12/12/2009

BUDGET DEFICIT & ITS

ECONOMI
CS
IMPLICATION : INDIAN
ECONOMY

LOVELY PROFESSIONAL UNIVERSITY | FARAZ ALAM

Homework Title / No. : FARAZ ALAM Course Code : ECO-515

Course Instructor : MS.PREETI SINGH Course Tutor (if applicable) : __

Date of Allotment : OCTOBER Date of submission : 12-12-2009

Student’s Roll No._____ B35______ Section No. : RS 1901

Declaration:
I declare that this assignment is my individual work. I have not copied from any other
student’s work or from any other source except where due acknowledgment is made
explicitly in the text, nor has any part been written for me by another person.

Student’s Signature :

FARAZ ALAM

Evaluator’s comments:
_____________________________________________________________________

Marks obtained : ___________ out of ______________________

Content of Homework should start from this page only

Page | 2
 ON

(BUDGET DEFICIT & ITS IMPLICATION : INDIAN GOVERNMENT)

Submitted in the partial fulfillment of the Degree of masters of business

administration

SUBMITTED BY:- GUIDED BY:-

Name : FARAZ ALAM MS.PREETI SINGH

Regd. No : 10906032

Roll No : RS1901 B35

SUBMITTED TO

Department of Management Lovely Professional University Phagwra .

Page | 3
 ACKNOWLEDGEMENT

I take this opportunity to present my votes of thanks to all those guidepost who really
acted as lightening pillars to enlighten our way throughout this project that has led to
successful and satisfactory completion of this study.

We are really grateful to our COD Mr.Devdhar shetty for providing us with an
opportunity to undertake this project in this university and providing us with all the
facilities. We are highly thankful to Miss Preeti Singh for her active support, valuable
time and advice, whole-hearted guidance, sincere cooperation and pains-taking
involvement during the study and in completing the assignment of preparing the said
project within the time stipulated.

Lastly, We are thankful to all those, particularly the various friends , who have been
instrumental in creating proper, healthy and conductive environment and including
new and fresh innovative ideas for us during the project, their help, it would have
been extremely difficult for us to prepare the project in a time bound framework.

Name - Faraz Alam

Regd.No - 10906032

Roll No. - RS1901 B35

Page | 4
Indian Economy Overview :
The economy of India is the twelfth largest economy in the world by market exchange
rates and the fourth largest by purchasing power parity (PPP). India has been one of
the best performers in the world economy in recent years, but rapidly rising inflation and
the complexities of running the world’s biggest democracy are proving challenging.
India’s economy has been one of the stars of global economics in recent years, growing
9.2% in 2007 and 9.6% in 2006. Growth had been supported by markets reforms, huge
inflows of FDI, rising foreign exchange reserves, both an IT and real estate boom, and a
flourishing capital market. Like most of the world, however, India is facing testing
economic times in 2008. The Reserve Bank of India had set an inflation target of 4%,
but by the middle of the year it was running at 11%, the highest level seen for a decade.
The rising costs of oil, food and the resources needed for India’s construction boom are
all playing a part. India has to compete ever harder in the energy market place in
particular and has not been as adept at securing new fossil fuel sources as the Chinese.
The Indian Government is looking at alternatives, and has signed a wide-ranging
nuclear treaty with the US, in part to gain access to nuclear power plant technology that
can reduce its oil thirst. This has proved contentious though, leading to leftist members
of the ruling coalition pulling out of the government.

As part of the fight against inflation a tighter monetary policy is expected, but this will
help slow the growth of the Indian economy still further, as domestic demand will be
dampened. External demand is also slowing, further adding to the downside risks. The
Indian stock market has fallen more than 40% in six months from its January 2008 high.
$6b of foreign funds have flowed out of the country in that period, reacting both to
slowing economic growth and perceptions that the market was over-valued. It is not all
doom and gloom, however. A growing number of investors feel that the market may now
be undervalued and are seeing this as a buying opportunity. If their optimism about the
long term health of the Indian economy is correct, then this will be a needed correction
rather than a downtrend.

The Indian government certainly hopes that is the case. It views investment in the
creaking infrastructure of the country as being a key requirement, and has ear-marked
23.8 trillion rupees, approximately $559 billion, for infrastructure upgrades during the
11th five year plan. It expects to fund 70% of project costs, with the other 30% being
supplied by the private sector. Ports, airports, roads and railways are all seen as vital for
the Indian Economy and have been targeted for investment.

Page | 5
Further hope comes from the confidence of India’s home bred companies. As well as
taking over the domestic reins, where they now account for most of the economic
activity, they are also increasingly expanding abroad. India has contributed more
new members to the Forbes Global 2000 than any other country in the last four
years.

History : India economy, the third largest economy in the world, in terms of
purchasing power, is going to touch new heights in coming years. As predicted by
Goldman Sachs, the Global Investment Bank, by 2035 India would be the third largest
economy of the world just after US and China. It will grow to 60% of size of the US
economy. This booming economy of today has to pass through many phases before it
can achieve the current milestone of 9% GDP.

The history of Indian economy can be broadly divided into three phases: Pre- Colonial,
Colonial and Post Colonial..

Pre Colonial: The economic history of India since Indus Valley Civilization to 1700 AD
can be categorized under this phase. During Indus Valley Civilization Indian economy
was very well developed. It had very good trade relations with other parts of world,
which is evident from the coins of various civilizations found at the site of Indus valley.
Before the advent of East India Company, each village in India was a self sufficient
entity. Each village was economically independent as all the economic needs were
fulfilled with in the village.

Colonization : The arrival of East India Company in India ruined the Indian economy.
There was a two-way depletion of resources. British used to buy raw materials from
India at cheaper rates and finished goods were sold at higher than normal price in
Indian markets. During this phase India's share of world income declined from 22.3% in
1700 AD to 3.8% in 1952.

