Choosing Stability over Populism

As the resilience of the domestic economy gets tested by global headwinds, deft fiscal manoeuvres may be necessary

Updated: February 2, 2023 07:40 IST | Neelkanth Mishra

This appeared in the Indian Express on February 2, 2023 (link)

As the state’s footprint on the economy has shrunk over the past three decades, the relevance of the annual Union budget for the economy has contracted accordingly. The advent of the Goods and Services Tax (GST), which shifted indirect taxation decisions to the GST Council, and the separation of reforms from the fiscal arithmetic has added to this trend. Nevertheless, presentation of the last full budget before the next general elections was an important event, not just for the commentariat, but also for the financial markets.

The government yet again showed its fiscal conservatism, choosing macroeconomic stability over populism: Many had feared fiscal giveaways last year too, given the politically important UP elections. This seems prudent, given the limited tolerance of financial markets globally to policy errors, and the economic damage market turbulence can cause. This is notwithstanding the increase in income tax slabs that helps a large majority of income-tax payers, as the foregone revenue of Rs 35,000 crore is only around a tenth of a per cent of next year’s GDP. The Union government’s commitment to the medium-term fiscal consolidation path was reiterated: A fiscal deficit of less than 4.5 per cent of GDP in fiscal year 2026.

That the underlying assumptions are realistic adds to the market credibility of the government’s resolve. A nominal GDP growth assumption of 10.5 per cent is slightly higher than the consensus among forecasters, but we believe this may turn out to be too conservative. Given the strong tax buoyancy this year, the government could have taken a slightly lower tax-to-GDP ratio next year than the unchanged number it has assumed, but the benefits of greater digitisation and formalisation may continue, and lower tax rates often help tax compliance.

Perhaps more importantly, the government chose to redeploy its savings from the fiscal support it had to provide during Covid and then in the aftermath of the Russia-Ukraine conflict to capital expenditure. Food and fertiliser subsidies had increased significantly during the previous three years, as had the expenditure on MGNREGA, as elevated unemployment increased demand for it. The allocations on all three fronts are lower for the next year, and understandably so: The already announced merger of the free-grains scheme with the PDS means that food subsidy can come down; the drop in global fertiliser prices necessitates less subsidy, and demand for MGNREGA work has already come down as the job market has improved. There is a risk that expenditure on all these fronts could eventually be higher, as energy prices could go up again, and headwinds to growth due to global problems could intensify. But the assumptions in the budget are reasonable on the current situation assessment.

This is not to say that we are out of the fiscal woods, and we will not be for all this decade. The general government debt to GDP ratio (which includes central and state debt) has fallen from 90 per cent in FY2021 to 83 per cent now, as nominal GDP growth has picked up, but it is still well above the 73 per cent seen pre-Covid, and the 60 per cent recommended by the FRBM Review Committee. For it to fall back to those levels, the primary deficit (fiscal deficit minus the interest payments) needs to fall to nearly zero. However, it is still near 3 per cent of GDP, and even at 4.5 per cent fiscal deficit in FY2026, the primary deficit would still be nearly 1 per cent of GDP.

This requires deft fiscal management. Economies like India need to grow out of their fiscal problems and cannot shrink into them. This is because a faster moderation in aggregate expenditure would cause the economy to slow down, risking a downward spiral where the debt-to-GDP ratio starts to climb. This is where the nature of government expenditure makes a difference. Allocations to railways and roads, as well as to schemes like Pradhan Mantri Awas Yojana and for energy transition should support growth both over the near term (via expenditure) as well as the medium-term (through cheaper logistics and greater energy self-sufficiency). It is encouraging to see the railways planning to spend Rs 2.9 lakh crore next year – their inability to invest rapidly and grow capacity has been a significant constraint on India’s growth. That they met their FY23 spending targets and asked for additional funds gives us a reason to be hopeful that they have turned the corner.

In FY2024, all the rise in spending is being financed through higher tax collections, with the deficit in rupees being largely unchanged: The fall in the deficit ratio is due to the growth in GDP. This process will likely continue for several years, and hopefully, in some years even the absolute deficit might come down, speeding up the process of fiscal consolidation. There may not be any room for fiscal profligacy for many years. In this regard, the demand to switch back to the old pension scheme for government employees, where taxpayer funds are used to guarantee benefits to a select group, is a risky one.

The substantial increase in annual net borrowing by the government from around four to six lakh crore rupees annually in the pre-Covid years to around Rs 12 lakh crore was a shock to the economy. Creating space for this level of borrowing is a challenge, even if in a depressed economy savings are high, and the demand for capital from businesses is subdued. Now that the net borrowing number has been relatively flat for three years and should hopefully be the same if not lower for the next few years, growth in the economy should make it incrementally easier to finance. That state governments this year may end up with an aggregate fiscal deficit of just 2.4 per cent of GDP versus the 3.4 per cent budgeted, given the surge in tax inflows and an inability to quickly ramp up spending, is also helping. The decline in bond yields on budget day is a sign, in our view.

In turbulent times like these, a good budget is just a starting point. The turmoil in the global economy is likely to continue, as the impact of higher interest rates shows up in weaker demand for consumption and investment, and geopolitical tensions continue to disrupt energy supplies and trade. As the resilience of the domestic economy gets tested by global headwinds, deft fiscal manoeuvres may be necessary, like they were this year.