The budget deficit is nothing more than the difference between the expenditures of the government and the tax revenues that government receives (Galbraith and Darity, 1995), similarly fiscal deficit too is termed as the difference between government’s spending and earnings, the difference between budget deficit and fiscal deficit is that in fiscal deficit the earnings from borrowings and liabilities is not counted (see appendix). For comparative purposes it is expressed as a percentage of Gross Domestic Product (GDP) of a nation.

Fiscal deficit holds an important position in macroeconomics theory literature because they have substantial effect on indicators of macroeconomic performance of a country like inflation, growth and as a consequence of these imbalances debt financing and debt management also becomes necessary. The stability of macroeconomics environment of a country is not only critical for business it is also important for country’s overall competitiveness in global spectrum (Fischer, 1993 global competiveness report). There are number of macroeconomic indicators like GDP, inflation, trade balance, current account balance, foreign exchange reserves, foreign investment inflows (exim bank, 2010). Fiscal deficit itself is an important macroeconomic indicator and it has direct effect on other macroeconomic indicators.

In spite of having such importance it is easy to ignore fiscal deficits because they do not have immediate effects, it is just like obesity. In case of obesity there is no immediate concern except the clothing size gets increasing, but in long turn obesity increases the risk of chronic heart attack or diabetes (Feldstein, 2004). Like obesity deficit is also caused by self-indulgent living that is governments spending more than its revenues. Another similarity of fiscal deficit with obesity is that severe the problem (obesity/fiscal deficit) more difficult is to correct it. (Feldstein, 2004). One of the biggest problems with running fiscal deficits is that it curtails the government’s ability to react to business cycles ( expansion, peak, contraction, trough and recovery of economic activities in a country) and this in turn increases economic and political instability in a country (global competitiveness report 2009).

2.2 Various effects of fiscal deficit:

Fiscal deficit is associated with various macroeconomic indicators like inflation, overall growth, trade deficit, capital deficit. Certain economic factor like crowding out effect is also associated with fiscal deficit. Apart from these factors fiscal deficit has strong connection with political and administrative factors like democracy and subnational governance. This section would look into these factors critically.

2.2.1 Effect of fiscal deficit on inflation

Monetarist argue that inflation is a monetary phenomenon while the structuralist school stress focus on structural factors prevalent in a less developed country to explain inflationary processes ( Ashra et al, 2004). Enlargement of fiscal deficit in relation to the overall economy increase money supply which in turn leads to accelerated inflation.

Macroeconomic theory states that persistent fiscal deficits are inflationary (Catao and Terrones, 2005). Sargent and Wallace, 1981 support the fact that fiscal deficit increase inflation theory and add that a government facing persistent deficit has to sooner or later finance these deficits with money creation ‘Seinorage’ thus producing inflation. Alesina and drazen,1991; Cukierman et al. 1992, Calvo and Vegh,1999 further added to this theory of fiscal deficit and inflation especially for developing countries because these countries are less tax efficient, less politically stable and have limited access to external borrowing all these factors lower the relative cost of Seinorage and thus increase dependence on the inflation tax. Monitiel, 1989 and Dornbusch et al. 1990 have a slight variation in their view they suggested that fiscal deficits makes room for inflation rather than playing the driving force. Blanchard and Fischer, 1989 in his paper mentioned that empiricaly little success has been met in finding a significant relationship between fiscal deficit and inflation however later fisher et al, 2002 using a panel of ninety four countries were successful in breaking his dilemma and proved that fiscal deficits is among the main drivers of high inflations. He further proved from his work that one percentage point improvement or decline in the ratio of fiscal balance to Gross Development Product typically raise or declines inflation by 4.5 percent.

Apart from the above studies trying to find a link between fiscal deficit and inflation few more studies have been done to obtain empirical support for cyclically recurring process of deficit-induced inflation and inflation-induced deficits. Aghelvi, 1977 did such study for Indonesia Aghelvi and khan 1978 for Brazil. Later Sarma 1992 followed the Aghelvi khan model and did a similar study for India and came to a similar result that deficit induce inflation and vice versa. Heller 1980 differed from these studies while doing a case study of 24 developing countries; his study found that cyclic recurring of fiscal deficit is not always true. Naastepad, 2003, not only regarded fiscal deficit as the main cause of inflation but also with balance of payment crisis and poor investment performance and growth in developing countries.

Although many economist have successfully linked fiscal deficit with increasing inflation, other economist have doubts regarding the above said relation although none of the doubting researchers were able to prove their point by their researches. On the whole it could be said that fiscal deficit has a strong direct relation with inflation.