After India got independence from this colonial rule in 1947, the process of rebuilding
the economy started. For this various policies and schemes were formulated. First five
year plan for the development of Indian economy came into implementation in 1952.
These Five Year Plans, started by Indian government, focused on the needs of Indian
economy. If on one hand agriculture received the immediate attention on the other side
industrial sector was developed at a fast pace to provide employment opportunities to
the growing population and to keep pace with the developments in the world. Since then
Indian economy has come a long way. The Gross Domestic Product (GDP) at factor
cost, which was 2.3 % in 1951-52 reached 9% in financial year 2005-06

Page | 6
Trade liberalization, financial liberalization, tax reforms and opening up to foreign
investments were some of the important steps, which helped Indian economy to gain
momentum. The Economic Liberalization introduced by Man Mohan Singh in 1991, then
Finance Minister in the government of P V Narsimha Rao, proved to be the stepping
stone for Indian economic reform movements.

To maintain its current status and to achieve the target GDP of 10% for financial
year 2006-07, Indian economy has to overcome many challenges.

Challenges before Indian economy:

• Population explosion: This monster is eating up into the success of India.

According to 2001 census of India, population of India in 2001 was
1,028,610,328, growing at a rate of 2.11% approx. Such a vast population puts
lots of stress on economic infrastructure of the nation. Thus India has to control
its burgeoning population.
• Poverty: As per records of National Planning Commission, 36% of the Indian
population was living Below Poverty Line in 1993-94. Though this figure has
decreased in recent times but some major steps are needed to be taken to
eliminate poverty from India.
• Unemployment: The increasing population is pressing hard on economic
resources as well as job opportunities. Indian government has started various
schemes such as Jawahar Rozgar Yojna, and Self Employment Scheme for
Educated Unemployed Youth (SEEUY). But these are proving to be a drop in an
ocean.
• Rural urban divide: It is said that India lies in villages, even today when there is
lots of talk going about migration to cities, 70% of the Indian population still lives
in villages. There is a very stark difference in pace of rural and urban growth.
Unless there isn't a balanced development Indian economy cannot grow.

Page | 7
These challenges can be overcome by the sustained and planned economic
reforms.

These include:

• Maintaining fiscal discipline

• Orientation of public expenditure towards sectors in which India is faring badly
such as health and education.
• Introduction of reforms in labour laws to generate more employment
opportunities for the growing population of India.
• Reorganization of agricultural sector, introduction of new technology, reducing
agriculture's dependence on monsoon by developing means of irrigation.
• Introduction of financial reforms including privatization of some public sector
banks.

Recent Growth Trends in Indian Economy :

India’s Economy has grown by more than 9% for three years running, and has seen a
decade of 7%+ growth. This has reduced poverty by 10%, but with 60% of India’s 1.1
billion population living off agriculture and with droughts and floods increasing, poverty
alleviation is still a major challenge. The structural transformation that has been adopted
by the national government in recent times has reduced growth constraints and
contributed greatly to the overall growth and prosperity of the country. However there
are still major issues around federal vs state bureaucracy, corruption and tariffs that
require addressing. India’s public debt is 58% of GDP according to the CIA World Fact
book, and this represents another challenge.

During this period of stable growth, the performance of the Indian service sector has
been particularly significant. The growth rate of the service sector was 11.18% in 2007
and now contributes 53% of GDP. The industrial sector grew 10.63% in the same period
and is now 29% of GDP. Agriculture is 17% of the Indian economy. Growth in the
manufacturing sector has also complemented the country’s excellent growth
momentum. The growth rate of the manufacturing sector rose steadily from 8.98% in
2005, to 12% in 2006. The storage and communication sector also registered a
significant growth rate of 16.64% in the same year. Additional factors that have
contributed to this robust environment are sustained in investment and high savings
rates. As far as the percentage of gross capital formation in GDP is concerned, there
has been a significant rise from 22.8% in the fiscal year 2001, to 35.9% in the fiscal year

Page | 8
2006. Further, the gross rate of savings as a proportion to GDP registered solid growth
from 23.5% to 34.8% for the same period.

Budget Deficit :
A Budget Deficit is a common economic phenomenon, generally taking place on
governmental levels. Budget Deficit occurs when the spending of a government
exceeds that of its financial savings. In fact, budget deficit normally happens when the
government does not plan its expenses, after taking into account its entire savings.
A budget deficit occurs when an entity spends more money than it takes in. The
opposite of a budget deficit is a budget surplus. Debt is essentially an accumulated flow
of deficits. In other words, a deficit is a flow and debt is a stock. An accumulated deficit
over several years (or centuries) is referred to as the government debt. Government
debt is usually financed by borrowing, although if a government’s debt is denominated
in its own currency it can print new currency to pay debts. Monetizing debts, however,
can cause rapid inflation if done on a large scale. Governments can also sell assets to
pay off debt. Most governments finance their debts by issuing long-term government
bonds or shorter term notes and bills. Many governments use auctions to sell
government bonds. Governments usually must pay interest on what they have
borrowed. Governments reduce debt when their revenues exceed their current
expenditures and interest costs. Otherwise, government debt increases, requiring the
issue of new government bonds or other means of financing debt, such as asset sales.
According to Keynesian economic theories, running a fiscal deficit and increasing
government debt can stimulate economic activity when a country’s output (GDP) is
below its potential output. When an economy is running near or at its potential level of
output, fiscal deficits can cause inflation.
Budgetary deficits when accrued for a very long span of time, say for several decades
or centuries, is termed as Government Debts. Under such circumstances, a certain
portion of the governmental expenditure is then utilized for repayment of such debts,
with some maturity. This maturity is capable of being re-financed, through the issuance
of fresh bonds on governmental level. However, it must be noted that while a budget
deficit is considered to be a flow, a government debt amounts to a stock. In fact,
government debts are nothing but an accrued flow of budget deficits.
The definition of a budgetary deficit essentially evolves from that of governmental debt.
When governmental debt is defined as the total amount owned by somebody, budget
deficit refers to the amount by which savings enhances or a governmental debt
develops. In fact, a practical example will clearly reveal the relationship existing
between budget deficit and governmental debt: Before the war in Iraq, the Americans
had a common tendency of mixing up the two different concepts of budget deficit and
government debt. This made them believe that the U.S. government was under
pressure of a huge budgetary deficit. The actual situation was that the American

Page | 9
government was in possession of a substantial budget surplus. The deficit which
actually existed in United States of America had in fact, worn out during 1998-2001.
This has made the American population believe that the budgetary deficits have
increased remarkably than it was earlier, when the condition was that there was
sufficient surplus, even without the funds gathered from the Social Securities programs.

