Most analysts expected it, but few foresaw it happening so soon. Earlier this week, data emerged from the government showing that the fiscal deficit for the first two months of this financial year had already hit 45% of the budgeted amount for the entire year.Expecting the fiscal deficit to come in at 4.1% of GDP for the whole of 2014-15 was widely predicted to be unrealistic, but the speed at which the gap between actual numbers and the projected figure has closed has exceeded earlier years. Last year, for instance, the fiscal deficit was around a third of the budgeted amount in the first two months of the year.Essentially, what the government did was roll over, to the next year, payments which would have ideally come in towards the end of the previous financial year. The petroleum ministry, for instance, saw its expenditure for the first two months of this year coming in at 39% of its annual budget. In the same months of last year, the petroleum ministry had spent virtually nothing. Effectively what the government had done was delay payments of the fuel subsidy to oil companies till 2014-15. This way, it didn’t have to account for the expenditure in the previous year, resulting in a lower deficit. “The government left a number of expenditures uncovered,” points out Rajiv Kumar, senior fellow at the Centre for Policy Research.“This happens every time, but this time around it has been excessive,” says Madan Sabnavis, chief economist at CARE Ratings. Given that it happens every year, what lies at the heart of the problem?Kumar points to the interesting fact that the fiscal deficit for the month of March last year was actually negative — in other words, the government received more funds into its coffers than was paid out of them for that month. “There was sharp fiscal compression in that month — more so than in earlier years,” he says, alluding to the fact that the government did not spend as much as it usually did.March is an unusual month for government spending as the cement sector is well aware. Every March, cement consumption across the country spikes sharply. In recent years, that spike has been anywhere between 10% and 13%, but it’s followed in the subsequent month by a sharp fall. The spike is often because government departments would like to use up their budgets before the end of the financial year and binge on construction activity which was originally budgeted but failed to take off.In contrast, in the early months of the new financial year, construction activity is slow as government budgets take time to be approved. Indeed government expenditure in March is regularly in excess of 15% of the budgeted amount for the year. In other months, the spending averages around 7-8%. In 2013 and 2014, though, the effect was more muted.This, along with rolling over subsidy payments to the next year, helped the government push the fiscal deficit into negative territory. On the revenue side, dividend payments were sharply higher than originally budgeted for 2013-14 — by as much as 44%. “Notice also that the budgeted dividend payments by public sector undertakings [PSUs] for 2014-15 are much lower than earned in 2013-14,” says Sabnavis. Effectively the government asked PSUs to pay up higher amounts in dividends the previous financial year, with the sweetener that they wouldn’t be forced to do so again next year.Then there is the tactic to give rosy estimates for the coming year, in order to give the markets and economists something to cheer about. Total subsidies for 2014-15 were pegged in the interim budget at just about 0.3% higher than the revised estimates for 2013-14. The government’s previous track record in managing subsidies gave little reason to believe this.Last year, for instance, revised estimates were higher than their original budgeted amounts by 11%. Despite that experience, budget estimates were pegged at a lower level than a year before. At the same time, expectations of tax revenues are pegged at overly optimistic levels as well. All this means little fiscal room for Arun Jaitley when he presents his first budget next week.While creative accounting happens in the private sector as well, the moving of numbers and spending around from one month to the next is much less used as a tactic. This is simply because corporates have to account for expenditures as and when they arise, irrespective of the actual payments of cash. In contrast, governments account for an expense only at the time the cash is actually handed over. This feature means there is an inbuilt incentive to a government which wants to paint a rosy picture of the budget numbers, to delay paying out what they owe to the next financial year.“The cash accounting system of the government enables it to roll over expenditures from one financial year to the next,” says Sabnavis. And while there have been moves by government accounting bodies to move towards a so-called ‘accrual’ system which is more in line with what corporates follow, there has been little progress on the ground.Another factor at play, to make budget numbers look good, is the Fiscal Responsibility and Budget Management (FRBM) Act passed by parliament in 2003, which requires governments to peg their deficits at a low level. Requiring someone to ‘hit’ a number (commit to a specific target) can be a double-edged sword, especially if that person can redefine that number to suit himself. What makes that target next to meaningless is if there are no penalties for not meeting that target. This is the case with the FRBM.Arguably, creative accounting was one consequence of the Act. Soon after the FRBM Act was passed, IMF economists Ricardo Hausmann and Catriona Purfield, in a paper on the FRBM Act, said: “The FRBM increases the incentives for the strategic use of estimates and for creative accounting.” One way this incentive worked in practice was for the government to route subsidy payments to oil companies in the form of bonds rather than cash. This ensured that such payments were ‘off-balance sheet’ and not reflected in government accounts, again a consequence of the cash accounting system.Between 2006 and 2007 (financial years), according to IMF data, the official fiscal deficit fell by 0.7 percentage points of GDP. However, if such bonds were included, the decline in the deficit was less than a third of the official decline, according to the IMF numbers. In 2012, the government amended the FRBM Act to give it even more leeway in managing budget numbers.Unintended Consequences There has been one more consequence of the FRBM Act. A recent curtain-raiser on the budget prepared by Deutsche Bank economists points out another reason why previous finance minister P. Chidambaram was able to hit a low budget deficit. The economists explain that this was possible “due to a sharper-than-planned compression of capital expenditure, which helped offset the weakness on the revenue front”.Again, successive governments when faced with the need to cut expenditure have resorted to slashing capital expenditure, while keeping current payments or ‘revenue’ expenditure intact. A focus on the fiscal deficit doesn’t distinguish between these two types of expenditures, though the distinction is often important. Capital expenditures can often be healthy since ostensibly, at least, they are directed towards creating new assets. The oft-cited argument that government expenditure crowds out, or displaces private investment, is not necessarily true in the case of capital expenditures by the government. In fact it can often work the other way round — a new government road connecting a remote area to a large town can actually incentivize private investors to set up a manufacturing plant in that area, for instance.The decline in capital expenditure as a proportion of overall government expenditure (to 14% of government expenditure in fiscal year 2014 from 23% in fiscal year 2005) pre-dates the FRBM Act. But given the increased focus in post-FRBM years on cutting expenditure to meet deficit targets, one important consequence has been cuts in capital expenditure which are often politically more convenient to make.The fiscal whammy comes at a bad time for the economy, which is still struggling to get to its feet. With oil prices higher because of heightened tensions in Iraq, the government has been forced to allow oil companies to raise petrol and diesel prices. Jaitley has already been making noises about needing to gear up for ‘tough times’ ahead, as has Modi. However, with a weak monsoon on the cards as well, it is unclear to what extent they can walk that talk.