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Effect Of Fiscal Deficit On Inflation

The budget deficit is nothing more than the difference between the expenditures of the government and the tax revenues that government receives (Galbraith and Darity, 1995), similarly fiscal deficit too is termed as the difference between government’s spending and earnings, the difference between budget deficit and fiscal deficit is that in fiscal deficit the earnings from borrowings and liabilities is not counted (see appendix). For comparative purposes it is expressed as a percentage of Gross Domestic Product (GDP) of a nation.

Fiscal deficit holds an important position in macroeconomics theory literature because they have substantial effect on indicators of macroeconomic performance of a country like inflation, growth and as a consequence of these imbalances debt financing and debt management also becomes necessary. The stability of macroeconomics environment of a country is not only critical for business it is also important for country’s overall competitiveness in global spectrum (Fischer, 1993 global competiveness report). There are number of macroeconomic indicators like GDP, inflation, trade balance, current account balance, foreign exchange reserves, foreign investment inflows (exim bank, 2010). Fiscal deficit itself is an important macroeconomic indicator and it has direct effect on other macroeconomic indicators.

In spite of having such importance it is easy to ignore fiscal deficits because they do not have immediate effects, it is just like obesity. In case of obesity there is no immediate concern except the clothing size gets increasing, but in long turn obesity increases the risk of chronic heart attack or diabetes (Feldstein, 2004). Like obesity deficit is also caused by self-indulgent living that is governments spending more than its revenues. Another similarity of fiscal deficit with obesity is that severe the problem (obesity/fiscal deficit) more difficult is to correct it. (Feldstein, 2004). One of the biggest problems with running fiscal deficits is that it curtails the government’s ability to react to business cycles ( expansion, peak, contraction, trough and recovery of economic activities in a country) and this in turn increases economic and political instability in a country (global competitiveness report 2009).

2.2 Various effects of fiscal deficit:

Fiscal deficit is associated with various macroeconomic indicators like inflation, overall growth, trade deficit, capital deficit. Certain economic factor like crowding out effect is also associated with fiscal deficit. Apart from these factors fiscal deficit has strong connection with political and administrative factors like democracy and subnational governance. This section would look into these factors critically.

2.2.1 Effect of fiscal deficit on inflation

Monetarist argue that inflation is a monetary phenomenon while the structuralist school stress focus on structural factors prevalent in a less developed country to explain inflationary processes ( Ashra et al, 2004). Enlargement of fiscal deficit in relation to the overall economy increase money supply which in turn leads to accelerated inflation. This could be summarised as follows:

Figure 1. How positive fiscal deficit increases inflationary tendencies

Source: Ashra et al, 2004

Macroeconomic theory states that persistent fiscal deficits are inflationary (Catao and Terrones, 2005). Sargent and Wallace, 1981 support the fact that fiscal deficit increase inflation theory and add that a government facing persistent deficit has to sooner or later finance these deficits with money creation ‘Seinorage’ thus producing inflation. Alesina and drazen,1991; Cukierman et al. 1992, Calvo and Vegh,1999 further added to this theory of fiscal deficit and inflation especially for developing countries because these countries are less tax efficient, less politically stable and have limited access to external borrowing all these factors lower the relative cost of Seinorage and thus increase dependence on the inflation tax. Monitiel, 1989 and Dornbusch et al. 1990 have a slight variation in their view they suggested that fiscal deficits makes room for inflation rather than playing the driving force. Blanchard and Fischer, 1989 in his paper mentioned that empiricaly little success has been met in finding a significant relationship between fiscal deficit and inflation however later fisher et al, 2002 using a panel of ninety four countries were successful in breaking his dilemma and proved that fiscal deficits is among the main drivers of high inflations. He further proved from his work that one percentage point improvement or decline in the ratio of fiscal balance to Gross Development Product typically raise or declines inflation by 4.5 percent.

