23 Deficit Financing
Mandeep kaur
Learning Outcome: After completing this module the students will be able to:
Understand the concept of Deficit Financing Understand the economic effects of Deficit Financing Understand the current trends and issues of Deficit Financing in India
Deficit Financing
1. Introduction
Deficit financing is the budgetary situation where expenditure is higher than the revenue. It is a practice adopted for financing the excess expenditure with outside resources. The expenditure-revenue gap is financed by either printing of currency or through borrowing. Thus, it is a method of meeting government deficits through the creation of new money. The deficit is the gap caused by the excess of government expenditure over its receipts. The expenditure includes disbursement on revenue as well as on capital account.
Various indicators of deficit in the budget are:
Budget deficit =total expenditure – total receipts
Revenue deficit = revenue expenditure – revenue receipts
Fiscal Deficit = total expenditure – total receipts except borrowings Primary Deficit = Fiscal deficit- interest payments
Effective revenue Deficit-= Revenue Deficit – grants for the creation of capital assets
Monetized Fiscal Deficit = that part of the fiscal deficit covered by borrowing from the RBI
2. Definitions
According to Tyler Lacoma “Deficit Financing is similar to debt financing, but refers to specific practices used by governments in order to increase the number of debt instruments they have currently in the market”
According to Indian Planning Commission “The term deficit financing is used to denote the direct addition to gross national expenditure through budget deficits, whether the deficits are on current revenue or of capital accounts.” According to Webseter Dictionary,”Deficit Financing is the instrument. In government, the practice of spending more money than is received as revenue, the difference being made up by borrowing or minting new funds. The term usually refers to a conscious attempt to stimulate the economy by lowering tax rates or increasing government expenditure.
According to Investopedia,”A fiscal deficit is regarded by some as a positive economic event. For example, economist John Maynard Keynes believed that deficit help countries climb out of economic recession. On the other hand, fiscal conservatives feel that government should avoid deficits in favour of a balanced budget policy.”
According to K. Akhila reddy,” Fiscal deficit is the difference between the governments total expenditure and its total receipts( excluding borrowing). If the government spends more than it earns that situation is called a fiscal deficit.
Fiscal Deficit = Government Spendings- Government Revenue
According to Prof. Dillard,” The programme of public investment should be financed by the borrowing rather than by taxation this kind of borrowing is called deficit financing.”
3. Methods of Deficit Financing
Borrowing from the Central Bank- Raising funds from the RBI in the form of new currency is one of the important instruments for the government in this regard.
Issue of New Currency- The government may either borrow from the Central Bank in the form of new currency or issue new currency itself to increase the money circulation in the economy.
Withdrawal of its accumulated cash balances from the RBI.
4. Objectives of Deficit Financing
To finance war- Deficit financing has generally being used as a method of financing war expenditure. During the time of war, it becomes difficult to mobilize adequate resources; hence, deficit financing is used as a means of raising funds. Remedy for depression – In developed countries deficit financing is used as an instrument of economic policy for removing the conditions of depression. Prof. Keynes has also advocated for deficit financing as a remedy for depression and unemployment.
Economic development- The main objective of deficit financing in an under developed country like India is to promote economic development. The use of deficit financing in fact becomes essential for financing the development plans.
For payment of interest – Loan which are taken by the govt. are supposed to be repaid with their interest for that government needs money deficit financing is an important tool to get the income for the repayment of loan along with the interest.
To overcome low tax receipts.
To overcome the losses of public sector enterprises For implementing anti-poverty programmes.
5. Economic Effects of Deficit Financing
Deficit financing has several economic effects which are interrelated in many ways:
Deficit financing and inflation
Deficit financing and capital formation and economic development Deficit financing and income distribution.
o Deficit Financing and Inflation: It is said that deficit financing is inherently inflationary. Since deficit financing raises aggregate expenditure and, hence, increases aggregate demand, the danger of inflation looms large. This is particularly true when deficit financing is made for the persecution of war. This method of financing during wartime is totally unproductive since it neither adds to society’s stock of wealth nor enables a society to enlarge its production capacity. The end result is hyperinflation. On the contrary, resources mobilized through deficit financing get diverted from civil to military production, thereby leading to a shortage of consumer goods. Anyway, additional money thus created fuels the inflationary fire. However, whether deficit financing is inflationary or not depends on the nature of deficit financing. Being unproductive in character, war expenditure made through deficit financing is definitely inflationary. But if a developmental expenditure is made, deficit financing may not be inflationary although it results in an increase in money supply. To quote an expert view: “Deficit financing, undertaken for the purpose of building up useful capital during a short period of time, is likely to improve productivity and ultimately increase the elasticity of supply curves.” And the increase in productivity can act as an antidote against price inflation. In other words, inflation arising out of inflation is temporary in nature.