The new Indian government unveiled a $210 billion budget that increases welfare and
rural spending in an effort to stimulate economic growth, but also will likely widen the
fiscal deficit to its largest gap in 18 years. Finance Minister Pranab Mukherjee said the
government would make it a priority to reach 9% gross domestic product growth in the
medium term and would seek to spend 9% of GDP on infrastructure development by
2014. Although world financial conditions have improved, there are still uncertainties on
the revival of the global economy, Mr. Mukherjee said. "We can't afford to drop our
guard," he told Parliament. "We have to continue our efforts to provide further stimulus
to the economy."

Investors have bid up Indian shares since the ruling coalition, the United Progressive
Alliance, won the general election in May. Many investors had been looking to the
budget to outline a program of economic overhauls to attract foreign investment and the
divestment of government stakes in state-owned companies to raise funds. But the
budget was short on both, and the benchmark Bombay Stock Exchange Sensex index
sank 5.8%, or 870 points, to 14043.

This budget gave little guidance on whether the government planned to pursue
changes, such as opening the economy further to foreign investors and companies,
during its five-year term. "The big picture and road map was missing in terms of
attracting foreign direct investment and the disinvestment program to raise revenues,"
said Andrew Holland, chief executive for equities at Ambit Capital in Mumbai.

One of the major problems facing the Indian economy is your large budget deficit and
the resulting high level of national debt. As you know, the budget deficit of the central
government is about six percent of GDP and this rises to about 10 percent of GDP if the
deficits of subnational governments are included. The combined government debt is
now close to 75 percent of GDP. It is with these worrying figures in mind that I decided
to speak today about the general problem of budget deficits and national debt.

India is certainly not alone in having budget deficits that are too high. France and
Germany now have deficits that violate the European Growth and Stability Pact. In the
United States, the budget deficit has risen from 1.5 percent of GDP in 2002 to 3.7
percent in 2003 and a projected 4.3 percent next year. Japan has the largest budget
deficit among the major industrial countries at 8 percent of GDP. And among the

Page | 10
emerging market economies, the average ratio of budget deficit to GDP is now about
four percent.

I will not be so foolish as to suggest specific policies by which India can reduce its
budget deficit. I know how difficult it is to prescribe policies in my own country. The
political and economic complexities of India make it even more difficult for an outsider to
offer specific suggestions here.

What I will do instead is to discuss the adverse effects of large budget deficits in general
and the way in which such deficits can become unsustainable, leading to national
insolvency and a debt default. I will consider the arguments that have been made by
those academic economists over the years who have tried to justify a policy of large
peacetime budget deficits. And I will consider in general terms the merits of different
ways of reducing budget deficits.

Large fiscal deficits have a variety of adverse consequences: reducing economic

growth, lowering real incomes, and increasing the risk of financial and economic crises
of the type that we recently witnessed in several countries of Asia and Latin America.
Since I am here in a central bank, I should add that, under some circumstances, fiscal
deficits can also lead to inflation. Even if a central bank prevents such inflationary
consequences , the other adverse ';real'; effects cannot be avoided. And under some
conditions that I will discuss later, budget deficits can lead to higher inflation despite the
attempt of the central bank to pursue a sound monetary policy.

To get a sense of the magnitude of these effects, consider just the impact of India’s
recent deficits on capital formation and growth. If India did not have its current central
government deficit of some 6 percent of GDP, the gross rate of capital formation could
rise form 24 % of GDP to 30%. The net rate of investment would rise relatively more.
Over the next decade, this greater rate of net capital accumulation would be enough to
add nearly a full percentage point to the annual growth rate, raising India’s level of GDP
a decade from now by about 10 percent. Eliminating the state deficits as well as the
deficit of the central government would substantially increase the size of this effect.
While such radical deficit reduction may not be achievable in practice, these
calculations indicate what could be accomplished with even smaller deficit reductions.

Unfortunately, it is easy to ignore budget deficits and postpone dealing with them
because the adverse effects of budget deficits are rarely immediate. Fiscal deficits are
like obesity. You can see your weight rising on the scale and notice that your clothing
size is increasing, but there is no sense of urgency in dealing with the problem. That is
so even though the long-term consequences of being overweight include an increased
risk of a sudden heart attack as well as of various chronic conditions like diabetes. Like
obesity, government deficits are the result of too much self-indulgent living as the

Page | 11
government spends more than it collects in taxes. And, also like obesity, the more
severe the problem, the harder it is to correct: the overweight man has a harder time
doing the exercise that could reduce his weight and the economy with a large deficit and
debt is trapped by increasing interest payments that cause the deficit and debt to rise
more quickly. I emphasize the analogy to stress the point that budget deficits need
attention now even when their adverse effects may not be obvious.

Different types of budget deficits:

Early Budget Deficit : This prevailed prior to the invention of bonds. At that time, such
deficits could only be funded with loans taken from either foreign nations or
private financiers. However, large long-term loans had a high element of risk
for the lender and consequently gave high interest rates. A permanent loan or
deficit is associated with sufficient risk factors for the lenders. At a later stage,
attempts were made on governmental levels to do marketing of such deficits
or debts by issuance of bonds , payable to the bondholders or bearers,
instead of the actual buyers. This indicates that such debts are saleable,
provided a person lends it to the other through state money. This
simultaneously brings about a reduction in overall rates of interest as well as
the risks associated with the entire process.

