of Budget=Deficit,Surplus,Balanced When | It is called a | outgoing money > incoming money | deficit budget. | outgoing money < incoming money | surplus budget. | outgoing money = incoming money | balanced budget. |
In reality, Government always has deficit budget. Because as long as there is Pakistan and China in the neighborhood, we’ll have to maintain a huge army, keep buying new tanks and missiles.
As long as there are poor people, we’ll have to keep running various Government schemes.
Mohan: come to the point.
Kelkar: The point is,
When Government spends beyond its aukaat, it creates a big pothole in the highway.
This pothole can be called a Revenue deficit, budget deficit, fiscal deficit or primary deficit – according to the formula you use to measure the depth of this pothole.
This pothole cannot be filled with cement, asphalt or dirt. It can only be filled with cash.

In the 1980s, Sukhmoy Chrokroborthy Committee came up with the fiscal deficit formula
Fiscal deficit= 1. Budgetary deficit (=total Expenditure minus total income) 2. + market borrowings (=through Government securities (G-Sec)/Bond) 3. + other liabilities (e.g. pension and provident to be given in future)
Mohan: but why should we calculate this fiscal deficit?
Kelkar: This fiscal deficit number tells you the depth of the hole and gives you the idea how much money do you need to borrow from the sources within India (internal borrowing – from RBI, Other banks etc) and from abroad (external borrowing- World Bank, IMF etc.)
Bigger the pothole, more cash you need to fill it up.
Here is some food for thought. Incoming Outgoing Breakup for USA budget 2011. Click on Image to Enlarge.

Mohan | then simply borrow money and fill up the pothole! What is the problem? | Kelkar | problem is “Paisaa Ped pe toh nahi lagtaa” (Money doesn’t grow on trees). When you borrow money, you’ve to pay interest (ब्याज) to the party, every year.To pay this interest in the future, you’ve three options.first option =Increase the current taxes or create new taxes. | Mohan | Not a good idea sir-ji. | Kelkar | alright, Second option =Create policies to help stimulate economic growth so that tax collection automatically increases with it, like FDI in aviation, power sector, retail, insurance and so on. | Mohan | But that’s Easier said than done :( | Kelkar | Then Third option : Print more currency and use it to fill up the pothole. This is called debt monetization. | Mohan | Now this third option sounds great :D | Kelkar | Actually that’s the stupidest of all three solutions. Let me explain with the usual example. |
Why Printing more money= Not good idea?
Suppose, Government orders RBI to print lots of cash to solve poverty.
Then Government launches “Rajiv Gandhi Suitcase yojana (RGSY)” under which every BPL family is given a suitcase containing Rs.10 lakh.
What will happen then?
They’ll all go and buy lots of onion,milk,mobile, cars, houses everything.
=Demand of product will increase, but the supply will remain almost the same as earlier.
So, there will be one customer offering Rs.400 per kilo of onion, then another guy would offer Rs.500 per kilo of onion=inflation =not good.
On the other hand, Suppose your boss pays you 10 lakh per year, but that means he definitely extracts work worth more than 10 lakhs from you and sells some goods/services to a third client. That’s why giving you 10 lakhs doesn’t increase inflation. (because some other client is buying the services you had produced). but giving 10 lakh to a poor without making him economically productive = increases inflation.
Hence printing money to solve problems= not good idea.

* Here is another example: Suppose that there is only one commodity that everyone needs to buy in order to live a good life say wheat. * Also, assume that our country produces 10,000 quintals of wheat every year. * There are a total of 25,000 people in the country who spend Rs. 400 each per year to buy wheat. * Since this Rs. 1 crore is spent to purchase ten thousand quintals of wheat, the cost of wheat is Rs. 1,000 per quintal. * Now suppose that to repay some of its debt, the Government decides to print some new currency notes. Say the Government prints new notes worth Rs. 10 lacs. * This means the amount of money available to spend increases from Rs. 1 crore to Rs. 1.1 crores. * Since the amount of wheat produced hasn’t increased, each tonne of wheat now costs Rs. 1,100, a 10% increase! (1.1 crores paid for ten thousand quintals = Rs. 1,100 per quintal). * So we have just seen that the effect of debt monetization is “inflation.” * Inflation acts like an invisible tax on all the people of a country. (recall the first option – increasing tax was not a good option.)