o Deficit Financing and Capital Formation and Economic
Development: The technique of deficit financing may be used to promote economic development in several ways. Nobody denies the role of deficit financing in garnering resources required for economic development, though the method is an inflationary one. Economic development largely depends on capital formation. The basic source of capital formation is savings. But, LDCs are characterized by low saving-income ratio. In these low-saving countries, deficit finance- led inflation becomes an important source of capital accumulation. During inflation; producers are largely benefited compared to the poor fixed-income earners. Saving propensities of the former are considerably higher. As a result, aggregate savings of the community becomes larger which can be used for capital formation to accelerate the level of economic development. Further, deficit-led inflation tends to reduce consumption propensities of the public. Such is called ‘forced savings’ which can be utilized for the production of capital goods. Consequently, a rapid economic development will take place in these countries.
o Deficit Financing and Income Distribution: It is said that deficit financing tends to widen income inequality. This is because of the fact that it creates excess purchasing power. But due to inelasticity in the supply of essential goods, excess purchasing power of the general public acts as an incentive to price rise. During inflation, it is said that rich becomes richer and the poor becomes poorer. Thus, social injustice becomes prominent. However, all types of deficit expenditure, not necessarily tend to disturb existing social justice. If money collected through deficit financing is spent on public good or in public welfare programmes, some sort of favourable distribution of income and wealth may be made. Ultimately, excess dose of deficit financing leading to inflationary rise in prices will exacerbate income inequality. Anyway, much depends on the volume of deficit financing.
6. Advantages of Deficit Financing in India
Firstly, as deficit financing does not impinge any trouble either to the taxpayers or to the lenders who lend their surplus money to the government, this technique is most popular to meet developmental expenditure. Deficit financing does not take away any money from anyone’s pocket and yet provides massive resources.
Secondly, in India, deficit financing is associated with the creation of additional money by borrowing from the Reserve Bank of India. Interest payments to the RBI against this borrowing come back to the Government of India in the form of profit. Thus, this borrowing or printing of new currency is virtually a cost-free method. On the other hand, borrowing involves payment of interest cost to the lenders.
Thirdly, financial resources (required for financing economic plans) that a government can mobilize through deficit financing are certain and known beforehand. The financial strength of the government is determinable if deficit financing is made. As a result, the government finds this measure handy.
Fourthly, deficit financing has certain multiplier effects on the economy. This method encourages the government to utilize unemployed and underemployed resources. This results in more incomes and employment in the economy.
Fifthly, deficit financing is an inflationary method of financing. However, the rise in prices must be a short run phenomenon. Above all, a mild dose of inflation is necessary for economic development. Thus, if inflation is kept within a reasonable level, deficit financing will promote economic development, thereby, neutralizing the disadvantages of price rise.
Finally, during inflation, private investors go on investing more and more with the hope of earning additional profits. Seeing more profits, producers would be encouraged to reinvest their savings and accumulated profits. Such investment leads to an increase in income, thereby, hereby setting the process of economic development rolling.
7. Adverse Effects of Deficit Financing
Deficit financing has several adverse effects on economy. Important evil effects of deficit financing are given below.
Leads to inflation – Deficit financing may lead to inflation. Due to deficit financing money supply increases and so does the purchasing power of the people, which increases the aggregate demand and thud, the prices increase.
Adverse effect on saving- Deficit financing leads to inflation and inflation affects the habit of voluntary saving adversely. In fact, it becomes impossible for people to maintain the previous rate of savings in the state of rising prices.
Adverse effect on Investment – Deficit financing affects investment adversely. When there is inflation in the economy, the trade unions tend to demand an increase in wages, for which they engage in strikes and lock outs. This is turn decreases the efficiency of labour and creates uncertainty in the business, which decreases the extent of investment in the country.
