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

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

Continuing episodes of technical incorrect economy.

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

Mohan is busy uploading (un)funny photos in his facebook album and tagging randomfriends 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 percentfor 2012-13. This is very dangerous; you need do fiscal consolidationimmediately!

Mohan Ya but what is fiscal deficit and why is it dangerous?

Kelkar What? 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 revisethe standard reference books either, so I’m unable to recall the conceptsright now, just like a no0b player of UPSC.

Kelkar Well fiscal deficit (FD) = Budgetary Deficit + Market borrowing + otherliabilities of Government

Mohan Please Explain in English, from the very beginning.

Kelkar

Ok then let us start from thebeginning.Every year, the Government puts out a plan for its income and expenditure for the coming year. This is, called annual Union Budgetand you need to get it approved by the parliament.

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

Kelkar For the answer Click ME

Mohan Ok 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 money Outgoing Money

Incoming money is divided into two parts. Tax and Non Tax

And outgoing money is divided into Plan and Non plan Expenditure.

Incoming Outgoing

Tax Non Tax Plan Non Plan

Kelkar: We can further refine this classification into Revenue/capital receipts andExpenditure.

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 money Outgoing

Tax RevenueNon Tax Revenue Plan

NonPlanDirect Tax Indirect Tax

1. Fees Collected (Drivinglicense, RTI, Passport)

1. income tax2. Corporate tax;3. Wealth tax4. Capital gain tax

(Vodafone case)

1. customduty,

2. exciseduty,

3. servicetax.

4. VAT

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 fiveyear plan. (FYP)

Non-plan Expenditure, obviously means spending money on activities that are notrelated with national five year plan. Check the table for examples.

Incoming Outgoing

Tax Revenue Non TaxRevenue

PlanExpenditure

Non PlanDirect Tax Indirect Tax

1. incometax

2. Corporatetax;

3. Wealthtax

4. Capitalgain tax

1. customduty,

2. exciseduty,

3. servicetax.

1. FeesCollected(Drivinglicense,RTI,Passport)

2. Fines andPenalties(Trafficviolationetc)

3. Incomefrom PSU(e.g.profitfromAirindia

1. MNGREA2. Janani

SurakshaYojana

3. JNNURM4. Indira

Awas

1. Salary ofjudges,bureaucratsand armymen

2. Buying newtanks andmissiles

3. Subsidies:Petrol,Keroseneetc.

4. Light bills of

(Vodafonecase)

4. VAT (lolz)4. Gifts.

(discussed

in 2nd

ARCarticle)

5. Grants(ForeignAid fromUN, Japanetc)

Yojana Governmentoffices.

5. Luxury Travelbills ofPratibha.

Mohan: ok so now what?

Kelkar: Now we classify the budget according to the balance between incoming andoutgoing money.

Types of Budget=Deficit,Surplus,Balanced

When It is called a

outgoing money > incoming money deficit budget.

outgoing money < incoming money surplus budget.

outgoing money = incoming money balanced 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 ahuge army, keep buying new tanks and missiles.

As long as there are poor people, we’ll have to keep running various Governmentschemes.

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 primarydeficit – 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.

In the 1980s, Sukhmoy Chrokroborthy Committee came up with the fiscal deficitformula

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 theidea 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.Click on Image to Enlarge.

Mohan then simply borrow money and fill up the pothole! What is the problem?

Kelkar

problem is “Paisaa Ped pe toh nahi lagtaa” (Money doesn’t grow ontrees). When you borrow money, you’ve to pay interest (�याज) to theparty, every year.To pay this interest in the future, you’ve threeoptions.first option =Increase the current taxes or create new taxes.

Mohan Not a good idea sir-ji.

Kelkaralright, Second option =Create policies to help stimulate economic growthso that tax collection automatically increases with it, like FDI in aviation,power sector, retail, insurance and so on.

Mohan But 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.

Mohan Now this third option sounds great :D

KelkarActually that’s the stupidest of all three solutions. Let me explain with theusual 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 whichevery 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 asearlier.So, there will be one customer offering Rs.400 per kilo of onion, then another guywould 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 hedefinitely extracts work worth more than 10 lakhs from you and sells somegoods/services to a third client. That’s why giving you 10 lakhs doesn’t increaseinflation. (because some other client is buying the services you had produced).but giving 10 lakh to a poor without making him economically productive = increasesinflation.

Hence printing money to solve problems= not good idea.

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 peryear to buy wheat.Since this Rs. 1 crore is spent to purchase ten thousand quintals of wheat, thecost of wheat is Rs. 1,000 per quintal.

