The building blocks of economic policy

The budget should be a part of the longer-term policy objective of increasing economic activity, prosperity and well-being

Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Economic policy choices are not easy in a country like India. At present, the complication has increased because of the currency swap and deceleration in economic growth. Union finance minister Arun Jaitley will have a difficult task at hand when he rises to present his fourth budget today. While every budget is presented in a somewhat different set of circumstances, the broader theme and the context of economic policy remain by and large the same. The budget should be a part of the longer-term policy objective of increasing economic activity, prosperity and well-being in the country.

In this context, economist and veteran policymaker Vijay Kelkar’s remarks at the CD Deshmukh Memorial Lecture last week can be extremely useful. They are not only relevant for the budget, but for economic policymaking in general. As former finance minister P. Chidambaram said in his 2013 budget speech: “…the last day of February (the budget day) is another day in the life of a nation”.

Here are five themes that should guide economic policy.

First, the policy should focus on market failures. Free markets work in enhancing prosperity but there are areas where state intervention is needed. However, in India, the state is dominant in sectors where it is not required and lacks capacity in areas where the intervention is actually desired. It often intervenes with no evidence of market failure, which affects resource allocation. This needs to change. In a column published in these pages on Tuesday, former Reserve Bank of India governor Y.V. Reddy, for instance, noted: “The manner in which the state functions, the behaviour of market participants and the framework of the relationship between state and market in India need to change.”

Second, policy intervention should be seen from the perspective of general equilibrium. Often, policy changes are made with narrow objectives, focusing on one sector or area. For example, in the context of the budget, India has a history of random tinkering with tax rates to promote one sector or the other, which has resulted in distortions. The most recent example is the suggestions made by the committee of chief ministers on digital payments—a host of fiscal measures that will further distort the tax system. The government should avoid such ideas.

Third, the government should spend more efficiently. There are demands for increasing spending in various sectors of the economy and they are often legitimate as India needs improvement in a number of areas. However, public spending has a cost. Kelkar and others have calculated that the marginal cost of one rupee of public spending to society is around Rs3. Therefore, the government should spend carefully as the cost to society is much higher than what gets recorded in the books. Kelkar noted in his lecture: “On the expenditure side, this is a call for reforms of expenditure programmes, so as to ensure that public money is only used for applications where the gains to society of Re1 of expenditure exceed Rs3.”

Fourth, individuals, including politicians, are driven by incentives. Policy changes should factor in the possibility that people can change their behaviour. Insights from public choice theory show that politicians and bureaucrats also work in self-interest. One of the reasons why India has had a high fiscal deficit bias is because higher government spending can lead to higher growth in the short run and could electorally benefit the ruling party. Therefore, it’s important to build checks in the system. As India has moved to a rule-based monetary policy framework, it also needs a better fiscal architecture. Even though India has the Fiscal Responsibility and Budget Management Act in place, experience shows that it is not sacrosanct. What is needed is an agency like the US Congressional Budget Office which independently reviews government finances so that the public in general is better informed. This will help reduce fiscal profligacy.

Fifth, policy should promote competition. A high level of competition is desirable in a market economy as it leads to efficient allocation of capital. The government has done well by getting the bankruptcy code passed as it will facilitate the closing of firms and the shifting of capital to more productive sectors of the economy. Also, as Kelkar argued, competition is the biggest reason to promote privatization of public sector companies as they distort the market because of access to government funding. Movement on privatization has been slow for a number of years due to a variety of reasons.

Following these broad principles in policymaking will help build credibility and lead to better economic outcomes in the medium to long run.

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