Budget 2012 primer: Revenues, expenditures and deficits

The Union budget, at the end of the day, is a simple exercise of balancing revenues and expenditures. The Indian government always runs an unbalanced budget with expenditures higher than revenues. When expenditures are higher than revenues, they result in a fiscal deficit, which has to be financed. India finances its fiscal deficit by issuing government bonds in the market, an activity that is called government borrowing.

The government is usually a wasteful spender. Government spending does not create much value as it spends on subsidies and interest payments on its debt. Hence a fiscal deficit leads to inflation in the economy as demand is propped up artificially by subsidies while the corresponding supply of goods and services lags behind, as there is less money to spend on creating capacities.

Two main offshoots of a fiscal deficit are a) government borrowing and b) inflation. A government that is borrowing more from the market than the demand that exists in the market will have to pay a higher price for its borrowing. A government creating inflation due to its fiscal deficit will also be impacted on its cost of borrowing as inflation drives up interest rates on government bonds - called yields.

The fiscal deficit then creates a cycle of more fiscal deficits, as the government has to pay more and more interest every year due to its accumulation of debt and due to higher interest costs payable on the debt.

 Budget 2012 primer: Revenues, expenditures and deficits

A government that is borrowing more from the market than the demand that exists in the market will have to pay a higher price for its borrowing. Reuters

The vicious cycle of fiscal deficits going higher due to borrowing and inflation can only be broken by increasing revenues and reducing wasteful expenditure. How does the government increase revenues and reduce wasteful expenditure?

Revenues are a function of tax collecting, sale of assets (including scarce assets such as telecom spectrum) and other income such as dividends. Tax collections can increase if a) the economy grows at a healthy pace, leading to higher tax collections without any tax rate increases, or even tax rate decreases; or b) tax rate increases or more of India's citizens are brought under the tax net. Tax collections are recurring revenues.

The government can sell its holdings is public sector enterprises and/or auction scarce resources such as telecom spectrum to raise revenues. The revenues from sale of assets are non-recurring revenues, as it does not happen year after year.

Other income such as dividends and interests are recurring revenues but there is not much scope to increase revenues from these sources in times of need.

Expenditures are primarily in the form of interest payments, debt repayments, subsidies, defence, salaries and wages of government employees, grants, social schemes and others. The government also spends on creating infrastructure. The government can reduce expenditures on certain heads such as subsidies, wages and spending on social schemes.

However, to reduce such expenditures, the government requires to reform policies. Subsidies have to go where they are absolutely necessary, wages have to be brought down by rationalising a bloated workforce and spending on social schemes has to be made more effective with higher accountability on utilization of funds for the social schemes.

Spending on creating infrastructure is positive in the long run as it reduces supply bottlenecks leading to lower inflation. Spending on infrastructure adds thrust to economic growth leading to more taxes and less deficits. However, the money required to spend on infrastructure can only come from money saved by reducing wasteful expenditure. The government has been unsuccessful in reducing wasteful expenditure and hence has less money to spend on creating infrastructure.

Once the budget is broken down into where revenues can be increased and expenditures can be cut it is easy to follow it without having to understand complicated jargon. In the next few parts of the Budget Simplified series, each factor of the budget will be looked into more detail. Stay tuned.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.

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Updated Date: Dec 21, 2014 04:46:22 IST