Come budget day, most analysts will be focused on one number—the fiscal deficit as a proportion of the GDP.
They will want to see whether finance minister Arun Jaitley sticks to his target of 4.1% for 2014-15 and 3.6% for 2015-16.
Since tax revenues have thus far fallen short of projections for 2014-15, analysts will expect Jaitley to cut expenditure significantly. For 2015-16, they will bank on a combination of expenditure compression and increased revenues from disinvestment to help him stick to the fiscal deficit target.
Such an approach ignores India’s fiscal history since the beginning of this decade. In 2001-02, the central fiscal deficit was 6% of the GDP, well into the danger zone. Analysts warned us that unless the government took the axe to expenditure, there was no way the deficit would be reined in.
Successive governments had little success on the expenditure front. And yet from 2003-04 onwards, the fiscal deficit began to decline until it touched a low of 2.54% in 2007-08, below the threshold of 3% that we are eyeing today.
How did this miracle come about?
Between 2003-04 and 2007-08, growth spurted on the back of the global boom and also driven by India’s high savings and investment rates. India’s growth rate in the period averaged 8.8%.
High growth reduces the fiscal deficit to the GDP ratio in two ways: It boosts tax revenues, thus reducing the former; and it boosts the latter.
Economic pundits had said that a reduction in the deficit was a pre-condition for growth to accelerate. Instead, India saw growth accelerating and fiscal deficit to the GDP ratio declining. A classic chicken-and-egg situation.
Tax reforms, aimed at increasing revenues, were also an important part of the improved fiscal story.
Since 2011-12, growth slowed down to well below the magic 7% mark. The revised GDP figures, using 2011-12 as the base year, estimate growth in 2012-13 at 4.7% cent and 6.4% (using factor prices, the same basis for the growth figures above). Thanks to the slowdown and the fiscal stimulus in the years following the financial crisis, the fiscal deficit again ballooned.
This historical record tells us three things.
One, India’s fiscal correction has not happened on account of a great deal of expenditure compression. Two, if we focus on tax reforms and other measures to enhance revenues, we are well placed to lower the fiscal deficit. Three, when India’s growth exceeds 7% and is close to 8%, the fiscal deficit is substantially self-correcting.
If we go by market prices, growth is projected to accelerate to 7.4% in 2014-15. This would mean we are again past the crucial 7% mark. If we can sustain the acceleration in 2015-16, we have a good chance of bringing the fiscal problem under control once again.
How do we ensure growth acceleration at a time when the global environment is unhelpful and we cannot bank on exports to propel growth?
We need to focus on domestic demand, especially investment demand related to the infrastructure sector. Private investment is not up to the job, given that leading private companies in infrastructure are mired in debt. Public investment alone can do it.
What, according to critics of government spending, are the difficulties in the way of stepping up public investment?
One, credit rating agencies and many foreign investors are keeping a hawk eye on the fiscal deficit to the GDP ratio. They will not take kindly to any significant departure from the targets to which finance minister Jaitley has committed himself. Two, the Reserve Bank of India (RBI) governor has linked any further cuts in the policy rate to evidence of fiscal consolidation happening. Three, a combination of fiscal laxity and monetary loosening could cause inflation to go out of control once again and the currency to depreciate steeply. This is undesirable at a time when interest rates in the US (paywall) are likely to rise.
Fortunately for Jaitley, the growth numbers put out by the government’s statisticians put him in a good position to address the first two concerns. If he assumes growth at market prices of 7.4% for 2014-15 and 7.5% growth on top of that for 2015-16, he can afford to spend more on public investment while keeping the deficit in check. He will be helped in this by assuming disinvestment receipts for 2015-16 of Rs50-60,000 crore.
Public investment does not have to come entirely from the budget. The government must lean on public sector enterprises to put their cash hoards to productive use. Combined with a further pruning of oil subsidies, Jaitley can settle for a fiscal deficit to the GDP ratio for 2015-16 of, say, 3.8%.
This should reassure foreign investors sufficiently. It should also provide the cue to the RBI to cut interest rates. There’s simply no excuse for the RBI not to do so. Wholesale price inflation has averaged a little over 1% in the last six months. Consumer inflation is well within the RBI’s target of 6% for 2015-16. Equally important, the Indian rupee has strengthened in both nominal and real terms over the past year as India’s external balances have improved and foreign investors have reposed faith in the Indian economy.
The combination of accelerating growth, falling inflation and an improved external account gives Jaitley a great opportunity to increase public spending on investment without compromising unduly on the fiscal deficit targets. Boldness lies in availing of this opportunity; not spending on public investment in today’s situation is not boldness, it is timidity.
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