Cutting deficits

Business Standard, 16 June 2004

The support given to the Congress government by the left parties is creating two kinds of fears in the minds of many people. The first is the fear that the economic policies of the government would move away from the market friendly policies being followed by the NDA. These fears have been heightened by numerous statements on disinvestment, labour laws, and reservation. Whether this fear is justified or not, and whether Dr Manmohan Singh's term will see India going back to a larger role for the public sector and an inspector raj will have to be seen. The choice of the PM and FM is a signal by the Congress that it will try not to let this happen.

The second fear created by the populist slogans in the CMP is that there will be a sharp increase in public spending on various social programmes. It is feared that the government will spend more on free power, free water, employment guarantee schemes, education, health, subsidies on petroleum products, interest payments, and so on. The obvious question is how will these be financed.

The saving grace seems to be that no one in the political system has demanded that higher expenditure be financed out of higher deficits. The CMP supports the FRBM that seeks to bring down the level of the revenue deficit to zero within the next 4-5 years. While disinvestment as a source of revenue is clearly in trouble, left leaders have suggested that rich farmers should be taxed, and professionals currently escaping the tax net should be brought into the tax system.

Lowering deficits is not a popular policy. It means raising taxes and cutting expenditure. It is much easier to be myopic and spend today, leaving it to future governments to face the music. Lower deficits also generate lower growth in the short run by reducing aggregate demand and reducing the feel-good factor. The fact that no political party is explicitly asking for higher deficits makes it easier for Mr. Chidambaram to go ahead with fiscal consolidation. This is very fortunate because high fiscal deficits have many undesired side-effects.

The 1980s witnessed high growth rates with high fiscal deficits. They ultimately spilled over onto the external sector and led to a current account crisis. The nineties did not see that happen because of a sharp rise in household savings. Distortionary tax exemptions and routing of household savings into government bonds through the banking system meant that the government borrowed the bulk of additional savings. The capture of additional private savings by the government also did not raise interest rates in the post-1996 years. Real interest rates did not rise because private demand was low. Currently, the economy appears to be on the upswing of a growth cycle. With an increase in private demand, the pre-emption of household savings by the government could put an upward pressure on rates.

Further, the increase in public debt has had a disasterous effects on the provision of public goods in India. Since half of government spending goes into servicing this debt, less money is available at all levels of government - central, state or local, for provision of public goods. Law and order, enforcement of contracts, health and education are important determinants of growth. While India has seen significant economic growth, improvements in public services and infrastructure has not kept pace. They are today severely constrained by the availability of resources. If interest payments use up the bulk of revenue collection, little is left for provision of public services.

Usually politicians are willing to ignore the long term interests of government finances and of the public in their attempts to provide hand outs to this or that section of the electorate. They rarely commit to cutting deficits. If the current governmment adopts a programme to do so, it is to be applauded.

It is, therefore, very disconcerting to find economists arguing in favour of running high deficits. Earlier this month Sudhir Mulji, in his column in this newspaper, argued that the government needs Keynesian policies. Notwithstanding the inefficiency of the government in undertaking public expenditure, the argument that the government can go ahead and borrow as much as it likes, rests on the belief that India has had fiscal deficits (combined deficit of the centre and states) of nearly 10 percent for over 20 years without facing a crisis, so all is well and the government can keep on borrowing. It ignores the fact that over these twenty years India has built up a debt GDP ratio of 85 percent. As this ratio has increased, the cost of servicing the debt has risen.

It is argued that if the government borrows more to invest then it will increase the productivity of private capital by creating infrastructure. One wishes this were true. Unfortunately, the Indian bureaucracy, which is expected to undertake this public investment, does not have a very good track record. Theft and corruption have plagued public spending in India. Returns are low, both in terms of GDP growth and user charges. The quality of national highways improved only after the autonomous body created for this purpose, the NHAI undertook the job. The state of the rest of the roads, government schools and hospitals are a sad commentary on the efficiency of public investment.

Higher deficits would increase demand. In a year where there has been GDP growth of 8.5 percent, capacity utilisation is high. Without capacity building on the supply side the danger of demand spillovers onto the external sector, or prices would be higher.

Fortunately, India has very few Keynesians like Sudhir Mulji. And, hopefully Mr. Chidambaram does not listen to the few that are there. If higher expenditure has to be incurred to pacify his supporters, he should raise the revenues to do so. The coming budget is a chance for Mr Chidambaram to show that at least some fears about his government are unfounded. He will have a far more difficult time on the front of market friendly reforms. He should, therefore, make the most of the chance to cut deficits and raise revenue.

Also, fortunately until now none of his comrades are suggesting that income tax rates be raised. No one is suggesting taxing of luxury goods. Mr Chidambaram should make the most of this by improving the efficiency of the tax system, expanding the tax base to services and lowering tax rates, a strategy likely to rake in higher tax collections. With emphasis on effective tax reform and fiscal consolidation, this budget could be another path breaker by the dream budget minister.

The author is at NCAER. These are her personal views.

Ila Patnaik

Ila Patnaik
ipatnaik at ncaer dot org