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At the macro level, an economy has four drivers of growth. Think of these as a four-wheel drive. If all are in sync, and revved up properly, then we get good speed i.e. growth of the economy. These drivers are all in the nature of the sources of demand, or spending on goods and services. The four are a) private consumption (nearly 60% of GDP), b) investment (30% in good times), c) net exports (what foreigners spend on Indian goods and services) and d) government. The net exports category is actually negative for India, because our imports exceed exports by about two percent. When the first three engines are sputtering, and not performing to full potential, then we need to rev up the last engine, that is government spending. This is technically called “expansionary fiscal policy”. Unlike the first three, the impact of increased government spending on the economy is limited, and the fiscal multiplier is close to one.
The problem with expanding government spending is that it can come only by raising resources from the public, either by taxes or by borrowing (which is taxes on the future generation). Raising taxes can hurt consumer spending negatively. And raising borrowing can hurt the “loan market” by pushing interest rates higher. It also causes the fiscal deficit to rise.
This brings us to the central issue of what the size of the deficit should be. For much of the past hundred years, and especially during and after the Great Depression years of 1929-1941, the efficacy of deficit spending has been accepted and is now unquestioned. Unlike a family or real persons, the government can easily spend beyond its means, because it has the power to tax, the current generation and future generations. Also unlike real persons, the government need not pay back its loans. It can keep doing fresh borrowing, i.e. take fresh loans to pay off older loans. Of course all this has to be done in a reasonably sustainable and manageable way, so as to not cause runaway inflation, or complete loss of confidence in the government.
So what should India’s fiscal strategy be especially in the context of the upcoming budget? Since other engines of growth are not revving at full potential, the fiscal push will become necessary. There is nothing sacred about the three percent number. It arose out of the Maastricht treaty of European nations, and could equally well have been 2.5 or 3.5. What is important is maintaining the sanctity and credibility of the budgeting process and the budget promise.
Recently the international rating agency Moody’s, upgraded India’s sovereign rating by one notch, after a gap of thirteen years. India’s rating now stands one notch above the lowest rating termed as “investment grade”. Rating agencies are notoriously fastidious, especially about a country’s ability to repay its debts. Hence they always focus disproportionately on debts and deficits. In that sense they are fiscal fundamentalists. Since their rating affects foreigners’ perception of the investment (and repayment) potential of a country, it is but natural that they look at debt servicing capability. Despite the red flags raised by many other “fiscal fundamentalists”, if Moody’s have decided to upgrade India, surely they know something that all of us must take cognisance of.
In particular we need fiscal support for helping exports, improving farm incomes, funding infrastructure in rural areas, incentivising labour intensive industries and affordable housing. All this is doable within a limit of the fiscal deficit being 3.5 to 3.7 percent of GDP.
Basically India’s demography is its strongest point. The fiscal spending on infrastructure and capital items, must be financed not only by current beneficiaries, but also by unborn beneficiaries. These assets like roads, railway, ports, airports, irrigation systems have a life of at least two or three generations, so fairness requires that all three generations must bear the burden equitably. It is this most important reason why higher fiscal deficit in “young” India is more acceptable than in the aging societies of Europe or Japan. Indeed those countries have a higher share of government spending in their GDP, because much of it goes to pay for social security to the elderly. But in India’s case, we are still at the infrastructure building stage.
So what should India’s fiscal strategy be especially in the context of the upcoming budget? Since other engines of growth are not revving at full potential, the fiscal push will become necessary. There is nothing sacred about the three percent number. It arose out of the Maastricht treaty of European nations, and could equally well have been 2.5 or 3.5. What is important is maintaining the sanctity and credibility of the budgeting process and the budget promise.
Having a target and achieving it is more important than blindly sticking to an internationally accepted number. India’s context given its young demography and development phase may be different. That of course does not mean that any number is ok. There are some constraints imposed by the overall resources of the economy, the potential taxpayer base and its paying capacity, and the feasible growth rate of the economy (and national income).
There should be a general escape clause to deviate from fiscal discipline, such as when the economy is sputtering and growth rate has fallen. Given that our growth rate is lowest in four years, it is a serious concern. This has come at a time when the whole world is experiencing, strong synchronized growth. Hence India needs to pull out all its fiscal stops to get back into a higher growth orbit.
The expert committee on Fiscal Responsibility and Budget Management (FRBM) has already given a detailed, well thought and researched report to the government. Of particular interest and importance is the dissent note submitted by the Chief Economic Advisor. The CEA has said that having multiple targets (of fiscal deficit, revenue deficit, debt to GDP ratio, etc) may be dangerous as they can be internally inconsistent, and can aggravate deficit during booms and busts of the business cycle. Instead it is best to have one target, say the debt to GDP ratio and a time line to achieve the target (say ten years).
There should be a general escape clause to deviate from fiscal discipline, such as when the economy is sputtering and growth rate has fallen. Given that our growth rate is lowest in four years, it is a serious concern. This has come at a time when the whole world is experiencing, strong synchronized growth. Hence India needs to pull out all its fiscal stops to get back into a higher growth orbit.
In particular we need fiscal support for helping exports, improving farm incomes, funding infrastructure in rural areas, incentivising labour intensive industries and affordable housing. All this is doable within a limit of the fiscal deficit being 3.5 to 3.7 percent of GDP. Of course what is more important is to keep an eye on the revenue deficit. Back in 1981 the ratio of revenue to fiscal deficit used to be barely 4.5% which climbed to a shocking 81% in 2010. Thankfully that is down to about 58% now, a drop of 17% in the past three years. That’s a healthy record (and was what perhaps enthused Moody’s). But on fiscal deficit itself, let’s be less fundamentalist and more pragmatic.