Home / Opinion / Back to the state: greater public expenditure needed

What is a sensible fiscal strategy in the face of an economic downturn? Increasingly, the answer seems to be obvious, even in a world that, until recently, had forgotten basic Keynesian insights: Governments should go for counter-cyclical macroeconomic policies to prevent further decline in economic activity and employment, and to ensure sustained growth in the future. That means easing both fiscal and monetary policy and not being obsessed either with the level of the deficit or the fear of “easy money" creating inflation, since the economic conditions of recession typically preclude both high deficits and inflation—at least in the short term.

Jayati Ghosh. Professor of economics, Jawaharlal Nehru University, New Delhi. Harikrishna Katragadda / Mint

So far, the government has mostly chosen the first set of fiscal policy options—of tax cuts and bailouts. It became evident around the middle of 2008-09 that the global recession was having sharp effects on the Indian economy in the form of falling exports, capital flight and a rapidly depreciating currency, which led to a domestic credit crunch and employment losses. But the early attempts to deal with it through successive stimulus “packages" involved relatively little in terms of additional direct spending, and were mostly directed towards various tax cut measures, with estimated revenue losses at around 1% of gross domestic product (GDP).

Also Read What to reform: fewer subsidies, more investment

Now that many analysts are claiming the worst is behind us, the clamour is to contain public spending on grounds of fiscal responsibility. But this is an extremely problematic argument. While the overall fiscal deficit (of the Union and state governments) in 2009-10 is likely to increase to around 12% of GDP, a large part of it would be the result of tax cuts and subsidies rather than direct spending.

There are several problems with relying on such price-based fiscal measures. They increase economic activity only if producers respond by cutting their own output prices and, in turn, generate demand responses; or if they enable firms that would otherwise have closed down to survive. But neither is inevitable, nor even very likely. Similarly, measures that try to provide additional incentives to exporting sectors, such as textiles, garments and leather, do not counteract the effect of large losses of export orders as major markets abroad shrink.

So, there are two strong reasons for winding down the tax cuts that were provided as almost knee-jerk policy responses to the economic downturn. First, these cuts crucially affect revenue buoyancy and therefore affect the government’s ability to engage in direct public spending, which is a far more effective way of dealing with the current slowdown. Second, enhanced spending is a much better way to combine counter-cyclical response with more ambitious medium-term economic goals. The tax cuts, bailout measures and subsidies have been ad hoc, non-systematic and not conforming with a planned programme based on current and future economic needs.

In contrast, public spending can enable economic and social goals as well as future growth, such as in infrastructure and other expenditure directed towards improving living conditions. In the recovery packages so far, some of the most critical areas of potential spending have been ignored or neglected, such as increased resources to state governments, direct investment to ensure mass and middle-class housing, interventions to improve the livelihood conditions of farmers, expansion of the public food distribution system, enlargement of employment schemes and provision of social security.

Instead of public expenditure for meeting infrastructure gaps, government strategy has pushed infrastructural investment financed not only with domestic debt, but also with external commercial borrowings. This adds to the debt spiral, and involves a currency mismatch, since infrastructure projects do not directly yield foreign exchange revenues, and the indirect impact on exports—though eventually likely to be positive—is difficult to assess. This could lead to solvency problems if the balance of payments remains weak and the rupee depreciates further.

So what the budget should ideally contain is an emphasis on wage-led growth, with fiscal policies that provide greater stimuli to production for mass consumption in the domestic market, such as through more spending on infrastructure, agriculture, public food distribution, health and education.

Such increased expenditure need not lead to a much larger fiscal deficit if the tax cuts provided in the midst of crisis are gradually withdrawn and existing loopholes for tax evasion effectively plugged.

All this is especially important because of the particular effects of the crisis on certain segments of the economy: migrant workers, especially those from backward, dry land regions, where agriculture is also in crisis; and informal sector workers, who have seen drops in both activity and wages. Deteriorating conditions for these groups can have a significant impact on socio-political tensions in the country, so it is important to direct spending towards such areas.

If the government does not choose this strategy, chances are that it will instead keep the tax cuts going and provide further concessions such as financial liberalization and privatization to attract private foreign capital back into India. This would be essentially an attempt to generate another speculative bubble. Such a course would not only be economically stupid. Given the explicit mandate on which the government was recently re-elected and the unpleasant consequences of allowing the adverse consequences of economic crisis to fester, it would also be politically unjustifiable.

Comment at theirview@livemint.com

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