Apart from the above studies trying to find a link between fiscal deficit and inflation few more studies have been done to obtain empirical support for cyclically recurring process of deficit-induced inflation and inflation-induced deficits. Aghelvi, 1977 did such study for Indonesia Aghelvi and khan 1978 for Brazil. Later Sarma 1992 followed the Aghelvi khan model and did a similar study for India and came to a similar result that deficit induce inflation and vice versa. Heller 1980 differed from these studies while doing a case study of 24 developing countries; his study found that cyclic recurring of fiscal deficit is not always true. Naastepad, 2003, not only regarded fiscal deficit as the main cause of inflation but also with balance of payment crisis and poor investment performance and growth in developing countries.

Although many economist have successfully linked fiscal deficit with increasing inflation, other economist have doubts regarding the above said relation although none of the doubting researchers were able to prove their point by their researches. On the whole it could be said that fiscal deficit has a strong direct relation with inflation.

2.2.2 Effect of Fiscal deficit on growth

Great degree of attention has been devoted in both theoretical as well as empirical literatures towards possible impact of different fiscal measures on growth (Adam and Bevan, 2005). While theoretical aspect points out the constraint in government budget where change in one aspect needs to be countered by changes elsewhere. Empirical literature clearly supports the fact that variations in subset items are growth neutral (gemmel, 2001/ 101 pdf). Eminent group of economists like Easterly et al. (1994), Kneller et al. (2000) and Miller and Russek (1997) assume that relation between deficit and growth is linear. Although Giavazzi et al. (2000) found their study to oppose the linear relationship of deficit and growth. Adam and Bevan, 2005 worked on the lines of Giavazzi and found that linear representation between deficit and growth reasonably fits the case of developing countries. At low levels of fiscal deficit the non-linearity is masked. They also found that for low and middle income countries the relation is non-linear.

2.2.3 Effect of Fiscal deficit on trade deficit

Fiscal deficit had been linked with trade deficit by certain researchers (Rosensweig and Tallman, 1991 1992) and these two are referred as twin deficits. Milne (1977) in her study of 38 countries finds a positive statistical relation between trade deficit and fiscal deficit. Arunro and Ramchandar,1998 have gone one step ahead and added that current account and fiscal deficits have important policy implications on a nation and they effect long term viability of economic progress of a nation, this implies that if the basic reason for rising trade deficit is the increasing central government budget deficit then the trade deficit cannot be corrected until the government deficits are put in place. However if such a view (role of budget deficit in trade deficit) is not correct then reductions in government budget deficit would not resolve the problem of trade deficit (Belongia and Stone, 1985). Enders and lee, 1990 and Abell, 1990 slightly differed from this point and suggested that there is a casual effect of movement in government deficit on trade deficit and contrary to all these Evan (1989) provides empirical evidence that there is no relation between the two deficits that is trade and fiscal deficit.

2.2.4 Crowding out effect of fiscal deficit

Due to an increased government spending often there is reduction in private investment and consumption this is known as crowding out in economics. Theoretical economic literature identifies two variants of crowding out real and financial. The real or direct crowding out occurs when an increased public investment displaces private capital formation, the real or direct crowding does not depend on the mode of financing the fiscal deficit (Blinder and Solow, 1973). Financial crowding is a phenomenon of partial loss of private capital formation, the reason for its occurrence is the increase in interest rates that is caused as a result of “pre-emption of real and financial resources by the government through bond-financing of fiscal deficit” (Buiter,1990) (wp06). Economist have empirically tested the real crowding out and found contradictory results. Ramirez (1994), Greene and Villanueva, 1990) in their study found that there is a complimentary type of relationship between public and private investment, the reason behind this analogy among the economists is the fact that increase in public capital formation stimulate aggregate demand and therefore increases private investment. It was also supported by the fact that higher stock of public capital, in particular infrastructure increases the return of private investment projects Aschauer (1989), and Erenburg (1993). (wp06)

Contrary to these views Blejer and Khan (1984), Shafik (1992), Parker (1995), found from their researches that there exists evidence for crowding out between public and private investment. These set of studies on crowding out argued that public investment might act as a substitute for private investment Sunderrajan and Takur (1980), Krishnamurty (1985), Kulkarni and Balders (1998). (wp06)