Cyclical Budget Deficits : At the lowest point in the business cycle, there is a high
level of unemployment. This means that tax revenues are low and expenditure (e.g. on
social security) high. At the basic level of the commercial cycle, the rate of
unemployment is pretty high. On the contrary, unemployment is low at the pinnacles of
the commercial cycle. This enhances tax revenue and leads to a fall in the expenditure
associated with social security. Conversely, at the peak of the cycle, unemployment is
low, increasing tax revenue and decreasing social security spending. The additional
borrowing required at the low point of the cycle is the cyclical deficit. By definition, the
cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.

Structural Budget Deficits : This refers to the deficit existing across the commercial
cycle. Such budget deficit prevails when the general government expenses exceed the
existing levels of tax. It is the deficit that remains across the business cycle, because
the general level of government spending is too high for prevailing tax levels. The
observed total budget deficit is equal to the sum of the structural deficit with the cyclical
deficit or surplus.

Page | 12
However in case of both Cyclic and Structural Budget Deficit, the visible total deficit is
equivalent to the sum of either the deficits or their surplus. Some economists have
criticized the distinction between cyclical and structural deficits, contending that the
business cycle is too difficult to measure to make cyclical analysis worthwhile.

The fiscal gap , measures the difference between government spending and revenues
over the very long term, typically as a percentage of Gross Domestic Product. The fiscal
gap can be interpreted as the percentage increase in revenues or reduction of
expenditures necessary to balance spending and revenues in the long run. For
example, a fiscal gap of 5% could be eliminated by an immediate and permanent 5%
increase in taxes or cut in spending or some combination of both. It includes not only
the structural deficit at a given point in time, but also the difference between promised
future government commitments, such as health and retirement spending, and planned
future tax revenues. Since the elderly population is growing much faster than the young
population in many countries, many economists argue that these countries have
important fiscal gaps, beyond what can be seen from their deficits alone.

INDIA : Budget deficit as a ratio to GDP

It has become an accepted practice with the Finance Ministers to present deficit
budgets and to relate the same as a ratio to the GDP, since a mild dose of deficit
finance can be a stimulant to the growth of the economy. The Union Finance Minister
presented the budget proposals for 2005-06 with a revenue deficit of Rs.95,312 crores
and a fiscal deficit of Rs.1,51,144 crores. As a ratio to the GDP the revenue deficit
would be 2.7 per cent and fiscal deficit 4.3 per cent.

He claims that the GDP-GFD ratio was brought down by 0.5 per cent in 2004-05 and
that the deficit would be brought down further to the level fixed by the Fiscal
Responsibility and Budget Management Act by 2008-09. However, the burden of
deficits has been rising year by year. In 1970-71, the fiscal deficit accounted for only
Rs.1,408 crores. It increased to Rs.8,299 crores by 1980-81, to Rs.44,632 crores by
1990-91 and to Rs.1,18,816 crores by 2000-01. There is thus a steep rise in the
absolute size of the fiscal deficits over the years without any sign of a fall.

Page | 13
Unreliable indicator

Admittedly, there is a consensus among the scholars that growth of deficit finance
beyond a limit can undermine the economy. However, nobody is sure as to the precise
limit up to which deficit can be resorted. Instead of prescribing such a safety limit, their
approach seems to be to look at the GDP-GFD ratio as an indicator for evaluating the
seriousness of the deficits in the economy and thereby to apply corrective measures. At
the same time, the governmental approach seems to be to raise the GDP by applying
further dose of deficits instead of reducing the expenditure or tax rates for populist
reasons. Even the Fiscal Responsibility and Budget Management Act seems to rely on
a reduction of GDP-GFD ratio as a sound measure for correcting the danger from deficit
financing. The question is how far can GDP-GFD ratio be regarded as an authentic
indicator for evaluating the seriousness of budget deficits in the Indian economy.

An evaluation based on GDP-GFD ratio by itself seems somewhat meaningless in a

country like India for a variety of reasons. First, much of the statistical data needed for
compiling the national product are inadequate and even unreliable. Secondly, the
periodical revision of the GDP, undertaken apparently for the purpose of
accommodating structural changes in the economy, very often results in an abnormal
spurt in the very size of the GDP. The revision with 1993-94 as the base resulted in
inflating the figure by 9 per cent in 1993-94, the base year itself, in comparison with the
estimates based on 1980-81 series. In the case of Kerala, the revision resulted in a
spurt of 18 per cent in the volume of SDP compared with the volume based on the
previous base.

Such abnormal increase in the size of GDP can certainly reduce the GDP-GFD ratio.
Changes in the data base as well as the methodology are stated to be the reasons for
the increase in the value added by certain activities/services. In the case of ownership
of dwelling houses for example, "the estimate of GDP in 1993-94 went up to Rs. 44,140
crores in the new series as against Rs.21,981 crores in 1980-81 series, showing an
increase of Rs. 22,159 crores," apparently on account of the change in the
methodology.

It may adopt new norms in the valuation of activities/services in the estimates of GDP in
the context of what some state accountants speak of as underestimation in areas like
that of the organised and unorganised service sector. In such an eventuality, budget
deficits can be brought down to the level stipulated by the FRBM Act, without actually
curtailing the deficits at all.

There is something definite about the volume of debt or the debt charges unlike the
ambiguity regarding the real size of the domestic product. In 1970-71, the revenue

Page | 14
receipts totalled Rs.3,293 crores. The interest charges on the other hand amounted to
Rs.606 crores accounting for18 per cent of the revenue receipts. By 1990-91 the
revenue receipts totalled Rs. 54,954 crores with the interest payments amounting to
Rs.21,498 crores. The interest payments accounted for 39 per cent of the revenue
receipts. The interest payments would be Rs 1,33,945 crores in 2005-06 against the
anticipated revenue receipts of Rs.3,51,200 crores. As a percentage, it accounts for
38.13. Apparently, very little correction has been effected in the deficits so far. In
addition to the interest payments of the Central government, the interest payments of
the State governments are also increasing at an alarming rate which is sure to add new
dimensions to the burden of the economy.

