Why govt should not try limiting its spending

Why govt should not try limiting its spending

Mumbai: Be assured: You will hear a lot about fiscal consolidation from finance minister Pranab Mukherjee on 26 February, when he presents the new government budget.

Then profligacy took over. Deficits grew, borrowing to finance current expenditure became an ugly habit and the road to the 1991 crisis was paved.

Consider a key metric, the ratio of the government’s gross fiscal deficit to the gross domestic product (GDP). There was only one year between 1977-78 and 2007-08—three whole decades—when the deficit ratio was below 4%.

Two things changed in the middle of the first decade of the new century. First, an unprecedented economic boom fattened the government’s tax collections and sliced away the deficit. Second, a bipartisan political deal helped push through a law—the Fiscal Responsibility and Budget Management Act—that, in effect, committed successive governments to the path of fiscal rectitude.

Two basic goals are enshrined in the law: a fiscal deficit not exceeding 3% of GDP by fiscal 2009 and a zero revenue deficit by the end of the same year. In other words, India was to go back to the fiscal profile it had in the 1970s and before.

The first United Progressive Alliance government was on course to meet this target, not because it had run a tight ship but because five years of record growth had led to a tax bonanza. However, there was a sharp deterioration in fiscal 2009, when the government ended the year with a fiscal deficit that was twice what it had initially budgeted for.

Also See Widening Gap (Graphics)

Suddenly, nearly a decade’s hard work was undone. The fiscal deficit for the current fiscal is budgeted at 6.8% of GDP, a level not seen since 1993-94.

The official line is that the government had to throw fiscal caution to the wind because it had to step in to support domestic demand in the midst of the worst global economic downturn since the Great Depression. But that is not the entire story. The government made the cardinal mistake of assuming that huge tax collections would keep flowing into the kitty and that it was thus safe to ramp up spending on politically attractive schemes such as the National Rural Employment Guarantee Scheme. Then reality hit, as tax collections became sluggish in the face of the economic slowdown but spending on various entitlements continued to grow.

India’s high fiscal deficit is part cyclical and part structural.

The biggest task now is to attack the deficit. There are only two ways to go about the job. One, the government can keep a tight control over its spending. Two, it can hope that robust economic growth fills the tax coffers. The third alternative—selling capital assets to fund revenue spending—is a bad idea.

The second option is preferable for a simple reason. Previous experience shows that the Indian government does a terrible job when it comes to cutting spending: it prefers to cut the capital expenditure that is needed for future growth while protecting current expenditure such as salaries and subsidies that win votes.

In short, despite all the bravado that will be on display on 26 February, the best chance India has to regain fiscal balance is to hope that the Indian economy resumes its earlier growth path very soon.

Graphics by Ahmed Raza Khan/Mint