In order to address the current slowdown, a revival of demand should be the way forward rather than putting all the focus on fiscal consolidation
Last week, we saw several leading economists argue against the reduction in personal income tax while others warned about the consequences of a likely deviation from the fiscal targets. This discussion was reignited by former Chief Economic Advisor when he presented his assessment in Bengaluru and strictly opposed a personal income tax cut. The Chief Economist of the International Monetary Fund, Gita Gopinath, too, echoed a similar view when she categorically advised against deviating from the fiscal deficits.
These views are important for the simple reason that they are coming from such distinguished academics. However, the problem is that they underscore the extent of India’s current demand slowdown. Any policy prescription is given after a sound prognosis of the problem. The suggestion against a fiscal stimulus comes from an understanding that the slowdown is likely to be more structural than cyclical.
However, the recent weakness in growth statistics, which continued till November, indicates that the extent of cyclical slowdown is far greater than what was originally anticipated. There is indeed a slowdown in demand, which has resulted in unutilised capacities, thereby curtailing private investment. Reduced investments have further resulted in lower growth and the cycle continues. It is, therefore, important to break this cycle rather than keep waiting for it to turn itself.
The most effective way to break this cycle is through the revival of demand, which has already shown signs of improvement. There are three main components of demand — for domestic goods and services by external sector (exports), private and Governmental. As is known, exports depend on a variety of factors such as global growth, trade environment and domestic competitiveness. The Government can only affect the latter. The HLAG has already proposed bold reforms, some of which have been implemented by the Government. Private demand, on the other hand, depends on overall growth. And Government demand is always an important aspect during an economic slowdown. This thought may appear to be Keynesian but it is a proven and effective strategy to address a slowdown.
During the 2008 recession, the US witnessed a substantial increase in its deficit even as the Federal Reserve System kept on expanding its balance sheets aggressively. Both these moves were important to address the economic slowdown, which originated from the financial crisis.
Therefore, India, too, needs to look at ways that can revive demand to break the cycle. The easiest way to achieve the same is for the Government to start clearing its dues on time. The Government knows this well and the same is a work-in-progress. The other methodology is to rationalise taxes as a part of a larger taxation reform, as envisaged in the Direct Tax Committee report. Whether this happens or not is another matter but it is definitely important to revive private demand. A reduction in the contribution to the Employees Provident Fund Organisation (EPFO) and other social security schemes can also help the Government achieve the goal.
The third aspect, of course, is to boost Government expenditure to ensure robust demand. This expansion should ideally come in the form of investments rather than simple unconditional cash transfers. An extensive cash transfer scheme is indeed needed. However, it must come as an alternative to our current poverty alleviation programmes rather than as a supplement to them.
India does have several opportunities for public investment — in roads, railways and the development of urban infrastructure. Moreover, a lot more can be done to augment social infrastructure by investments in healthcare and education. These are the areas that are likely to drive future growth. While the multiplier for investments in these areas may not be as high in the short run, it will yield rich dividends over a period of time.
As far as consolidation of poverty alleviation programmes is concerned, now is indeed the right time to evaluate the impact of associated schemes and discuss whether a direct cash transfer module can be more effective. This exercise is important as India is a capital constraint economy and, thus, the prudent use of public finances can help meet some of its urgent investment needs.
In an exercise undertaken under the guidance (and jointly with him) of Surjit S Bhalla, it was found that the recent asset transfer by the Modi Government did amplify India’s already good record of poverty alleviation. This suggests that we can move towards an innovative approach for our poverty alleviation programmes using an unconditional cash transfer scheme as a substitute for food, fuel and fertiliser subsidies and MGNREGA. Such a cash transfer programme can prove to be far more effective over the coming years given that it will be well targetted, thanks to the Jan Dhan-Aadhaar-Mobile trinity. Over time, it may be fiscally efficient, thereby reducing the burden of these programmes on the exchequer. A case in point is the food subsidy Bill, which has nearly doubled between 2013 and 2019. This shows the extent of the Government’s commitment towards these programmes.
A key question when one talks about the fiscal deficit is to do with its financing. Many talk about the limited fiscal space. Indeed, this is true but a major component of the fiscal deficit at present is the interest rate on previous borrowings. This is where the role of the Reserve Bank of India (RBI) becomes important. The Central Bank needs to urgently intervene to reduce the yield on Government Securities (GSecs). Reducing the yield can free up further fiscal space for the Government to provision for a fiscal stimulus in the coming financial year. The fiscal stimulus is unlikely to be inflationary, given that our growth rate is significantly below the potential and, therefore, rate cuts should continue while the RBI should keep on intervening to ensure that real GSec yields reduce. Perhaps, it should also redefine the real GSec yields by taking non-food CPI as the appropriate indicator for inflation.
Another important decision was announced in the previous Budget but is yet to take off and this is to so with sovereign bonds. In principle, the idea is good and helps resolves many problems on the fiscal front. The only concern has been that low cost may induce the Government to borrow excessively from abroad, thereby resulting in unsustainable build-up of public debt. Tweaking the Fiscal Responsibility and Budget Management rules to limit the extent of foreign borrowings can resolve this problem. Not exploring sovereign bonds will only put us at a disadvantage. The fact remains that India is a capital deficient nation and sovereign bonds are a good way to ensure adequate funds for fiscal needs. Moreover, this will ensure that our domestic savings can be utilised by the private sector and cost of borrowing will go down, thereby making them more competitive.
India’s medium-term potential continues to be great despite the current economic slowdown. However, getting out of the slump should be a priority given the risks it poses to our growth ambitions. It is evident that fiscal perma-hawks are against a slippage, but then, evidence from the last five decade shows that fiscal expansions are indeed effective when it comes to revival of growth. At a time when our exposure to foreign debt is low and inflation is muted, we do have a significant opportunity to take necessary bold measures to move closer to our potential. Failure to do so would be a waste of the work done over the last five years to ensure such stable fundamentals.
While many would continue to argue against a fiscal expansion, it appears to be the best way to break the cycle. Therefore, augmentation of Government demand in the right area should be the way forward rather than continuing with the fiscal consolidation path. However, in the event of deviation from the target, the Government must come clear on its future fiscal consolidation path and commit to factor market reforms over the next couple of months. Doing so will revive the sentiment and sending a signal to the international community that India means serious business and is committed to its fiscal consolidation targets.
(The writer is a New Delhi-based policy researcher)