Mohan : Does that mean fiscal deficit =bad?
Kelkar: not always bad. It depends on the situation.
When fiscal deficit = NOT BAD? * If the money that the Government had borrowed was used to increase the amount of wheat production, then the inflation could have been avoided. (for example borrowing money to create new canal or irrigation project) * If Such irrigation project led to an increase in wheat production from 10,000 quintals to 11,000 quintals. * In that case, even with an increase of money to 1.1 crores, the cost of wheat would remain steady at Rs. 1,000 per quintal. * Thus we’d have economic growth and also avoid inflation * Clearly then, it was a good thing that the Government borrowed money to implement this program.
Thus, fiscal deficit is not necessarily a bad thing, always.
When and why is fiscal deficit= BAD?
Creates inflation * A large and persistent fiscal deficit =something is wrong in the economy. * It can mean that the Government is spending money on unproductive programmes which do not increase economic productivity. (For example MNREGA, most of the money is eaten midway by the Sarpanch and Local officers.) =Bad * Now these rich Sarpanch and Local officers buy more gold, land and cars= demand increased but other normal people don’t have that much money = inflation. (demand pull type).
Black Money * Fiscal deficit= crudely speaking when incoming money is less and outgoing money is more. So, incoming money is less = tax collection machinery is not effective = perhaps lot of people are evading the taxes = black money =inflation (demand pull type) = Very bad. * In extreme conditions, inflation can give way to hyperinflation that can completely destroy a country. =very bad.
Bond Yield increased
From Eurozone Greece Exit article, You already know what is bond yield. If not click me
When Government keeps borrowing and borrowing to fill up the fiscal deficit pothole, then bond yield will increase = not good because more and more of taxpayers’ money (i.e. Government ‘s incoming money) will go in repaying that bond interest rate rather than going into education or healthcare.
Crowding out investment
We already saw that, Fiscal deficit pothole can only be filled with cash. This cash has to be borrowed from RBI, other banks, FII etc. who buy the Government bonds.
So, that much money (Credit/loan) is not available for other needy businessman. thus fiscal deficit “Crowds out”investment from private sector. Now that needy businessman will have to borrow money at higher interest from another party (this is how fiscal deficit increases ‘interest rates’)= input cost of product increased = he will increase the MRP of his product or service to maintain the same profit margin = inflation. (cost-push type)

Twin deficit hypothesis * This hypothesis says that as the fiscal deficit of the country goes up its trade deficit (i.e. the difference between exports and imports) also goes up. * Hence, when a government of a country spends more than what it earns, the country also ends up importing more than exporting. * In India, the trade deficit story is basically about oil and gold – two commodities that the country does not produce much but imports a hell of a lot.
Current Account Deficit (CAD) * When India imports more than it exports = leads to Current Account Deficit. (we already discussed it earlier, click ME) * CAD is another pothole but it can be filled only with foreign currency (mostly dollars!) * This increases the demand of dollars in Forex Market = rupee weakens against dollar= price of petrol will increase= again inflation= bad.
Subsidy Burden = fiscal deficit increased * the government of India does not pass on a major part of the increase in the price of oil to the end consumer and thus ‘subsidises’ diesel, LPG and kerosene . * So oil companies sell at a loss, and the government compensates these companies for the loss (by giving them bonds). * This increases government expenditure, which, in turn, increases the fiscal deficit.
Interest Payment
In this financial year alone (2012-13), the government will pay more than 4 lakh crore just as interest payment on debt taken earlier! = more imbalance between incoming and outgoing money.
