India is one of the fastest growing economies in the world. The foreign exchange reserves reach a new high every week ($141 billion at last count), inflation has been controlled and nominal interest rates continue to be low.

Yet there are concerns about India's fiscal deficit. The combined deficit of the central and the state governments stands at greater than 10 per cent of the GDP (gross domestic product). The public debt has almost reached four and half years of revenue.

So there are reasons to worry.

What is fiscal deficit?

Fiscal deficit is essentially the difference between what the government spends and what it earns. It is expressed as a percentage of GDP.

This is done as it may not be appropriate to compare the deficits of different years in absolute terms. This percentage though can be misleading. The revised estimates for the financial year (FY) 2004-05, suggest that the government earned Rs 366,560 crore (Rs 3,665.60 billion) and it spent Rs 505,791 crore (Rs 5,057.91 billion). The fiscal deficit stands at Rs 139,231 crore (Rs 1,392.31 billion), which is equivalent to 4.5 per cent of the GDP.

Similarly, in the year 2005-06, the government hopes to earn Rs 363,200 crore (Rs 3,632 billion) and plans to spend Rs 514,344 crore (Rs 5,143.44 billion).

The deficit the government plans to run is Rs 151,144 crore (Rs 1,511.44 billion), which is equivalent to 4.3 per cent of the GDP.

What this shows us is that in the year 2004-05, the government spent a whopping 38 per cent more than what it earned. In the year 2005-06, this percentage might go up to 41.6 per cent. This is very large but the same when expressed as a percentage of GDP sounds less.

Expenditure

The expenditure of the government can be classified into plan expenditure and non-plan expenditure.

Plan expenditure is an expenditure that the government plans to incur on a scheme to be implemented in a given year. For example, in the year 2003-04 (as per the revised estimates for that year), the government had allocated Rs 2588.62 crore (Rs 25.886 billion) for construction of national highways. This expenditure that was incurred for construction of national highways came in as a part of plan expenditure.

Non-plan expenditure is defined as expenditure committed by the expenditure. Interest payments, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure.

Non-plan expenditure is generally an outcome of plan expenditure. For example, the national highways the government constructed in the year 2003-04 and before, need to be maintained. All the expenses going towards this is treated as non-plan expenditure.

The budgeted allocation for the maintenance of national highways in the year 2004-05 stood at Rs 746.70 crore (Rs 7.467 billion).

Expenditure on both plan and non-plan front can be categorised into capital and revenue expenditure. Capital expenditure includes that expenditure which leads to creation of assets whereas revenue expenditure does not involve asset creation and is recurring in nature.

The construction of the national highways in the year 2004-05 would involve expenditure on aggregate, bitumen or cement (depending upon the nature of the road) and certain machinery.

This expenditure would be classified as capital expenditure. The labour charges would be classified as revenue expenditure. Once the plan expenditure is over the maintenance of the road would start.

The expenditure on this would be non-plan and can be further categorised into non-plan capital expenditure and non-plan revenue expenditure.

The devil is in the detail

The government fails to match its expenses with what it earns and thus has to resort to deficit financing. It makes good of this gap by borrowing in various ways. On this borrowing, the government has to pay a certain amount of interest. The interest payments as explained above are a part of non-plan expenditure.

If we take a look at figures starting from 1994-95 till 2002-03, non-plan expenditure has been steadily rising from 9.2 per cent of the GDP to 12.1 per cent of the GDP. Of that the interest payments have steadily risen from 4.3 per cent of the GDP to 4.8 per cent of the GDP.

The plan expenditure varied from 4.6 per cent of the GDP in 1994-95 then steadily fell to 3.8 per cent of the GDP in 1998-99 to rise gain to 4.6 per cent of the GDP in 2002-03.

The actual estimates for the year 2003-04 puts interest payments at Rs 124,088 crore (Rs 1,240.88 billion) -- 4.53 per cent of GDP. The plan expenditure for the same year stood at Rs 122,280 crore (Rs 1,222.80 billion) -- 4.46 per cent of GDP.

The revised estimates for the year 2004-05 puts interest payments at Rs 125,905 crore (Rs 1,259.05 billion) -- 4.07 per cent of the GDP. The plan expenditure for the same period stood at Rs 137,387 crore (Rs 1,373.87 billion) -- 4.44 per cent of the GDP.

The budgeted estimates for the year 2005-06 put interest payments at Rs 133,945 crore (Rs 1,339.45 billion) -- 3.82 per cent of the GDP. The plan expenditure for the same period is Rs 143,497 crore (Rs 1,434.97 billion) -- 4.08 per cent of the GDP.

From 1995-96 till the year 2003-04, the component of interest payments in the annual Budget has been greater than plan expenditure though in the financial year 2004-05 plan expenditure was greater than the interest payments. Non-plan expenditure other than interest payments (like subsidies, pensions, salaries, etc) has also been going up.

This shows that India is spending more on interest payments and other non-planned expenditure than on development.

The government wants to invest in infrastructure, power, primary education, health and water supply to put India on the fast track to growth. But it simply doesn't have the money to implement its strategy. The deficit is essentially servicing current consumption and not financing capital investment, which should be the case.

The current situation leads to a very interesting conclusion. We all know that deficit financing involves the government financing its excess expenditure over revenue through borrowing.

