BackIndia needs a dose of supply-side economics
India needs a dose of supply-side economics
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One useful way to understand the economic situation right now is through a motoring analogy: Has the Indian economy hit a speed bump or is it suffering from engine trouble?
It increasingly looks like the latter. The economy has been losing momentum for several quarters. The Reserve Bank of India has already indicated that the rate of economic growth that can be sustained without sparking off an inflationary fire is now 7%, a full 1.5 percentage points lower than the years before the financial crisis.
India seems to have moved to a lower growth trajectory. And India is likely in a structural rather than cyclical slowdown.
The problem has its roots in two policy failures: the lack of any significant economic reforms since 2004 and the callous disregard of the growing fiscal deficit after 2008.
Both policy failures are intimately linked to the politics of the United Progressive Alliance. Both have combined to lead India down a path marked by declining growth and rising inflation. Both have put future prosperity at risk.
What India needs right now is a healthy dose of supply-side economics—a set of policies that will help raise the national investment rate as well as address serious structural constraints such as energy.
So the implicit economic strategy in the finance minister’s speech on Friday will be as important as the actual budget arithmetic.
To be sure, the wide gap between government revenue and spending is the most immediate source of worry. India has traditionally been more successful in closing this gap through increasing tax revenues rather than spending cuts. The politics of austerity can be a death warrant in India.
Raising tax revenue in a slowing economy is a tough task. What needs to be watched is whether the cycle of tax cuts that began in 1985 will now be replaced by a regime of rising tax rates. There is ample speculation about the revival of the wealth tax, a special tax for the super-rich, higher taxes on stock market profits, a tax on personal wealth held abroad. The other option is to move ahead with overdue tax reforms, especially the direct taxes code and the goods and services tax.
There are challenges on the spending side as well. The ruling alliance is committed to ambitious entitlement programmes that are supposed to help the poor.
The regime led by Sonia Gandhi and Manmohan Singh has front-loaded a lot of these spending commitments, perhaps in the belief that guaranteed 9%-plus growth would generate ample tax revenue to fund these commitments. The recent loss of economic momentum has torn that assumption to shreds, hopefully forcing the government to take a hard look at its spending bill. One obvious, though politically challenging, target would be subsidies, especially the fuel and fertilizer subsidies that are cornered by the middle class and large farmers.
Budget 2012 will be unveiled at a time when there are momentous changes in the Chinese economy. Its labour force is peaking. Wage costs are going up. There is continuous international pressure on its government to let the yuan appreciate even further. These developments have encouraged the Chinese leadership to accept a lower growth target as well as to begin moving its economy up the value chain.
The changes in the Chinese economic model open up a tremendous opportunity for India to move in as the low-cost workshop of the world, generating millions of jobs that will allow people to escape the overcrowded farming sector.
However, the process will not be an automatic one. India needs huge investments in infrastructure, energy and skills before it can step into the void. It needs more efficient markets for factors of production such as capital, land and labour. It needs a single domestic market that allows companies to plan their manufacturing facilities in an efficient manner.
The new budget needs to be understood against this wider backdrop. A fiscal correction will raise national savings. Economic reforms will boost investment activity. These will help shift the aggregate supply curve to the right.
India can neither create enough jobs nor fund an ambitious welfare state without faster economic growth. It is no coincidence that the rate of poverty reduction in India picked up between 2005 and 2010, a five-year period when economic growth averaged 8.6%, and when 67 million Indians were pulled above the international poverty line of $1.25 a day, according to World Bank data.
Supply-side policies are the best bet if India has to steer clear of the new normal of 7% growth, some 2.5 percentage points below its peak in 2006-07.
Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome atcafeeconomics@livemint.com
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