As we know, the major sources of public revenue are taxes, fees, prices, special assessments, rates, gifts etc., etc. If during a given period of time, the government expenditure exceeds government revenue and the deficit is met by borrowing, it is called deficit financing or income creating finance. In order to have a significant expansion effects therefore, a program of public investment should be financed by borrowing rather than by taxation. This kind of borrowing or loan expenditure is popularly called deficit financing.
Deficit financing is said to have been practiced if state adopts any one or all the methods mentioned below:
(a) The government draws upon the cash balances of the past.
(b) The government borrows from the central bank against government securities.
(c) The government creates money by printing of paper currency and thus meets the expenditure over receipts.
(d) The government borrows externally.
Deficit financing was considered to be a very dangerous weapon by the classical economists. The modern economists are, however, leaning towards it and recommend it to be used for accelerating economic development and achieving high level employment in the country.
The problem to be solved here is:
(i) Whether income creating finance should be adopted for increasing total effective demand.
(ii) If deficit financing is desirable for ensuring high level of employment, then to what extent should it be carried out.
(iii) What are its good and bad effects?
Deficit financing is being practiced by advanced as well as underdeveloped countries. The advanced countries use it as an instrument of increasing effective demand whereas the underdeveloped countries employ it for increasing the rate of capital formation.
The scope of deficit financing for accelerating economic growth in backward economy is very bright as they are caught in a vicious circle of underdevelopment. They use funds for investment when the resources of the country are not adequate to initiate the processes of take off. So arises the need for deficit financing.
The underdeveloped countries are confronted with the following problems:
(i) The rate of growth of population is faster than the rate of economic development.
(ii) The state revenue received through taxes, fees, etc., is not sufficient to provide full employment to the labor force.
(iii) The per capita income is extremely low and so is the capacity to save.
(iv) Foreign loans for development purposes are not without strings and are also not available in desired quantity.
(v) There is a dearth of stock of capital in the country.
(vi) People lack initiative and entrepreneurial ability.
(vii) People are mostly extravagant and there is less voluntary savings.
(viii) A greater portion of the population lives in villages and are contended with their lot.
(ix) The government cannot incur the displeasure of the people by enhancing the tax rates beyond a certain limit. It cannot also impose additional taxes for the same reason.
(x) Thus there is too much evasion of taxes.
Under the conditions stated above, the reader can easily visualize the state of affairs with which a government of the backward country is confronted. Still no government would like to be a silent spectator and would desire that the standard of living of the people should go up in the shortest possible period of time. It will try to find money from the blue if necessary for spreading economic development of the country. Here deficit financing comes to its rescue. The state uses this instrument for lifting the economy out of depression and for accelerating economic development in the country. If, however, the state can increase the volume of resources by increasing the tax rates, imposing additional taxes or mobilizing enlarged saving, then it is not desirous to adopt deficit financing as it is a very delicate instrument.