There are two ways of putting money into people’s pockets — either you pay them more or you tax them (and what they buy) less. Finance Minister Yashwant Sinha, in his remix of P Chidambaram’s Dream Budget, has done both.

He has announced a cut in tax rates, reduced excise duty on motor vehicles, and provided more concessions for housing loans. This, along with cheaper credit, is expected to raise consumer demand. Now all that he has to do is to sit back and watch industrial growth go up, up and away, at least in the short run.

And it has to be given to him. The logic is faultless. The increase in demand that the Budget hopes to generate is likely to be important for reviving the economy, not least because of the slowdown in industrial growth, low growth in non-administered prices and falling imports last year. As well, hopefully, the expansion in aggregate demand, along with incentives to investors, will raise investment, again at least in the short run.

But what about long-run growth strategies? A rise in demand can give boost to growth in the short run. But long-run growth objectives require a different medicine, namely, a sharp and sustained increase in the savings ratio.

This is because, as a matter of accounting, investment has to be financed by savings. The total investment in the economy is equal to the sum of domestic savings and foreign savings.

But foreign savings (capital inflows) have to be accommodated either by an increase in the current account deficit or in foreign exchange reserves. Since reserves can increase only so much (as they are costly to hold and have implications for money supply) the bulk of the increase in foreign investment would be matched by a rise in the deficit in the current account.

Indeed, who better to remind the finance minister of this than his own officiating chief economic advisor, Rakesh Mohan, the author of the “India Infrastructure Committee Report”. That report clearly sets down the limits of the extent to which external savings can be mobilised for investment in India on a sustained basis. And that was in 1996, that is, before the East Asian crisis. The analysis is even more relevant now.

Let us briefly revisit the argument in that report. Output growth, it says, can be raised either by increasing the level of investment or raising its productivity. Ideally, since economic reforms are designed to improve productivity in the economy, higher growth should be achieved by the same or even lower levels of gross domestic investment.

With levels of gross domestic investment ranging from 23 to 27 per cent in 1992-1998 and an average GDP growth rate of 6.8 per cent, the average incremental capital output ratio (ICOR) for 1992-98 was about 3.6 per cent.

The East Asian experience suggests that while reforms do help in raising productivity, it is not easy to reduce the ICOR below 3.5 per cent. Instead, increases in growth in most of the high-growth Asian countries have come from high rates of gross domestic investment. This may be more true for a large country like India which has enormous variation, making it difficult to bring about uniform increases in productivity.

One must hope that efforts to improve productivity will continue and — politicians willing — even be successful. But even if the ICOR is reduced to about 3.3 per cent, the target of 9 per cent growth can be achieved only by an investment rate of about 30 per cent of GDP. There is no getting away from this basic reality.

How is this investment to be financed? The key issue here is one of sustainability of external capital inflows. The absorption of external capital inflows depends on the existence of a sustainable level of current account deficit.

In 1999-2000 external capital inflows constituted about 1 per cent of GDP. Clearly, they can be higher but, in the current context, it is unlikely that international capital markets would consider a current account deficit of more than 2.5 per cent as sustainable. This implies that a domestic saving rate of at least 27-28 per cent of GDP is needed to finance investment.

The savings rate in 1999-2000 was about 22.3 per cent. Public sector dissavings constituted 1.2 per cent and private corporate 3.7 per cent of GDP in 1999-00. The major component of saving was household savings. This stood at 19.8 per cent of GDP in 1999-00.

Actually, given the national accounts methodology, the reliable statistic within household savings data is only household financial savings, which in 1999-00 constituted around 11 per cent of GDP.

Household physical savings are, in fact, estimated as a residual in the national accounts. So it is really the household financial saving rate that provides a measure of the resources that households make available to industry or government.

It is, in other words, what constitutes the surplus resources available with the household sector that may be used for investment in industry. Apart from setting its own house in order, government policies aimed at raising the overall saving rate must target household financial savings.

Is there not a contradiction here? On the one hand, I am arguing that the finance minister needed to raise consumption in order to boost industrial growth and, on the other, that household savings must also increase.

No, because the boost to consumption is coming from an increase in disposable incomes and the additional disposable income can be partly consumed and partly saved. It is here the key to the long-term growth problem lies.

What the government needs to do is to make sure that the entire increase in disposable income does not go to finance consumption. Or, the marginal propensity to consume, the ratio of additional consumption to additional disposable income, must not be one.

In other words, the marginal propensity to save, or the additional saving coming from the addition to the disposable income, must be made positive. This can only be done through incentives that encourage households to save.

Consider this. More than half of household financial savings are in instruments such as small savings, provident funds, pension and life insurance funds for which tax exemptions are given. This constituted 5.6 per cent of GDP in 1999-00!

Also, consider the fact that independent research has shown that savings in India are highly sensitive to tax incentives. In addition, households with income above Rs 5 lakh often use of Section 88 of the Income Tax Act to its maximum. In other words, Rs 60,000 is saved in PF and PPF to get the maximum permissible rebate.

The limit of Rs 60,000 has remained constant since 1978 even though incomes have been rising. If this limit were raised, it would increase the amount higher-income households would invest in these instrument.

So, while on the one hand interest rates on small savings have been lowered making them less attractive, limits for tax exemption should have been increased so that the incentive to save did not reduce. After all, whatever the amounts of foreign capital India is able to woo, it cannot match the importance of household savings in the country.

(The author is a Senior Economist at NCAER)