DEFICIT FINANCING

Outline:
1) Concepts of deficit/types of budget deficits
2) Definition, methods and objectives of deficit financing
3) Effects of deficit financing
4) Limits to deficit financing

INTRODUCTION
Budget is a financial statement of the government dealing with the public revenue
and public expenditure and balancing both of them. When the total revenue is more
than the total expenditure it is called surplus budget. When total revenue is equal
to the total expenditure it is called balanced budget. If the total expenditure exceeds
the total revenue it is called a deficit budget. In most of the developing countries
and under developed countries there is always deficit budget and it has become a
permanent feature.

CONCEPTS OF DEFICIT/TYPES OF BUDGET DEFICITS

Deficit budget has been classified into different types. Explain below are the
different concepts/types of budget deficit

1) Revenue Deficit:
Revenue deficit occurs when the revenue expenditure exceeds revenue receipts.
Generally, a prudent public finance management aims at creating surplus which can
be directed towards development expenditure.
𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐃𝐞𝐟𝐢𝐜𝐢𝐭 = 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐑𝐞𝐜𝐞𝐢𝐩𝐭 − 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐄𝐱𝐩𝐞𝐧𝐝𝐢𝐭𝐮𝐫𝐞
where:
Revenue Receipt < Revenue Expenditure

2) Budgetary deficit:
Budgetary deficit denotes the difference between all receipts and expenditure of the
government, both revenue and capital. It implies that government incurs more
expenditure that its normal receipt from revenue and capital goods.

𝐁𝐮𝐝𝐠𝐞𝐭 𝐃𝐞𝐟𝐢𝐜𝐢𝐭 = 𝐓𝐨𝐭𝐚𝐥 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 − 𝐓𝐨𝐭𝐚𝐥 𝐄𝐱𝐩𝐞𝐧𝐝𝐢𝐭𝐮𝐫𝐞

where:
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 Total Revenue < Total Expenditure
Total Revenue = Revenue Receipts + Capital Receipts
Total Expenditure = Revenue Expenditure + Capital Expenditure

3) Fiscal Deficit:
Fiscal deficit is the excess of total expenditure (both revenue and capital accounts)
over revenue receipts and non-borrowing types of capital receipts such as recoveries
of loans and grants.
𝐅𝐢𝐬𝐜𝐚𝐥 𝐃𝐞𝐟𝐢𝐜𝐢𝐭 = 𝐓𝐨𝐭𝐚𝐥 𝐑𝐞𝐯(𝐞𝐱𝐜𝐥 𝐛𝐨𝐫𝐫𝐨𝐰𝐢𝐧𝐠𝐬) − 𝐓𝐨𝐭𝐚𝐥 𝐄𝐱𝐩𝐞𝐧𝐝
where
Total Revenue = Revenue Receipts + Capital Receipts (excluding borrowings)

Fiscal deficit is treated to be a complete and comprehensive deficit. It is an

internationally recognized concept. Out of all the concepts above, the fiscal deficit
is regarded as the internationally recognized measure of deficit. It is the most
appropriate and reliable measure showing the clear picture of the fiscal mess.

4) Primary Deficit:
Primary deficit is equal to fiscal deficit minus interest payments.
𝐏𝐫𝐢𝐦𝐚𝐫𝐲 𝐃𝐞𝐟𝐢𝐜𝐢𝐭 = 𝐓𝐨𝐭𝐚𝐥 𝐑𝐞𝐯(𝐞𝐱𝐜𝐥 𝐛𝐨𝐫𝐫) − 𝐓𝐨𝐭𝐚𝐥 𝐄𝐱𝐩𝐞𝐧𝐝(𝐞𝐱𝐜𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬)

Primary deficit is considered to be an indicator of the actual position of the

government finance as it keeps away the interest payments.

