Dont loosen the purse strings

Financial Express, 10 October 2006

First quarter 2006 GDP growth figure of 8.9 percent is higher than what most people expected. However, while the GDP numbers are great news, they should not set the stage for high and unsustainable government spending. Instead, they must alert us to the need for anti-cyclical policies.

Part of the UPA's belief that it can raise the expenditure GPD ratio comes from the view that high growth rates are here to stay. High GDP growth would give a higher tax collections. Higher taxes would support higher government spending, be it on the employment guarantee programme or on government employees through another pay commission.

The belief in higher trend growth rests on two assumptions. One, higher savings rates and, second, improved efficiency.

It is believed that if India's saving rate rises from the present 29 percent by another 3 to 4 percent, this will add one percentage point to GDP growth rate. While it is correct to think that India's household savings rate will rise because of the demographic shift taking place in the population today that is reducing the dependency ratio, the shift could take about a decade. Moreover, the overall savings rate will also depend on the public savings rate. The government's fiscal adjustment programme does not suggest that the government will be able to reduce fiscal deficits to allow India to increase the gross domesic savings rate by 3 to 4 percent in the next 4-5 years.

The second assumption is that efficiency improvements will raise GDP growth. This can happen only if there is progress on economic reforms. The current productivity increases which are the mainstay of high growth in India currently have come from economic reforms that unleashed forces in private sector growth. India can continue to ride on the gains from previous reforms, but unless the government pushes further on this front, it will not give the economy higher efficiency growth. For example, privatisation of the public sector could increase efficiency and raise GDP growth, but will the UPA government be able to give India this increase in efficiency? Infrastructure can become a big bottleneck unless reforms in power and transport move ahead with greater speed. Despite this understanding at the highest levels of government, progress on this front is inadequate. However, lower trend growth is not the only thing that can go wrong in projections about India's GDP growth. The missing element is predictions about the cyclical component of growth. The growth witnessed in the last 3 years is a combination of two factors -- one, a step up in the trend growth rate, and two, the high of the business cycle. The global cycle could see a downturn. US housing data is already showing a downturn. Some see the fall in global oil prices as a sign of a slowdown in demand. The large US current account and fiscal deficits would need large adjustments not only in the US economy, but all over the world. India may not be insulated against a downturn in the global business cycle, and may witness a slowdown in growth related to it.

In recent years in India there has been a sharp rise in corporate tax collections, which have a high buoyancy. So when GDP goes up by 1 percent, corporate income tax goes up by 1.2 percent. When a downturn hits the economy this is among the first sources of revenue that will be hit.

Unfortunately, the way the FRBM is set up, it exacerbates the business cycle. Today when collections are high, a government with a view to meeting its FRBM targets can spend more with a clear conscience. This means higher public spending when the going is good. Instead of cutting down on expenditure to prevent overheating, the policy is pro-cyclical.

And, when growth is low then instead of running higher deficits to add to demand and implement an anti-cyclical fiscal policy, the government will cut spending.

In other words, the high GDP growth rate has come on the back of pro-cyclical fiscal policy and further encourages pro-cyclical fiscal policy.

In summary, the high GDP numbers are worth celebrating but they may not be here to stay. The higher trend cannot be taken for granted. In addition, India has yet to incorporate business cycles as part of its reality as a modern economy and frame policies accordingly. The consequence may be to set ourselves up for a fiscal crisis later.

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