Vertical Fiscal Imbalance Variation

Vertical Fiscal Imbalance Variation

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When people ask ‘what is fiscal imbalance’, it generally means that they are not very well acquainted with the idea and thus, it becomes important to define the term in the first place. Fiscal imbalance generally happens when the future debt commitments of a government are not in line with its projected income streams. Income streams and commitments are calculated based on their present value and offered some rebate on the risk-free rate in addition to a certain spread. The government’s revenue and expenditure may be impacted due to two types of imbalances – vertical fiscal imbalance and horizontal fiscal imbalance.

While we will deal here with vertical imbalance meaning (VFI), its variation and significance, we will also try and understand its implications on the gross domestic product (GDP) and how the imbalance may affect GDP. In a vertical fiscal imbalance situation, the revenues and expenditures in different levels of government do not match correctly and that can be a hindrance to the fiscal performance of a nation. Thus, large vertical imbalances can lead to poor fiscal performance. While sub-national budgets are usually balanced irrespective of whether there are revenues or transfers, the financial performance at the central level depreciates marginally at higher VFI levels.

A vertical fiscal imbalance variation can also be seen in many states due to their budgets, revenue generation sources and spending obligations. This variation can be predicted and plotted to understand the causes for the same and the steps can then be taken to reduce the imbalance. However, if the imbalance is unprecedentedly high, it becomes important for a sub-national government to look into the basic reasons for the same and take corrective steps so that the financial situation does not go out of hand. Therefore, keeping the variation within check is very important for any state as well as the central government to roll out their policies efficiently.

A high variation may also have detrimental effects on the overall GDP of a country and thus, it also becomes crucial to understand vertical fiscal imbalance ratio correctly for all the stakeholders. It is a straightforward ratio that can be calculated by dividing all the revenue sources of a sub-national government by its total current expenditure. A lower value for the same is highly desired by all governments, central or state, to ensure healthy growth.