DEFINITION OF DEFICIT FINANCING

Deficit financing—Financing of a deliberately created gap between public revenue
and expenditure or a budgetary deficit. This gap is filled up by government
borrowings which include all the sources of public borrowings. In simple terms it
means the way the gap between excess of government expenditure over its receipts
is financed.

The method adopted by the government to finance the overall budget deficit in the
current and capital account together is known as deficit financing.

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Deficit financing has become an important tool of financing government
expenditure.

METHODS OF DEFICIT FINANCING

Governments can adopt three methods of deficit financing and the impact is different
in each case.

Firstly governments can borrow from non-bank investors or commercial banks.

This is considered non-inflationary as it tends to replace private expenditure. For
example when government borrows from commercial banks, their liquidity is
reduced so that it reduces loans to the private sector. Thus the government borrowing
from commercial banks replaces private expenditure and hence it is non-inflationary.
If the non-bank investors get loans from the commercial banks against their fixed
deposits and use it to lend to government it would be inflationary.

In the second case when the government draws from its cash balances with the
central (National) bank it is not inflationary.

But in the third method when the government borrows from the central bank
against its securities, the central bank creates new money by resorting to the printing
press. This would again result in a secondary reaction of expansion of bank credit.
This type of deficit financing by loans from central bank tends to be highly
inflationary.

OBJECTIVES OF DEFICIT FINANCING

Deficit financing has been ascribed an important role in fiscal policy on account of
increases in public expenditure on various accounts. The different objectives of
deficit financing make it clear.

1) To finance wars.
Deficit financing has been found to be the simplest and quickest method to finance
huge War expenditures. War time emergency makes it difficult for government to
raise urgent resources through its usual methods of taxation and public borrowing.

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The funds obtained through deficit financing are used by the government to purchase
goods and services to fight war. This raises the aggregate demand. Resources are
mobilized by the government not for productive purpose but for war efforts which
is unproductive. Thus the rise in aggregate demand and non-availability of sufficient
goods result in an inflationary price rise.

2) To fight unemployment during depression.

Keynes advocated deficit financing as an important tool of solving the problem of
involuntary unemployment during depression. This unemployment during
depression occurs due to lack of effective demand since private spending is low.
Therefore the only way to combat unemployment would be for the government to
invest in public works programmed to create employment.

Further during depression welfare payments to be made by the government would

also increase. Government cannot get finance for this expenditure out of taxation or
public borrowing as taxable capacity and ability to contribute to government loans
is very low during depression. Hence the government has to borrow from the
banking system. Thus deficit financing becomes the best mode of financing anti-
deflationary expenditure.

Keynes suggested that the investment undertaken by the government will result in a
multiple increase in incomes via the multiplier effect. However the operation of the
multiplier may not be that successful in underdeveloped countries as there is
unutilized or idle capacity in both agricultural and industrial sectors. Supply of
working capital is also very low. On the other hand marginal propensity to consume
is very high. Thus Keynes' multiplier may actually raise the aggregate demand
instead of raising the aggregate supply. Hence deficit financing to combat
unemployment in underdeveloped countries requires great caution in handling so
that inflationary pressures are not generated.

3) To promote economic development.

Deficit financing can go a long way in promoting economic development in
underdeveloped countries. There are two issues to be discussed here. First refers to
the way in which deficit financing can be used to finance development projects.
Second whether deficit financing for development results in inflationary potential.
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The major obstacle to development in developing countries is low rate of capital
formation which is not enough for sufficient investment to provide jobs for the large
number of unemployed. With increasing population the level of unemployment also
increases necessitating greater capital formation. Low incomes of people reduce the
taxable capacity as well as ability to save. For the same reason, government cannot
raise resources through public borrowing too. Hence deficit financing becomes the
only way of mobilizing required resources, in developing countries.

Deficit financing can help to stimulate the rate of investment indirectly. Deficit
financing for development first of all increases incomes and thus savings too. It
results indirectly in forced saving too because when the government purchases goods
and services for its projects, people do not get them. So the reduced private spending
results in larger saving.

