Mr Chidambaram has given animal spirits a much needed boost. The timing was just right a push to demand to reverse the slowdown, and allow the utilisation of capacity that had been built up over the last two years. But the most common reaction to the budget, along with the exhilaration, has been one of surprise. How did he do it? There was a strong perception that the state was borrowing and spending so much in excess of its revenue that there was no way for a 14-party coalition to improve matters.
The government itself may have been surprised by the revised estimates in the budget. But two developments have helped the government; the fall in interest rates for government borrowing, and the relatively higher rates of growth achieved in the last three years.
Revised estimates (RE) of interest payments were Rs 1,500 crore lower than budget estimates (BE) for 1996-97. Yields realised, at the cut off price, on auctions of government of India 364-day treasury bills tell us why: interest rates peaked at 13.12 per cent in April 1996, but were down to 12.61 per cent in August. The average rate for the half year ending February 1997 was 10.92 per cent. For 91-day treasury bills, the rates fell similarly from a peak of 12.4 per cent in June 1996. The peak in interest rates coincided with a slackening in the growth of broad money, and not with a peak in government borrowing from commercial banks.
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Interest payments account for 25 per cent of the governments expenditure. Therefore, the impact of a change in interest rates on the budget is so large, that the government stands to gain considerably if interest rates remain low. Moreover, stock markets will revive if interest rates are low, and this will help public sector disinvestment, which is essential for an efficient restructuring of capital assets with the state, and for maintaining high public investment. From the point of view of the budget, low interest rates are better than low inflation.
But does inflation have to rise if interest rates are low? Although a short while ago commentators were decrying the high interest rates, now they are raising the bogey of inflation. Some critics think the budget has inflationary potential. Monetary policy has to follow a tightrope, laxity can lead to inflation, but restriction can raise real interest rates. In addition, when capital flows are large at the margin, expected exchange rates can depreciate to equate demand and supply in the market of foreign exchange. This was one of the factors leading to the depreciation of the rupee in 1996 and the rise in forward premia. There is danger of such a situation building up again. But if foreign inflows are used productively, they can help our interest rates to approach low international levels, while in the short-run, import of goods, and in the long-run, the efficient expansion of productive capacity relieves supply constraints and prevents inflation. In the Indian context, where the share of administered prices
is high, cost effective supply expansion is the best way to contain inflation. Expenditure, government or private, that raises demand in the current period but supply in the next will not be inflationary.
The RBI has more autonomy now and does not have to automatically finance the budget deficit. The needs of the economy, and negotiation with the fiscal authorities, will determine the monetised deficit. One cannot say, by looking at it alone, if the forecast for the latter (Rs 16,000 crore is too much or too little. In 1995-96, although the rate of growth of the money supply was below its target, RBI credit to the government was 19,871 crore. Monetary policy has to keep a balance between the different ways in which the monetary base can expand. In the near future, the unsterilised accumulation of foreign exchange reserves is going to be a major factor in this expansion. Foreign inflows must be utilised and not just hoarded, after a point.
It is noteworthy that small savings accruing to the government rose by 68.75% in the RE as compared to the BE in 1995-96 and have exceeded their BE by Rs 1,000 crore in the last year. One explanation is a high propensity to save a sudden rise in income. In such circumstances, tax shelters for savings tend to be utilised to the full. When the finance minister has put more money in the hands of the people, a good strategy to raise savings would be to increase the limits on savings that qualify for tax rebates. Current limits have become too low in the face of rising incomes and inflation. Any nominal limits have to be continually revised.
But will cutting tax rates raise tax revenues? Such policies have had indifferent success in the West. But if there is a Laffer curve in India it is very different from the Western variety. Here lower tax rates maybe necessary to make a broader tax base possible. It is iniquitous that 12 million salaried classes should pay steep taxes, while other groups, equally well off, do not contribute. Lowering tax rates, combined with punitive measures aided by improved data bases, will raise collections from all groups. A perception of fairness is a necessary cement for a viable social contract. There are other considerations: since Indian savings rates are closer to Asian ones, and the State provides nowhere near European standards of social infrastructure, more money must be left in peoples hands to raise savings and secure their future. Second, a large percentage of salary earners are government employees. Lower tax rates may save the government money in implementing the report of the pay commission.
Third, it is a well known principle in economics that revenue is maximised when prices are cut, if demand is elastic. Tax rates are a special kind of price, in that low rates can help provoke the high growth or elasticity that will justify them. The higher growth in the region is one reason why Asian tax rates are lower than European ones.
In the first budget after the elections, changes were marginal, but were in the right direction, rectifying the too violent a swing to the market-led paradigm. The rise in public investment, the attention given to the infrastructure and to the welfare of the poor, may have been inadequate, but they were necessary corrective actions. Quiet and marginal changes may be a sober reflection of ground realities, or they may spring from a failure of the imagination. Six years into the reforms, why has India not reached double digit rates of growth ? Other countries have shown that it is feasible. The state has a major role to play as a leader in encouraging the animal spirits essential for sustained effort.