Accumulated debt

The conditions of buoyancy which the country now experiences may not remain forever.
There are indications of the country falling into a debt trap. The accumulated debt of the
Central and State governments put together adds up to Rs. 30,00,000 crores. Some of
the State governments like that of Bihar have not been able to pay the salary of its
employees for months on account of non-availability of funds. All such indicators point
to the heavy burden on the economy brought about mainly by the growing volume of
deficit financing. The positive factors like the accumulated foreign exchange reserves
and the inflow of private transfer payments, which prop up the economy from crumbling
under the heavy weight of the mounting deficit finance, may not be able to hold for long.
Drastic reduction of the deficit financing and not adjustment of the GDP-GFD ratio is the
only way out for salvaging the economy and keeping it intact.

Page | 15
Primary deficit, total deficit, and debt :
The government’s deficit can be measured with or without including the interest it pays
on its debt. The primary deficit is defined as the difference between current government
spending and total current revenue from all types of taxes.
The total deficit (which is often just called the ’deficit’) is spending, plus interest
payments on the debt, minus tax revenues. Therefore, if Gt is government spending and
Tt is tax revenue, then Primary deficit = Gt – Tt If Dt − 1 is last year’s debt, and r is
the interest rate, then Total deficit = Gt + rDt − 1 – Tt Finally, this year’s debt can be
calculated from last year’s debt and this year’s total deficit: Dt = (1 + r)Dt − 1 + Gt – Tt
Economic trends can influence the growth or shrinkage of fiscal deficits in several ways.
Increased levels of economic activity generally lead to higher tax revenues, while
government expenditures often increase during economic downturns because of higher
outlays for social insurance programs such as unemployment benefits. Changes in tax
rates, tax enforcement policies, levels of social benefits, and other government policy
decisions can also have major effects on public debt. For some countries, such as
Norway, Russia, and members of the Organization of Petroleum Exporting Countries
(OPEC), oil and gas receipts play a major role in public finances. Inflation reduces the
real value of accumulated debt. If investors anticipate future inflation, however, they will
demand higher interest rates on government debt, making public borrowing more
expensive.

Budget deficit and Debt formula:

Calculation of budgetary deficit is dependent on the following formula: To calculate a
debt D, the formula used is:
D = RBt - 1 + Gt(r - g) - Tt , where, R= real rate of interest ,Bt - 1= debt of the previous
year
r=rate of interest ,g= rate of growth , Gt= government expenses and, Tt= tax revenue
However, the budget deficit of every country has its individual factors responsible for
such situation to arise, hence varies worldwide. This is precisely why the rising
development of Indian economy is directly unfolds the inflationary impacts, which results
from the financial deficits in such Asian countries.

Page | 16
Deficits and Debt Ratios :

The appropriate size of the national debt, like the ideal weight for an individual, is a
complex question. But basic common sense tells us that the ratio of debt to GDP should
not be allowed to rise year after year. I may not know my optimal weight but I know that
I am in trouble if I am gaining five pounds a year, or even three pounds a year. In fiscal
terms, a country should recognize that it is in trouble if it sees its ratio of debt to GDP
rising year after year.

There is therefore nothing arcane about the appropriate standard of a sound fiscal
policy. The basic rule is that government revenue must exceed government non-interest
outlays. The excess of revenue over non-interest outlays must be sufficient to finance
enough of the interest payments on the public debt to avoid a rising ratio of debt to
GDP. To make this operational, it is necessary to be clear about the definition of the
budget deficit and about the role that the rate of interest on the national debt plays in
determining the debt dynamics.

The budget deficit is traditionally defined as the difference between total government
outlays, including the interest on the national debt, and the government’s revenue
receipts. A more complete definition of the deficit is that it is the difference between the
size of the government debt at the end of the year and the corresponding size of the
debt one year earlier. These two are equivalent if the government debt is defined as the
stock of outstanding bonds. A more general definition of the government debt, however,
would include the value of off-budget liabilities like future social security pensions and
such contingent liabilities as the cost of dealing with insolvent banks and money-losing
state enterprises. Unfortunately, the available statistics on debt and deficits generally
ignore these broader considerations. Although I will therefore not present data on this
broader concept of the national debt, everything that I say today about deficits and debt
should be interpreted in this larger context.

A budget deficit implies that the national debt is increasing. But since the GDP is also
rising, the ratio of the national debt to GDP may or may not be increasing. That depends
on whether the growth rate of the national debt is more than or less than the growth rate
of GDP. A continually increasing ratio of debt to GDP runs the risk that the debt will get
on an unsustainable path leading to national insolvency. Even if the debt ratio is not
explosive in this way, a high ratio of debt to GDP has serious adverse consequences. It
is important therefore to understand what drives the ratio of debt to GDP and, if it is
converging to some equilibrium level, what determines that level.

Page | 17
To do so it is useful to distinguish the standard budget deficit from the primary budget
deficit. The primary deficit is the standard deficit minus the interest on the government
debt. Equivalently, as traditionally measured, the primary deficit is government non-
interest outlays minus total revenues.

To be more explicit, the total or standard deficit can be written as G + i * Debt - T where
G is noninterest government outlays, i is the interest rate on the government debt, and T
is taxes and other government revenue. The primary deficit is then G - T.

With this notation, it can be shown that the change in the ratio of debt to GDP can be
written as

D { Debt / GDP } = [ G - T ] / GDP + { i - [ (D GDP )/ GDP] }( Debt / GDP)

i.e., as the sum of the primary deficit per dollar of GDP plus the difference between the
interest rate and the growth rate of GDP ( D GDP )/ GDP ) multiplied by the initial ratio
of debt to GDP.

