Government is undertaking difficult job of dialling back its spending, marking a near complete unwinding of the pandemic-driven fiscal expansion
Written by Neelkanth Mishra
February 2, 2024 06:55 IST
This appeared in the Indian Express on 2 February, 2024 (link).
Economic theory suggests that governments should spend more when private firms and households do not feel confident and hold back spending. Once the latter feels confident, the government should dial back on its expenditure. This counter-cyclical fiscal strategy smoothens growth and makes it more sustainable. While governments, especially democratically elected ones, find the first part easy to do, they are generally reluctant to step back when the economy recovers.
However, surprising forecasters positively, the government continued to prioritise macroeconomic stability over easy political gestures. The fiscal deficit target of 5.1 per cent of GDP for FY2024-25 (FY25) is lower than even the lower end of the range of economist projections of 5.2 per cent to 5.5 per cent. The finance minister also reiterated the commitment to bring the deficit down below 4.5 per cent of GDP by FY2025-26 (FY26). The targeted primary deficit ratio for FY25 is 1.5 per cent, lower than the primary deficit seen in FY20. If the government achieves its FY26 deficit target, the primary deficit can be 0.8 per cent of GDP, close to pre-Covid levels of 0.4 per cent, marking a nearly complete unwinding of the fiscal expansion driven by the pandemic.
Interest costs, after all, reflect past deficits. The pandemic-era fiscal scars would continue to be visible through higher interest expenses for a while given the nearly 10 per cent point jump in the debt-to-GDP ratio. Fiscal discipline is necessary for many more years for the debt-to-GDP ratio to fall back to pre-Covid levels near 70 per cent. Even that is some distance from the 60 per cent of GDP that the FRBM Review Committee (to which this writer was an advisor) believed in 2016 was appropriate for India.
Improving the quality of spending is important when trying to bring down an elevated debt-to-GDP ratio, one of the major vulnerabilities for the economy. A high ratio limits the state’s ability to support growth if the economy sees an unexpected growth shock and pushes up interest costs. This ratio rose due to the government absorbing a large part of the economic losses during pandemic-driven lockdowns.
The ratio will fall if the denominator (GDP) grows faster than the numerator (debt). But this needs deft management. The fiscal deficit ratio must fall to slow down growth in government debt, but if it is brought down too rapidly, it hurts GDP growth. The government seems to be calibrating its tightening as it gains confidence in the economic recovery – from 0.5 per cent in FY23 to 0.6 per cent in FY24 and now 0.7 per cent in FY25. It also needs to keep improving the quality of spending – money spent on building roads or railway tracks boosts GDP when being built, but also supports growth in later years by carrying goods/people. Spending more on consumption, on the other hand, mostly has a one-time impact on growth.
That year-on-year growth in capital expenditure (11 per cent) will continue to be faster than overall spending (6 per cent) is therefore encouraging. A large part of the increase in capex is for the interest-free loan to be given to private firms for research — this would take time to ramp up, and it is unclear whether Rs 740 billion can be disbursed within a year, but the government’s focus on medium-term drivers of growth is clear. Expenditure excluding capex and interest costs is budgeted to be nearly unchanged year-on-year. Given the decline in global fertiliser prices, the fertiliser subsidy bill is expected to be lower.
Underlying this consolidation and adding to the quality of the budget are credible assumptions. The 10.5 per cent nominal GDP growth assumption is reasonable, and the increase in tax-to-GDP budgeted is consistent with prior trends. The steady 5 basis points (1 basis point is one-hundredth of a percent) annual improvement in personal income tax as a share of GDP between 2001 and 2019 has accelerated post-Covid, rising 20 bps annually. Corporate taxes as a share of GDP had risen from around 1.6 per cent in 2001 to nearly 4 per cent in 2008, but then fell to 2.3 per cent in 2020. Since then, as corporate profits rebounded, so did corporate taxes, improving to 2.7 per cent of GDP in FY24, and should improve further in FY25. Indirect taxes have been relatively steady as a percentage of GDP, with volatility only due to changes in excise duty on fuel. The slight increase in GST as percentage of GDP budgeted in FY25 should be achievable, too.
Further, the move towards improved transparency in budget numbers, by reducing extra-budgetary spending, has continued. Once adjusted, the primary deficit in FY25 may already be close to pre-Covid levels and could be below them in FY26.
By sticking to the fiscal consolidation path it promised, the government has also embarked on a welcome trend towards medium-term fiscal management. This provides predictability to the private sector and financial markets. The push for India’s inclusion in the emerging market bond indices came not from the government, but from global bond investors that wanted to have exposure to India. It would be interesting to see how rating agencies, which continue to rate India much below similar-sized peers, respond to the government’s actions.
An unchanged fiscal deficit in absolute terms in a growing economy means financing it becomes progressively less of a concern. However, there lies a concern so far not sufficiently emphasised in public discussion: The two major sources of deficit financing for the government are market borrowings (bonds), and inflows to small-savings schemes.
Over the last decade, inflows into these have risen from less than 0.5 per cent of GDP to more than 2 per cent of GDP now. Despite inflows in FY24 running nearly Rs 1.5 trillion ahead of expectations, the government has not revised these assumptions upwards, and for FY25, assumes a decline in these flows. The government could thus end the year with a much higher-than-normal cash balance.
Higher government cash balances are not without costs to the economy. When government cash balances reach levels Rs 3 to 4 trillion higher than normal, as they were last week, liquidity stresses in the banking system intensify far more than intended by monetary policy. They drive overnight borrowing rates well above the intended policy stance, undoing some of the gains from fiscal discipline.