Fiscal consolidation?

Spending more and taxing less will be a burden on government finances

The fiscal deficit of 4.8 per cent in 2003-04 is earning Jaswant Singh much applause. The deficit was lower than the budgeted level of 5.6 per cent.

Is a fiscal deficit of nearly 5 per cent of GDP in a high growth year good macroeconomic policy? Or, is it that Jaswant Singh's 2003-04 Budget estimates were made keeping in mind that 2004-05 was to be an election year?

Let us not forget that Budget estimates for 2003-04 were striking in their modesty. In fact, they were so modest that even if the monsoon had not smiled upon the FM, the government would have been trumpeting its fiscal marksmanship as targets would have been met quite easily. India would still have been "shining".

Compared with a growth projection for tax revenues of 30 per cent in the previous year, the 2003-04 Budget anticipated only 12 per cent growth in tax revenues.

These tax projections are made on the basis of low GDP and industrial growth projections. When these projections were made for the year 2003-04, nobody expected that GDP would grow by over 8 per cent. It therefore makes little sense to applaud higher than budgeted collections too much.

It might make more sense to revise the "projections" based on higher growth and then calculate the shortfall or overshooting. Meeting deficit targets should not be an indicator of the credibility of the minister and his staff. Nor is it the achievement that it is made out to be.

Indeed, focusing on good fiscal marksmanship in 2003-04, with respect to projections made in February 2003, is a bad idea. So little is known about 2003-04 in February 2003, that it seems rather pointless to make a big fuss about the arbitrary projections made then.

Since the performance of the Indian economy continues to be strongly influenced by the monsoon, targets set before the monsoon can often been unrealistic.

If marksmanship is the goal, it makes sense to change over to a fiscal year that runs from August 1 to July 31. In this case, a Budget presented on July 31 will be rooted on some information about the monsoon that would shape the economy from August to July.

Consider what is being estimated for the 2004-05 Budget now, albeit recognising that it is a mere vote on account. A forecast of 8 per cent GDP growth in 2004-05 forms the basis for estimates for taxes and expenditures in 2004-05. A second year of 8 per cent GDP growth is a tall order. Two consecutive years above 8 per cent have never taken place in India's history.

It will be a very lucky finance minister who can meet the targets. However, as a strategy for the first year of a government it may be helpful to create an environment for fiscal consolidation. If in opposition, it will give the BJP ammunition against the new government.

The more important policy question is what should be the goal of fiscal policy. Macro economics teaches us that one of the major goals of fiscal policy is that it should be counter-cyclical, i.e. it should counteract the ups and downs of the business cycle.

If we had good GDP and industrial forecasts available when the Budget is being cooked, better countercyclical fiscal policies could be prepared and more successfully implemented by governments.

As of today, GDP forecasts in India remain poor, and most forecasters rarely stick their necks out. Forecasts are informally often made around a cocktail party consensus.

For this reason, the forecasters find it very difficult to handle very good years and very bad years. In addition, governments, especially those in fiscal stress, who never run fiscal surpluses even in good years, find it difficult to announce large budget deficits in bad years.

The economy grew very well in 2003-04, so tax revenues have been strong and expenditures have grown slowly. A lack of a clear perspective on following a countercyclical fiscal policy, coupled with the impending elections, have led Jaswant Singh to come up with a flurry of expenditure and taxation proposals.

In the coming year new expenses and reduced tax revenues will further stimulate the economy, at a time when the economy is doing well. That is, fiscal policy is being pro-cyclical.

If fundamentals of the economy were truly strong, this would be questioned. However, when people secretly believe that the recovery is tentative, that it could falter if the government did not nudge it along, they don't object. In contrast, in a developed economy there would be fears of overheating and inflation if such a policy were being followed.

How can we do things differently? A possible strategy could be as follows:

• The average GDP growth over the last 20 years should be used as the GDP growth estimate that goes into the Budget process. Right now, this gives us an estimate of 5.7 per cent.
• If GDP growth proves to be above this long-run average, then tax revenues should be buoyant, and expenditures for programmes such as employment and poverty programmes should be lower. So the fiscal deficit should be much smaller than budgeted. Given the FRBM, we are destined to soon eliminate the revenue deficit. In that world, we should run a fiscal surplus in a good year.
• If GDP growth proves to below this long-run average, then tax revenues will do badly, expenditures will be higher, and the fiscal deficit should be larger than budgeted.

This scheme requires well designed expenditure programmes, especially poverty alleviation programs which are inherently countercyclical. One known in India today, for a poverty alleviation program, is Maharashtra's Employment Guarantee Scheme (EGS), which guarantees a job at a low wage to anyone who asks for it.

EGS expenditures are counter-cyclical in a way that does not require complex efforts on the part of the state. In a good year, labour market conditions will be tight, and spontaneously, fewer people will step forward to benefit from EGS, so the expenditure on EGS will be lower.

In a bad year, more people will spontaneously come forward to harness EGS, so EGS expenses will be higher. In this fashion, EGS expenditures can be counter-cyclical. The same, however, cannot be said about most spending programmes of the government.

In summary, the fiscal deficit numbers are not as much a sign of good fiscal policy as of a well thought out election strategy. The danger with this election strategy is that Jaswant Singh has proposed expenditures which will fritter away gains to the fisc.

Spending more and taxing less, thanks to the present good times, will leave behind a long term burden on government finances which is difficult to meet in bad times. Building such traditions is a mistake.

You can contact Ila Patnaik at ipatnaik@ncaer.org

(The writer is with the National Council of Applied Economic Research, New Delhi. The views expressed are personal.)