[Economy] Fiscal Consolidation, Fiscal Deficit : Meaning, Implications, Explained Why Vijay Kelkar Committee was formed?

Z-Miscellaneous271 Comments

India Yearbook
  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

Set Location: Prime Minister’s Office (PMO), New Delhi.

Prime Minister Manmohan Singh 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.

KelkarSir, 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!
MohanYa but what is fiscal deficit and why is it dangerous?
KelkarWhat? you’re an economist and yet you don’t know what is fiscal deficit?
MohanWell 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.
KelkarWell fiscal deficit (FD) = Budgetary Deficit + Market borrowing + other liabilities of Government
MohanPlease Explain in English, from the very beginning.
KelkarOk 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.
MohanSide question: why do I need to get it approved by the parliament?
KelkarBecause Article 112 of the Constitution says so!
MohanOk 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 moneyOutgoing Money

Incoming money is divided into two parts. Tax and Non Tax
And outgoing money is divided into Plan and Non plan Expenditure.

IncomingOutgoing
TaxNon TaxPlanNon 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 moneyOutgoing
Tax RevenueNon Tax RevenuePlanNon Plan
Direct TaxIndirect 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.

IncomingOutgoing
Tax RevenueNon Tax RevenuePlan ExpenditureNon Plan
Direct TaxIndirect 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

WhenIt is called a
outgoing money > incoming moneydeficit budget.
outgoing money < incoming moneysurplus budget.
outgoing money = incoming moneybalanced 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.

fiscal deficit potholes

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.
US Budget for 2011

Mohanthen simply borrow money and fill up the pothole! What is the problem?
Kelkarproblem 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.
MohanNot a good idea sir-ji.
Kelkaralright, 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.
MohanBut that’s Easier said than done 🙁
KelkarThen Third option : Print more currency and use it to fill up the pothole. This is called debt monetization.
MohanNow this third option sounds great 😀
KelkarActually 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.
printing currency leads to inflation

  • 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)
Vijay Kelkar Committee on fiscal consolidation

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
  • 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?
Mohanok so far I understood

  1. What is fiscal deficit.
  2. Why and when fiscal deficit is bad.

But what is this fiscal consolidation?

KelkarFiscal consolidation means doing everything to fix the fiscal deficit problem in its root and preventing heavy fiscal deficits situation from occurring in future.
MohanBut How can we do that?
KelkarJust 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.)

Mohanhmm 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.
KelkarSir this is the matter of economy not railway accidents. It requires an expert on economy.
MohanThen make a Committee headed by Montek Singh
Kelkarbut Media won’t like his recommendations. (Everyone who earns more than Rs.20 is not a BPL and he should pay 10% income tax.)
MohanThen make a Committee headed by some columnist from The H*****!
KelkarBut Madam-ji wouldn’t like his recommendations. (hand over Finance Ministry to Fidel Castro)
MohanThen whom should I appoint?
KelkarThe expert is sitting in front of you.
MohanAlright, 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.
KelkarWhat???

  • 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?

MohanChillx. I was joking. You may go now. If I need any more help, I’ll give you a miss call.
KelkarPM and miss-call? Another joke?
MohanNo, I’m serious! Miss call= Government expenditure on phone bills reduced= fiscal consolidation.
KelkarWhaat an idea sir-ji.

Then Vijay Kelkar set out for a journey to prepare a ‘roadmap’ for fiscal consolidation.

In September 2012, He submitted his report to the Government.

We’ll see the recommendations of Kelkar Committee in future article. (To Be continued.)

Mock Questions

Which of the following statements are correct?

  1. Salaries paid to Constitutional bodies is an example of Planned Expenditure
  2. Fiscal deficit is always higher than budgetary deficit.
  3. Fiscal deficit cannot be financed through external borrowing.
  4. Kelkar Committee was created to suggest the roadmap for implementation of Direct Tax Code.
  5. High and persistent Fiscal Deficit is a sign of healthy and growing economy.
  6. To achieve Fiscal consolidation, Government should increase the non-plan expenditure.
  7. Fiscal consolidation means the steps taken by Government to increase its shareholding in PSUs.
  8. Vijay Kelkar is the chairman of 14th Finance Commission.

Descriptive 15 marks (150 words)

  1. What is fiscal deficit. What’re the salient features of FRBM Act?
  2. Major recommendations of Kelkar Committee on Fiscal consolidation.

All of my articles on Economy are Archived on this link: mrunal.org/economy
Ref:

  1. Wheat example from Parijat Garg’s article on governindia.org
  2. Kelkar’s Character is portrayed according to his bio on http://www.rediff.com/business/1998/sep/11kelkar.htm
  3. US budget from www.sankey-diagrams.com
  4. Twin deficit etc from http://www.dnaindia.com/money/column_of-deficits-falling-rupee-good-economics-and-mindless-austerity_1690732
  5. Education GDP http://www.sunpost.in/2012/05/17/india-spends-3-85-gdp-on-education/

Mrunal recommends

  1. (free) NCERT, NIOS, TN-Books
  2. Environment by ShankarIAS
  3. Indian Polity M.Laxmikanth (Hindi | English)
  4. Art & Culture by Nitin Singhania (Hindi | English)
  5. Spectrum: Modern History (Hindi | English)
  6. Bipin Chandra: Post Independence
  7. Fast-track to Arithmetic Rajesh Verma
  8. MK Pandey’s Analytical Reasoning
  9. Disha’s Topicwise Paperset (Hindi | English)
  10. School Atlas
  11. Mains: Language papers
  1. (free) NCERT, NIOS, TN-Books 4 History,Geo,Sci
  2. Indian Polity M.Laxmikanth (Hindi | English)
  3. Spectrum: Modern History (Hindi | English)
  4. Maths: Quantam CAT Sarvesh Kumar
  5. Objective General English SP Bakshi
  6. Word Power made Easy -Norman Lowe
  7. Topic wise Solved Paperset by Disha


So far 271 Comments posted

  1. dhanjit choudhury

    plz explain how state can be a producer and or supplier of the private goods and services………..

