Finance Minister Nirmala Sitharaman will present her second Budget on February 1 amid a slowdown in GDP growth and an increase in the rate of unemployment. Even supply-side economists are acknowledging that the current situation is because of the problem of aggregate demand. The demand-side economists, anyway, have been arguing for expansionary fiscal policy. In this context, if the government reduces expenditure to GDP ratio, it would be taking an absolutely wrong fiscal policy approach.
In a slowdown, it is not abnormal to expect that there would be a revenue shortfall. If GDP grows at a lower rate, then the tax revenue would also grow at a lower rate. Moreover, there would be pressure from the industrialists’ lobby to reduce the profit tax rate and so on and so forth. However, if the revenue as a proportion of GDP falls, then the fiscal deficit to GDP ratio would rise in order to maintain the same level of government expenditure as a proportion of GDP. If the fiscal deficit to GDP ratio is kept constant, then the expenditure-GDP ratio would fall, which would aggravate the situation of unemployment.
Right Fiscal Policy
Now, the question is what the government should ideally do in this kind of a situation? What would be the right fiscal policy under demand depression? Well, the government should increase its expenditure as a proportion of GDP. It should try to raise as much revenue as possible and incur larger fiscal deficit as a proportion of GDP to finance a higher level of government expenditure to GDP ratio. Mainstream economists may find it difficult to recommend an increase in fiscal deficit to GDP ratio under any circumstances. However, the need of the hour is to inject extra demand in the economy at the aggregate level.
Larger fiscal deficit to GDP ratio means higher purchasing power in the hands of the people which would generate higher aggregate demand in a demand-constrained situation. This would help in reviving the growth and generating employment opportunities. Some may say that a larger fiscal deficit may cause foreign indebtedness. But there is no need for foreign borrowing in the Indian context today. There are also fears that large domestic borrowing by the government may cause crowding out of private investment. But, the domestic saving would also be higher in case of higher fiscal deficit because of higher growth in GDP.
Moreover, the interest rate is administered by the monetary authority. So, the possibility of crowding out due to a rise in real rate of interest is unlikely, provided the monetary authority remains alert. Above all, the government may borrow from the Reserve Bank of India (RBI) instead of borrowing from commercial banks, if required. This process of monetisation has been stopped since 1996 in India because there was a system of automatic unlimited monetisation of fiscal deficit. However, this does not mean we would not be able to use this instrument of financing fiscal deficit even in emergencies. Expansionary demand management policy or monetisation is not necessarily inflationary – it is not inflationary particularly in a demand-constrained situation.
Sustainability of public debt and cost of debt servicing is another concern. However, the interest payment component on domestic debt is, at the end of the day, a transfer of money from taxpayers’ pocket to the bondholders’ pocket. Since government bonds are primarily held by commercial banks and insurance companies in India, the interest is paid to them from where they pay deposit rates to the common people. As all the economic agents involved in this process are domestic parties, there is no net loss of aggregate demand considering the economy as a whole. The debt-GDP ratio would not increase unless the effective interest rate on government debt exceeds the growth rate of nominal GDP. Even if the debt-GDP ratio increases, nothing happens. There is no reason to believe that the people would lose faith in government bonds if they don’t lose faith in currency notes – issued with same government guarantee – called money.
Therefore, in a demand-constrained situation, the government should undertake the Keynesian policy of ‘digging holes and filling them up’ (read deficit financing). If the growth rate recovers, the government revenue would also be buoyant in the days to come and the fiscal deficit to GDP ratio would automatically come down. On the other hand, if the growth rate does not revive, the future revenue would be lower and even if the government expenditure remains the same, the future fiscal deficit as a proportion of GDP may rise. It would depend on the values of government expenditure multiplier and the revenue elasticities. Again, the government expenditure multiplier would be larger if the composition of government expenditure ensures pro-poor distribution of income. The poorer section consumes proportionately more out of their income. Consumption creates demand and saving does not. Hence, if the poorer section gets more purchasing power, the effectiveness of the government expenditure in increasing GDP (ie Keynes-Kahn multiplier) rises.
Bridging the inequality gap at the aggregate level makes not only government spending multiplier higher but also the effectiveness of private investment or even that of net export more effective in increasing GDP. Therefore, the right direction of fiscal policy would be to enhance pro-poor expenditures like expenditure in MGNREGS, in health and education and in the social sector, in general, as opposed to giving tax concessions to big corporates. Increasing the net capital expenditure of government in strategic sectors is also important for attracting private investment, for generating employment and growth as opposed to net disinvestment.
Under fiscal stress of lower revenue and higher expenditure needs, instead of incurring higher fiscal deficit as a proportion of GDP, the Central government might choose the easy way out of reducing transfer of resources to the States. States are already complaining that they are not getting compensation due to revenue loss after implementation of GST in time. Moreover, the State’s finance, operating under the FRBM cap, is in an extremely tight situation after more centralisation of taxes and increased expenditure responsibilities. Any reduction in transfer to States as a proportion of GDP would simply mean transferring Centre’s fiscal deficit to States (as a percentage of GDP).
Moody’s might downgrade India because of higher fiscal deficit of Central government as a proportion of GDP. However, they may also downgrade us because of lower growth rate. Moreover, people would suffer more from unemployment and poverty, from lack of government-sponsored education and health facilities, infrastructure, etc, in case of a non-expansionary, non-pro-poor fiscal policy in the face of a slowdown. The choice is amply clear.
(The author is Assistant Professor, Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi)