NCF 2005

Deficit Financing

Introduction

Deficit financing is the budgetary situation where expenditure is higher than the revenue. It is a practice adopted for financing the excess expenditure with outside resources. The expenditure revenue gap is financed by either printing of currency or through borrowing.

Nowadays most governments both in the developed and developing world are having deficit budgets and these deficits are often financed through borrowing. Hence the fiscal deficit is the ideal indicator of deficit financing.
In India, the size of fiscal deficit is the leading deficit indicator in the budget. It is estimated to be 3.9 % of the GDP (2015-16 budget estimates). Deficit financing is very useful in developing countries like India because of revenue scarcity and development expenditure needs.

Meaning of Deficit Financing:

The National Planning Commission of India has defined deficit financing in the following way. The term ‘deficit financing’ is used to denote the direct addition to gross national expenditure through budget deficits, whether the deficits are on revenue or on capital account.

Objectives

i. To finance defence expenditures during war

ii. To lift the economy out of depression so that incomes, employment, invest­ment, etc., all rise

iii. To activate idle resources as well as divert resources from unproductive sectors to productive sectors with the objective of increasing national income and, hence, higher economic growth

iv. To raise capital formation by mobilizing forced savings made through deficit financing

v. To mobilize resources to finance massive plan expenditure

Content

The ‘Why’ of Deficit Financing:

There are some situations when deficit financing becomes absolutely essential. In other words, there are various purposes of deficit financing.

To finance war-cost during the Second World War, massive deficit financing was made. Being war expenditure, it was construed as an unproductive expenditure during 1939-45. However, Keynesian economists do not like to use deficit financing to meet defence expenditures during war period. It can be used for developmental purposes too.

Developing countries aim at achieving higher economic growth. A higher economic growth requires finances. But private sector is shy of making huge expenditure. Therefore, the responsibility of drawing financial resources to finance economic development rests on the government. Taxes are one of such instruments of raising resources.

Being poor, these countries fail to mobilize large resources through taxes. Thus, taxation has a narrow coverage due to mass poverty. A very little is saved by people because of poverty. In order to collect financial resources, government relies on profits of public sector enterprises. But these enterprises yield almost negative profit. Further, there is a limit to public borrowing.

In view of this, the easy as well as the short-cut method of marshalling resources is the deficit financing. Since the launching of the Five Year Plans in India, the government has been utilizing seriously this method of financing to obtain additional resources for plans. It occupies an important position in any programme of our planned economic development.

The ‘How’ of Deficit Financing:

A budget deficit arises when the estimated expenditure exceeds estimated revenue. Such deficit may be met by raising the rates of taxation or by the charging of higher prices for goods and public utility services. The deficit may also be met out of the accumulated cash balances of the government or by borrowing from the banking system.

Deficit financing in India is said to occur when the Union Government’s current budget deficit is covered by the withdrawal of cash balances of the government and by borrowing money from the Reserve Bank of India. When the government draws its cash balances, these become active and come into circulation.

Again, when the government borrows from the RBI, the latter gives loan by printing additional currency. Thus, in both cases, ‘new money’ comes into circulation. It is to be remembered here that government borrowing from the public by selling bonds is not to be considered as deficit financing.

Effects of Deficit Financing:

Deficit financing has several economic effects which are interrelated in many ways:

i. Deficit financing and inflation

ii. Deficit financing and capital formation and economic development

iii. Deficit financing and income distri­bution.

i. Deficit Financing and Inflation:

It is said that deficit financing is inherently inflationary. Since deficit financing raises aggregate expenditure and, hence, increases aggregate demand, the danger of inflation looms large. This is particularly true when deficit financing is made for the persecution of war.

It is the deficit financing that meets the liquidity requirements of these growing economies. Above all, a mild dose of inflation following deficit financing is conducive to the whole process of development. In other words, deficit financing is not anti- developmental provided the rate of price rise is slight.

However, the end result of deficit financing is inflation and economic instability. Though painless, it is very much inflation-prone compared to other sources of financing.

The impact of deficit financing on the price level in both developed and underdeveloped countries can be demonstrated in terms of the Fig. 12.3.

On the horizontal axis the volume of deficit financing and on the vertical axis price level is measured. In developed countries, a rise in deficit financing from OD₁ to OD₂ causes price level to rise towards full employment price OP₂.

But a smaller dose of deficit financing in developing countries leads to a rise in price level from OP₁ to OP₂. Thus, deficit financing and, hence, increased money supply is always associated with a high degree of inflation in developing countries like India.

One estimate suggests that a deficit budget covered by deficit financing of one per cent leads to a rise in the price level by approximately 1.75 per cent.

ii. Deficit Financing and Capital Formation and Economic Development:

The technique of deficit financing may be used to promote economic development in several ways. Nobody denies the role of deficit financing in garnering resources required for economic development, though the method is an inflationary one.

Economic development largely depends on capital formation. The basic source of capital formation is savings. But, LDCs are characterized by low saving-income ratio. In these low-saving countries, deficit finance- led inflation becomes an important source of capital accumulation.

During inflation, producers are largely benefited compared to the poor fixed-income earners. Saving propensities of the former are considerably higher. As a result, aggregate savings of the community becomes larger which can be used for capital formation to accelerate the level of economic development.

However, the multiplier effect of deficit financing in poor countries must be weaker even if these countries exhibit underemployment of resources.

In other words, national income does not rise enough due to deficit financing since these countries suffer from shortage of capital equipment and other complementary resources, lack of technical knowledge and entrepreneurship, lack of communications, market imperfections, etc.

Due to all these obstacles these countries suffer from deficiency in effective supply rather than deficiency in effective demand. This causes low productivity and low output. Thus, deficit financing becomes anti-developmental in the long run.

However, this conclusion is too hard to digest. It helps economic development, although not in a great way. It is true that deficit financing is self-defeating in nature as it tends to generate inflationary forces in the economy. But it must not be forgotten that it is self-destructive in nature since it has the potentiality of raising output level to counter the inflationary threat.

iii. Deficit Financing and Income Distribution:

It is said that deficit financing tends to widen income inequality. This is because of the fact that it creates excess purchasing power. But due to inelasticity in the supply of essential goods, excess purchasing power of the general public acts as an incentive to price rise. During inflation, it is said that rich becomes richer and the poor becomes poorer. Thus, social injustice becomes prominent.

However, all types of deficit expenditure, not necessarily tend to disturb existing social justice.

Advantages and Disadvantages of Deficit Financing:

The most easiest and the popular method of financing is the technique of deficit financing. That is why it is the most popular method of financing in developing countries.

Its popularity is due to the following reasons:

(a) Advantages:

Firstly, massive expansion in governmental activities has forced govern­ments to mobilize resources from different sources. As a source of finance, tax-revenue is highly inelastic in the poor countries. Above all, governments in these countries are rather hesitant to impose newer taxes for the fear of losing popularity. Similarly, public borrowing is also insufficient to meet the expenses of the state.

As deficit financing does not impinge any trouble either to the taxpayers or to the lenders who lend their surplus money to the government, this technique is most popular to meet developmental expenditure. Deficit financing does not take away any money from anyone’s pocket and yet provides massive resources.

Secondly, in India, deficit financing is associated with the creation of additional money by borrowing from the Reserve Bank of India. Interest payments to the RBI against this borrowing come back to the Government of India in the form of profit. Thus, this borrowing or printing of new currency is virtually a cost-free method. On the other hand, borrowing involves payment of interest cost to the lenders.

Thirdly, financial resources (required for financing economic plans) that a government can mobilize through deficit financing are certain and known beforehand. The financial strength of the government is determinable if deficit financing is made. As a result, the government finds this measure handy.

Fourthly, deficit financing has certain multiplier effects on the economy. This method encourages the government to utilize unemployed and underemployed resources. This results in more incomes and employ­ment in the economy.

Fifthly, deficit financing is an inflationary method of financing. However, the rise in prices must be a short run phenomenon. Above all, a mild dose of inflation is necessary for economic development. Thus, if inflation is kept within a reasonable level, deficit financing will promote economic development —thereby neutralizing the disadvantages of price rise.

Finally, during inflation, private investors go on investing more and more with the hope of earning additional profits. Seeing more profits, producers would be encouraged to reinvest their savings and accumulated profits. Such investment leads to an increase in income—thereby setting the process of economic development rolling.

(b) Disadvantages:

Disadvantages of deficit financing are equally important.

The evil effects of deficit financing are:

Firstly, it is a self-defeating method of financing as it always leads to inflationary rise in prices. Unless inflation is controlled, the benefits of deficit-induced inflation would not fructify. And, underdeveloped countries— being inflation-sensitive countries—get exposed to the dangers of inflation.

Secondly, deficit financing-led inflation helps producing classes and businessmen to flourish. But fixed-income earners suffer during inflation. This widens the distance between the two classes. In other words, income inequality increases.

Thirdly, another important drawback of deficit financing is that it distorts investment pattern. Higher profit motive induces investors to invest their resources in quick profit-yielding industries. Of course, investment in such industries is not desirable in the interest of a country’s economic development.

Fourthly, deficit financing may not yield good result in the creation of employment opportunities. Creation of additional employ­ment is usually hampered in backward countries due to lack of raw materials and machineries even if adequate finance is available.

Fifthly, as purchasing power of money declines consequent upon inflationary price rise, a country experiences flight of capital abroad for safe return—thereby leading to a scarcity of capital.

Finally, this inflationary method of financing leads to a larger volume of deficit in a country’s balance of payments. Following inflationary rise in prices, export declines while import bill rises, and resources get transferred from export industries to import- competing industries.

Conclusion

In spite of this, deficit financing is inevitable in LDCs. Much success of it depends on how anti-inflationary measures are employed to combat inflation. Most of the disadvantages of deficit financing can be minimized if inflation is kept within limit.

And to keep inflation within a reasonable and tolerable level, deficit financing must be kept within safe limit. Not only it is difficult to lay down any ‘safe limit’ but it is also difficult to avoid this technique of financing required for planned development. Still then, deficit financing is unavoidable.

It is an evil but a necessary one. Considering the needs of the economy, its use cannot be discouraged. But considering the effects of deficit financing on the economy, its use must be made limited. So, a compromise has to be made so that the benefits of deficit financing are reaped too.

References

·        https://www.indianeconomy.net

·        https://www.britannica.com