World Bank chief economist and senior vice-president Nicholas Stern has recommended that to stop fiscal targets going awry, India should adopt automatic adjustment mechanisms at the policy level. He suggested there should be similar efforts at the state level to reduce the risks of macro-economic instability and lower the pressure on interest rates.
Establishing fiscal institutions based on medium-term rules and targets would enhance fiscal stability and help improve the investment climate in India, he said.
Delivering the NIPFP silver jubilee lecture on 'Public finance and policy for development: Challenges for India', Stern said India's high fiscal deficits have been sustained in recent years without an exploding debt-to-GDP ratio by a favourable interest rate/growth rate differential.
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However, it would be dangerous to take the continuation of this differential for granted. "There is a real fiscal crisis in the making," he said.
Other than macro-economic instability, India's trade barriers which were still very high were inhibiting its growth, he added.
Stern said that while market-oriented reforms had unleashed some of the growth potential, weak governance and the relatively unfriendly business environment continued to tell on firms.
This was reflected in the low levels of foreign direct investment (FDI) coming into the country, he said.
The World Bank economist said India needed to accelerate economic growth and job creation through increase in productivity, both of the individuals and the firms. It should also enable poor people to participate in opportunities created by growth, he said.
In the long run, per capita income in a densely populated country like India can increase only through productivity gains arising from entrepreneurship, innovation, capital accumulation and from adoption of new technologies, he said.
All these factors are damaged by a weak investment climate. On the empowerment of the poor, he said the government needed to spend on education and health programmes and provide for social protection programmes.
The government spending on health and education in India is low by international standards, Stern said.
The government spending on power and other economic subsidies that create open-ended fiscal demands, lack transparency and adequate targeting, and create large economic distortions.
Rather than the public distribution system, a more effective basis for social protection could be constructed through targeted income transfer programmes like cash transfers or food vouchers, Stern said. Such programmes have a greater impact on the reduction of inequality than direct taxation, he said.