The idea of budget deficit primarily developed after World War II as countries’ revenue was no more enough to support its expenditure. Before that, a government always generated balanced budget where its expenditure was equal to its revenue except in cases of war where expenses were much higher. During World War I, countries like England and United States tried to mobilize additional revenues to meet with the war expenses and their income tax system was an evident example of this. Additionally, as the prevailing practice was fiscal prudence, the countries generally had surpluses following these years which was used to pay off national debts.
Government expenditure is one of the indicators of a country’s Gross Domestic Product (GDP) and is determined by a country’s annual budget outlay. The outlay also gives an insight into the country’s expected revenue for the year. Any financial situation in which there is an excess of the country’s total budget expenditures over its total budget receipts (excluding any borrowings) during the fiscal year is termed as fiscal deficit.
2. The Theoretical Debate
Keynesian economics supports government spending on infrastructure, unemployment benefits and education, as it believes that government should play an active role in increasing demand so as to boost growth. However, neo-classical economists criticized the Keynesian view on fiscal policy and explained its impact on private saving through theory of Ricardian equivalence. As per Ricardian equivalence, increased debt-financing will not help increase demand in any way as consumers will start saving, anticipating an increase in taxes to pay off these debts.
The classical and neo-classical economists also believed that an increase in public spending will increase the interest rates leading to the “crowding out” of private investments based on the assumption that the economy is at full employment or potential production. Similarly, if the economy is in an allocative and productive situation, public spending would require reallocation of certain factors of production from private to public sector, which would only move the resources from one sector to another without increasing the overall production or capacity in the economy, making public spending ineffective.
Keynesian economists, on the other hand, argue that fiscal deficits result in an increase in domestic production which makes the private investors more optimistic about the economy increasing the private consumption and investment, thus, leading to a “crowding in” effect. However, the crowding in effect is based on the assumption that the unemployment level is very high and public spending in such a case would increase employment rather than interest rates.
3. Fiscal Deficit: The Nepalese Context
As a developing country, Nepal has been experiencing fiscal deficit since the first fiscal budget of the country prepared in 1951 A.D. and the trend has continued till the recent budget which showed an estimated fiscal deficit of around NPR 524.50 billion. Despite facing budget deficits early on, it was during the 80s that the internal borrowing of the country escalated drastically. Within this duration of rapid increase, growth rate also fluctuated within a very wide margin of 6.3% and 68.2% and reached the peak during the time when fiscal deficit was highest which shows the inclination towards Keynesian economics.
On the other hand, budget deficits were found to be interest rate neutral in Nepal and were not crowding out private investment. Changes to interest rates are directly related to changes in price levels which is one of the causes behind macroeconomic instability. Additionally, changes in interest rate is also one of the driving factors of budget deficit-led economic growth. . However, given that budget deficit were found to not have any significant effect on interest rates in Nepal, an inclination towards Ricardian approach can be observed in the Nepalese economy.
4. Short Run Implications
In the short run, fiscal deficit has shown growth and stability as government helps to reduce recession by increasing spending on employment opportunities and lowering tax to increase revenue of the businesses. Fiscal deficit leading to deficit financing increases the money supply in an economy, which in Nepal, is done through foreign loan and domestic borrowing. As per the money market equilibrium, increase in money supply leads to a decrease in interest rates and a decrease in interest rates leads to an increased demand for money, hence, again, leading to an increase in interest rates.
The initial decrease in interest rate leads to increase in investment and consumption due to the increase in purchasing power of the public. This leads to an increase in aggregate demand. However, as the interest rate rises, a subsequent fall in aggregate demand is observed. Nonetheless, the overall effect is positive. Therefore, in the short run, as aggregate demand rises, the national income tends to increase with an increase in price level due to which deficit financing leads to growth in the short run.
5. Long Run Implications
Matter of long-run deficits depends entirely on how and where government spends its budget rather than the act of spending itself. The extent to which fiscal deficits affect the economic growth was seen to depend on the expenditure composition as well as the source of financing. In countries where the expenditure was concentrated on administrative expenses like wages, the economic growth was observed to be low whereas in countries where the spending was focused in areas of capital formation and other non-wage goods and services, the output was prominent. Similarly, if the deficit is financed through seigniorage, it can stimulate or enhance growth whereas in case of financing through domestic or external debt, negative marginal effects were observed in both low and high deficit countries.
In the long run, a higher level of money supply also results in increase in the price level. Higher price level causes decline in exports and increase in imports due to increase in prices of local goods, ultimately impacting balance of payment and depletion of the international reserves of the country. This pressure also affects the strength of the domestic currency. Thus, higher level of fiscal deficit is likely to lead to macroeconomic instability.
In unstable macroeconomic situations, economic growth is difficult to come by. If government spends more by borrowing from the private sector, it reduces private sector investment thus lowering the growth rate as government spending crowds out private sector spending. However, in case of Nepal, so far, such events of “crowding out” and macroeconomic instability due to budget deficits are yet to be observed.
Various conclusions have been derived regarding the impact of fiscal deficit on a country’s GDP. A budget deficit implies reduced taxes and increase in government expenditure which leads to an increase in aggregate demand and hence, the increase in GDP. Productive expenditure has been observed to have a positive relationship in the long run with economic growth. In this regard, an increase in budget deficit is likely to have a positive impact on the economy.
Nonetheless, higher level of fiscal deficit refers to an increase in money supply that pushes prices upwards thus increasing the macroeconomic instability. Fiscal deficit has also been observed to have negative effects on private investments, foreign direct investments and net exports.
Staying conscious regarding the negative effects of a budget deficit, although Nepal has been trying to maintain lower fiscal deficits, this would lead to government cutting expenditure to maintain macroeconomic stability which would compromise both growth and development. Additionally, the number of resources available in the economy for growth is limited, which must be used effectively. Given that Nepal’s economy is yet to show any definitive short run or long run effects of budget deficit, debate regarding government led growth and private sector growth has continued in Nepal.
* The author is a B.B.A. graduate from Kathmandu University School of Management, Nepal.
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