Now suppose that to repay some of its debt, the Government decides to printsome 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 wheatnow costs Rs. 1,100, a 10% increase! (1.1 crores paid for ten thousandquintals = 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 firstoption – 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 amountof wheat production, then the inflation could have been avoided. (for exampleborrowing money to create new canal or irrigation project)If Such irrigation project led to an increase in wheat production from 10,000quintals 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 inflationClearly then, it was a good thing that the Government borrowed money toimplement 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 unproductiveprogrammes which do not increase economic productivity. (For exampleMNREGA, most of the money is eaten midway by the Sarpanch and Localofficers.) =BadNow 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 outgoingmoney is more. So, incoming money is less = tax collection machinery is noteffective = 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 cancompletely destroy a country. =very bad.

Bond Yield increased

From Eurozone Greece Exit article, You already know what is bond yield. If not clickme

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 ratherthan going into education or healthcare.

Crowding out investment

We already saw that, Fiscal deficit pothole can only be filled with cash. This cash hasto 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 needybusinessman will have to borrow money at higher interest from another party (this ishow fiscal deficit increases ‘interest rates’)= input cost of product increased = hewill increase the MRP of his product or service to maintain the same profit margin =inflation. (cost-push type)

Twin deficit hypothesis

This hypothesis says that as the fiscal deficit of the country goes up its tradedeficit (i.e. the difference between exports and imports) also goes up.Hence, when a government of a country spends more than what it earns, thecountry also ends up importing more than exporting.In India, the trade deficit story is basically about oil and gold – two commoditiesthat 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. (wealready discussed it earlier, click ME)CAD is another pothole but it can be filled only with foreign currency (mostlydollars!)This increases the demand of dollars in Forex Market = rupee weakens againstdollar= 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 priceof oil to the end consumer and thus ‘subsidises’ diesel, LPG and kerosene .So oil companies sell at a loss, and the government compensates thesecompanies for the loss (by giving them bonds).

This increases government expenditure, which, in turn, increases the fiscaldeficit.

Interest Payment

In this financial year alone (2012-13), the government will pay more than 4 lakh crorejust as interest payment on debt taken earlier! = more imbalance between incomingand 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 thecausality 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 costof oil in rupee terms — leading to a higher fiscal deficit.

Now in the opening lines, Kelkar said Fiscal deficit would be around 6%. What doesthat 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 secondform (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 thepercentage 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 tryand 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 makingthem more economically productive = dangerous because of the various reasonsseen above.

Fiscal Consolidation: What is it?

Mohan

ok 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 deficitproblem in its root and preventing heavy fiscal deficits situation fromoccurring in future.

Mohan But How can we do that?

Kelkar Just 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 blackmoney6. stop ministers from using Business class airtickets and other

wasteful Government expenditures. (= take austerity measures)

+ Policy reforms such as FDI (to create environment conductive foreconomy = that will automatically increase productivity and tax collection.Recall the second option.)

Mohanhmm that itself sounds like a problem. I think I should make anotherCommittee (so that I don’t have to implement its recommendations). Letme check my phonebook for retired judges.

KelkarSir this is the matter of economy not railway accidents. It requires anexpert on economy.

Mohan Then make a Committee headed by Montek Singh

Kelkarbut Media won’t like his recommendations. (Everyone who earns morethan Rs.20 is not a BPL and he should pay 10% income tax.)

Mohan Then make a Committee headed by some columnist from The H*****!

KelkarBut Madam-ji wouldn’t like his recommendations. (hand over FinanceMinistry to Fidel Castro)

Mohan Then whom should I appoint?

Kelkar The expert is sitting in front of you.

Mohan

Alright, tomorrow morning you goto the finance Minister along with yourclass 10,12,college marksheets, extra-curricular activity certificates andjob experience certificates (if any) and get the appointment letter fromhim.

Kelkar

What???

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 ofIndia!

and now you’re asking the Vijay Kelkar to submit his class 10-12marksheets and extra curricular activity certificates?

MohanChillx. I was joking. You may go now. If I need any more help, I’ll give youa miss call.

Kelkar PM and miss-call? Another joke?

MohanNo, I’m serious! Miss call= Government expenditure on phone billsreduced= fiscal consolidation.

Kelkar Whaat an idea sir-ji.

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

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

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

Mock Questions

Which of the following statements are correct?

1. Salaries paid to Constitutional bodies is an example of Planned Expenditure2. 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 itsshareholding 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 onhttp://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/

URL to article: http://mrunal.org/2012/09/economy-fiscal-deficit-fiscal-consolidation-kelkar.html

Posted By On 30/09/2012 @ 23:42 In the category Economy