2.2.5 Democracy and subnational effect on fiscal deficit

In a democratic nation divided governments and alternating governments are the two main factors of a political system that generate myopic and inefficient policies (Person and Tabelliniu, 2000). Political competition assures that the current ruling party can lose in the next upcoming election, this modifies the planning of government. The incumbent government knows this fact and thus can induce an excessive expenditure because future costs are not completely internalized. The incumbent government strategically misbalances its count to improve its probability of re-election (Alsina and Tabellini, 1990) (5.pdf)

In democracy a political bias exists in favour of deficit finance. (Buchanan and Wagner,1977). Politicians at periodic bases face test of their incumbency. The budgetary policies can enhance or retard the likelihood of their remaining in office. Generally tax reductions and increase in expenditure strengthen a politician’s base of support contrarily If the politician increases tax and reduction in expenditure this will tend to weaken his base. It is noticed that politician use budgetary policy to strengthen their electoral base this in turn increases state expenditure and reduces taxes (bbfratc, Wagner and Tollison), which harms the fiscal stability and give rise to deficit. (Buchannan and Wagner, 1977) are of the view that balanced budget which has mix of deficit budget and budget surplus is better for macroeconomic stability of any country.

Rodden (2002) states the fact that the fiscal deficits are greater in nations where subnations are more dependent on national transfers for financing their spendings and where they have freedom of borrowing from capital markets. Wibbels, 2003 also supports the statement and his work shows fiscal deficits are larger in federal compared to unitary nations in the developing world.

2.2.5.1 Is a strong central government a solution for fiscal deficit in subnational governance?

As a solution large number of researchers had advocated a strong central governments with the authority to impose hard budget constraints on subnations by monitoring and regulating subnational debt ( poterba and von hagen, 1999) If at central government is a single majority government then the national party leaders can force the subnationals to internalise the cost of their policies towards national fiscal stability( Samuel, 2000; stepan, 2000) Khemani, 2007 summarises this by stating the fact that a dominant national party leading the centre as a favourable condition for fiscal discipline in a federation. Wibbels, 2003 argues to the above discussed statement he opines that if the central authority is strong enough to impose discipline on subnational governments then there are chances of the central government itself getting disciplined by market considerations of efficiency. Khemani, 2007 in his work found that if the government in centre and state is of same political party then the level of deficit is more compared to states governed by opposing political parties. The reason behind this could be the financing of the deficit of these states is by means of subsidized credit taken from financial markets. These financial markets are indirectly controlled by central government (same political party).

2.2.5.2 Subnational governance in Indian context

The 1991 economic liberalization policies not only specifically reduced central control over industrial policy and public sector investments but also increased prominence of state level regulations. This increased competition among states for private investment (Sinha, 2004). From 1960 to present, state governments are responsible for 50 percent to 60 percent of total government expenditure in india ( rao and singh, 2005). While seeing the revenues it was found by Rao and Singh, 2005 that state governments collect nearly 30 percent of the total revenue. The reason behind this discrepancy is the fact that revenue generation power of state governments is limited compared to high yielding tax assigned to the central government.

State deficits are financed majorly by direct loans from central government ( constituting about 60 percent of total borrowing by major states) and the rest is financed by borrowings from financial markets. These market sources are heavily regulated by the centre ( khemani, 2007). State also gets finances by means of borrowings from state owned public enterprises. The burden of these borrowings also fall ultimately on central government (mccarten,2003) new 1pdf Nooruddin and chibber, 2008 found in a study that voters support parties in expectation of benefiting from state expenditure on public service. When state lacks the fiscal space necessary to provide public services, voters have little to re-elect these parties and look forward to alternative choices. New 3pdf

2.3 Sustainability of fiscal deficit

Fiscal deficit has a strong effect on macroeconomic scenario of a nation. If ignored it leads a nation to serious economic problems. Several countries in past have ignored fiscal and as a result have faced severe problems. Therefore it becomes of prime importance for a country to adopt a sustainable fiscal deficit policy.

