India needs more investment at this stage of the business cycle. What we are getting instead is more consumption spending by the government. The result: slowing growth and persistent inflation.
Take a look at the chart. The rapid acceleration in economic growth after fiscal 2004 coincided with an increase in the investment ratio and a sharp fall in the revenue deficit. All three are interlinked.
The Atal Bihari Vajpayee government used its ample political skills to push through legislation that sought to impose strict limits on the fiscal deficit, which is the most comprehensive measure of the state of public finances. The Fiscal Responsibility and Budget Management Act also said that the government should aim for a zero revenue deficit by 2009. In other words, the government should not borrow to finance its current expenditure; all borrowing should be exclusively for capital spending. Lower revenue deficit helped release funds for investment spending. The investment rate soared. Economic growth accelerated.
This virtuous circle was protected in the first Manmohan Singh government. Then things went into reverse gear after 2008. The rapid deterioration in public finances has been disingenuously justified as a response to the global economic crisis. The government claimed that it had let the fiscal deficit slide to protect the economy from the worst effects of the global recession.
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Actually, fiscal deterioration began before the 2009 elections and much before the world economy went into a tailspin after the collapse of Lehman Brothers. Remember that the farm loan waiver had been announced in February 2008. The revenue deficit had shot up by 3.5 percentage points in FY09 itself to 4.54% of the gross domestic product (GDP). The primary deficit was up 3.41 percentage points. This deterioration in public finances was cemented in the 2009 budget presented by Pranab Mukherjee.
This column had asked in March 2009: “The Manmohan Singh government has pushed the fiscal deficit 3.5 percentage points above its budgeted target for the current fiscal year. Most of this has come from higher revenue spending and subsidies. We have to add to that the 1.8 percentage points of bonds issued outside the budget to fund oil and fertilizer subsidies. The very least this profligate government can do is to explain to citizens why it chose to spend an extra 5.3% of national output on higher staff salaries, subsidies, farm loan write-offs and the rest. Would it have been better for economic growth if all this money had been accounted for by a huge tax cut or higher capital investment?”
Ahmed Raza Khan/Mint
Also See | Fiscal Deterioration (PDF)
What has happened in the last three years is a very dramatic shift from investment to consumption. Reserve Bank of India deputy governor Subir Gokarn did well to point out in a recent speech: “We should not underestimate the role of (the) very dramatic expenditure switch between investment and government spending. Keep in mind the fact that the investment-GDP ratio includes public investment, while the fiscal deficit largely comprises a revenue deficit, i.e., what the government borrows in order to meet its operating (as opposed to capital) expenditure. Cutting consumption, while raising investment is a textbook formula for accelerating growth.”
At the heart of this problem is the political strategy of the United Progressive Alliance (UPA). It gambled on the fact that the economy would continue to cruise in the fast lane, and thus generating ample tax revenues for the government to fund social programmes that would win elections. The fundamental flaw in this assumption is that growth requires investments, while the pattern of government spending has been skewed towards consumption.
First, the stimulus given to consumption without similar attention to investment—either through public spending or further economic reforms to encourage business investment—has created inflationary pressures in the Indian economy. Much has been made about the need for an adequate supply-side response to rising prices, and new capacity that will help cool inflation. There has been little by way of any actual policy thrust.
Second, the assumption about predictably-high growth has also run into trouble. The recent slowdown has hurt tax revenues. The latest government data shows that tax revenues till September were a mere 4.1% higher than those in the corresponding period of the previous year. Total revenues were down 24.2%, while total expenditure was up 11.4%. Most private sector economists predict that the government will significantly overshoot its fiscal deficit target.
India has one of the highest fiscal deficits among the emerging economies of Asia, Latin America and Africa. Egypt, Venezuela, Pakistan and Indonesia are among the handful of countries that do worse; the first three in that list are notoriously mismanaged. India is not in good company at all. Much of our fiscal deficit is made up of the revenue deficit, a perverse stimulus to consumption in an economy that needs investment. The flaw is not just economic. It reflects a fundamental problem in the political strategy of the UPA.
Niranjan Rajadhyaksha is executive editor of Mint. Comments are welcome at firstname.lastname@example.org