Inequality – in case of deficit financing income distribution becomes unequal. During deficit financing deflationary pressure can be seen on the economy which makes the rich, richer and the poor, poorer. The fixed wage earners are badly affected and their standard of living deteriorates.
Problem of balance of payment – Deficit financing leads to inflation. A high price level as compared to other countries makes the exports more expensive On the other hand rise in domestic income and price may encourage people to import more commodities from abroad. This creates a deficit in balance of payment, and the balance of payment becomes unfavourable.
Change in the pattern of investment- Deficit financing leads to inflation. During inflation, prices rise and reach to a very high level in that case people instead of indulging into productive activities they start practising speculative activities.
8. Deficit Financing and Inflation
Deficit financing, through creation of new money, increases the aggregate demand in the economy, while the supply of goods and services does not increase in the same proportion. This creates an inflationary gap causing rise in prices. Following arguments are generally given to support this contention-
In developing economies, a part of the newly created money through deficit financing may be absorbed by the non monetised sector (barter system) which tends to get monetised during the development process. This reduces the inflationary impact of deficit financing.
In a developing economy, there exist a large amount of unutilised or underutilised resources. When the supply increases through deficit financing, these resources may be utilised for productive purposes.The production of goods may, therefore, increase and reduce the inflationary pressure generated by deficit financing.
The new money generated by deficit financing is often utilised for productive purposes in a peace time developing economy. This may result in the production of additional goods and services and this reduce the inflationary pressure of deficit financing. This phenomenon is much more marked if the money created by the deficit financing is used in the promotion of quick-yeilding projects.
In a developing economy the volume of transaction goes up with the process of development. A part of the new money created by deficit finanacing may be utilised to meet the needs of increased transactios. This will also have effect of reducing the inflationary effect of deficit financing.
In spite of the arguments given above, the price may go up due to deficit financing. Following arguments are given to show that even a peacetime developing economy may experience inflationary pressures due to deficit financing-
Deficit financing increases the money supply, while the real outputs and services may not increase in the same proportion. This is bound to give rise to inflationary pressures in the economy.
There may be temptations on the part of the governments to resort to deficit financing even for non productive purposes. Some governments use deficit financing to meet their deficit on current account. This type of deficit financing definitely results in raising prices.
Following the principle of unbalanced growth, many developing countries may set up capital intensive heavy and basic industries to develop their economies. These industries have long gestation periods and their output start coming in the market after several years. The increased money supply to set up these industries is, therefore, not matched by the supply of goods and services in the short run. The prices are bound to rise in such a condition.
There are certain in built rigidities and bottlenecks in a developing economy which prevent the actual output from rising to its potential. The increased money supply is, not matched by the real output. This creates inflationary pressures in the economy.
The majority of people in developing economies are poor. When their incomes increase, on account of expanding money supply in the economy, this give rise to higher consumption. These poor people have a very high propensity to consume and hardly any-thing is saved by them to invest. This obviously goes to raise the price level in the economy.
The governments in developing countries do not have the necessary expertise and administrative experience to keep the inflationary forces in check through the instruments of monetary and fiscal policies. They are, therefore, not able to control the inflationary impact of deficit financing.
9. How to Reduce the Inflationary Pressure of Deficit Financing
Deficit financing is very useful weapon for ensuring the high level of employment in the advanced countries. Following are the important measures which can be adapted to control.
Formulation of Import and Export Policies: A country should frame its import and export policy in such a manner that the supply of an essential goods may not fall.
Proper Allocation of Resources: The rise in price due to deficit financing can be controlled by proper allocation of resources. Developing countries should prepare effective plans and resources of the country may not be wasted in unproductive projects.
Fiscal Policy: The inflationary pressure can be controlled, if a government increases the rate of taxes on luxuries and introduces the compulsory saving schemes.
Monetary Policy: An effective monitory policy can be adopted to reduce the inflationary pressure. Most of developing countries are also using these weapons against the inflatory pressure to reduce the inflation.
