Monday, 1 February 2016

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Budget Deficits Explained,,,

Economics | Budget Deficits Explained

As the word suggests, it refers to the amount by which Spending exceeds Income.

There are 3 types of Budget Deficits –

1. Revenue Deficit(RD), 2. Fiscal Deficit (FD) and 3. Primary Deficit(PD).

These cannot be understood without a basic knowledge of the Budget. In a separate note, we will see their relationship with other terms like Balance of Payment ( BoP ), Current Account Deficit (CAD), etc and understand the concept of twin deficits. However in this note, we restrict our conversation to Union Budget.

I. Union Budget

The Union Budget is divided into 2 Budgets

Revenue Budget (RD)Capital Budget (CB)

Why is it split this way?

To understand this, let's assume a hypothetical situation where

A. Your monthly take-home salary is 50K. Your monthly consumption is 10K (includes basic necessities like groceries, water, electricity, etc.).

B. At the same time, you decided to buy a house for 100K, sold shares worth 50K and took a loan of 10K.

Now, lets examine the components of A –

It has income that's more or less fixed every month(your salary), you do not draw down on your assets to earn this money i.e. Household revenue receipt. It contains expenditures that are recurring i.e. they happen every month and you have very little control over them (changes in your lifestyle will impact them). Moreover no assets/capital is created by these expenditures i.e. Household Revenue Expenditure.

Together, they constitute your household revenue budget.

Let's examine components of B  now–

This income from loan is a liability as you have to return it. It's not something you have earned. It's borrowing, it's a debt. Moreover, its not fixed as you won't be taking a loan every month. It's a one time receipt. Since it creates debt, it is debt creating capital receipt.Shares you sold gave you 50K. You have lost your asset now. It's also one time payment as you can't sell same shares again( you have already sold your stocks). It does not create debt i.e. non debt creating capital receipt. Together, they constitute household capital receipt.B also has expenditure that leads to asset creation ( you can sell your house to recover money, you can give it on rent and earn regular income) i.e. Household capital expenditure.  Part B constitutes household Capital Budget

 'Analyzing your monthly finances in the above manner makes it very clear as to how much money you owe, what assets you bought and sold and what's your regular expenditure. Any other classification would miss all these important components. Extrapolating this to the Budget –

A represents Revenue Budget and B represents Capital Budget.

Formally defining,

RB consists of Revenue Receipts(RR) and Revenue Expenditure(RE) met from these RR. Where

RR = Income that neither creates liability( borrowing) nor reduces asset( divestment, auction of natural resources), It includes Tax + Non Tax Revenues( Service charges, dividends from PSUs, interest govt. receives, Grants in aid etc) RE = All expenditure that doesn't lead to capital/asset creation.

CB consists Capital Receipts(CR) and Capital Expenditure (CE). Further CR has 4 components(becomes important for prelims).

CR = CRa + CRb + CRc + CRd where, CRa = Proceeds from Disinvestments say of PSUs. CRb = Recovery of past loans. CRc = Sale of assets/capital by the Govt for eg. Coal Blocks, 2G,3G, etc. CRd = Loans raised by Government (on which it has to pay interest)

Similarly, CE consist of capital expenditure on acquisition of assets/capital like

CE = CEa + CEb + CEc where, CEa = Loans given to States and UTs CEb = Repayment of Past Loans CEc = Investment in infrastructure

It would help you to keep in mind the components of the CR and CP.

Now that the above terminology is clear, let's move and define the Deficits.

II. Deficits

Revenue Deficit(RD) refers to the excess of revenue expenditure over revenue receipts RD = Revenue Expenditure(RE) – Revenue Receipts(RR)

Pretty simple and straightforward. What does it signify?

It signifies if the day to day expenditure of the govt can be
met by its day to day income.

This is a very important deficit. It talks about component A. What happens if my monthly take home salary is 50K and my consumption is 60K? You can see that I'll have to take loans to meet my monthly expenditures. But how will I repay the loans???

Same is for the economy. A healthy economy shouldn't be taking loans to meet its day to day expenses or it might end up falling in the debt trap.

This deficit was so important that the FRBM Act. 2003 laid down rules to bring this deficit to absolute 0 by 2008-09.

Fiscal Deficit(FD) is the difference between the total expenditure and [revenue receipts plus non-debt capital receipts] FD = Total Expenditure(TE) – (RR + CRa+CRb+CRc)

Sounds complicated! Well not exactly. Lets go back to our example.

Total Expenditure ( TE ) for that month is-

10k (monthly consumption i.e. RE)+100k(purchase of a house i.e. CE) = 110k.

Total Receipt (TR ) is-

50k (salary i.e. RR) + 50k ( share sale i.e. non debt capital receipt) + 10k ( loan i.e. Debt creating Capital receipt).

Put everything in formula-

FD= TE – ( RR + Non debt CR )

FD= 110k- ( 50k + 50k )

FD= 10k

If you look carefully this figure represents the loan you took to buy your home!

Similarly, at the Budget level, it indicates the amount the Govt has to borrow to meet its annual targets.

Primary Deficit(PD) is measured by fiscal deficit less interest payments. Primary Deficit (PD) = FD – Payment of Interests from previous loans

PD has special significance.

It shows what the Fiscal Deficit would've been for this particular year if no interests were to be paid. It ignores the loans taken by the previous Govts. in previous financial years.It talks about the health of our economy. Lets understand how

Lets consider few cases.

1. PD = 0.

It implies FD = Payment of Interests from previous loans.

This implies that the present government has recognized the need to tighten its belt, is now balancing its budget and FD is due to mess created by previous governments who borrowed irresponsibly.

2. PD = FD

It implies that Payment of Interests from previous loans are 0. Meaning we are taking loans to meet other targets and not payment of past loans. This implies previous governments acted very responsibly and balanced their budgets.

There is another kind of Deficit – Effective Revenue Deficit(ERD)

This was introduced in 2012 – 2013. This deficit tries to take into account the asset creation that happens at the state level.

ERD = RD – (grants for creation of capital assets)

We included all loans given to the states as one single category, revenue expenditure, without classifying which ones are being used for asset creation i.e. Capital Expenditure and which ones to meet other expenses i.e. Revenue Expenditure.

Those which are used for asset creation at the state level are subtracted from the revenue deficit to arrive at Effective Revenue Deficit.

By:: Shubham mishra

 

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