Why growth matters

Indian Express, 23 February 2011

India's long term growth story remains intact. Yet, in the recent period, investor confidence in India has declined. The last decade saw high private corporate investment as the main engine of growth. Investment growth has been at risk since the global financial crisis impacted business prospects. In recent months, there has been a decline in the stock market, and in foreign investment into India. Budget 2011 must focus on improving the investment climate to sustain India's high GDP growth.

Policy makers in India were able to respond quickly to the demand contraction caused by the crisis through expansionary fiscal and monetary policy, and the Indian economy continued to witness high growth. But now it seems that the policy stance might have been excessively expansionary as inflation, the fiscal deficit and current account deficits rose sharply. The focus now needs to turn away from pumping higher aggregate demand to keep up production, to longer term investment that can increase the productive capacity of the economy.

The Finance Minister's post-crisis budgets focussed on safety nets required to prevent the global recession from hurting the poor in India. The reforms required to keep investors optimistic about medium term prospects for the Indian economy were not put on the front-burner. Even the reforms promised by the UPA itself were not carried through. The dismantling of the licence raj regime, however slow, that has characterised the last 20 years, was put on hold. The years under the leadership of the man who initiated reforms saw a reforms-deficit emerging, as government actions failed to meet expectations. The corruption scandals hitting the government have only made the situation worse.

A difficult question faced by the government is one of government finances. The UPA has put government spending on a new path. Concerns about the expansion of government spending programs and the consequent borrowing that these may entail would mean rising interest rates, high inflation, pre-emption of household savings by the government and a possible rise in the debt-GDP ratio to unsustainable levels. The question the government needs to ask is: this path sustatinable for the country at the current level of development and income? Can adequate resources be raised to sustain the growth in expenditure that this may require? What should be the approach that can prevent India from ending in a fiscal mess?

While subsidies are a legacy of the past, the UPA has focussed on setting up a large welfare programs such as the NREGA. These have become one of the major sources of concern as they mean larger and larger government spending. Expenditure requirements of the Food Security Act and wage indexation for NREGA have been among important concerns.

Is spending on large welfare programs sustainable for India? It has been seen that countries with low per capita income of USD 1000, such as India, have tax collection to domestic production ratios (Tax/GDP) of less than 20 percent. It is only when a country's per capita income rises to about 10 times as much, that the government is able to collect more than 20 percent of domestic production in taxes. There are a number of reasons for this. A large part of the economy is in the informal sector, with little participation in production chains where taxes need to be paid; agricultural income is often out of the ambit of the tax system; the use of modern information technology is limited in the bulk of the country and it is easy to avoid paying taxes. Consequently, the developing country average for tax payments is 18 percent, which is roughly where India is today, when we combine central, state and local government tax collections.

While resources can be raised by disinvestment or by selling spectrum, reducing subsidies and increasing efficiency in the immediate context, the tax to GDP ratio cannot be expected to rise unless the structure of the economy changes adequately, and income levels are at about USD 10,000 per capita. Until then the growth in expenditure, can be met through higher revenue collection which can come through higher GDP growth, with the tax to GDP ratio at roughly where we are now.

The above argument, as Vijay Kelkar points out in a recent paper, implies that the government needs to focus on higher GDP growth. Tax policy has to be consistent with the objective of higher GDP growth. The most important front on which the government can act is to implement the Goods and Services Tax (GST). This will help production significantly as India will able able to reap the benefits of being a common market. However, very little progress has been made on the GST and the government has extended the deadline for implementation of the GST many times. It must now take the initiative and implement a Central GST where goods and services have a single rate and a single administration. This can pave the way for the next steps, both in terms of tax policy and IT systems which will be required for a nationwide GST. While it is ideal if every state joins in, if even after being put on the defensive by the Prime Minister's reference to its stance on GST, the BJP chooses to oppose it, the Congress needs to go ahead and put together states willing to join, and the Congress ruled states, leaving out those unwilling to join. The implementation, especially the handling of turf issues, with central and state tax administrations is not going to be quick or easy, and Pranab Mukherjee needs to make a beginning.

The focus on GDP growth needs to be put on the expenditure side as well. Faced with a trade-off between spending on building highways and bailing out loss making public sector enterprises in competitive markets, the former needs to take a clear precedence. Further, there are a number of issues including foreign investment, infrastructure, taxes, an so on, for which a laundry list of reforms is available. These reforms require political initiative and if the government wishes to pull out of the reform deficit, it can push ahead. Given the credibility of the government and given its track record on implementation of promised made in the past, the budget has to emphasise concrete action rather than make big promises.

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