The vicious circle: Trade to Fiscal deficit
Thus, in India’s case, a greater trade deficit also leads to a greater fiscal deficit. So the causality in India’s case is both ways. * A high fiscal deficit leads to higher trade deficit. * And high trade deficit leads to higher fiscal deficit. * And this, in turn, also leads to a weaker rupee, which, in turn, pushes up the cost of oil in rupee terms — leading to a higher fiscal deficit.
Now in the opening lines, Kelkar said Fiscal deficit would be around 6%. What does that mean?
There are two ways to express Fiscal Deficit. 1. Absolute Value: Rs. 521,980 crores on March 31, 2012 . 2. Percentage: 5.9% of GDP.
In newspapers and economic discussions, the Fiscal is usually expressed in second form (percentage). * You might think 5 or 6% is such a trivial amount, why Kelkar is so worried? * Well, to understand the gravity of the situation, you’ve to compare the percentage with other percentages. 1. Around 3.8% of India’s GDP goes in Education. (2012) 2. Around 6% of India’s GDP goes in Fiscal Deficit. (2012) 3. Greece’s Fiscal deficit was more than 10% of its GDP and look how much trouble it is facing. (recall Eurozone Article) * Therefore, we must not only pay attention to the fiscal deficit, we must also try and understand the different areas of Government spending. * Is the Government borrowing money to spend on programmes that lead to increased economic productivity or is it spending on unproductive programs? * Remember, even directly giving money (or amenities) to BPL, without making them more economically productive = dangerous because of the various reasons seen above.
Fiscal Consolidation: What is it? Mohan | ok so far I understood 1. What is fiscal deficit. 2. Why and when fiscal deficit is bad.But what is this fiscal consolidation? | Kelkar | Fiscal consolidation means doing everything to fix the fiscal deficit problem in its root and preventing heavy fiscal deficits situation from occurring in future. | Mohan | But How can we do that? | Kelkar | Just try to reduce the outgoing money and increase the incoming money. (Look at that plan-non plan table again.)That means 1. Cut down subsidies. 2. Stop leakages in subsidies. 3. Reform the tax structure (implement GST). 4. Improve the performance of PSUs. 5. Recover blackmoney 6. stop ministers from using Business class airtickets and other wasteful Government expenditures. (= take austerity measures)+ Policy reforms such as FDI (to create environment conductive for economy = that will automatically increase productivity and tax collection. Recall the second option.) | | | Mohan | hmm that itself sounds like a problem. I think I should make another Committee (so that I don’t have to implement its recommendations). Let me check my phonebook for retired judges. | Kelkar | Sir this is the matter of economy not railway accidents. It requires an expert on economy. | Mohan | Then make a Committee headed by Montek Singh | Kelkar | but Media won’t like his recommendations. (Everyone who earns more than Rs.20 is not a BPL and he should pay 10% income tax.) | Mohan | Then make a Committee headed by some columnist from The H*****! | Kelkar | But Madam-ji wouldn’t like his recommendations. (hand over Finance Ministry to Fidel Castro) | Mohan | Then whom should I appoint? | Kelkar | The expert is sitting in front of you. | Mohan | Alright, tomorrow morning you goto the finance Minister along with your class 10,12,college marksheets, extra-curricular activity certificates and job experience certificates (if any) and get the appointment letter from him. | Kelkar | What??? * I served as the finance Secretary of India (despite not being an IAS). * I served as an executive director in IMF. * Hell I even served as the chairman of 13th Finance Commission of India!and now you’re asking the Vijay Kelkar to submit his class 10-12 marksheets and extra curricular activity certificates? | Mohan | Chillx. I was joking. You may go now. If I need any more help, I’ll give you a miss call. | Kelkar | PM and miss-call? Another joke? | Mohan | No, I’m serious! Miss call= Government expenditure on phone bills reduced= fiscal consolidation. | Kelkar | Whaat an idea sir-ji. |