Conventional wisdom tells us that money that is borrowed needs to be invested in areas where the return generated is greater than interest to be paid on the debt (i.e. the return generated should be greater than the cost of capital).

But the government cannot always work with the profit motive in mind. The government is not earning enough to pay back the interest on its debt. So what is it doing? It is taking in more debt to repay its earlier debt and the interest that is to be paid on the existing debt. Not a healthy sign one must say.

Low interest rates

From December 1997 to Jan 2004, the average bank rate fell from 12 per cent to 6 per cent. The prime-lending rate of banks fell from a peak of 15 per cent to 11 per cent. The interest rates were brought down substantially, apparently with the objective of boosting business activity.

But what happened makes one think that the government wanted to finance its deficit at lower interest rates rather than encourage business lending. Ironically, lending by banks to industrial clients did not really pick up.

The falling interest rates gave very little incentive to banks to lend to industrial clients, as the returns were not high enough to compensate for the risk involved. Given this, it made more sense for banks to invest in government securities where the risk involved was minimal.

Banks invested much more than what was statutorily required. (Banks have to invest a minimum of 25 per cent of their net banks deposits in government securities). And this helped the government finance its deficits at lower interest rates.

Apart from the government, large corporates also benefited as they could replace their earlier high cost loans with cheaper loans.

This scenario encouraged banks to concentrate on the retail segment. Banks gave out loans to finance expenditure, which did not help in capital formation. Charitable trusts, poor pensioners, senior citizens and widows saw the value of their savings come down considerably.

The fact that India does not have a social security system in place did not help.

Revenue Deficit and Fiscal Responsibility and Budget Management Act (FRBMA)

Revenue deficit is the difference between the revenue expenditure and the revenue receipts (the recurring income for the government). When a country runs a revenue deficit it means that the government is unable to meet its running expenses from its recurring income.

The FRBMA was notified on July 2, 2004 and came into force on July 5, 2004. This Act requires the reduction of fiscal deficit and elimination of revenue deficit by March 31, 2009.

The FRBMA requires the Government of India to reduce fiscal deficit by a minimum of 0.3 per cent of the GDP every year and revenue deficit by 0.5 per cent each year, so that the fiscal deficit is not more than 3 per cent of the GDP by March 31, 2009.

The idea seems to be that deficit, if any, should be used to finance capital expenditure that leads to asset formation and not on revenue expenditure, the benefits of which do not go beyond that particular year.

The FRBMA has certain loopholes. It does not require capital expenditure leading to a deficit to recoup its cost of capital (i.e., the return generated on the investment done through capital expenditure need not be greater than the interest to be paid on it). This might lead to the overall spending and deficits to be quite unconstrained.

For the year 2005-06, Finance Minister P Chidambaram has chosen to overlook the requirements of FRBMA. The fiscal deficit for the year has been budgeted at 4.5 per cent of the estimated GDP, which will be 0.1 per cent less than the required reduction.

The revenue deficit target for the year 2005-06, if FRBMA requirements were followed, had to be at 1.8 per cent of the GDP. But it has been budgeted at 2.7 per cent of the GDP.

Given the strong growth experienced by the Indian economy better progress could have been made on this front. One reason for ignoring FRBMA for this year is the fact that the government has increased grants to the states in line with the recommendations of the Twelfth Finance Commission.

The government might miss its revenue deficit target of 2.7 per cent of the GDP in the coming year on account of a likely undershooting of tax revenue collections, as highly optimistic assumptions of tax revenue growth have been made. This would lead to the budgeted fiscal deficit also shooting up.

The way out

Taxes are the most important source of revenue for the government. India's tax/GDP ratio stands at around 10 per cent. This is much less than the average ratio of 20 per cent across the emerging market countries.

For the OECD (Organisation for Economic Cooperation and Development) countries the ratio stands at 37.5 per cent. Increasing tax rates is not really an option, as it will hit those who have already been paying taxes.

So this leaves us with the other option of widening the tax net. The government seems to have taken steps to widen the net but much remains to be done. The services sector, which forms almost 50 per cent of the economy, contributes less than 5 per cent of the total taxes collected. This anomaly needs to be corrected.

More and more people should be brought under the tax net. Income should be taxed irrespective of where it's coming from. Agricultural income should be taxed, as it's the bigger farmers who are gaining from the exemption and not the smaller farmers for whom it's meant.

And if India continues to grow at rates at which it has been doing in the recent past, fiscal deficit will automatically come down to the extent expenditure is held in check.

In closing

Whenever the government runs a deficit it has to meet the deficit either by borrowing or by printing money. Macroeconomic theory tells us that if the government borrows heavily by selling government bonds, bond prices go down and the interest rates go up and this leads to the crowding out of private investment.

If the government prints money to finance the deficit and production does not increase immediately, this leads to increased inflation as more money in the economy chases the same amount of goods.

India is not showing any of the above symptoms; interest rates continue to be low and inflation is well under control. Moreover, foreign institutional investors are making a beeline for investment into the Indian markets. There are no telltale signs of a crisis.

Given that the Indian economy is looking very robust as of now, the government should have tried and built some cushion on the fiscal side so that when the growth slows down it could go in for increased spending to 'pump prime' the economy. The government thus has missed an opportunity to correct India's fiscal imbalance.