2.2.2 Effect of Fiscal deficit on growth

Great degree of attention has been devoted in both theoretical as well as empirical literatures towards possible impact of different fiscal measures on growth (Adam and Bevan, 2005). While theoretical aspect points out the constraint in government budget where change in one aspect needs to be countered by changes elsewhere. Empirical literature clearly supports the fact that variations in subset items are growth neutral (gemmel, 2001/ 101 pdf). Eminent group of economists like Easterly et al. (1994), Kneller et al. (2000) and Miller and Russek (1997) assume that relation between deficit and growth is linear. Although Giavazzi et al. (2000) found their study to oppose the linear relationship of deficit and growth. Adam and Bevan, 2005 worked on the lines of Giavazzi and found that linear representation between deficit and growth reasonably fits the case of developing countries. At low levels of fiscal deficit the non-linearity is masked. They also found that for low and middle income countries the relation is non-linear.

2.2.3 Effect of Fiscal deficit on trade deficit

Fiscal deficit had been linked with trade deficit by certain researchers (Rosensweig and Tallman, 1991 1992) and these two are referred as twin deficits. Milne (1977) in her study of 38 countries finds a positive statistical relation between trade deficit and fiscal deficit. Arunro and Ramchandar,1998 have gone one step ahead and added that current account and fiscal deficits have important policy implications on a nation and they effect long term viability of economic progress of a nation, this implies that if the basic reason for rising trade deficit is the increasing central government budget deficit then the trade deficit cannot be corrected until the government deficits are put in place. However if such a view (role of budget deficit in trade deficit) is not correct then reductions in government budget deficit would not resolve the problem of trade deficit (Belongia and Stone, 1985). Enders and lee, 1990 and Abell, 1990 slightly differed from this point and suggested that there is a casual effect of movement in government deficit on trade deficit and contrary to all these Evan (1989) provides empirical evidence that there is no relation between the two deficits that is trade and fiscal deficit.

2.2.4 Crowding out effect of fiscal deficit

Due to an increased government spending often there is reduction in private investment and consumption this is known as crowding out in economics. Theoretical economic literature identifies two variants of crowding out real and financial. The real or direct crowding out occurs when an increased public investment displaces private capital formation, the real or direct crowding does not depend on the mode of financing the fiscal deficit (Blinder and Solow, 1973). Financial crowding is a phenomenon of partial loss of private capital formation, the reason for its occurrence is the increase in interest rates that is caused as a result of “pre-emption of real and financial resources by the government through bond-financing of fiscal deficit” (Buiter,1990) (wp06). Economist have empirically tested the real crowding out and found contradictory results. Ramirez (1994), Greene and Villanueva, 1990) in their study found that there is a complimentary type of relationship between public and private investment, the reason behind this analogy among the economists is the fact that increase in public capital formation stimulate aggregate demand and therefore increases private investment. It was also supported by the fact that higher stock of public capital, in particular infrastructure increases the return of private investment projects Aschauer (1989), and Erenburg (1993). (wp06)

Contrary to these views Blejer and Khan (1984), Shafik (1992), Parker (1995), found from their researches that there exists evidence for crowding out between public and private investment. These set of studies on crowding out argued that public investment might act as a substitute for private investment Sunderrajan and Takur (1980), Krishnamurty (1985), Kulkarni and Balders (1998). (wp06)

2.2.5 Democracy and subnational effect on fiscal deficit

In a democratic nation divided governments and alternating governments are the two main factors of a political system that generate myopic and inefficient policies (Person and Tabelliniu, 2000). Political competition assures that the current ruling party can lose in the next upcoming election, this modifies the planning of government. The incumbent government knows this fact and thus can induce an excessive expenditure because future costs are not completely internalized. The incumbent government strategically misbalances its count to improve its probability of re-election (Alsina and Tabellini, 1990) (5.pdf)

In democracy a political bias exists in favour of deficit finance. (Buchanan and Wagner,1977). Politicians at periodic bases face test of their incumbency. The budgetary policies can enhance or retard the likelihood of their remaining in office. Generally tax reductions and increase in expenditure strengthen a politician’s base of support contrarily If the politician increases tax and reduction in expenditure this will tend to weaken his base. It is noticed that politician use budgetary policy to strengthen their electoral base this in turn increases state expenditure and reduces taxes (bbfratc, Wagner and Tollison), which harms the fiscal stability and give rise to deficit. (Buchannan and Wagner, 1977) are of the view that balanced budget which has mix of deficit budget and budget surplus is better for macroeconomic stability of any country.

Rodden (2002) states the fact that the fiscal deficits are greater in nations where subnations are more dependent on national transfers for financing their spendings and where they have freedom of borrowing from capital markets. Wibbels, 2003 also supports the statement and his work shows fiscal deficits are larger in federal compared to unitary nations in the developing world.

2.2.5.1 Is a strong central government a solution for fi