Countercyclical fiscal policy may not help

The Economic Survey 2020-21 offers the spirit of generous optimism on the growth front but this comes coupled with an overdose of complacency. Growth, it is proclaimed, will be achieved, but the path leading to a sustainable growth is missing. As Krishnamurthy V. Subramanian, Chief Economic Adviser, said in the Survey Preface: “… after experiencing a sharp contraction of 23.9% in first quarter of 2020-21, India is expected to be the fastest growing economy in the next two years. Projections by various national and international agencies including the IMF project this resilience of the Indian economy.” The question is how can the country get there if the road to reach that prized destination is not charted out carefully.

A large fiscal slippage has its adverse impact not only on the domestic economy, particularly the private sector which is currently in the forefront of the revival by boosting investment, but also for foreign investors.

Further, a ‘V’-shaped recovery does not provide any comfort level when it is seen in conjunction with the 2019-20 latest data for real growth, savings and investment. Given the growth of 4 per cent with an investment – GDP ratio of 32.2 per cent, the implicit Incremental Capital to Output Ratio (or ICOR) for 2019-20 worked out to 8 as against around 5 in 2018-19, with a growth rate of 6.5 per cent and an Investment - GDP ratio of 32.7 per cent. The ICOR is a critical ratio that indicates how new capital invested is delivering against increased economic activity. The number 8 seen here is a new high, and it indicates lower output even if investment is high. This is otherwise inefficiency in the economy. The historical ICOR for India has been 4 on an average.

When things fall precipitously as they did during the Sars-Cov-2 pandemic, then a spring action bounce back is a given. It mimics a ‘V’ but cannot be read as a sign of a stable recovery in the immediate. Thus, what is important is not the ‘V’-shaped recovery but to move the economy to a higher sustainable growth trajectory. The important contributory factor in this regard is the enhancement of the savings rate. This could be done with only a roadmap that shows and creates adequate fiscal space in the Union Budget 2021-22 to be presented to Parliament on Feb.1 2021

One important element in this regard is to translate the government dis-savings generated by revenue deficit to government savings by a revenue account surplus. This aspect unfortunately has been relegated to background in the fiscal road map of the Union government, as seen from actions of the government in the recent past.

Any move to budget for higher spending will result in a higher fiscal deficit and given the downward rigidities in revenue expenditure will record a higher revenue deficit which has been our experience during the entire period of FRBM since 2003, which in turn has had its part in not letting India stand up to the unprecedented crisis wrought by the pandemic. This is the trap we are caught in.

This gives us a not-so-hopeful indicator of what may be coming in the Union Budget. Going by the monthly data released by the Controller General of Accounts (CGA) for the period April- November 2020, there has been a complete collapse of revenue receipts with a contraction of 12.6 per cent in gross tax revenue and a decline of 20.2 per cent in the assignment of tax revenues to State governments and further a decline of 46.6 per cent in the net tax revenue (gross tax revenue minus assignment to States). There has been some slowdown in the expenditure but such a massive shortfall in the revenue side would translate to a heavy fiscal slippage and could also adversely impact the budget arithmetic for 2021-22. It is important therefore for the government to carefully make the estimates which will be realistic and would not result in large fiscal slippages or numbers that are wonky.

A large fiscal slippage has its adverse impact not only on the domestic economy, particularly the private sector which is currently in the forefront of the revival by boosting investment, but also for foreign investors. The Economic Survey was categorical in denouncing the credit rating agencies but the Foreign Direct Investments and Foreign Portfolio Investments do give importance to rating agencies. In this context, a large fiscal slippage does not augur well and so also the comments on the rating agencies. If it indicates that dramatic slippages are in the offing, then that is a clear red flag.

What is important is aggregate supply management with emphasis on reducing the input cost of production and increasing labour productivity through appropriate technology.

Another important aspect for the Union Budget 2021-22 is the countercyclical fiscal policy, implying more spending by the government, precisely the point that has been highlighted in the Economic Survey. The arguments set out in the Economic Survey on growth, debt sustainability, countercyclical fiscal policy and crowding out are designed to support higher spending by the government. It is important to mention that if the Indian economy is moving out of the recessionary phase, as is being said here by the government through the Survey, there is no need of a countercyclical fiscal policy. Any move to budget for higher spending will result in a higher fiscal deficit and given the downward rigidities in revenue expenditure will record a higher revenue deficit which has been our experience during the entire period of FRBM since 2003, which in turn has had its part in not letting India stand up to the unprecedented crisis wrought by the pandemic. This is the trap we are caught in.

The argument that higher fiscal deficit accompanied by a large component of revenue deficit will not result in higher interest rate is not convincing. Sustaining the financing of higher fiscal deficit through large market borrowing sooner or later will increase the interest rate and eventually will crowd-out private investment. This also will put pressure on the debt and liquidity management of the RBI. The higher capital expenditure allocation by itself is not growth enhancing. It should be self-financing, implying that the return on capital should be at least equal to the cost of borrowing.

With regard to allocation of expenditure and health infrastructure and education, it is pertinent to mention that according to our Constitution these are primarily State government fiscal responsibilities. Therefore, what is important is cooperative fiscal federalism. There are views that fiscal federalism currently is at the crossroads. It is important to set it right through the budgetary directions in allocation of grants and devolution of taxes as per the 15th Finance Commission. What is more important is preventing fiscal slippage in this because the Union government fiscal slippage will carry adverse implications for State budgets.

The Economic Survey has highlighted the aspect of basic needs and has worked out a Basic Need Index (BNI). Delivery of basic needs such as sanitation, drinking water, etc. are provided by local government. In this regard, the crucial aspect is provision of finance for the local government. Unfortunately. there is no clear roadmap indicated for this at least in the Economic Survey. It is important for the Central and State government to follow the recommendations of the Finance Commission on local governments.

A clear roadmap needs to be set out in respect of infrastructure investment, with clear guidance to State and local governments in terms of financing infrastructure projects.

The Economic Survey of the government in many ways has given what essentially are text book recommendations, particularly with regard to the fiscal policy. In the name of the countercyclical fiscal policy, the Union Budget should avoid higher fiscal deficit accompanied by higher revenue deficit as explained earlier. Furthermore, a countercyclical fiscal policy is a reflection of aggregate demand management of the economy. But aggregate demand management at this juncture will not move the economy to a sustainable level of growth. There are potential dangers of inflation and that may adversely impact RBI’s monetary management in terms of controlling inflation and anchoring inflation expectation. In this regard, the suggestion in the Economic Survey to change the weighting pattern of food inflation will not be a solution as these changes are cosmetic. This is like changing some calibration on the weighing scale to show that the person has become fitter!

What is important is aggregate supply management with emphasis on reducing the input cost of production and increasing labour productivity through appropriate technology. The Economic Survey has indeed highlighted regulation and innovation. A clear roadmap needs to be set out in the Union Budget in respect of infrastructure investment, with clear guidance to State and local governments in terms of financing infrastructure projects. Most importantly, the highlight should be on the tax–GDP ratio roadmap, particularly on GST.

The Union Budget 2021 -22 is critical for the Indian economy in many ways, but this year is quite obviously special and even unprecedented, given the collapse we have seen because of the pandemic. Therefore, the direction and fiscal management is important in these difficult times. In that, the Union Budget cannot escape from providing a prudent fiscal roadmap for the medium term, with emphasis on non-inflationary financing the fiscal deficit rather than the fiscal deficit per se.   

(Dr. R K Pattnaik is a former Central banker and a faculty member at SPJIMR. Views are personal)