If the government uses deficit financing to undertake productive projects then output
would increase and it may not be inflationary. But there are certain rigidities in the
developing countries which do not result in complementary factors for investment.
Firstly there is a lack of entrepreneurship and technical know-how. Secondly there
is no adequate infrastructure such as organizations, market communications etc.
These market imperfections fail to increase effective supply along with increasing
demand and these causes rising prices.

Further elasticity of supply is not the same in different sectors of the economy. For
example elasticity of supply tends to be low in agriculture than in industry. In the
initial stages of development if the government expenditure is directed towards these
sectors whose elasticity of supply is low, it is certain to increase incomes and demand
in these sectors but lack of supply response would raise prices. In all these cases, if
deficit financing used for development schemes results in inflationary price rise, the
government should carefully raise taxation to siphon off the excess purchasing
power in the hands of the people.

Another way in which deficit financing can promote development is when it

increases the incomes of the entrepreneurs whose propensity to save is high. In fact
this may result in greater inequality of income. But in the initial stages, higher
propensity to save of the entrepreurial class is a welcome feature in the interest of
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general economic development. This fits into the theory of imbalanced growth given
by A.O. Hirshman.

In general it is accepted now that so long as care is taken to avoid inflationary

potential, deficit financing is a very useful instrument of development in developing
countries. Deficit financing should preferably be used for quick yielding projects in
the initial stages so that the increase in production will control inflationary pressure.
If development projects have long gestation period, deficit financing for such
projects would bring in inflationary price rise. Hence in developing countries deficit
financing should be carefully used in the initial stages to lay a good foundation for
necessary infrastructure for development.

4) To mobilize surplus, idle and unutilized resources.

Keynes had advocated deficit financing for the mobilization of surplus labour and
other resources during depression. This argument may be applicable to
underdeveloped countries only with limitations. If deficit financing is used to
employ such labour in the agricultural sector in these countries, it may create
inflationary price rise.

On the other hand deficit financing is recommended for its ability to create new
resources in these countries. When deficit financing raises prices in these countries,
it reduces consumption and savings become forced. Thus deficit financing is
recommended in developing countries for the mobilization of forced savings or for
the creation of new resources, which again can be used for next stage of
development. That is why W. A. Lewis said that "Inflation for the purpose of capital
formation is in due course self-destructive".

5) To finance the Plans.

In developing countries where planned economic development has been adopted,
huge resources are required for implementation of government investment. The
government takes greater interest to create infrastructure, industrial development in
vital sector besides transport and communication. Deficit financing is a. useful tool
to finance the Plans.

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 6) To serve as an alternative tool.
Underdeveloped countries suffer from low taxable capacity and low savings. Hence
government's ability to raise resources gets constrained. Therefore there is no harm
in resorting to deficit financing as an alternative source of mobilizing resources
besides taxation and public borrowing.

EFFECTS OF DEFICIT FINANCING

Deficit financing can make or mar progress if it is not carefully planned. It has
diverse effects depending upon how it is handled. The major effects pertain to
inflation and distribution of income.

1) Deficit financing and inflation.

There are two views regarding the impact of deficit financing on prices. The first
view is that deficit financing is pro inflationary. This view holds that the first impact
of deficit financing is on the creation of new money. Deficit financing is
recommended for the creation of capital goods whose gestation period is long. There
is increase in money incomes in this sector. But consumer goods producing sector
does not respond quickly to bring more production. This results in rise in prices of
consumer goods which may prove to be spiraling. The price rise will be greater if
market imperfections exist as bottlenecks to increased production.

