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Wednesday, February 07, 2018

Revenue Deficit vs Fiscal deficit and Fiscal responsibility

"Ballooning Revenue Deficit is far more worrisome than nominal slippage in fiscal deficit" said Mythili Bhusnurmath in ET. Her views are correct. But how to curb Revenue deficit. Let us understand the terms a bit more in detail.

Revenue deficit is amount by which Revenue expenditures exceed Revenues. 

What are revenues or Revenue receipts?
Revenues can be tax or non-tax. Tax component includes share of tax of Union Government in general taxes and "cess" or specialized taxes accruing to Union Government alone. [Refer Note 1]. Non-tax revenues includes interest on loans to various entities (state governments, etc.),  profits and dividends from enterprises, duties and fines received, grants from multilateral agencies or other governments etc.

What are revenue expenditures?
Revenue expenditures includes:
  1. Salaries and pension paid to government employees
  2. Subsidies
  3. defense expenditure (relates to national security)
  4. Government procurement from stationery to vehicles to arms and ammunition for police (internal security)
  5.  Expense required for running government schemes and programs
  6. Interest paid on borrowings - domestic and external.

Fiscal Deficit is more like capital account deficit.
Capital Account Receipts side includes recovery of loans to States etc., receipts from disinvestment or privatization and borrowing (external and domestic). Capital expenditures includes investments in Public sector companies, investments in public projects, etc.

Further, accounting 101 will tell you that revenue deficit accumulates in the Fiscal side and it has to be financed through borrowing which sits on the capital account. The servicing of this borrowing is done through revenue expenditures. These twin deficits thus, are quite interlinked. Mathematically, it is true that we can reduce Fiscal deficit (FD) while Revenue Deficit (RD) remains high. But it is true only for small values of RD. But a more ideal situation is when FD is higher (though less than the 3%) and RD is zero or lower. Then, one presumes, your excess FD would be mostly because of high quality capital expenditure. This capital expenditure will yield more Revenues and thus lower RD in the future. [Refer Note 2].

The Problem
For past decade or more, reverse is true. Most of borrowing is used for revenue expenditures - i.e. payment of salaries to bureaucrats. In return, bureaucrats and government employees have stifled any possible revenue growth for citizen or companies thereby reducing the revenues. This widens the revenue deficit and pushes the system into a negative spiral.

It is clear that the present malaise is largely self-inflicted. Imposing FRBM target without first having a RD at zero or lower is a recipe for disaster. At present, government appears to throw disinvestment money after revenue expenses and that is very bad idea. It erodes the structure of the economy.

How to kickstart the positive spiral?
The government is now required to first ensure that RD is reduced to zero but using revenue receipts. That requires expansion of tax base which is impossible without taxing agriculture. Thereafter, using asset sales i.e. disinvestment or privatization route, reduce the lower quality borrowing. Most of the borrowing by the government should be directed towards investments that yield revenues in the future and thus create structural zero- revenue deficits or revenue surpluses. This is the improvement in quality of budget is what prudent observers seek.

Notes:
  1. Indian federal structure implies that both center and states have power to tax and they have share in the tax. Most of the taxes are shared and go into "consolidated fund of India" for central share and "consolidated fund of the state" for state taxes.
  2. Ideally, the any borrowing or loan or debt should create more revenue than expenses required to service it. To do that, borrowing must be invested in revenue boosting ventures. Companies borrow to buy new machine that can increase production. Similarly nations should invest in those assets that will increase profits for citizens and companies and thus improve tax receipts.