Deficit Financing

Deficit Financing is the phrase used to describe “the financing of a deliberately created gap between public revenue and public expenditure or a budgetary deficit, the method of financing resorted to being borrowing from the RBI.”

When the Government has to spend more than what it can raise through taxes, non-tax and other sources, it borrows from the market.It cannot borrow above a certain amount from the market as it may push up interest rates and crowd out private investment.Then it borrows from the RBI. In other words, when the resources from taxes, user charges, public sector enterprises, public borrowings, small scale borrowings and others are not enough, RBI is approached for loans. It is called deficit financing.

Managing Fiscal Deficit

Reduction of fiscal deficit is important as Large and persistent fiscal deficits are a serious cause of concern because it poses several risks:

• First, fiscal deficits may cause macroeconomic instability by inflating the economy as money supply rises.
• Second, they negatively impact on savings rates, reducing investment and jeopardizing the sustainability of high growth.
• Thirdly, private investment may be crowded out. Interest rates go up to make cost of credit high for investment thus pulling down growth.
• Fourthly, the continuing large deficits, even if they do not spill over into macroeconomic instability in the short run, will require higher taxes in the long term to cover the heavy burden of internal debt.

High tax rates will place India at a significant disadvantage to other fast-growing countries. Also, as the FRBM Act says, inter generational parity is hurt if debt mounts as future generations will have to pay higher taxes to help the government repay the debt.However, the extent of reduction and the manner of reduction matter. More resources should be raised on the revenue side (taxes etc). Expenditure control should not involve cuts on social sector expenditure as it hurts the poor and demographic dividend cannot be reaped.