Further, a part of the increased incomes, in the absence of sufficient goods to spend,
may be channelized into commercial banks who may use it for further credit
creation. In fact in developing countries the inflationary pressures are due to
monetary expansion after deficit financing. Inflation then tends to be demand-pull
type while deficit financing in developed countries causes cost-push type of inflation
on account of long-term gestation projects. The poor developing countries are not
well equipped in terms of monetary and fiscal policy to control inflation. Hence there
is a possibility that unabated inflation on account of deficit financing may hinder
economic development of these countries.

The second view holds that deficit financing is not necessarily inflationary because
public sector has emerged as a dominant sector in these economies. If this additional
finance is utilized for productive purposes, it need not be inflationary. Deficit
financing is required to provide finance for increasing output at stable prices. If
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deficit financing is not resorted to there may be a decline in prices which will have
an adverse effect on output and employment.

W. A. Lewis points out that there are three stages in the impact of deficit financing.
In the first stage, only capital goods industries are created through deficit financing
and as they have long gestation, prices rise steeply. In the second stage, the rise" in
prices makes people reduce consumption which results in forced savings which
increases investment. In the third stage, the capital formation of the first stage begins
to bring consumer goods to the market which helps to lower prices. Therefore deficit
financing is 'dangerous and painful' only in the first stage. In Lewis' view inflationary
potential of deficit financing is therefore self-destructive. Others however point out
that if the consumer goods are not increased in the second and third stages due to
some constraints, inflation becomes rampant.

2) Effect on distribution of income.

Deficit financing has certain undesirable effects on the distribution of income.
Deficit financing provides incentives to entrepreneurs through larger profits on
account of rising prices. But the same rising prices reduce real incomes of the wage
earning class. This leads to a distribution of income in favour of the profit earning
classes. Hence inequality of incomes widens. This is very much against the social
objectives of equitable distribution of income and wealth.

Thus an analysis of the objectives and effects of deficit financing proves that it is a
double-edged sword. Its effects can be good so far as it promotes capital formation
and does not allow for a steep increase in prices. Its effects can be harmful if the
inflationary potential goes uncontrolled, bringing about adverse effects on
distribution of incomes and wealth, thus increasing inequality. The exact impact of
deficit financing depends upon the mode of deficit, governments' attitudes and
policies, reaction of the private sector and growth of the public sector.

Deficit financing can be a very useful and effective fiscal tool for development in
under developed countries if it is used only for capital formation to channel resources
into productive areas. The mild price rise on account of deficit financing in the early
stages acts as an incentive to entrepreneurs to increase productive activity. Such a
functional rise in prices is harmless.
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LIMITS TO DEFICIT FINANCING
It is now recognized that deficit financing is a bad master but can be a good servant
i.e., it should be handled carefully without using it excessively. This raises the
question as to what is the safe limit for deficit financing. Several factors are to be
considered in determining the safe limit.

1) Growth rate of the economy and money supply.

The money supply should expand to facilitate the growth rate of the economy.
Suppose the total money supply in the economy is 4,000 million dollars and the
growth rate of the economy is 5 per cent, it requires an additional money supply of
$200 billion per annum to sustain the growth rate. Hence deficit financing can be
used to create 200 billion dollars per annum. But since it is used for productive assets
creation, deficit financing can be even more than 5 per cent of the money supply.
Thus even 7 or 8 per cent expansion in money supply on account of deficit financing
need not be inflationary in developing countries.

2) The efforts made by the government to mobilize its resources.