10. What should be the extent of Deficit Financing?
Whenever more resources are needed to meet the increased public expenditure, the governments of the underdeveloped countries are always tempted to use deficit financing because it is subject to less public uproar than addition taxation. Deficit Financing is undoubtedly inevitable. it has to, however, be kept within the ‘safe’ limit so that inflationary forces do not appear in the economy. But nobody knows the ‘safe’ limit. In view of all these, it is said that deficit financing is an ‘evil’ but a ‘necessary evil’. Much of the success of deficit financing will be available to the economy if anti-inflationary policies are employed in a just and right manner. A mild degree of inflation say up to a price rise of 3% per annum is considered tolerable and even essential in a developing economy. Thus deficit financing which leads to a moderate price increase can be thought to be justifiable.
Another important criterion is the creation of money supply. Deficit financing which leads to a greater increase in money supply has a greater inflationary potential so it must be restrained. Similarly when the rate of growth of national income is high, a higher amount of deficit financing can be absorbed by the economy without much price rise.
The extent of deficit financing will also depend on the effectiveness of fiscal and monetary policies adopted to curb the inflationary forces so generated and the efficiency of the administrative machinery to deal with abnormal situations.
Other Conditions that Determine the ‘Safe Limits’of Deficit Financing
o Excess Capacity: If there is utilised or under utilised in the industrial and agricultural sector of the country, deficit financing will not be inflationary.
- o Stability of Wages: when the government succeeds in stabilising the money wages in economy, deficit financing will not be inflationary.
- o Direct Control: When the government administration is efficient and honest in implementation of measures of direct control to counteract inflationary forces, the scope of deficit financing would be greater and non inflationary.
It may be concluded thus that a reasonable limited deficit financing can promote economic development but undue reliance on deficit financing is certainly harmful.
- Deficit Financing in India
Budget 2015-16 sought to achieve the delicate equilibrium between the concerns of stirring growth, accommodating the resource transfer that greater fiscal federalism entailed and ensuring fiscal consolidation. This was intended to be achieved through higher capital expenditure, greater net resource transfers to states, higher gross tax revenues and expenditure rationalisation. The Budget also signalled government’s intent on fiscal Consolidation with respect to all major deficit indicators (Table1), albeit with a revised medium-term framework that opted for shifting the fiscal deficit target of 3 per cent of the GDP by one year, from 2016-17 to 2017-18
Accordingly, the envisaged fiscal deficit to GDP targets was 3.9 per cent in 2015-16, 3.5 per cent in 2016-17 and 3.0 per cent in 2017-18.
11.1 Trends in Deficit Financing
Budget 2015-16 sought to contain the fiscal deficit at Rs. 5.56 lakh crore (3.9 per cent of GDP) as against Rs.5.13 lakh crore (4.1 per cent of GDP) in 2014-15 (RE). Revenue deficit (RD) was estimated at Rs. 3.94 lakh crore (2.8 per cent of GDP) in 2015-16 (BE) as against Rs.3.62 lakh crore (2.9 per cent of GDP) in 2014-15 (RE) (Figure 1).
Figure 1: Trends in Deficits as a percentage of GDP
Unlike some other countries, the financing of fiscal deficit in India is mostly from domestic sources. Domestic sources constitute roughly 98 per cent of the deficit financing, and approximately 84 per cent of domestic financing is from market borrowings (Figure 2)
12. Summary
Deficit financing is inevitable in LDCs. Much success of it depends on how anti-inflationary measures are employed to combat inflation. Most of the disadvantages of deficit financing can be minimized if inflation is kept within limit.
And to keep inflation within a reasonable and tolerable level, deficit financing must be kept within safe limit. Not only it is difficult to lay down any ‘safe limit’ but it is also difficult to avoid this technique of financing required for planned development. Still then, deficit financing is unavoidable.
It is an evil but a necessary one. Considering the needs of the economy, its use cannot be discouraged. But considering the effects of deficit financing on the economy, its use must be made limited. So, a compromise has to be made so that the benefits of deficit financing are reaped too.
Suggested Readings:
- Cherunilam Francis (2012) ,Business Environment Text and Cases , 21st ed.,Mumbai: Himalaya Publishing House.
- Lekhi, R.k,(2013), Public Finance, Kalyani publication
- Puri,V.K.,S.K. Misra (2013), Indian Economy, 31st ed., Mumbai: Himalaya Publishing House.
- Shukla, M.B.(2012).Business Environment Text & Cases. New Delhi: Taxmann Publications.