Why is fiscal consolidation so important?

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Last Updated06/02/2024

Recently, the Union Finance Minister announced that the Centre would reduce its fiscal deficit to 5.1% of GDP in 2024-25.
She further added that the fiscal deficit would be pared to below 4.5% of GDP by 2025-26.
The government’s revised estimates also lowered the fiscal deficit projection for 2023-24 to 5.8% of GDP.

It refers to the shortfall in a government’s revenue when compared to its expenditure.
When a government’s expenditure exceeds its revenues, the government will have to borrow money or sell assets to fund the deficit.
- Taxes are the most important source of revenue for any government.
When a government runs a fiscal surplus, on the other hand, its revenues exceed expenditure.
- It is, however, quite rare for governments to run a surplus.
Most governments today focus on keeping the fiscal deficit under control rather than on generating a fiscal surplus or on balancing the budget.

The national debt is the total amount of money that the government of a country owes its lenders at a particular point in time.
It is usually the amount of debt that a government has accumulated over many years of running fiscal deficits and borrowing to bridge the deficits.
The fiscal deficit is generally expressed as a percentage of a country’s GDP since the figure shows how easily the government will be able to pay its lenders.
The higher a government’s fiscal deficit as a share of GDP, the less likely its lenders will be paid back without trouble.
Countries with larger economies can run higher fiscal deficits (in terms of absolute numbers of money).

The government mainly borrows money from the bond market where lenders compete to lend to the government by purchasing bonds issued by the government.
- In 2024-25, the Centre is expected to borrow a gross amount of ₹14.13 lakh crore from the market, which is lower than its borrowing goal for 2023-24.
When a government borrows from the bond market, it not only borrows from private lenders but also indirectly from the central bank.
The RBI may purchase government bonds in the secondary market, from private lenders who have already purchased bonds from the government.
As a government's financial situation deteriorates, demand for its bonds decreases, necessitating higher interest rates to attract lenders.

The impact of monetary policy is significant, with central bank lending rates, previously low, rising after the pandemic.
This increase in rates makes it more costly for governments to borrow money, potentially driving the Centre's focus on reducing its fiscal deficit.

There is a strong direct relationship between the government’s fiscal deficit and inflation in the country.
When a country’s government runs a persistently high fiscal deficit, this can eventually lead to higher inflation.
- The government will be forced to use fresh money issued by the central bank to fund its fiscal deficit.
The fiscal deficit also signals to the market the degree of fiscal discipline maintained by the government.
- A lower fiscal deficit may thus help improve the ratings assigned to the Indian government’s bonds.
When the government is able to fund more of its spending through tax revenues, it gives more confidence to lenders and drives down the government’s borrowing cost.
A high fiscal deficit can also adversely affect the ability of the government to manage its overall public debt.
A lower fiscal deficit may help the government to more easily sell its bonds overseas and access cheaper credit.