Home / Opinion / Online Views /  Fixing the fiscal deficit with maximum gain and minimum pain

Everyone knows the fiscal deficit needs to be cut. The problem lies in how to do it. Won’t a reduction in the deficit lead to lower growth in the short run? Won’t lower growth lead to a higher deficit because tax collections will fall? And while everyone wants a reduction in subsidies, won’t the impact on the poor at a time of low growth be devastating? The International Monetary Fund, or IMF, in an annexure to its recent country report on India, looks at these knotty issues and comes up with three alternative paths to fiscal piety. Each of these routes will reduce the deficit by 5% of the gross domestic product (GDP) in five years, but they take different approaches to reach that goal.

The first path moots cutting government expenditure by 2% of GDP, scale down subsidies by 2% of GDP and improve tax collection by 1% of GDP by implementing the goods and services tax, or GST. The total reduction in deficit will be 5% of GDP.

The second road has a twist. It aims to boost government investment by 2% of GDP over the next five years to lift growth. But if we increase government investment expenditure, how do we reduce the deficit? That will require the government to prune consumption expenditure by 3% of GDP and increase tax collection by 2% of GDP, more than in the first path. Subsidies need to be cut by 2% of GDP, the same as in the first scenario. The net result: again lowering the deficit by 5% of GDP.

The third road is friendlier to the poor. As in the second road, here, too, consumption expenditure is to be pruned by 3% of GDP, subsidies cut and tax collection increased by 2% of GDP each, but the difference is that government investment is to be increased by 1% of GDP, while the other 1% is to be transferred to a social safety net for what the IMF mystifyingly calls liquidity-constrained individuals, a natty euphemism for the poor. (So India is no longer a poor country, we’re merely liquidity-constrained. Poverty is abolished with the coining of a shiny new weasel phrase. Hallelujah.)

So, which road should the government take? All of them lead to the five-year goal of a reduction in the fiscal deficit by 5% of GDP. The difference lies in the amount of pain involved in getting there. Take the impact on growth. The immediate result of reducing the deficit is demand compression. Growth suffers because the supply-side response takes time. The solution is for the government to accelerate investment. Under the second scenario, where investment spending is accelerated, IMF believes growth will bounce back after three years, unlike in the first case, where the effect of expenditure cuts and a higher tax collection hurts growth. Under the third socially-friendly scenario, output bounces back faster than in the first case, but slower than in the investment-boosting situation.

The study says cutting untargeted subsidies is the most growth-friendly tool, while slashing the deficit by reducing investment is the most damaging. A lot of the subsidies do not reach the people intended, but there’s also another reason why clipping subsidies may not hurt the poor very much.

Here’s the clincher, admirably summed up in the IMF study: “The rupee benefit enjoyed directly through consumption of subsidized fuels by the richest decile of households is more than seven times that enjoyed by the poorest decile, nearly 45% higher than the total benefits enjoyed by bottom 40% of the population, and 40% higher than those enjoyed by the next richest decile. Similarly, the indirect benefits through distorted prices of other goods and services disproportionately benefit the top 10% of the population; more than 10 times the indirect benefits of the lowest decile, 75% higher than the total benefit of the bottom 40% of the population, and more than double the benefits enjoyed by the next richest decile." What could be more damaging to the tall claims of so-called inclusive growth? This shows the Indian state, far from being socialist, actually uses subsidies to benefit the upper class (often euphemistically labelled the middle-class in India).

The best route to fiscal rectitude lies, therefore, in reducing subsidies, improving tax collection (IMF talks about better tax efficiency, but there’s no compelling reason why we shouldn’t tax the rich more also) and increasing investment, which will help boost growth. At the same time, we must have well-targeted social transfer payments. And, of course, there’s plenty of scope for continuing with the reform process, which will improve productivity and help growth.

However, pruning subsidies is going to add fuel to the raging inflationary fires. IMF projects wholesale-price inflation at 7.2% at end-March 2014, while the Consumer Price Index for industrial workers is projected at 9.7%. That will severely limit the scope for monetary policy easing. It’s one of the reasons GDP growth is projected at 6% in 2013-14, hardly a big bounce from this fiscal’s 5.4%.

The latest data on the central government’s finances show that total expenditure for the April-December 2012 period increased by 10.6%, compared with a year ago, against a budgeted growth of 13.1% for FY13. Unfortunately, capital expenditure, which was budgeted to increase 30.6% this fiscal, went up by only 9.6% in the April-December period. As has been the norm, the government is pruning its deficit in the worst possible way, by reducing its capital expenditure.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at

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