Fiscal policy reset needed, especially after a difficult Covid phase

Government intervention during the pandemic seemed conscious of the fact that India's fiscal position was not very strong at the beginning of the crisis

The first Budget of the third Narendra Modi government is expected to present the medium-term roadmap for the Indian economy. While the message from the top is that of continuity, structural shifts will be required in some areas. One such key area is the conduct of fiscal policy.

Fiscal backdrop

The last term of the government was perhaps the most difficult in recent memory for fiscal management because of the pandemic-related disruptions. However, after a contraction in the pandemic year, the Indian economy recovered quickly and has been growing at an annual rate of 7 per cent or more.

The biggest policy target thus should be to build on the post-pandemic recovery and sustain the momentum for an extended period. The Union government, and particularly the leadership team at the Ministry of Finance, must be commended for not going overboard with expenditure increases during the pandemic, unlike many advanced economies, despite similar advice given for India by well-known economists.

If the government had heeded suggestions like monetising the Budget deficit worth 5-10 per cent of gross domestic product (GDP), India would have been in significant problems. The government rightly made selective interventions such as cash transfers to the most vulnerable sections of society and distribution of free food grains.

The government intervention seemed conscious of the fact that India's fiscal position was not very strong even at the beginning of the crisis, with a debt-to-GDP ratio of around 75 per cent. Nonetheless, the Union government’s fiscal deficit increased from 4.6 per cent of GDP in 2019-20 to 9.2 per cent in 2020-21, partly because of a sharp decline in revenue collection on account of pandemic-related disruptions.

During the recovery period, the government proceeded with fiscal consolidation while supporting the economy with higher capital expenditure. The Union government’s capital expenditure increased from 1.67 per cent of GDP in 2019-20 to 3.4 per cent in the current year.

Why a reset is needed

As announced in the interim budget, the government will target to contain the fiscal deficit at 5.1 per cent of GDP in the current year. It is following a glide path to reduce the fiscal deficit to below 4.5 per cent of GDP by 2025-26. This means it would take a few more years before the fiscal deficit could stabilise at 3 per cent of GDP or below. However, the old fiscal target would need to be reassessed. The beginning of the government’s new term is a good opportunity to start the exercise.

As things stand, according to projections of the International Monetary Fund, the general government deficit will remain above or close to 7 per cent of GDP at least till 2028.  The general government debt would also not come down to the pre-pandemic level of 75 per cent of GDP, which was anyway higher than desired, at least by 2029. The fiscal position thus will need to be appropriately addressed to both create policy space and increase investor confidence. Since the expansion has happened more at the Union level, it will also need to make steeper corrections.

As of now, nearly half of the Central government’s net revenue is going in interest payments. Over time, this could seriously hamper its capacity to respond to emerging demands on the budget or undertake developmental work. A correction is also necessary to align the fiscal deficit to the economy’s financing capabilities.

In this context, it is worth recalling how fiscal rules and targets evolved thus far. Contrary to popular belief, the fiscal deficit target of 3 per cent in the rules of Fiscal Responsibility and Budget Management (FRBM) Act, 2003, was not borrowed from the European Union or elsewhere. It was broadly based on the projections of household financial savings and the need for making sufficient corrections to bring down the general government debt. Later in May 2016, the Union government constituted a committee to review the working of the FRBM Act and suggest the way forward.

The committee headed by veteran bureaucrat and economist NK Singh recommended moving to public debt as the medium-term anchor for fiscal policy. It suggested a debt ceiling of 60 per cent of GDP — 40 per cent at the Union level and 20 per cent for states. The debt-to-GDP ratio at that time was about 70 per cent.

The committee suggested fiscal deficit as the key operational target. Given the net household financial savings at about 7.5 per cent of GDP and external borrowing needs — current account deficit — of about 2.5 per cent of GDP, the available savings was worth about 10 per cent of GDP. The committee assumed it would be allocated equally between the government and the private sector.

This meant that both Centre and state governments were expected to run a combined fiscal deficit worth 5 per cent of GDP. While similar assumptions were behind initial FRBM rules, given the size of the government, it can be argued that more savings should have been left for the private sector.

In any case, the targets were not achieved and, thanks to the pandemic, India is currently way off the mark. The situation has been further complicated by net household financial savings, which dropped to 5.3 per cent of GDP in 2022-23. In other words, public sector financing needs are more than the surplus of the household sector.

