Fiscal tightening must do its part

Financial Express, 21 February 2007

How will the cut in diesel and petrol prices affect the inflation rate? What else does the government need to do to reduce inflation? While monetary policy tightening is currently being used as a mechanism to control inflation, what is the role of fiscal policy?

I argue below that the reduction in the prices of petrol and diesel will certainly impact inflation but the overall effect will not be as straight forward as the government might hope. There will be an immediate impact on the inflation rate for the relevant week, which will, undoubtedly, make good newspaper headlines, but the impact on demand is not necessarily clear and it is time to have a tighter fiscal policy.

First, there will be a direct and obvious impact of the cut in diesel and petrol prices on inflation. A reduction in petrol and diesel prices reduces wholesale price index for fuel. This has a weight of about 22 percent in the overall WPI. The reduction of price of these two items will, therefore, pull down the inflation rate. This will show up very quickly -- in the week in which prices are cut.

Following this immediate direct impact is the next round of the effect. This is not so relevant for petrol, but is very important for diesel. The price of diesel permeates through the whole economy through transport prices. All transport will become cheaper. Products like vegetables and fruit for which transport is a large component will see lower prices. This feeds into the wholesale prices of primary products, another approximately 14 percent of WPI, and will thus pull down WPI. Transport costs also feed into the prices of manufactured goods and the WPI for manufactured goods would also reduce.

Until now we have seen that a cut in the price of diesel and petrol will reduce the embarassing inflation figures and the government will no doubt look better. But this is where the good news ends. When petrol and diesel get cheaper, the consumer has more money in his pocket. It is like an "income effect"; a reduction in the price of petrol or diesel is exactly like a slightly higher income. The consumer feels slightly richer and buys more of other goods. This fuels demand for other goods and pushes up inflation.

The overall effect depends on complex estimation of the magnitudes of the various forces at work. But one point should be clear. When inflation has been creeping up all around, measures that control inflation in a specific way will have only a limited impact. A reduction in overall demand requires many more steps. One of these is monetary policy, because inflation is ultimately a monetary phenomenon. But equally, we are at a rare time when fiscal policy can also be used to affect inflation. Deficit reduction is deflationary. When the tax/GDP ratio goes up by 1%, and government expenditure does not go up by 1%, then aggregate demand drops. The FRBM framework was concerned about India's high debt ratios, and did not focus on counter-cyclical fiscal policy.

There is, hence, a powerful case for the finance minister to go beyond the FRBM and use the present combination of strong GDP growth, high growth in tax revenues and inflationary pressure to deliver a big improvement in the fiscal deficit in the coming budget. The fiscal deficit is what matters here: whether the government spends on current expenditure or capital expenditure is no different when it comes to cutting aggregate demand.

In addition to deficit reduction, what else can fiscal policy do in order to combat inflation? The second powerful tool available is to have a low tax/GDP ratio and a correspondingly low expenditure/GDP ratio. Shrinking government is deflationary.

The logic here works as follows. Suppose there is a government which has both taxes and expenditure set at 10% of GDP. A bigger or smaller deficit is not under discussion - we only think about a balanced budget. In this, suppose a decision is taken to raise taxes and expenditure by 1% of GDP. Here, 1% of GDP comes out of the pockets of households, and goes to government, which spends it all.

This expands aggregate demand, because if that last 1% of GDP had been left with households, they would have saved roughly one quarter of it. If that last 1% had been left in the pockets of households, a spending of roughly 0.75% of GDP would be spent. But if this last 1% of GDP goes into the hands of government, then the full 1% of it gets spent.

Conversely, if a government goes down from a balanced budget with taxes and expenditure of 11% of GDP down to a balanced budget with taxes and expenditure of 10% of GDP, this is deflationary.

In summary, the main task of inflation control can and should be placed upon monetary policy. But this requires fundamental reform of India's monetary framework, which cannot be done overnight. In the short run, the finance minister does have some important levers in his hand in terms of decisions leading up to the next budget. A sharp effort at cutting government expenditure, and a sharp effort at cutting the fiscal deficit, would help quench the frightening fires of inflation.

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