The real problem with the fiscal deficit comes from the fiscal multiplier. The fiscal deficit draws funds away from private investment (which is considered more 'productive') and usually ends up financing either some consumption subsidy or some (unproductive) wage bill, paid out to some snoring clerk.
But let's start at the beginning. A government has revenues from taxes, most of which are not collected, and it spends money, most of it badly. The people who benefit from this failure are the tax dodgers, tax collectors (who help the tax dodgers), government contractors, government employees (other than the tax collectors) and recipients of government subsidies.
This is a small proportion of the population, compared to everyone else. There is an inherent unfairness in all this. Almost everyone who does anything useful in the economy, is excluded out of the above list. When it becomes too big a proportion of the population, you have to change your name to Greece.
In India, only 3.5 per cent of the population pays taxes, so increasing coverage and improving the tax-GDP ratio is of paramount importance. The courage that is needed to include hitherto "holy cow" sectors, will of course, be missing for a long time. Even if we ignore the ratio of tax-payers in a poor country, we still need to focus on sectors: services is too large a sector to be left out of the net.
But the real problem is still not tax rates/structure, tax collections and coverage. It's government expenditure and the inefficiency embedded in it. Governments all over are inefficient spenders of money, and their spending has a low 'multiplier', i.e. it generates very little related economic activity. When somebody sets up a steel plant, for example, he creates a permanent source of fresh demand for various goods and services that go into steel-making. He also produces an impetus to invest in downstream projects, like cars and consumer durables. Such expenditure has a big economic multiplier.
It is not that there is no space on government expenditure to do that. When a government builds a good road to a particular town, industrial investment and consequent employment goes up. On the other hand, it could use the same money to subsidise kerosene for a poor villager, who just burns it and goes back to his mundane existence. The same money spent on subsidising a solar lantern, would provide the same villager with a long-term source of lighting. But the vested interests and inertia that holds up government decisions and the democratic process in India, is our biggest bugbear.
Take fuel subsidies. Some courage has been shown in bringing down diesel subsidies, although much more should be done. The money saved can go into capital subsidies for the solar sector, which would provide a huge multiplier, compared to the irrational fuel subsidies. The same goes for food and fertiliser subsidies; while there is still something to be said for food subsidies, there is almost nothing to recommend fertiliser subsidies.
In fact, the most distorted policy framework exists in agriculture and the sectors that directly deal with it, i.e. procurement, logistics, distribution and supply chain, fertilisers and other inputs like seeds. Considering that 70 per cent of the Indian population is engaged in this sector, there is a disproportionate impact of government policy on the quality of lives of most of the population.
The biggest multipliers in the economy right now would be in the area of energy production and distribution, infrastructure development and social infrastructure and health. The biggest drag would be coming from consumption subsidies and administrative expenditure on salaries, besides interest. It becomes a simple equation after that: how much money did you put into the former, and how much of it came from the latter? That is the simple question to ask after any budget exercise.