  2. Anil Hasani

    killer sense of humour sir

  3. mayankmishra

    very good article…and hilarious too…

  4. mayankmishra

    why cant we print money secretly and give that money to world bank,imf loans ?

    1. E.P.SANTHANAKUMAR

      hi frnds me too having same doubt why can’t we print money secretly and use it for transactions

      1. ABCD

        IMF , WB make use of Dollar as transaction . Even if we still wish to convert domestic currency to Dollar , the result could cause stag-flation .

    2. Nikhil Jain

      We can print money only against our bullion reserve. We cant print more money as it will carash the economy and also decrease bullion reseve.

    3. Anas Mansuri

      but World bank, IMF and other international bodies accept only foreign currency mostly dollars. So we have to print more fake dollars or Yuan like ISI of Pakistan.

  5. Deepali

    Hi Mrunal,

    Very well explained. Appreciate the effort.
    The new layout seems a little distorted. Certain texts are not clearly aligned and the whole thing is justified to the right. I suppose its work in progress.

  6. saurabh verma

    i am a follower of ur site since beigining,i truly enjoyed ur sense to simplfy the hard topic thank you for this .but this new layout version is not comfortable as previous version

  7. sandipan

    I think the correct formula is:

    Fiscal deficit = Budgetary deficit – (Borrowings + Other liabilities)

  8. bhanu singh

    sorry to say but…..anywhere if i am wrong then correct me..please ………….why not discussed about capital recieved and capital expenditure………and this is a question of upsc 2010……how to fiscal consolidate………1-praise to fdi….2-privatisation of higher educational istitutions …3-downsizing of officers..4-offloading/sale shares of PSUs…………………options are…………a-1,2,and 3….b-2,3,and 4……..c-1,2,and 4….d-only 3 and 4

    1. Devesh

      d answer to ur question: 1,2, 4 are ryt

  9. srikanth

    how to calculate gdp article in iyor site not open sir showing error please reslove this problem

  10. srikanth

    money/bitcoins:In this section 4,5,6,7 articles was not open please slove the problem

  11. Neeranshu

    Sir, some of your articles are showing page error.please help to resolve them
    Thanq

    1. Vivek Sahu

      we are not able to check out many old articles, Manu should appoint a committee of retd. judges before going out of govt. on this

  12. Rohit

    aarey yaar…..many of the LINKS in this page as well as other pages arent working :(..

  13. nidhimail.com

    thank you, Mrunal sir

  14. Naseeruddin

    Thank you so much sir i was bit afraid of economy subject but as i started reading your articles i am feeling myself as economics graduate 😛
    My intention of posting message here is i am trying to know MORE about current account deficit but the link which you had provided in this article is NOT working Please resolve the problem
    (TO Friends ..Please help me with current account defict topic mail([email protected]) me if you have previous article of mrunal sir or else other)

  15. Mansi

    mrunal sir.. the link for CAD is missing… please help 🙁 🙁

  16. SHOAIB

    why foriegn investors always put fiscal consolidation as a precondition?they also press inflation to be curtailed…..while funds come india in the expectation of higher interest rate they would get here?

  17. Rahul

    Sir,Can you please explain a bit more about Current Account Deficit.Why it should be compensated only by dollars?
    The link you have given is broken

  18. ravi

    i am not able to find current account deficit , inflation and other basic articles..please help me…

  19. ravi

    wowowow !!! for the inormative article… no teacher cur have explained in a better way.. Take a bow man.. !!

  20. Saurabh Bahl

    I am not able to open web page on Current account deficit. It is throwing a msg “The page you are looking for cannot be found”.

  21. arvind shukla

    Mohan Side question: why do I need to get it approved by the parliament?

    Mrunal sir iska answer nahi mil raha hai

  22. PAWAN DEKATE

    the wau u explain is very licid & clear sir

  23. srikar

    sir nicely explained keep on going…………………………………………………………..

  24. samantha

    Thank u sir…..it is very useful for beginners. ….good idea sir ji….

  25. Abhijeet

    Killer……………………….

  26. vijay

    very well explained sir..thank u very much

  27. kajal

    Thank you so much sir,after surfing so many website this is the best content i ever get

  28. Pratap

    I think the third option that are mentioned for interest of the borrowed money between the discussions of manu and kelkar is not only solution to the interest of borrowed money but also the borrowed money also. without going to borrowed money we can print the money. But the problem is that printing the borrowed money will be more devaluation of rupee than printing the interest of the borrowed money.

  29. ol

    Sir,you are just too good at making someone understand concept base topic…hat to u

  30. rahul

    sir, what if we print notes and spent it on production in a sustainable manner?

  31. Rohan Gupta

    Nice article..good work work mate keep it up..

  32. Vikash kumar

    Sir you are great eco itna easy ho sakta hai kb socha tak nai tha

  33. Subho

    Miss call part was awesome 😀

  34. rohit

    ACCORDING TO SOME INTELLECTUALS STOP PRINTING HIGHER DENOMINATION OF CURRENCY CAN BE AN EFFECTIVE WAY OF CURBING BLACK MONEY GENERATION?WHAT CAN BE NEGATIVE OR POSITIVE ASPECTS..

  35. dr.senthil kumar

    what an idea sir ji for explaining fiscal deficit!!!!!!!!

  36. Priyanka

    Where is answer of mock test to check?

1 3 4 5

Write your message!