Deficit financing should be used only as a last resort after all alternative source of
finances are exhausted. The public will not mind the effects of deficit financing when
they know that the government has undertaken all efforts to mobilize other resources
and only when they are exhausted, deficit financing is adopted.
3) Control of incomes and prices.
Deficit financing to finance government projects enters the income stream in the
form of wages and salaries. It is this increasing incomes and wages which exert an
inflationary pressure. Hence a proper control over income and prices acts as a control
over the inflationary potential of deficit financing.
4) The growth of monetized sector.
It is the existence of a large non-monetized sector which aggravates the inflationary
potential of deficit financing. The extent to which the non-monetized sector is
brought into the ambit of monetized sector, acts as a safe limit to deficit financing.
5) Increase in the production of public sector.
Deficit financing is incurred to finance public sector projects. If their production
increases, this increase in production will cushion the inflationary potential of deficit
financing. It is for the same reason deficit financing should not be incurred for
unproductive purposes.
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 6) Promotion of imports.
Deficit financing is bound to increase incomes in the initial stages which causes an
increase in demand for goods and services. Since production does not increase
immediately in the early stages, the inflationary pressures can be kept within safe
limits by permitting import of goods. This of course depends upon the foreign
exchange reserves to the country.
7) Restriction on credit.
A large portion of new money created through deficit financing may reach the
banking sector in which case it gives them an opportunity to create credit further.
Restriction on credit can limit inflationary pressures.
8) Direct and indirect control.
Government should adopt various measures to control prices directly and indirectly.
Direct control refers to the control of prices beyond the stipulated levels. It is a type
of administered prices. Indirect controls result in government's improving the public
distribution system to supply goods to the people at reasonable prices.
9) Public spirit of cooperation and toleration.
Some economists point out that "The role of public understanding and public
cooperation is a factor in tending to diminish the price effect of deficit financing".
Unless the government enjoys the public cooperation, it will have to face open,
popular and political opposition to further use of deficit financing when the prices
rise excessively. The spirit of tolerance on the part of public acts a limit on
government's use of deficit financing.

In the final analysis the state of the economy, the purpose for which deficit financing
is incurred, the control over money expansion, prices and incomes, the magnitude of
the deficit financing, are all factors /which, limit the government's powers to resort
to deficit financing excessively.

Fiscal Policy: Further explanation

Fiscal policy is defined by Arthur Smithies as "a policy under which the government
uses its expenditure and revenue programme to produce desirable effect and avoid
undesirable effects on the national income, production and employment". This
definition acknowledges that the government expenditure and taxation are the two
fiscal tools which can have desirable as well as undesirable effects on macro
variables like income, production and employment.
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Otto Eckstein defines fiscal policy as "changes in taxes and expenditure which aim
at short run goals of full employment, price level and stability". This definition adds
two more goals of fiscal policy viz., price level and stability.

Urusula Hicks broadens the scope of fiscal policy. She defines it as a policy
"concerned with the manner in which all the different items of Public Finance ... may
collectively be geared to forward the aims of economic policy". Thus besides public
expenditure and taxation, public debt can be included as the third element of fiscal
policy.

Gerhard Colm therefore defines fiscal policy "as the conduct of the government
expenditure, revenues and debt management in such a way as to take fully into
account the effect of these operations on the allocation of resources and the flow
of funds, and thereby their influence on the levels of income, prices,
employment and production".

Fiscal policy differs from monetary policy in its mode of operation, Gardner Ackley
points out "unlike monetary policy these measures involve direct government
entrance into the market for goods and services (in case of expenditure) and a direct
impact on private demand (in the case of taxes)". Thus the impact of fiscal policy on
aggregate demand is direct while the monetary policy can affect the aggregate
demand only indirectly through the banking sector.

Fiscal Instruments
Government expenditure, taxation and public borrowing are three fiscal tools which
act as levers to bring changes in income, employment and prices.

1) Public Expenditure
Government expenditure incurred in any way results in an increase in wages and
salaries of its employees in the form of interest payment on debts or results in welfare
payments like pensions or social security benefits. They tend to increase the
disposable incomes of the people which cause an increase in the aggregate demand
for goods and services. Thus an increase in government expenditure increases
aggregate demand while a decline in public expenditure decreases aggregate
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demand. Therefore during inflation public expenditure should be reduced to control
the demand-pull inflation. During depression public expenditure gains much
importance. Keynes had established that the Great Depression of 1930s was caused
by deficiency of aggregate demand. Private investment will be sluggish during
depression. Expenditure on public works programmes must be increased to raise
aggregate demand.

