What is Deficit Financing: its Causes and Importance

Deficit Financing

Deficit financing is when a government spends more money than it earns through revenue (like taxes) and covers the gap by borrowing or creating new money. In a deficit budget, an excess of government expenditure can be financed either by drawing on the government's cash balance or by borrowing from the central bank or external sources.

Definition: "The government employs deficit financing to fill the deliberately created gap between public revenue and public expenditure".

Sources of Deficit Financing 

In LDCs, the budget deficit is financed in the following two ways.

1. Internal Borrowing

2. External Borrowing

1. Internal Borrowing

There are two types of internal borrowing: Bank Borrowing and Non-Bank Borrowing

Bank Borrowing:

This type of borrowing takes place in three ways.

a. The central bank issued the new currency notes in the amount borrowed by the government at zero gold. This is a significant cause of inflation in the country.

b. The government draws the cash balances of the past from the central bank to meet the budget deficit.

c. The government also borrows from commercial banks against government securities.

Non-Bank Borrowing

This type of borrowing takes place in two ways:

a. The government can borrow from nonbank institutions like investment banks and insurance companies by selling treasury bills, short-term bonds, and defense savings certificates.

b. The government can borrow from the general public by selling prize bonds, saving certificates, investment bonds, etc.

2. External Borrowing 

External debt occurs when the government borrows money from foreign countries and international financial institutions, such as the IMF, World Bank, Asian Development Bank, etc.

Causes of Deficit Financing 

Indisciplined Fiscal Policy 

Public debt increases constantly due to indisciplined fiscal policy,  inefficient budget planning, wasteful spending, and corruption, which can also lead to persistent deficits, pushing governments toward financing these gaps through borrowing.

Increase in Public Expenditure

In developing countries, public expenditures are highly significant in alleviating poverty and reducing income inequalities. Sometimes, the government may increase spending on infrastructure, social programs, defense, or other public services. If revenue collection (through taxes) does not rise proportionately, it leads to a budget deficit. For countries facing security issues or conflicts, the government may increase defense spending beyond what their regular budgets can sustain.

Tax

There are a large number of weaknesses in the tax structure of low-developing countries. Tax evasion is so common that customs and sales tax are the primary sources of tax revenue. Declining tax revenues, due to economic downturns, poor tax administration, or tax evasion, can reduce government income, pushing the government to borrow.

 Social Welfare Commitment

The rising costs of social security, pensions, and other welfare programs, especially in aging populations, can strain government budgets, requiring deficit financing to maintain these commitments. The government may expand social programs during periods of economic difficulty or in response to public demand. New or enhanced welfare programs can increase government spending, leading to a budget shortfall that must be financed through borrowing.

High Population Growth Rate

A rapidly growing population increases demand for essential public services like healthcare, education, transportation, and social welfare. It puts pressure on public expenditures, which have been raised continuously. Hence deficit in the budget was bound to increase.

In some cases, population growth may not translate into a proportional increase in tax revenue, particularly in developing economies where large segments of the population are not part of the formal economy. Population growth can stimulate economic growth in the long run, but in the short and medium term, it often creates financial pressure on governments, potentially leading to increased deficit financing.

Importance of Deficit Financing

Deficit financing is a significant source of capital formation in LDCs. In LDCs, the saving rate is low, which keeps investment low in the country. Thus, deficit financing can trigger the process of capital formation in a country. It also affects people's incomes because, due to deficit financing, the government starts new big projects like energy power projects, health, education, etc.
The vicious circle of poverty is a circular flow of forces that act and react in such a way as to keep a developing country in a state of poverty. By injecting more money into the economy through deficit financing, the volume of investment and productivity of all the sectors of the economy could be increased, which would help to break the vicious cycle of poverty. Conversely, an increase in the stock of capital leads to an increase in the country's employment opportunities.

Deficit financing makes it possible to produce goods on a large scale through capital-intensive techniques. In this way, the purchasing power of the people increases in the country, but the size of both national and international markets will be extended.

How Deficit Financing Affects Economic Development

Deficit financing has some positive and negative effects. Positive effects mean economic development is possible through deficit financing, which leads to balanced economic growth. In this way, this process improves the quality of all human lives by raising people's levels of living, self-esteem, and freedom of choice in every field of life. During times of economic recession or slow growth, deficit financing can stimulate economic activity by increasing government spending on infrastructure, social programs, and public services. This can boost demand, create jobs, and increase overall economic output. It can help to reduce unemployment, improve living standards, and reduce poverty by funding public works, job creation programs, and other development initiatives. 

Deficit financing has negative effects on economic development. Continuous deficit financing without addressing structural issues ( like low tax revenues or excessive government spending ) can lead to chronic fiscal imbalances. This weakens a government's ability to respond to future economic challenges and undermines long-term development. Excessive deficit financing, particularly through the printing of money, can lead to inflation. Rising prices erode purchasing power, reduce savings, and can destabilize the economy, hindering sustainable development.

In the context of productive investment, deficit financing can support economic development by stimulating growth, reducing unemployment, and funding essential infrastructure. However, excessive or poorly managed deficit financing can lead to inflation, higher debt burdens, and reduced investor confidence, ultimately stalling economic development. It is essential to balance the short-term benefits with long-term sustainability.