Budget 2023: What is fiscal deficit and why is it a big deal

As we approach the Union Budget for financial year 2023-24, the market is abuzz with expectations that the government will continue with its infrastructure and capex push to boost medium-term growth.

Meanwhile, industry associations are seeking a cut in taxes to boost consumption as well as sector-specific support in the upcoming Union Budget.

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Finance Minister Nirmala Sitharaman will need to do a fine balancing act, just like she did in the last couple of budgets that had to deal with the worst of the impact of COVID-19.

To be sure, the Indian economy is recovering but faces headwinds like sharp global monetary tightening, geopolitical uncertainties and shifting of supply chains.

With the Reserve Bank of India (RBI) doubling down on bringing inflation within the target band, after having failed on its price management mandate, the finance minister has her task cut out.

She must support growth. However, her hands are likely to be tied by a prior commitment to lower the fiscal deficit, after it ballooned during the pandemic.

So what is fiscal deficit?

Simply put, it’s the budget gap, i.e., the difference between the revenue and expenditure of the government.

The central government earns from direct and indirect taxes, like the income tax and the goods and services tax (GST), as well as customs, excise duties and various cesses. It also collects proceeds from the disinvestment of its stake in public sector enterprises, earns dividends and interest.

This money is then spent on revenue, or committed spending, like salaries and pensions as well as on capital expenditure. The government also pays interest on the loans it takes from the market.

It is important to note that the fiscal deficit is not an unwelcome phenomenon. Just like individuals borrow to spend, so do governments.

In fact, a government is typically the most creditworthy borrower in a country. It, therefore, pays the least interest rate.

How is fiscal deficit bridged?

The government funds the fiscal deficit through several routes: by issuing government bonds in the market, through short-term borrowings that typically mature within a financial year, and through collections from small savings schemes.

Like any other borrower, the government has to pay interest on these borrowings.

However, since a bulk of its debt is held within the country and is rupee- denominated, the government does not face the risk of a sharp rise in interest rates when foreign investors flee the market. As a prudential measure, the RBI caps the amount of bonds foreign investors can ordinarily hold as a percentage of the total outstanding debt.

Also read: India's growth rate cycle has likely peaked, says Nomura

Why is the fiscal tool an important one?

The fiscal impulse, or the additional spending the government does, is a strong tool the state has.

A fiscal boost, delivered right, can lift a slowing economy by putting more cash in people’s hands, or by incentivising long-term growth through building infrastructure.

On the other hand, runaway deficits run the risk of investors losing confidence in the debt and currency of a particular country – as wide deficits ultimately lead to inflation. They can also hurt growth and financial stability.

So, at any given point of time, the government of the day has to take a call on how much it wants to push the fiscal pedal.

Also read: 'Highly doable' for Centre to cut fiscal deficit to 4.5% of GDP by FY26: MPC's Ashima Goyal

What are rules of the fiscal game?

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003, was enacted to provide a legislative framework for reducing the deficit and debt of the central government to a sustainable level so as to ensure inter-generational equity in fiscal management and long-term macroeconomic stability.

The FRBM Act, 2003, and the FRBM Rules, 2004, made under the Act are in force from July 5, 2004. The FRBM framework mandated the central government to limit the fiscal deficit up to three percent of gross domestic product (GDP) by March 31, 2021.

It further provides that the central government shall endeavour to limit the general (Centre plus states) government debt to 60 percent of the GDP and the central government debt to 40 percent of GDP by March 31, 2025.

However, due to the unprecedented nature of the COVID-19 shock, the fiscal deficit was increased from 3.5 percent of GDP in budget estimate 2020-21 to 9.5 percent of GDP in revised estimates for the same year.

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As the pandemic lingered into 2022 and with increased welfare-related spending, the fiscal deficit for 2021-22 stayed elevated at 6.9 percent of GDP. The government expects the deficit to ease to 6.4 percent of GDP and wants to continue with fiscal consolidation to attain a level of fiscal deficit lower than 4.5 percent of the GDP by 2025-26.

The government’s debt-to-GDP is also expected to stay elevated.