The government all over the world need money to function and deliver certain services. Though the government gets the money from its taxpaying individuals and companies, it is not enough.
Therefore, the government chooses to borrow from the markets. However, the government belongs to people and when the government borrows money, it borrows on the behalf of people.
Have you ever wondered what would happen if the government is unable to pay the debt it took? Ideally, one should borrow as much as it can repay. Nevertheless, is there a limit to how much a government can borrow?
For a long time, the situation went without any control. The government had no limits over its debts. However, the government is liable to its citizens in a democratic country. To put a limit to it arrived Fiscal Responsibility and Budget Management (FRBM) Act in 2003. The piece dives in the checks and balances over government fiscal discipline.
The difference between demand and supply is a deficit. Therefore, when we say 'fiscal deficit,' it is the difference between expenditure (the demand for money) and receipt (the supply of money) of the government. If government has to spend Rs.100 but has only Rs.70, the fiscal deficit is Rs.30 (or here 30%). Government goes out and loans this Rs.30.
Out of all the money it earns, some of it comes from recurring activities, like a tax. This recurring money coming to government is 'Revenue receipt.' The government gets its tax every year. The profits from PSUs, interests received on money lent are all part of this revenue receipt.
The government also has to bear some recurring expenditures. It has to pay interests on debts it has taken and pay salaries of all the employees nationwide. All such activities are borne as 'Revenue expenditure.'
This difference between Revenue receipt and revenue expenditure is called as 'Revenue Deficit.'
However, sometimes, the government buys land and machinery to support its growth. The money paid to purchase such assets is 'capital expenditure'. On the other hand, the government sometimes sells off its assets. For example, the PSU disinvestment, the money generated on the sale of assets, is called 'capital receipt.'
The fiscal deficit is a collective term for revenue and capital deficits.
What does the government plan?
The government has a singular aim. It is to reduce all its deficits and earn more than it spends. While it wants to minimize its fiscal deficit, the government should eliminate its entire revenue deficit.
Revenue deficit is bad because it is creating no value or asset. It is the money being spent on operations. To understand the evil of revenue deficit, assume the state of a person with a salary of Rs. 10000 buys an expensive watch for Rs.15000. He is under a debt of Rs.5000 with only that fancy watch with him.
Capital expenditure is not as bad if under control. It is as if a person with Rs.10000 salary buys a new machine in his office for Rs. 15000. He owns an asset. Though he is under a debt of Rs.5000, that machine would improve his productivity and increase his earnings in the coming time.
Hence, though fiscal deficit should be minimized, it is okay if it is spent on creating more assets, but to a specific limit.
The FRBM Act
The FRBM Act actually plays a vital role here. It clarifies the government of its fiscal responsibilities. It tells the government how much it can afford to loan, and hence government prioritizes accordingly.
The act establishes that fiscal deficit should be brought down to only 3% of GDP. This target has been deferred many times since 2008. However, the amended act of 2018 makes it tough to be delayed. Now this target has to be achieved by FY 2021. The government also targets to eliminate revenue deficit (0%).
It caps the total debt taken to only 60% of total GDP (40% for the center and 20% for states). Assume one buys a machine worth Rs. 50000. All his belongings collectively value Rs.1 Lakh. His earning is Rs 10000, he loans Rs. 50000 to buy the machine with an EMI of Rs. 12000 per month.
Now, if he were a nation, the total debt on him is Rs.50000. The value of debt is 50% of his GDP (Rs 1 Lakh). Since his earning is Rs. 10000 while he has to pay Rs.12000, this shortfall of Rs. 2000 is his deficit (2% of his GDP).
India’s current debt is 70% of its GDP.
What if there is a calamity?
The act carefully carves out escape clauses. The government is allowed to borrow and spend more than its fiscal deficit in the conditions of war and natural calamity.
In addition, if the government acknowledges the failure of one of its structural reforms, it is allowed to jump the line to provide respite to people. Moreover, it is also permitted if GDP falls more than three percentage points as compared to the previous year.
However, in either case, the deviation cannot be more than 0.5%. That means fiscal deficit can vary to 3.5% of GDP, while revenue deficit may reach 0.5% of GDP.
This act is a much-needed reform India has been waiting for. As citizens, it is our responsibility to hold the government accountable for its extravagant spending.
This act tries to inculcate fiscal discipline in the governments. If governments follow it, it will prevent India from falling into default traps like Greece or Venezuela forever. We have all been taught since childhood to eat only as much as we can chew. Maybe it is a good time for governments to follow the same.