Although I have expressed this relation in terms of the nominal interest rate and the
nominal growth rate, the same rule holds if we replace the nominal interest rate with the
real interest rate (i minus the inflation rate) and the nominal growth rate with the real
growth rate ( ( D GDP )/ GDP minus the inflation rate).

This equation tells us that the ratio of debt to GDP will unambiguously rise if there is a
primary deficit (i.e., if government non-interest spending exceeds revenue, G - T greater
than zero) and if the interest rate on the national debt exceeds the growth rate of GDP.
The logic of this is clear. The primary deficit adds to the national debt and the positive
difference between the interest rate and the growth rate of GDP means that the interest
payments alone cause the debt to rise faster than GDP.

To reduce the ratio of debt to GDP there must be either a primary surplus (i.e., revenue
must exceed noninterest outlays) or the economy must grow faster than the rate of
interest, or both. If only one of those conditions holds, it must be large enough to
outweigh the adverse effect of the other.

The relation between the interest rate and the GDP growth rate varies from time to time
and from country to country. In the United States over the past five years nominal GDP
grew at an annual rate of 4.7 percent while the implicit interest rate on the government
debt was 7.1 percent. Over those same five years, the U.S. also had a primary surplus
of 3.2 percent of GDP. With an average debt to GDP ratio of 40 percent, the ratio of
debt to GDP declined by about 2 percent per year, from 0.45 in 1997 to 0.34 in 2002.

Page | 18
The future may not be as favorable. Recent calculations by the official U.S.
Congressional Budget Office based on plausible policy assumptions imply that the
primary deficit could average about 0.8 percent of GDP over the next five years if the
economy grows at a moderate rate of 3 percent a year. Over the same five years, the
Congressional Budget Office estimates that the rate of GDP growth will exceed the
interest rate by 0.7 percent. Combining these figures with the initial ratio of debt to GDP
implies that the debt to GDP ratio would rise from 39.6 percent of GDP at the end of
2004 to 42.9 percent at the end of 2009. Policy actions could of course reduce that
primary deficit. And faster economic growth would reduce the primary deficit (by
increasing tax revenue) and could cause the interest rate to be smaller than the growth
rate, further reducing the debt to GDP ratio. Even a relatively small increase in the
growth rate could prevent the rise in the debt to GDP ratio.

In India in recent years the primary deficits have been above 1.5 percent of GDP and
the implicit rate of interest on the national debt has exceeded the nominal growth rate of
GDP by more than three percentage points. The ratio of the central government debt to
GDP was about 60 percent on average over these years. Combining these figures in
the way implied by the basic equation implies that the ratio of debt to GDP will rise at
about three percent per year. That is what was happening until recently. The debt to
GDP ratio rose from 54 percent in 2000-01 to 65 percent in 2003-04. That’s the bad
news. The good news is that cutting the deficit, and therefore the primary deficit, by
about 1.5 percent of GDP could prevent this rise in the debt to GDP ratio. I will return
later to discuss approaches that any country must consider as it tries to reduce the
primary deficit and the relative level of public debt.

Page | 19
Rising Debt Ratios :

Experience around the world shows that a rising ratio of debt to GDP increases the
probability of some kind of debt default or debt restructuring. The financial markets are
forward looking and respond to that risk by insisting on higher interest rates to induce
investors to hold government bonds. But those higher interest rate cause the debt to
grow even faster. It is in that way that high debt ratios can become unstable without any
increase in the primary deficit.

While an increase in the debt ratio can in principle be reversed, it becomes harder to do
so as the interest rate rises, accelerating the growth of the debt and decreasing the
growth of GDP. A continuing rise in the ratio of debt to GDP is a path to insolvency and
economic crisis. But even a stable but high ratio of debt to GDP has serious adverse
effects on the economy by crowding out private capital formation and imposing a higher
tax burden to service the debt.

What determines the stable level of the debt to GDP ratio? The basic equation for the
growth of the debt to GDP ratio implies that there is no change in the ratio when the
primary deficit as a fraction of GDP is equal to the product of the debt to GDP ratio and
the difference between the interest rate and growth rate:

(G - T) / GDP = [ D GDP/ GDP - i] (Debt/GDP)

This implies that a stable ratio of debt to GDP must satisfy

(Debt/GDP) = {(G - T) / GDP} / [ (D GDP/ GDP) - i]

For example, a primary deficit equal to one percent of GDP and a growth rate that
exceeds the interest rate by 2 percentage points, will eventually produce a debt to GDP
ratio of 50 percent. Doubling the primary deficit would cause the equilibrium debt ratio to
double as well. But even with no change in the primary deficit, a fall in the difference
between the growth rate and the interest rate from 2 percentage points to 1 percentage
point, would also cause the debt ratio to double.

It is clear from this arithmetic that it is very easy for an economy to shift from a stable
debt ratio at a low level to one at a substantially higher level in response to a relatively
small change in government spending, taxes, interest rates or economic growth.

Page | 20
Pro-deficit Economic Arguments :

Budget deficits and debt ratios have not always been as high as they are now. And
while deficits during major wars were common, peacetime deficits were unusual. In the
United States, the entire national debt, including the substantial debt incurred during the
Civil War, was fully paid off by a series of surpluses in the latter part of the 19th century.

In retrospect, it is quite remarkable that the political process supported the opposition to
budget deficits and national debt for such a long time. Without a strong intellectual and
moral opposition to deficits, powerful populist political pressures can lead to large
budget deficits. Budget deficits are potentially popular because they allow higher levels
of government spending and lower levels of taxation. Deficits shift the fiscal cost to
future generations that are not yet voters. And deficits impose burdens on the economy
that, unlike the very tangible benefits of more spending and lower taxes, are not directly
visible to current voters.

