Should high fiscal deficit be frowned upon?

By A Vasudevan

“The term ‘deficit financing’ is used to denote the direct addition to gross national expenditures through budget deficits, whether the deficits are of revenue or of capital account.  The essence of such a policy lies, therefore, in government spending in excess of the revenue it receives in the shape of taxes, earnings of State enterprises, loans from the public, deposits and funds, and other miscellaneous sources.  The government may cover the deficit either by running down its accumulated balances or by borrowing them from the banking system (mainly from the central bank of the country and thus ‘creating’ money).”

                                            The First Five Year Plan, Government of India, 1952, pp. 59-60

The above quote from the First Plan believed to have been drafted by K N Raj that had been also used by other well-known senior economists including V K R V Rao and A K Dasgupta, has undergone a transformation.  The concept of the gross fiscal deficit (GFD) is now widely used since it is consistent with the internationally accepted standards of fiscal statistics. The data on GFD expressed in relation to gross domestic product (GDP) for India are available in official publications for the years beginning 1970-71.  In the early 2000s, after experiencing external payments crisis due to large fiscal deficit in the 1990s, India laid down a statutory rule on GFD/GDP at 3 per cent mimicking the one prevalent in advanced economies, hoping that it would make the country fiscally sustainable.

Heightened security and healthcare concerns call for increased expenditure

Monetisation of fiscal deficit, the main source of ‘created’ money, is said to carry the risk of inflation. India has had monetisation through ‘automatic’ issuance of ad hoc treasury bills till 1996, a period that represented higher growth variability than in subsequent years. The caution of economists for minding the safe upper limits to deficit financing right from about the end of 1950s was, however, found to be not easily implementable partly due to economic uncertainties in the globalised world as at present and shocks such as the current pandemic.    

Now there is a debate as to whether a large fiscal stimulus would lead to high inflation, warranting a hike up in policy rates of interest at the possible expense of growth.  As of now, the stimulus represented by GFD/GDP is expected to be above the single digit.  The highest ratio ever recorded in India, however, was 9.6 per cent in 2001-02. And the highest domestic and foreign liabilities to GDP of the Centre and States was 82.13 per cent in 2004-05.  These ratios may be noted for not impeding growth prospects in subsequent years.  

A surge in overall health expenditure including that on imports would help reduce illnesses and promote family welfare.  Besides, it will foster improvements in clean ecology and environment as well as in labour productivity.

The impact of the pandemic attack on India’s fiscal deficit needs to be seen in the context of three challenges India faces at present: the defence of borders in the light of the evolving power play in the Western and North-western parts of India and the attendant terrorist attacks on India, the uncertainty about the longevity of the Covid-19 pandemic and the related diseases and the investment slowdown with attendant uncertainty about growth prospects.

Barring the last of the three challenges, the other two should be regarded as public goods that need to be provided whatever be the economic cost, if we define public good as non-rivalrous and non-excludable.  The Governments, both at the Centre and the States, have therefore very little option but to sharply increase expenditure on internal and external security, health and related infrastructure and education activities, apart from the normal development and maintenance expenditures. The surge in public expenditure will raise the combined Centre and States GFD/GDP possibly to above the single digit.

Of the three challenges stated above, the least discussed is about defence needs and actions that need to be taken to thwart security threats and protect the territorial integrity not only in the immediate present but also in the medium and long-term periods. 

Monetisation of fiscal deficit, the main source of ‘created’ money, is said to carry the risk of inflation

Regarding health, the average public expenditure to GDP was around 1 per cent of the GDP while private expenditures to GDP were about 2.5 per cent over the last twenty years or so, not even one fourth of the total expenditures to GDP that a poor country like Sierra Leone in West Africa had incurred in 2018 as per the latest World Bank data.  There is a huge gap in health care. 

What is very critical is that health related infrastructure in India requires the need to bolster the current capacity in terms of the existing number of doctors, nurses, and other supporting staff and the other hospital infrastructure like the number of hospitals, health centers, hospital beds, ventilators, oxygen concentrators, ICUs, and operation theatres.  Besides, R & D efforts of the pharma industry would have to be given a sharp boost to take care of Covid cases as well as other serious illnesses. If actual supplies of medicines and vaccines are not available from domestic sources to meet the high domestic demand within a given period, medical including vaccine imports would become essential.  A surge in overall health expenditure including that on imports would help reduce illnesses and promote family welfare.  Besides, it will foster improvements in clean ecology and environment as well as in labour productivity.  

The impact of the possible large fiscal deficit now may dissipate if the recent elimination of retrospective taxation, sharp flows of foreign investments, dampened inflation expectations, hopes of successful privatisation plans and signs of noticeable economic recovery across sectors materialise to invigorate the animal spirits.

Now that the new vaccination policy is unveiled to ensure that vaccines to thwart Covid are provided almost free for the adult population by the end of December 2021, the combined fiscal deficit of the Centre and States would go up sharply beyond the minimum two-digit figure in relation to GDP.  However, its success would depend on the governance mechanisms and implementation strategies.  The supply of and demand for vaccines and its matching at every vaccination center on a daily basis is critical. This will require that supplies have to be sharply ramped up even if it necessitates imports of vaccines and elimination of bottlenecks related to infrastructure and logistics.   

On infrastructure and development related activities in India, the ongoing discussion is largely on their support to employment creation, investment rate and growth prospects and economic equity.  These issues would prevail so long as there are no adequate structural reforms of the product and factor markets and financial sector.  Otherwise, the currently estimated potential growth of 6-7 per cent may not be sustained. 

The impact of the possible large fiscal deficit now may dissipate if the recent elimination of retrospective taxation, sharp flows of foreign investments, dampened inflation expectations, hopes of successful privatisation plans and signs of noticeable economic recovery across sectors materialise to invigorate the animal spirits.

(The writer is a former Executive Director, RBI and former Special Adviser to the Governor, Central Bank of Nigeria)