The budget must balance growth and public debt

Photo: Mint
Photo: Mint


A slowdown in nominal growth will make fiscal compression harder but we should move towards fixing the primary deficit

Nirmala Sitharaman will present the last full budget of the second Narendra Modi government next week. National elections are due next year, so the February 2024 budget will likely be an interim accounting exercise to keep India’s wheels of administration moving till the next regime is sworn in.

Two themes provide the backdrop of fiscal policy since July 2019. First, the credibility of budgeting has improved over the past four years, thanks to more transparent accounting as well as more reasonable assumptions on economic growth. Such credibility will matter when the bond market absorbs the new budget numbers, and decides the interest rates on government bonds.

Second, public finances have been hit hard by two exogenous shocks which no government could have controlled: the dislocation during the covid pandemic after March 2020, followed by a jump in energy prices after the Russian invasion of Ukraine in February 2022. These two shocks messed up the finances of most countries, and India has been no exception. However, the Indian fiscal response to the pandemic was more careful than in many other large economies, which has led to inflation levels that were not seen in those countries for several decades. The Indian finance minister had budgeted a fiscal deficit of 6.4% of gross domestic product (GDP) for the financial year that will end in March. It is very likely that this core fiscal target will be met, despite the fact that the subsidy bill will overshoot the budgeted target by over 2 trillion. The decision of the government to extend the free food provision under the Pradhan Mantri Garib Kalyan Anna Yojana through most of this financial year as well as the decision to protect farmers from rising global fertilizer prices are the main reasons for a higher subsidy bill.

However, this extra spending will not push up the fiscal deficit because there is likely to be an almost-matching increase in net tax collections above the budgeted target this year. The main reason why this extra money has flowed into the tax coffers is high growth in nominal GDP; it will be lower in the next financial year as economic growth loses steam while price pressures ease. The growth in tax collections will thus be more modest in 2023-24.

The temptation to reduce taxes on the incomes earned by the middle class is attractive before an election year. However, it would be more prudent to keep tax rates unchanged for now, and go in for a more effective overhaul of the direct tax code later. This includes both a reduction in tax rates as well as minimizing various distortionary exemptions that people with good accountants can game. The longer-term goal of Indian tax policy should be to collect more direct taxes while reducing the burden of indirect taxation, which is more regressive.

The anticipated economic slowdown reduces the space for a sharp fiscal correction in the financial year that will begin in April. The finance minister said earlier that the fiscal deficit of the Union government would be brought down to 4.5% of GDP by the end of 2025-26. That will be 1.9 percentage points over three years. The current state of the economy—as consumer demand slows down, private sector investment spending remains weak and exports stutter—suggests that the government should approach the task of further fiscal correction asymmetrically, say 50 basis points in the next financial year and then 70 basis points in the two subsequent years.

Such a modest fiscal correction may be manageable despite weaker growth in tax collections. How? The restructuring of food subsidies announced a few weeks ago will create ample savings to help the fiscal balance. A lower subsidy bill can account for most of the desired fiscal correction, as long as tax collections chug along in tandem with nominal growth in the underlying economy. However, this slightly optimistic assessment does not take into account any sudden spike in government spending for select interest groups or a hasty tax cut in the months leading to the next general elections.

A modest fiscal correction of around 50 or 60 basis points comes with two concerns. First, despite the surprising improvement in overall state government finances, the consolidated fiscal deficit of both the Union and states could be around 8.5% in 2023-34. At a time when bank credit to the private sector is growing, and there is anecdotal evidence of some companies switching back from the foreign to domestic market for funds as a result of narrowing interest rate differentials, the consolidated government borrowing will soak up most of the available pool of domestic financial savings of households. Bond markets will be on alert. The Reserve Bank of India may have to be on standby to buy government bonds as part of its open market operations, at a time when it is trying to run a tighter monetary policy. It is a tricky coordination task.

Second, the broader task of fiscal management in any economy is not the annual deficit target, but stabilization of the public debt ratio. The pandemic shock sent Indian public debt soaring to about 90% of GDP, the highest ever. It has now come down a bit, but is still around 15 percentage points higher than what is considered comfortable. Interest payments on this debt already soak up around half of the net tax collections of the Union government, leaving less money for public goods, infrastructure, social sector spending and defence. (Spending on defence anyway needs to increase over the coming decade as the Chinese threat along our borders intensifies.)

Public debt dynamics will need to be tracked closely. The government continues to borrow at interest rates that are lower than the growth of the economy in nominal terms, which means that there is less pressure on the government to address its primary imbalance, or the fiscal deficit minus interest payments. In its recent review of the Indian economy, the International Monetary Fund estimated that the debt-stabilizing primary deficit is 2.3% of GDP. It will be a number worth watching on 1 February.

Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.

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