It is unfortunate that, starting with the 1940s, economists developed a series of different
arguments that encouraged the political process to accept larger and larger peacetime
deficits. These analyses started with simple arguments and were followed by new
theories of economic growth, theories of household saving behavior, and models of the
global capital markets. The arguments were intellectually quite different from each other
but they all lead to the same conclusion: that budget deficits in peacetime were not a
problem for the economy.

This conclusion ran counter to earlier analyses that emphasized that savings increased
the rate of growth by increasing the amount of capital per worker. The reason for the
new conclusion was the recognition that the higher capital intensity of production that
resulted from a higher saving rate would eventually require an even higher saving rate
to maintain the increased rate of growth. With no further increase in the net saving rate,
the rate of growth of aggregate income would eventually converge back to the sum of
the growth rates of population and productivity.

Although the new theory was technically correct, it was also misleading in focusing on
the very very long run. With reasonable economic parameters, a rise in the saving rate
could actually raise the growth rate by a significant amount for several decades.
Moreover, even as the growth rate returned to its initial value, the level of real per capita
income would remain permanently higher. With time, these technical aspects of the
neoclassical analysis became understood among economists. But for at least a
generation of economists who had grown up with the neoclassical growth models, there
remained a residual sense that a higher saving rate is not the path to increased growth
and , even more incorrectly, to higher real incomes.

Page | 21
It is of course difficult to know how influential a change in professional economic
thinking is in changing economic policy. It is my judgement that the general acceptance
by mainstream economists of the notion that budget deficits do not reduce long-term
growth played an important role in decreasing the opposition to large peacetime budget
deficits. This was reinforced in the 1960s by the widespread professional acceptance of
the original Phillips curve theory that implied that an expansionary fiscal policy could
permanently reduce the rate of unemployment if the economy accepts a permanently
higher rate of inflation. With the additional view that inflation had at most a derisively
small economic cost (the ';shoeleather'; costs of households making extra trips to the
bank) and might actually increase productivity (by encouraging the replacement of cash
balances in households’ portfolios with claims on real capital), the case for budget
deficits seemed quite compelling.

By the late 1970s the economics profession was coming to reject all of these
arguments. A higher saving rate was seen as important for growth and for raising real
incomes, the long-run Phillips curve was discredited, and the high rate of inflation in the
1970s was recognized as a serious problem. But the 1980s brought yet another
example of the ';deficits don’t matter'; argument, the so-called Ricardian-equivalence
proposition. Here the argument is that budget deficits do not change national saving
because individuals increase their personal saving to offset exactly the rise in the
budget deficit.

The key assumption of the Ricardian-equivalence model is that successive generations

are linked by an operative bequest motive. If I plan to bequeath some amount of money
to my children and the government cuts my taxes (or gives me additional benefits
through government spending) while increasing the future taxes that will have to be paid
by my children, I will offset this government action by increasing my saving to keep my
real income and the real incomes of my children unchanged. While this seems plausible
enough once the premise of an operative bequest motive is accepted, there are so few
planned bequests that this is not empirically significant. The absence of significant
planned bequests is not surprising in an economy in which economic growth raises the
incomes of future generations so that even an altruistic parent sees no need to reduce
his own consumption in order to raise the consumption of his adult children after he has
died. By now many, I would think most, economists have recognized the practical
irrelevance of the Ricardian-equivalence theory and concluded that budget deficits do
reduce national saving.

There is yet one more line of argument that implies that budget deficits are not as
important in the capital accumulation process as they might seem at first. A fully
integrated global capital market implies that the domestic levels of investment, capital
stock, and productivity in an economy do not depend on the domestic saving rate.

Page | 22
Capital flows among countries to equate the real rate of return. A country with a high
saving rate exports capital to the rest of the world and a country with a low saving rate
imports capital. In this context, a large budget deficit that reduces national saving will
not hamper domestic investment but will instead induce a capital inflow from abroad.

Although an integrated global capital market is a helpful analytic abstraction, it is not a

description of the actual global capital market. Charles Horioka and I showed some
years ago that persistent differences in national saving rates among industrial countries
translates into persistent differences in investment as a share of GDP. The global
capital market is surprisingly segmented, with about 80 percent of a sustained rise in
incremental savings retained in the saving country. This finding has been replicated with
more recent data and shown to hold for a wide range of developing as well as industrial
countries. The implication is clear: a country that reduces its national saving by a large
budget deficit will have a similar adverse effect on the its national investment rate.

Economic Crises :

In addition to the adverse effects of budget deficits on capital accumulation, economic

growth, future tax rates, and inflation, budget deficits can also be the source of the kind
of financial crises that were experienced in Latin America and south Asia in the past
decade. This is particularly true when the budget deficit is financed by borrowing abroad
in a different currency like the dollar or euro. A country that borrows dollars to finance its
budget deficit runs the risk that an unwillingness of foreign lenders to keeping rolling
over existing debt will cause a substantial decline in the exchange rate, leading to a
financial crisis.

This is what happened in Thailand in 1998 when foreign lenders decided to stop rolling
over Thai dollar obligations. They did so because the growing accumulation of foreign
debts denominated in dollars raised doubts about the eventual ability of the government
of Thailand and its private sector borrowers to be able to repay foreign obligations.
When this happened, the exchange rate shifted from 25 bhat per dollar to about 50 bhat
per dollar. Thai companies that owed dollars to foreign lenders or to domestic banks
saw the value of their obligations double when measured in bhat. For many highly
leveraged borrowers, the doubling of their debt meant bankruptcy. Thai banks that had
made dollar loans to these borrowers were unable to collect but still owed dollars to
foreign creditors, forcing the banks themselves into bankruptcy. With companies and
banks in bankruptcy, the economic activity collapsed and the county suffered a severe
crisis.

