Fiscal policy reset

The upcoming interim Budget will be the last fiscal policy exercise of the second Narendra Modi government. It would also mark the end of what has perhaps been the most difficult five-year term for fiscal management in recent memory. Although government finances are still recovering from the shock induced by the Covid-19 pandemic, the policy establishment, particularly the Ministry of Finance led by Union Finance Minister Nirmala Sitharaman, must be commended for its adept handling of the situation. Managing government finances during the pandemic period was extremely difficult. There was no playbook available for reference. The experience of the global financial crisis (2008) was not of much use — it was, after all, only a financial crisis! Here was a situation where the entire country had to be locked down. Besides, there was a very limited understanding of the virus in the initial phase. Worse still, India was not the only country dealing with such conditions.

What this meant was businesses stopped functioning, except those considered absolutely essential. This led to massive job losses, particularly in small enterprises and contact-intensive services, with very little visibility. Making any medium-term economic projection was nearly impossible. Governments in advanced economies rolled out massive support programmes without caring much about financial implications. India did not have that option. Its debt to gross domestic product (GDP) and the general government Budget deficit were already on the higher side, and a very large deficit would have significantly increased financial stability risks. It is worth remembering that it was not only the expenditure side that Budget managers had to worry about. Revenues were under severe pressure because of the nationwide shutdown.

There were calls from influential economists to simply monetise debt and spend about 5-10 per cent of GDP to extend relief and support demand. Indian policy managers did well by not going down that path despite overwhelming intellectual support. They rightly opted for targeted options like providing cash support and free food grains to the most vulnerable sections of the population. India did suffer because of the lack of medical capacity, but no amount of fiscal intervention could have developed it overnight. Nonetheless, the fiscal deficit of the Union government increased from 4.6 per cent of GDP in 2019-20 to 9.2 per cent in 2020-21. The increase was also partly driven by the cleaning up of books and accounting for off-budget borrowings. Fortunately, a better understanding of the virus over time and scientific breakthroughs allowed for the reopening of the economy, leading to improved economic activity and revenue flows.

It is against this backdrop that the government is targeting to contain the fiscal deficit at 5.9 per cent of GDP in the current year. A slower reduction can be attributed, in part, to increased capital spending. In absolute terms, the Union government’s capital expenditure tripled between 2018-19 and 2023-24.  The government prioritised economic revival after the pandemic through increased capital spending. However, now that the economy is growing at a higher-than-expected rate, it is time to accelerate the pace of fiscal consolidation, and the upcoming Budget could be a good starting point. The Finance Minister has said that the industry should not expect any big announcements. The government would also do well to refrain from populist announcements before the general elections.

The government intends to reduce the fiscal deficit to below 4.5 per cent of GDP by 2025-26. This would mean the consolidation over the next two years, on average, will need to be worth 0.7 per cent of GDP per year, compared to 0.5 per cent in the current fiscal year. There are a variety of reasons why the government will need to increase the pace of consolidation. According to the International Monetary Fund’s projections, the general government debt is expected to increase from an estimated 81 per cent of GDP in 2022-23 to 82.4 per cent in 2024-25. A slower pace of consolidation will not bring down the debt level quickly and remain a source of macroeconomic risk. Moreover, higher debt will necessitate increased allocations to interest payments over time, leaving fewer resources for other commitments. Already, the central government’s interest liability has gone up from about 36 per cent of its revenue in 2019-20 to over 41 per cent in 2023-24. Any further increase will restrict the government’s capacity to manoeuvre.

Drawing up a more ambitious consolidation path, to be sure, will not be easy and require adjustments on the expenditure side. It is worth noting that the nominal growth rate in the current fiscal year — according to the first advance estimates of the National Statistical Office — is estimated to be just 8.9 per cent, compared with 16.1 per cent in 2022-23, largely because of the collapse in the wholesale price index-based inflation rate. Given that the Reserve Bank of India has rightly reiterated its commitment to the target of 4 per cent consumer price inflation, the government is unlikely to get a large nominal growth advantage on a sustained basis. High nominal growth not only increases revenues but also expands the nominal size of the economy at a faster rate, making the deficit targets easier to attain. Moderate inflation will yield moderate growth in tax collection. A substantial increase in tax buoyancy can only materialise over a period of time. The Union government’s tax collection, for example, has hovered around 10-11 per cent of GDP for nearly two decades. Thus, a faster consolidation will require expenditure adjustments. This will not be easy but remains a necessity for the next leg of responsible fiscal management.