A working paper of the International Monetary Fund has questioned the conventional wisdom about the path to fiscal consolidation adopted by governments during the recent economic slowdown. Fiscal consolidation refers to the collective attempts by a government to rein in public expenditure and hike tax collections at a time of economic slowdown to contain the burgeoning fiscal deficit.
In India, Finance Minister P. Chidambaram had outlined a fiscal consolidation plan after taking charge in October last year which talks about a year-wise planned reduction in the fiscal deficit from 2012-13 to 2016-17 — drawing from the recommendations of the Kelkar committee. This would involve rationalisation of the Central schemes, strict control and monitoring of public expenditure and reform of taxation.
With the IMF paper raising doubts about the efficacy of such measures in fuelling growth and reviving the economy, the government’s approach is not without its problems.
The paper, co-authored by Olivier Blanchard and Daniel Leigh, director and economist at the International Monetary Fund respectively, released in January 2013, found that in advanced economies, stronger planned fiscal consolidation has led to lower growth than expected. This is a significant development as multi-lateral institutions such as the IMF and World Bank have traditionally advocated containing public spending and reining in fiscal deficit as a path to revive economic growth.
Though the paper carries a disclaimer stating that it should not be “reported as representing the views of the IMF”, its contents do raise some doubts about the path adopted by economies to recover growth.
The World Economic Outlook of the IMF published in October 2012 found that “growth disappointments were larger in economies that planned greater fiscal cutbacks”. The forecast data presented by the paper is drawn from forecasts of growth and fiscal consolidation in the 2010 IMF World Economic Outlook for 26 European economies.
Speaking to The Hindu , a senior official of the Ministry of Finance explained: “The exercise of fiscal consolidation has to be carried out cautiously to ensure that essential expenditure is not cut down. The emphasis should be on revenue-led consolidation through progressive taxation. Productive expenditure by the government should be protected. Even in distinguishing between capital and revenue expenditure, one has to be careful in not weeding out useful revenue expenditure by the government. For instance, building a school is categorised as capital expenditure, but maintenance of the school which comes under revenue expenditure is also equally important. Austerity measures often have huge social implications for the poor, which is not desirable in an emerging economy like India. There could be other approaches for reviving the economy, for instance Japanese Prime Minister Shinzo Abe has planned huge public expenditures to kick start the economy. Fiscal deficit is after all an outcome variable and meeting the target in terms of numbers is not an end in itself. Therefore, it is important to protect crucial expenditure. ”
Speaking at the release of the World Economic Situation and Prospects 2013 on January 17, Dr. Nagesh Kumar, chief economist at the United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP), outlined the need for a long-term plan for India rather than short-term austerity measures: “The Finance Minister had laid down a long-term five-year roadmap for fiscal consolidation. A very strong emphasis on austerity measures can be self-defeating.”
The paper emphasises that a decision on the appropriate method for pursuing fiscal consolidation needs “much more than an assessment regarding the size of short-term fiscal multipliers”. It clearly states that it is not an argument against fiscal consolidation as such as all advanced economies face the challenge of “fiscal adjustment in response to elevated government debt levels and future pressures on public finances”. However, it states that the “short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation in any single country”.
The paper also looks at whether fiscal consolidation reflects changes in government spending or changes in revenue. It concludes that “forecasters significantly underestimated the increase in unemployment and decline in private consumption and investment associated with fiscal consolidation.”