Page | 23
In an open economy with no capital account restrictions a rising ratio of government
debt to GDP can lead to an economic and financial crisis even if the debt is not to
foreign lenders and is not denominated in dollars. As the debt to GDP ratio rises,
domestic individuals and businesses will seek ways to transfer funds abroad to invest in
alterative assets in order to avoid the risks inherent in domestic banks and domestic
bonds. This shift of funds can reduce the exchange rate, raising domestic interest rates
and weakening domestic banks.

In short, while a high ratio of debt to GDP can do substantial damage to the economy, a
debt to GDP ratio that is rising can signal fiscal insolvency and cause a financial and
economic crisis.

Ways to tackle Deficit :

There are only three basic ways to reduce the fiscal deficit and one additional way to
reduce the equilibrium ratio of debt to GDP and the risk that the debt ratio will reach an
unstable level. The three ways to reduce the budget deficit are to cut non-interest
government outlays, to increase tax or other revenue, and to reduce the rate of interest
on the government debt. A faster rate of economic growth would also reduce the
equilibrium ratio of debt to GDP and the risk of a shift to an unstable path of debt to
GDP. Let me consider each of these options in turn.

Reducing non-interest outlays is always politically difficult but it is not impossible.

Fortunately, what matters is not the absolute level of government outlays but the ratio of
outlays to GDP. It is necessary therefore only to slow the growth of noninterest
spending to less than the growth of GDP. Despite the difficult of doing this in a
democracy, the United States did succeed in reducing the ratio of noninterest outlays to
GDP during the eight years of the Ronald Regan presidency from 20.8 percent of GDP
in 1980 to 19.4 percent of GDP in 1988. Nondefense discretionary spending – i.e.,
spending excluding defense and the so-called entitlements that are not subject to
annual Congressional appropriations (like Social Security pensions, Medicare benefits,
etc) – fell one-third from 4.7 percent of GDP in 1980 to 3.1 percent of GDP in 1988.

Spending reductions must of course be made program by program even if overall

spending goals and limits help to achieve that aggregate spending reduction. In many
emerging market countries, stopping support for money-losing state owned enterprises
by imposing a hard budget constraint or by privatizing the entity can be a major source
of spending reduction. The key to thinking about all forms of government expenditures
is to recognize that the cost of providing a government outlay includes not only the
direct outlay itself but also the deadweight loss associated with raising the revenue to
Page | 24
pay for that outlay. That incremental deadweight loss depends on the means of
financing the increased outlay. An increase in the income tax that distorts work behavior
and the form of compensation or an increase in the budget deficit that reduces national
saving can produce deadweight losses that are as large as the outlay itself, thus
doubling the true cost of the outlay. Paying attention in this way to the total cost of
spending may help to reduce the level of spending therefore that source of the deficit.

Raising revenue is the alternative way to reduce the primary deficit. The way in which
that revenue is raised in very important. An increase in the tax on labor income or
investment incomes can entail large deadweight losses. That form of tax can also
reduce the rate of economic growth, raising the ratio of government outlays to GDP,
increasing the equilibrium ratio of debt to GDP, and increasing the likelihood that the
economy will shift to an unstable path.

It is far better to seek ways to increase collections with the existing law by reducing pure
tax evasion. A second best strategy is to find ways to reduce loopholes that allow
technically legal but unjustifiable tax avoidance. Finally, tax reforms that strengthen
incentives can raise revenue by increasing output and by causing more output to be
treated as taxable income rather than disguised in other non-taxable forms of
compensation.

Taxes are not the only source of non-debt government revenue. Charges for
government services can be an important source of revenue, especially in an economy
like India where the government provides such a wide range of public services.
Charging for some public services may also make it possible for private providers to
offer these services, covering their own costs with charges and making a profit as well.
But it is also important to recognize that raising charges for the use of public services
can lead to the suboptimal use of those services. Tolls on highways and bridges can
bring in revenue but may not be optimal if they discourage the use of otherwise
uncongested facilities.

The optimal user charge is however more complicated than the traditional rule that the
user charge should be no more than marginal cost. The traditional rule must be
modified to recognize that all sources of revenue involve deadweight losses. The
optimal charge for the use of an uncrowded bridge should not be the zero marginal cost
but a positive price that makes the deadweight loss per rupee of revenue equal to the
deadweight loss of generating revenue in other ways. For example, if raising an
incremental rupee of revenue with the income or value added tax involves a deadweight
loss of one-half rupee, the appropriate charge for the uncrowded bridge should also be
such that the toll generates a deadweight loss of one-half rupee per rupee of revenue.

Page | 25
Reducing the interest rate on the government debt is of course another way in principle
to reduce the budget deficit and the equilibrium ratio of debt to GDP. Although the
government cannot reduce that interest rate directly, it can do so indirectly by actions
that make the debt less risky. A sound monetary policy that reduces inflation risk can
reduce the real interest rate. Budget policies that reduce expected future primary
deficits can also reduce the real rate of interest.

Finally, an increase in the rate of economic growth would lower the equilibrium ratio of
debt to GDP and reduce the risk of an unstable rising ratio of debt to GDP. Since a
lower primary deficit permits more investment and therefore faster economic growth,
any policy that reduces the primary deficit brings an extra benefit in this way, creating a
virtuous circle. There are of course many other things that a government can do to raise
the rate of economic growth: increasing market flexibility, improving infrastructure,
reducing regulations, and removing financial and legal barriers to individual
entrepreneurship. India is clearly engaged in a wide variety of such pro-growth policies.
If they are successful, they will reinforce sound fiscal management to achieve lower
budget deficits and to reduce the relative size of the national debt. It is important that
such pro-growth policies as well as explicit deficit reduction initiatives be adopted in the
years ahead.

Page | 26
References :
• Managerial Economics – Tata McGraw Hill

• www.economywatch.com

• www.indianeconomy.org

• www.wikipedia.org

• www. finmin.nic.in

• www.cmie.com

• www.rbi.org.in

• www.bloomberg.com

• www.indiadaily.com

• www.indiabudget.nic.in

• www.mostlyeconomics.wordpress.com

Page | 27