This is not being reflected in an increased current account deficit, largely because private sector investment remains weak. Assuming net household financial savings revert to the average of the past 10 years — barring the pandemic year when it surged on account of precautionary savings and the inability of households to spend — of 7.3 per cent, along with a sustainable current account deficit of about 2 per cent, India would have financial savings worth about 9 per cent of GDP.

This clearly means the general government deficit will need to be reduced substantially to leave enough for the private sector. Things obviously will be significantly more difficult if household financial savings fail to recover. One reason for the decline in household financial savings could be the real negative policy rates maintained by the Reserve Bank of India (RBI) during and after the pandemic to support economic recovery and higher government borrowings.

To improve saving conditions in India, financial repression will need to be reduced. Progressively bringing down the statutory liquidity ratio of the RBI will help in this context. Aside from domestic conditions, it is worth highlighting that global financing conditions will likely remain tight.

Along with a “higher for longer” policy stance on account of higher inflation, the Budget deficit in the US has moved up structurally. According to the projections of the Congressional Budget Office, the Federal fiscal deficit in the US is likely to average 6.7 per cent of GDP over the next 30 years, which is about 3 percentage points higher than the average of the past 50 years. Structurally higher fiscal deficit in the largest economy will corner more global savings and keep the cost of money elevated.

What needs to be done?

It is clear that the government needs to substantially reduce the fiscal deficit. The pace of reduction despite buoyant revenues has been somewhat slow because of significantly higher capital expenditure. Moving forward, the government would need to address both the revenue and expenditure.

On the revenue side, it will be critical to address the impending issues in the goods and services tax (GST). The indirect tax system, which just completed seven years of implementation, has underperformed. For instance, as highlighted by this newspaper, the total GST collection in the last fiscal year was worth 6.1 per cent of GDP compared to collections worth 6.3 per cent of GDP from taxes subsumed in GST in 2016-17. The present collection also includes compensation cess, which was to be discounted two years ago but continues because of pandemic-related disruptions.

The underperformance is largely on account of premature rate reduction. As economist Arvind Subramanian and others have argued in this newspaper, the Centre suffered significantly more because of the underperformance. Therefore, it is important to rationalise rates and slabs urgently.

The GST Council will also soon need to make a decision on the cess as the debt raised to compensate states during the pandemic period is repaid. It would be well advised to remove the cess and move to a simple GST rate structure.

On the direct taxes, the base will need to be increased with possible use of big data and better monitoring. Anomalies in capital gains tax structure also need to be addressed to make it simple. Notably, an analysis by the Fifteenth Finance Commission suggested India’s tax gap was worth 5 per cent of GDP. Differently put, the government was collecting taxes worth 5 per cent of GDP less than the potential. Bridging this gap will virtually solve the fiscal problem for India. Restarting the disinvestment process in a big way at this stage can also help smoothen the fiscal consolidation process.

On the expenditure side, the government has done well to contain the revenue expenditure in recent years, but compulsions of coalition politics could put pressure. The government should also review the capital expenditure part.

This is not to suggest that India does not need more capital expenditure. But it should come without disturbing the macroeconomic balance. At some point the government will need to start borrowing less to make way for the private sector. Growth driven by government expenditure may not be sustainable for long. Other cylinders of the economy need to start firing and the policy objective should now be to address structural issues constraining economic activity.

The immediate step

Given the structural changes underway both in the global and Indian economy, it will be prudent to review India's fiscal position thoroughly. The government can form an expert group or the second FRBM review committee to suggest the way forward in the coming months.

The recommendations can be incorporated starting the next Budget in February 2025.

Among other things, the group can reassess the new sustainable level of public debt, given the tolerance for debt has increased globally. It can suggest the level of fiscal deficit needed to reduce the public debt to a more sustainable level. The analysis will need to account for changes in the savings and investment patterns in the economy.

Further, the fact that inflation expectations are better anchored after the implementation of the flexible inflation targeting regime, nominal growth is likely to be lower than in the previous periods, which will have implications for fiscal management. All these factors will need to be baked in while determining the sustainable medium-term fiscal path.

A strong fiscal position is necessary for higher sustainable growth. Regular assessment of fiscal position in light of changing macroeconomic situation would have been routine had India opted for an independent fiscal council as recommended by the FRBM review committee among others.