In 1785, the nawab of Awadh had to deal with a devastating famine that would last a decade. As the famine continued and hit both his poor and rich subjects, the nawab was under pressure to find a way to keep the economy running and generate employment across social strata. So he decided to commission a grand construction project. Labourers would work during the day while the elites would dismantle it all in the anonymity of the night. Incidentally, this was 150 years before celebrated economist John Maynard Keynes came up with his signature theory of how governments could escape economic slowdown by making people dig holes and then fill them up.

For those unfamiliar with how this story ends, the nawab’s fiscal stimulus ultimately birthed one of the most iconic structures of present-day Lucknow—the Bara Imambara.

What Keynes and the nawab had realized was that government spending has a multiplier effect. The first people to receive money from the state’s coffers will save some of it and use the remaining to pay for goods and services from other citizens. They in turn will repeat the exercise with other people they get in touch with and so on, creating a ripple effect of sorts. Also, increased government spending on investment can help create a positive business environment that “crowds in" risk-averse private players, further contributing to growth. This is known in economic jargon as fiscal multiplier—i.e. how much the economy grows for an extra rupee of government spending. If it is more than one, then there is evidence of the multiplier effect working.

As is apparent from that, government spending need not always lead to amplified growth. Debt sustainability aside, spending in the form of freebies and handouts raises aggregate demand and in the process could push up inflation. Meanwhile, the government will have to wade into the credit market to binge-borrow, pushing up interest rates and “crowding out" the private sector by making the cost of credit too high. The initial boost in the economy from government spending ebbs as the private sector starts to feel the pinch, and reduces economic activity.

There isn’t much academic research done on fiscal multipliers for India. But a study done by the National Institute of Public Finance and Policy (NIPFP) a few years back places the figure at 2.5 for capital expenditure, and less than 1 for revenue expenditure. Revenue spending is generally on consumption items like salaries, interest payments, subsidies, handouts, etc. Capital spending, on the other hand, is government investing in creating capital assets—like investment in roads, railways, airports and the like.

Which means that every extra rupee of capital expenditure by the government ultimately has an imact on GDP (gross domestic product) by as much as Rs2.50. On the other hand, every extra rupee of revenue spending ends up affecting the economy by less than a rupee. Other studies have different estimates based on data and methodology, but the verdict is more or less similar—capital spending has much more impact on India’s GDP growth than revenue spending.

However, the Central government spends only 12% of its budget on capital expenditure, while the remaining 88% is on revenue. Additionally, successive budgets have a historical trend of cutting capital spending to accommodate its revenue nemesis, which is obviously more politically sensitive. In fact, the Central government is spending more on subsidies or public sector salaries than it is on capital expenditure—which remains at a meagre 1.6% of GDP.

In other news, India faces one of its most pronounced investment slowdowns in the recent past. Over the last 10 years, India’s investment as a percentage of GDP has plummeted from a record high of 42% to a worrying 32%. Private sector investment is primarily responsible, owing to a mix of procedural barriers, poor business sentiment and burgeoning non-performing loans in the banking sector. In fact, it is public investment that has been holding the fort, underlining the need to keep that momentum intact in the forthcoming budget.

However, while increasing capital spending is a no-brainer, it is easier said than done. There will be multiple pressures on the budget this year. India has one of the highest levels of combined Centre and state spending among G-20 countries, and to keep favour among the global credit rating agencies, it has to demonstrate credible fiscal consolidation. On the other hand, the recent drop in growth forecasts does make a compelling case for the government to loosen its purse strings through easy-to-use fiscal handouts. Additionally, increasing crude oil prices, salary revisions, increased interest payment obligations, and GST (goods and services tax) compensation to states will all present compelling reasons for more revenue spending.

The government has two reasons to defy those temptations. One: If the aim is to boost growth, then the evidence on fiscal multipliers suggests that capital spending will do a much better job of “multiplying" GDP than revenue expenditure. And two: Increased public investment is urgently needed to crowd in private investment and reverse the investment cycle.

I am sure the nawab of Awadh would have advised the same!

Aurodeep Nandi is senior economic adviser at the British High Commission, New Delhi.

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