FISCAL DILEMMA

1. Context

The elevated levels of India’s fiscal deficit and public debt have been a matter of concern for a long time in India. Even before the COVID-19 pandemic, debt levels were among the highest in developing and emerging market economies. The pandemic pushed the envelope further and relative to GDP, the fiscal deficit in 2020-21 increased to 13.3% and the aggregate
public debt to 89.6%. As the economy recovered after the pandemic, the deficit and debt ratios have receded to 8.9% and 85.7%, respectively.

2. Fiscal Deficit

A fiscal deficit is a financial situation that occurs when a government's total expenditures exceed its total revenue or income during a specific period, usually a fiscal year.
In simpler terms, it means that the government is spending more money than it is earning through various sources, such as taxes, fees, and other revenues.
The fiscal deficit is an essential indicator of a country's financial health and reflects the gap between the money the government spends on public services, infrastructure projects, social welfare programs, defense, and interest payments on existing debts, and the money it collects from various sources.
When a government faces a fiscal deficit, it needs to finance the shortfall through borrowing.
Governments typically borrow money by issuing government bonds or taking loans from domestic or international financial institutions. The accumulated borrowing over time leads to the creation of national debt.

3. Causes of Fiscal Deficit

Economic Downturns: During economic recessions or downturns, government revenues tend to decline as economic activity slows down. At the same time, government spending may increase to provide stimulus and support to the economy. This combination of reduced revenue and increased expenditure can lead to a fiscal deficit.
Insufficient Tax Revenues: If a country's tax collection system is inefficient or ineffective, it may not generate enough revenue to cover the government's expenses. Low tax compliance rates, tax evasion, or outdated tax policies can contribute to a fiscal deficit.
High Public Spending: Governments may have high spending commitments, including expenditures on public services, infrastructure development, defense, and social welfare programs. If spending is not matched with adequate revenue generation, it can result in a fiscal deficit.
Social Welfare Programs: Social welfare initiatives, such as healthcare, education, unemployment benefits, and pension schemes, can be costly for the government. While they are essential for the well-being of citizens, funding these programs without appropriate revenue sources can lead to fiscal deficits.
Interest Payments on National Debt: If a significant portion of the government's budget is allocated to servicing the interest on the accumulated national debt, it can strain the budget and contribute to a fiscal deficit.
Infrastructure Investment: Governments often invest in long-term infrastructure projects, such as roads, bridges, and public transportation systems. While these investments can promote economic growth, they require substantial initial funding and can contribute to a temporary fiscal deficit.

4. Public debt

Public debt, also known as government debt or national debt, refers to the total amount of money that a government owes to external creditors (such as foreign governments, international organizations, and investors) and domestic creditors (like individuals, banks, and institutions) resulting from past borrowing and deficit financing.
It is a key component of a country's overall debt burden and is a measure of the government's accumulated financial liabilities over time.
Governments borrow money to finance various activities, including infrastructure development, social welfare programs, defense, and other public services when their expenses exceed their revenues.
The main sources of public debt include issuing government bonds, treasury bills, notes, and loans from domestic and foreign lenders.

Public debt can be classified into two main categories:

Internal Debt: This refers to the debt owed by the government to its own citizens and domestic institutions. Internal debt is denominated in domestic currency and is typically held in the form of government bonds, savings certificates, and other securities.

External Debt: This refers to the debt owed by the government to foreign lenders and entities. External debt is denominated in foreign currencies and may include loans from international financial institutions, foreign governments, and private investors.

5. Challenges of High Fiscal Deficits and Debt in India

Debt-Dynamics Equation: When GDP growth surpasses effective interest rates on government bonds and there's no primary deficit, overall debt declines. However, financial repression to keep interest rates low can cause distortions in the economy.
Costs of High Deficits: Carrying high deficits and debt has significant costs for the economy. Interest payments consume over 5% of GDP and 25% of revenue, hindering investment in education, healthcare, and infrastructure.
Impact on Fiscal Policy: High debt levels limit the government's ability to implement counter-cyclical fiscal policies and respond to economic shocks effectively.
Captive Debt Market: The debt market in India is primarily dominated by commercial banks and insurance companies, leading to limited resources for lending to the manufacturing sector and higher borrowing costs.
Impact on Sovereign Rating: High deficits and debt can lead to lower sovereign ratings, increasing the cost of external commercial borrowing.
Inter-generational Burden: Large deficits and debt burden future generations as today's borrowing is taxing tomorrow.
Regional Disparities: States like Punjab, Kerala, Rajasthan, and West Bengal face higher debt-to-GSDP ratios, exacerbating economic challenges.
Green Transition: High debt levels may impede funding for emerging priorities like transitioning to a green economy.
Difficulty in Calibration: High debt makes it difficult to calibrate fiscal policies effectively to address economic fluctuations.
Need for Prudent Fiscal Management: Addressing high deficits and debt requires prudent fiscal management to ensure sustainable economic growth and development.

6. Challenges of Fiscal Consolidation and Policy Interventions

Achieving the recommended debt-to-GDP ratio of 58.2% (14th Finance Commission) seems unfeasible in the medium term.
Even before the pandemic, aggregate public debt was at 74.3% in 2019-20, reaching 89.7% in 2020-21 due to the pandemic.
Despite a nominal GDP recovery of 18.5% in 2021-22, the debt ratio declined only slightly to 85.7%.
The high primary deficit in 2022-23 (3.7% of GDP) and budgeted deficit in 2023-24 (over 3%) indicate persistently elevated debt levels.
The stable Goods and Services Tax (GST) platform is expected to improve tax administration and compliance, increasing the tax-GDP ratio by 1.5 to 2 percentage points in the medium term.
The need to reconsider the state's role and vacate activities better suited for the market rather than competing with it.
The slow pace of disinvestment at the central level is a concern.
Enforcing rules on States' borrowing is crucial to impose hard budget constraints and ensure macroeconomic stability.
Cash transfers are preferred over subsidizing commodities and services for effective redistribution.
The Union government should lead by example in following and enforcing fiscal responsibility rules effectively in States.

For Prelims: Fiscal deficit, public debt, fiscal consolidation, 14th finance commission, Tax-GDP ratio.

For Mains: 1. Discuss the concept of public debt and its significance in the context of fiscal sustainability. Examine the key sources of public debt and the reasons why governments resort to borrowing. (250 words).

Source: The Hindu

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