In Budget-2020, the finance minister had raised the actual fiscal deficit for FY20 by 50 bps to 3.8% and the projected deficit for FY21 by 30 bps to 3.5%. While the government managed to honour the FY20 fiscal deficit, FY21 is a different ball game altogether. Revenues have plummeted due to the slowdown and expenditure outlays have shot up due to the stimulus.
The fiscal deficit for FY21 will be a lot higher than 3.5%. The big question is how much will the fiscal deficit spill over in FY21. Will the government project a liberal fiscal deficit for FY22 or revert to its conservative stance?
What is fiscal deficit and why it matters?
Fiscal deficit is also the budget deficit and shows the amount of spending that cannot be provided for by the budget. That gap is called the fiscal deficit and is normally met through borrowings. In India, the Fiscal Responsibility & Budget Management (FRBM) Act was passed in 2004 and since then there is a target fiscal deficit defined each year. The government normally manages to respect these targets with some leeway. FY21 could be the first year when the budget is likely to overshoot by a margin.
Why is there so much focus on fiscal deficit? There are two macro implications to fiscal deficit. Firstly, fiscal deficit is indebtedness of the government and severely hampers the debt servicing ability of the government. It could also force the government to monetize the debt by printing notes which can be inflationary.
There is a second more important reason why fiscal deficit is a concern. Most leading sovereign rating agencies like Moody’s and S&P use fiscal deficit as an important parameter for assigning ratings. For emerging economies like India, any pressure on fiscal deficit is taken as a negative point.
How will fiscal deficit look like in FY21?
Fiscal 2021 is more than 75% through and most of the damage to the fisc was caused by the lag effect of the COVID pandemic. GDP contracted by -23.9% in Q1 and by -7.5% in Q2. Even the most conservative estimates now peg the full year GDP contraction at -7.7%. There could be upgrades but the final figure is unlikely to be very different.
A sharp fall in GDP implies a sharp fall in direct and indirect tax collections. For the current year it is estimated that the revenue shortfall alone is likely to be around Rs725,000cr if you add up the underperformance in direct taxes, indirect taxes and disinvestments.
Then there is the expenditure side. The government and the RBI have already given out close to $350 billion through fiscal and monetary incentives in 3 phases. That may be smaller than other economies in absolute terms, but is large as a share of GDP. There have been some cost cuts and cost savings too, but all these put together would not be enough.
It is estimated that the rupee fiscal deficit for FY21 could spike from Rs8,00,000cr to Rs14,50,000cr. The -7.7% GDP contraction will imply that the fiscal deficit as percentage of GDP goes up from 3.5% to around 7.5%. That is already being built into most estimates of fiscal deficit for FY21.
What about fiscal deficit for FY22?
That is the real challenge! FY21 could end up with fiscal deficit of 7.5% and there is not much of a choice. But, what should be the strategy for FY22. There are two extreme views on this subject. There is the pump priming view that is OK with fiscal deficit going for a toss in FY22 but wants growth at all costs. Conservative economists are calling for tightening from April itself, even if it means a loss of growth. The truth obviously lies in between.
Former CEA, Shankar Acharya, offers a balanced solution. The sharp recovery in FY22 will result in buoyancy in direct and indirect taxes. According to Acharya, government should not go too much on the defensive but set a more realistic fiscal deficit target of 4.75% to 5.25% for FY22. According to Acharya, since we are talking about a much larger GDP base, this automatically means more fiscal deficit in rupee terms.
FY22 will also need additional outlays for vaccine rollout, managing the logistics and prioritizing health expenditure. Economists like Acharya have been calling for a 3.5% revenue deficit target and 5% fiscal deficit target for FY22, which should address the revenue buoyancy, lag effect spending and the COVID outlays.
The bigger challenge in the Budget 21 will be to address the state deficit. One way could be to set the state deficit target at 3.5% of GSDP. That way, the combined fiscal deficit in FY22 can be brought down to 8.5% from 13% in FY21. That may be a good fiscal start!