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As we know, the major sources of public revenue are taxes, fees, prices, special assessments, rates, gifts etc. If during a given period, government expenditure exceeds government revenue and the deficit is met by borrowing, it is called deficit financing or income generation finance. Therefore, to have a significant expansionary effect, a program of public investment must be financed by borrowing rather than by taxation. This type of borrowing or debt expenditure is popularly called deficit financing.
Deficit financing is said to be practiced if the state adopts any or all of the methods mentioned below:
(a) The government uses the cash balances of the past.
(b) The government borrows from the central bank against government securities.
(c) The government creates money by printing paper currency and thus meets expenditure in excess of receipts.
(d) The government borrows externally.
Deficit financing was considered a very dangerous weapon by the classical economists. However, modern economists are leaning towards it and recommend using it to accelerate economic growth in the country and to get higher level of employment.
The problem to be solved here is:
(i) Whether income generating finance should be adopted to increase aggregate effective demand.
(ii) If deficit financing is desirable to ensure high level of employment, to what extent it should be done.
(iii) What are its good and bad effects?
Deficit financing is being adopted by advanced and underdeveloped countries. Advanced countries use it as a means of increasing effective demand while underdeveloped countries use it to increase the rate of capital formation.
The scope for deficit financing is very bright to accelerate economic growth in backward economies as they are trapped in the vicious cycle of underdevelopment. They use the money for investment when the country’s resources are not enough to start the process of moving forward. Hence the need for deficit financing arises.
Underdeveloped countries face the following problems:
(i) The rate of population growth is faster than the rate of economic development.
(ii) The revenue of the state through taxes, duties etc. is not sufficient to provide full employment to the labor force.
(iii) The per capita income is very low and the capacity to save is also very low.
(iv) Foreign loans for development purposes are not unconditional and are also not available in desired quantities.
(v) There is a shortage of capital reserves in the country.
(vi) People lack initiative and entrepreneurial ability.
(vii) People spend mostly extravagantly and voluntary savings are less.
(viii) A major part of the population lives in villages and is satisfied with their position.
(ix) The government cannot buy the displeasure of the people by increasing the tax rates beyond a certain limit. He cannot levy additional tax for the same reason.
(x) Thus there is a lot of evasion of taxes.
Under the conditions mentioned above, the reader can easily imagine the situation which is faced by the government of the backward country. Still, no government would like to remain a mute spectator and would like to raise the standard of living of the people in the shortest possible time. It will try to find money out of the blue if necessary to spread the economic development of the country. Here deficit financing comes to its rescue. The state uses this tool to pull the economy out of recession and accelerate economic growth in the country. However, if the state can raise the quantum of resources by raising tax rates, levying additional taxes or by mobilizing increased savings, it is not inclined to adopt deficit financing as it is a very delicate instrument.
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