2.3.1 Sustainability of global fiscal deficit

Government’s policies that influence various macroeconomic conditions are termed as fiscal policies. These policies affect macroeconomic indicators and government effort to control the economy of the country. In long run these policies should be feasible so that various macroeconomic indicators does not clash among each other, this is known as sustainable fiscal policy. To analyse the sustainability of fiscal policy two approaches have been used by Uctum and Wickens, 2000 (1) testing the staionarity of debt or deficit (2) other studies looking at the cointegration relationship linking the primary deficit.

Blanchard et al 1990 using sustainability indicator find that most OECD countries have sustainable policies in the medium term. European stability and growth pact has made two important implications for fiscal policy. First it puts limit 3% of GDP as the maximum budget deficit and secondly it imposes fines on those counties who have excess to this percentage (Hallet and Mcadam, 2003). The idea behind these implications is that random shock or cyclical movement should not take deficit beyond 3% except in exceptional circumstances (Eichengreen, 1997). If problems are found in fiscal sustainability consequently programmes are run in these countries to counter the problem of fiscal deficit. Interestingly experiences have shown that such programmes aiming to reduce fiscal deficit usually fail to restore price stability and reduce current account deficit in short run ( Taylor,1990; Corbo and Fischer 1995; Rodrick 1995).

2.3.2 Sustainability of Indian fiscal deficit

India has faced both current account deficits and budget deficits since 1960s (infact from the very first union budget but the phenomenon of fiscal deficit became more prominent from the sixties). Economists have considered these twin deficit problems as two unrelated problems (Parikh and Rao, 2006). Virmani, 2001 was among first to argue that because of roles of invisibles in India’s balance of payment the methods of financing budget deficit have implications for current account deficits, so these two are inter related. Similar conclusion was reached by Cerra and Saxena, 2002. Anuro and Ramchander, 1988 found using granger casualty test that unlike many developed countries causations in India seems to runs from current account deficit to fiscal deficit.

India has one of the highest overall national fiscal deficits in the world (Buiter and patel, 2006) (new11) and India’s inflation depends on both domestic supply and world inflation (Minford and Walters, 1989). In Indian context many economist have expressed their concern over the building governments deficit and mounting debt, solvency condition seems to be violated in Indian case and there are chances that with existing trend the public sector may become bankrupt in finite times (Buiter and Patel, 1992, 1995; Jha 1999)(new 4)

Many studies have tested sustainability of public debt in Indian context. Buiter and Patel (1992) tested sustainability of debt of various public sectors (centre, state government and public sector units) and found that Indian public debt was unsustainable. Rajaraman and Mukhopadhay, 2000 after performing stationarity test on aggregate public debt series of the central and state government between periods 1952 to 1980 found that debt- GDP ratio is on unsustainable path. Contrary to these studies Goyal et al , 2004 conducted a series of tests on central, state and combined finances and found that individually the finances of both the central and the state are unsustainable, the second of the their test conclude that combined finances of centre and state are sustainable when structural break is taken into account. The reason behind these findings could be that India is a vast country and has twenty eight states and seven union territories. The state government have independent executive, legislative and judicial wings and this fact makes sustainability of public finance an important issue ( Goyal et al, 2004) ( pdf 9).

As said above indian debt-GDP ratio is not on sustainable path to bring it on sustainable path indian government passed the Fiscal Reforms and Budget Management Act (FRBMA) in 2003, it is an important institutional mechanism formed to ensure fiscal prudence and support for macroeconomic balance. According to the Rules framed under the Act the target was to eliminate revenue by 31 March 2009, and fiscal deficit to be reduced to no more than 3% (much on the lines of European stability and growth pact) of estimated GDP by March 2009 (11th five year plan growth vol. 1, 2008)

The legitimate size of a sustainable fiscal deficit is debatable but it is beyond any question that India’s fiscal deficit is not on the higher side but on the danger level, and unless it is handled properly by reducing it in an planned and determined way it will pose as a serious threat both on the broader reform processes as well as ability and creditability of the government to meet prioritized infrastructure and other social expenses (Shirazi and Zagha, 1994) (11 pdf). The major factor that have added to the growth of fiscal deficit in India and many other developing nation are subsidies, public transfers and interest payments (Roy and Tisdell, 1998)