Government expenditure on public works programme or welfare benefits either way

result in an increase in incomes. This increase in incomes causes an increase in
consumption. Increase in consumption again results in the secondary increase in
income. This income-consumption effect goes on and the initial increase in public
expenditure brings about a multiple increase in income.

2) Taxation Policy
The effect of taxation is different from that of public expenditure. An increase in
taxation reduces disposable incomes. This reduces their Consumption and savings.
An increase in taxation reduces aggregate demand while a decline in taxation
increases it. During inflation therefore taxation should be raised to reduce the
disposable incomes of the people. This will help to control inflationary pressures.
During depression taxation should be reduced to leave more disposable incomes to
encourage people to spend.

3) Government Borrowing
The third fiscal tool is government borrowing. Public debt policy influences
aggregate demand through the volume of liquid assets. When government floats a
loan there is a transfer of liquid funds from the private sector to the government
which reduces the purchasing power of the private sector. At the time of interest
payments and repayment of debt, there is transfer of funds from the government to
the private sector which increases the purchasing power in the hands of the private
sector.

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OBJECTIVES OF FISCAL POLICY

Fiscal policy is now considered an important instrument to achieve the

macroeconomic goals. The classical economists had believed in automatic full
employment and so they advocated laissez faire. There was no need for government
interference in the economic system. Taxation was to be minimum to meet the
requirements of the government expenditure on law and order and defense only.
They advocated a balanced budget. Thus minimum taxation to meet only essential
public expenditure and balanced budget were the principles of sound public finance
in classical theory.

In sharp contrast to such a passive role for fiscal policy, modern economists like
Keynes assigned an active and positive role to fiscal policy. Fiscal policy should be
used to regulate and control the economy with the help of fiscal tools like taxation,
public expenditure and public borrowing. This was called the principle of
Functional finance.

The concept of Functional finance has been developed by A.P. Lerner. Functional
finance evaluates fiscal policy by its effects on the way it functions in an economy.
According to the principles of Functional finance, fiscal policy must first remove the
factors that cause inflation and deflation so that economic stability can be
maintained. Secondly, the purpose of borrowing is not to raise money only but to
make people hold more bonds, and less money. Hence public borrowing should be
used to control purchasing power in the economy. Thirdly taxation is also to be used
not only to raise revenue for the government but also to control purchasing power in
the hands of the people. Fourthly, any excess of government expenditure over its
revenue should be met with by public borrowing. But if borrowing is not possible,
it should be covered through deficit financing or printing of new money, more so in
depression.

Thus Functional finance assigns an important role to fiscal policy viz., to control
cyclical fluctuations in the economy by avoiding inflation and deflation and also to
achieve and maintain full employment and price stability. It means budget need not
be balanced. Thus the principle of functional finance replaced the principles of sound
finance.
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Musgrave however feels that there can be no simple set of principles to demarcate
fiscal policy. There are actually a number of unrelated issues. Musgrave hence
points out that fiscal instrument should be used
1) to secure adjustments in/the allocation of resources
2) (2) to secure adjustments in the distribution of income and wealth and
3) (3) to secure economic stabilization.
This theoretical development has considered the conditions of developed countries
while setting forth general objectives of fiscal policy. The objectives of fiscal policy
in developed countries are bound to be different from developing countries. In the
developed countries the major objectives are full employment, economic stability
and a high and stable rate of growth. In developing countries besides these three, the
major objective is to stimulate capital formation and encourage investment, to
achieve economic development. Hence the major objectives of fiscal policy may be
identified as follows.

Objectives of fiscal policy

1) Full employment
2) Price stability
3) To accelerate the rate of economic growth.
4) Optimum allocation of resource
5) Equitable distribution of wealth and income.
6) External stability.
7) To promote capital formation and investment.
8) To remove regional imbalance

To be updated later!!!

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