The question that Mr. Chidambaram needs to answer before getting to the brass tacks of the budget: can he afford to be obsessed over meeting a fiscal target at any cost?

The task of budget-making for a large and diverse economy like India is always challenging. It becomes even more so (as is the case this year) when there are severe macro-economic imbalances to deal with like high inflation and a wayward current account deficit. After all, the budget is not just a compendium of tax proposals and expenditure allocations. It is the government’s master plan for economic management.

The problems do not stop with the mere existence of these macro-economic maladies. What queers the pitch further for Finance Minister, P. Chidambaram, this year is the fact that the relationship between these macro-economic variables is defying textbook logic. Growth is exceptionally weak — the Central Statistics Office’s advance estimate of 5 per cent for 2012-13 is lower than even the most pessimistic forecasts. Yet, contrary to what economic theory would predict, it has failed to pull down headline inflation that remains stubbornly close to 7 per cent for wholesale prices and an even more alarming 10 per cent for the consumer price index. Economics 101 also tells us that slowing growth should also compress the current account deficit or CAD (roughly the trade deficit adjusted for invisible flows) by pulling imports down. However, the CAD was at a historically high 5.4 per cent for the second quarter of 2012-13; it is likely to be significantly higher for the third quarter.

The implication is that the finance minister will have to carefully choose the front that he fights his hardest battle on. I think there is fair consensus on the fact that the principal task of the 2013-14 budget would be to get growth out of the doldrums. This is easier said than done. Reviving sentiment and lifting ‘animal spirits’ can only be a part of the formula. There are harder economic choices to be made.

Take the case of fiscal consolidation. There is no doubt that reducing the fiscal deficit is important. It is equally important not to forget that there is a trade-off between growth and fiscal compression. The developments in Europe over the past couple of years - where the quest for austerity at any cost has severely hurt growth – are a stark reminder of the fact that this trade-off is sharp.

The question that Mr. Chidambaram needs to answer before getting to the brass tacks of the budget: can he afford to be obsessed over meeting a fiscal target at any cost? Or should he follow a more calibrated, nuanced approach towards fiscal discipline that allows him some leeway in going a little over his targets over the year?

The risk of a ‘fundamentalist’ approach to fiscal consolidation is the following. Unless growth picks up dramatically, revenues are unlikely to move up sharply. If the government is fixated on with somehow meeting an aggressive fiscal deficit target (say 4.8 per cent of GDP or lower) then the burden of fiscal correction will be on expenditure. Non-plan expenditures like interest payments and salaries tend to be somewhat inelastic. There is a limit to which subsidies can be brought down.

Thus, it is possible that a large part of the fiscal compression could be met through cuts in plan expenditure. This seems to be precisely what is happening at the moment in the quest to willy-nilly produce a fiscal deficit ratio of 5.3 per cent for 2012-13. There are significant risks to pruning plan expenditures mercilessly. For one, it could hurt investment expenditures of the government, precisely the kind of expenditure that we need at the moment to push growth up. To the extent that these plan expenditures augment the supply-capacity of the economy, cuts in these expenditures could compromise this. If the supply-side of the economy remains constrained, lingering high inflation will be the consequence. Thus, there is a strong case to focus on the ‘quality’ rather than the quantity of fiscal consolidation and to achieve this through a balance of revenue increase and prudent expenditure compression. If the result is a less ‘appealing’ deficit target or some slippage over the year, so be it.

On the issue of inflation management, it might help to pay attention to the fact that the upward pressure on rural wages continues unabated. High wages are known to feed price pressures and it appears that the rural economy is sitting on large pile of cash that is supporting excess demand in consumer items particularly food. At least some of this cash transfer is likely to have come on the back of the MNREGA. Thus it is imperative to take a fresh look at some of the sacred cows of public policy like the employment guarantee programme. If indeed it is contributing to price-pressures, streamlining it would meet the dual objectives of harnessing inflation and reducing spending.

Budget 2013-14 will be about striking some difficult balances between conflicting economic objectives. Such a reconciliation is possible only if North Block is willing to shed some dogmas and think outside the box of conventional wisdom.

The author is chief economist, HDFC Bank.

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