2.5 measures to achieve sustainable fiscal deficit

The causes and consequences of rising government deficit had received attention in both developed countries and less developed countries( Blanchard, 1985; Buiter and Patel, 1992) .Recordance equivalence (re) theorem had been widely discussed in context of funding government deficit (Barro,1987; Seater 1993) RE theorem states that whether the budget debt is financed by debt issue or tax increase it is inconsequential, such an equivalence arises because today’s deficit financing acts as tomorrow’s tax liabilities (Ghatak and Ghatak, 1996, new 10). Also as discussed earlier the association of fiscal deficit with subnation governance has some serious setbacks. There in order to look for sustainable fiscal deficit policy both these issues need to be sorted out.

2.5.1 Fiscal decentralization

Fiscal decentralization occurs through transfer of monetary powers or authorities for public spending and revenue collection from central to local government (Neypati, 2010,new 8). Fiscal decentralization is considered to be a feature of economic reform programme because of certain points (1) since local governments have better local information decentralization of spending increases efficiency and therefore better chances are there of it matching with the preferences of citizens (Oates, 1972, 1993) (2) fiscal decentralisation increases accountability and transparency of public goods (De Mello 2000a) (3) tax payers are more comfortable with accountable local governments ( Wasylenko, 1987) with all these factors it appears that fiscal decentralization can become an important tool to reduce debt.

2.5.1.1 Problems with fiscal decentralization

But contrary to this Neypati, 2004 and king and Maa 2001, both find negative relation between fiscal decentralization and inflation (one of the main characteristics of fiscal deficit). Jin and Zou, 2002 found in their research that although expenditure decentralisation increases the size of government aggregate but revenue decentralization has the opposite effect. De Mello 2000b did research on number of countries and found that fiscal decentralization helps in reduction of government debt, especially in low income countries. Zang, 2006 and Bouton et al, 2008 said that without a proper central redistribution system fiscal decentralisation may give rise to a more unequal income redistribution if revenue bases vary across regions. Tanzi 2000 adds that effectiveness of fiscal decentralisation depends upon factors such as size of country, extent of privatization in economy, local government’s ability to raise revenue, transparency and local administration effectiveness.

2.5.2 Tax reforms

To achieve fiscal consolidation tax reformation is critical. The reformation in tax system is also important because it minimizes distortions in the economy and creates stable and predictable environment for the markets to function (Rao, 2005). Ahmad and stern, 1991 are of the view that in many developing countries tax policy is directed towards the correctness of fiscal imbalances. Bird, 1993 observed tax reforms in many countries and said that “fiscal crisis has been proven to be mother of tax reform” ( 14.pdf)

Kurian (1999) stated that failure to contain wasteful expenditure and reluctance to raise additional resources is the main reason afflicting most of the state finance. He further added that tax wars among the states governments to attract private investment in the wake of economic reforms, pay revision to government employees led to starvation of funds of states. Chelliah et al (2002) discussed in their paper that one of major reasons behind below par revenue receipt is the fault in tax administration. They debated to modernize tax administration of states. Mukesh et al (2002) discussed about the cause of fiscal indiscipline at state level and cited weal intergovernmental fiscal relations as prime cause leading to fiscal indiscipline among states.

2.6 Summary of literature review

The paper has discussed the various aspects of fiscal deficit till now. Both the international and the national (in context to India) scenario have been discussed. Since fiscal deficit itself is a macroeconomic criteria and in turn it had effect on other macroeconomic criteria’s like inflation, current account, trade deficit various aspects of these macroeconomic criteria’s have been discussed. Apart from this the paper has also discussed the democratic and subnational effect of fiscal deficit, the reason of these discussions being India possess both these characteristic. The paper has also introduced the topic of tax reform on fiscal deficit as this could be one of the keys in managing fiscal deficits. The discussion till far have found out various characteristics of fiscal deficit by undergoing the works of various economists in the field of fiscal deficit. The paper would further focus on how to handle the fiscal deficit of a country, how it can be checked and then reduced in a phase wise manner. The paper has figured out the characteristics of fiscal deficit and by further working on these points would pave the way of ‘decoding the fiscal deficit code in context of India’

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