Fiscal Deficit - Meaning, components & causes

You’ve likely encountered or heard the term "fiscal deficit" in discussions about government budgets and economic policies. In the recently announced Budget 2024, the government has pegged the fiscal deficit target for FY25 at 4.9% of GDP versus 5.6% in FY24. Understanding this term is important as it provides insight into a country's financial health and policy decisions.

Understanding the fiscal deficit

The fiscal deficit refers to the difference between the government’s total expenditure and its total revenue (excluding money from borrowings).

When a government spends more than it earns, it results in a fiscal deficit. This gap is often filled by borrowing, leading to increased national debt. The fiscal deficit is a key indicator of a government's financial health and its ability to manage its finances.

How is fiscal deficit calculated?

Calculating the fiscal deficit is straight forward. It involves subtracting the government's total revenue from its total expenditure.

The formula is:

Fiscal deficit = Total expenditure − Total revenue (excluding borrowings)

Where

1. Total expenditure: Sum of all government spending, including capital and revenue expenditures.

2. Total revenue: Sum of all government earnings from taxes, duties, fees, and other non-borrowing sources.

Components of fiscal deficit

To fully grasp the fiscal deficit, it's essential to understand its components. These are broadly divided into the components of total income and expenditure of the government.

Components of the total income of the government

1. Tax revenue: This includes income tax, corporate tax, Goods and Services Tax (GST), and other indirect taxes.

2. Non-tax revenue: Earnings from services provided by the government, interest receipts, and dividends from public sector enterprises.

3. Grants: Financial aid from foreign governments or international organisations.

Components of expenditure

1. Revenue expenditure: Day-to-day expenses like salaries, subsidies, and interest payments on previous borrowings.

2. Capital expenditure: Long-term investments such as infrastructure development, healthcare facilities, and education.

Causes of fiscal deficits

1. High government spending: Large expenditures on building public infrastructure, subsidies, social welfare programmes, and public sector wages can lead to a fiscal deficit.

2. Low revenue collection: Inefficiencies in tax collection and lower-than-expected economic growth can reduce government revenue.

3. Economic slowdown: During economic downturns, revenue collections decrease, but the need for government spending on social programmes often increases.

4. Debt servicing: High-interest payments on existing debt can consume a significant portion of revenue, contributing to the deficit.

How does the government balance the fiscal deficit?

1. Reducing expenditure: Cutting down on unnecessary expenses and improving efficiency in public spending.

2. Increasing revenue: Enhancing tax collection mechanisms and broadening the tax base.

3. Privatisation: Selling government stakes in public sector enterprises to raise funds.

4. Borrowing: Governments issue bonds or take loans, though this can lead to increased future debt.

5. Economic reforms: Implementing policies that boost economic growth, thereby increasing revenue collections in the long term.

Also Read: Managing economic cycles with fiscal and monetary policies

Conclusion

Understanding the meaning of fiscal deficit and its impact on a country's economy is essential for comprehending broader economic policies and strategies. Managing fiscal deficit is crucial for the government to maintain sustainable economic growth by funding long-term productive assets. However, high fiscal deficits for a prolonged period can negatively impact economic stability and affect a country's sovereign ratings.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.