A changing fiscal framework

There used to be a time — and this was well before India began to globalise — when each Union Budget announced sales tax increases on tobacco products, especially cigarettes. The demand for cigarettes being somewhat inelastic, the rise in tax was expected to be a shot in the arm for the revenue-starved government of our poor country.

Increase in excise duty

India is less poor now, having risen to the rank of an emerging market economy. Yet, COVID-19 has ushered in a cataclysm. As opposed to a Budget estimate of 3.5% for fiscal deficit, the revised estimates show a 2.7 times larger deficit of 9.5% for FY 2020-21. Moreover, a comparison of the government’s revised Budget estimates with the original Budget estimates reveals a fall in receipts from every source of taxation except excise. The revised Budget shows a rise of ₹94,000 crore on account of excise duties alone. Presumably, the increase comes from the much-debated excise duty increases on petroleum and diesel. As far as the Budget documents go, the excise duty rise will hardly compensate for the huge falls in other tax revenues. It is not surprising, therefore, that despite the excise rise, the fiscal deficit continues to be higher than the Budget estimate. In fact, the larger excise duty collection is not large enough to have significantly reduced the inflated fiscal deficit figure.

Given the nature of the products on which the excise duty has gone up, prices of commodities will rise in general, directly or indirectly. This is because all these commodities fall either in the category of final goods, which individuals purchase for personal consumption, or in the category of intermediate goods, which are used to produce a variety of essential services such as public transport, agricultural water supply, hotels and restaurants

. With annual output shrinking by an estimated 7.7%, it is straightforward to conclude that unemployment has risen significantly. The accompanying price rise will be the unemployed persons’ worst nightmare. The result will be severe inequality.

New philosophy

As far as shrinkage in output is concerned, it is the unavoidable lockdown that needs to be blamed rather than the government’s mismanagement of the economy. The associated inequalities though cannot be delinked from policy and, as political opponents will argue, COVID-19-linked income inequities ought to have been addressed through higher taxation of the rich. Even though such criticism does not lack wisdom, it appears that the philosophy underlying the government’s economic policy framework has changed, a change that has not received adequate attention. In what follows, we shall address the issue from a pure economist’s point of view.

In this context, it is well worth our while to pursue Volume 1 of the Economic Survey 2020-21. Chapter 2 of the document considers the basics of fiscal policy with reference to Olivier Blanchard’s 2019 presidential address to the American Economic Association. Professor Blanchard’s view may appear to run counter to our own Fiscal Responsibility and Budget Management (FRBM) Act, according to which the fiscal deficit must be capped under 3.5% or so. The idea underlying the prescription was that a fiscal deficit automatically transformed to government debt. Such debts along with their servicing liabilities have a tendency to magnify over the years, thereby imprisoning governments in debt traps, where present borrowings keep increasing to repay past borrowings and service charges. This leaves little room for growth enhancing expenditure and reduces a government’s credit worthiness in the eyes of lenders.

Professor Blanchard, and following him the Economic Survey, propose a different viewpoint altogether. Debt-financed fiscal spending, according to them, could well be a driver of growth. It can improve the standard of living of the entire population, without necessarily removing inequality. The inequality, however, could well be benignant, for even though the rich will grow richer, the poor will escape out of poverty.

A government’s fiscal expenditure, Professor Blanchard points out, has stronger multiplier effects during recessions than during booms. In an economic boom, state expenditure may crowd out private expenditure on account of a rise in the interest rate. During recessions, private expenditure is low in any case, on account of a rise in precautionary savings and the grim state of long-term expectations. The government, however, is not affected by such psychological constraints. Its fiscal expenditure produces positive growth and this in turn can generate a feel good factor for the private sector over time, raise animal spirits, and improve the state of the economy.

Blanchard’s argument

What, however, constitutes the government’s spendable resource? The obvious answer is debt, or the fiscal deficit itself. What will prevent the government from sinking into a debt trap? Professor Blanchard shows that the debt-to-GDP ratio can be prevented from exploding if the rate of growth of GDP happens to be higher than the sovereign rate of interest. This is the case in developed economies. In such economies, debt financed government expenditure will create a positive primary surplus (defined as the total government receipts minus expenditure net of interest payments) out of which interest payments can be made to keep the debt-GDP ratio under control. There will, of course, be a maximum value that this ratio can attain, a value that is higher the larger is the excess of the growth rate over the interest rate.

According to the Economic Survey, India’s average interest rate and growth rate over the last 25 years (leaving out FY 2020-21) have been 8.8% and 12.8% respectively. Hence, Professor Blanchard’s condition is satisfied, so that debt financing of recession ought not to raise FRBM issues involving fear of future taxation to address past debts. To some at least, the argument may sound like an excuse for not resorting to higher taxation of the rich to remove economic inequality.

The philosophy of the Economic Survey, on the other hand, appears to be that expenditure causes growth, rather than distributional equality. With improved growth, standards of living will rise across the population, bringing affluence of a sort to the economically deprived even as it makes the rich grow richer.

This, of course, is not to support excise duty increases, for it goes against the very principle of the Blanchard argument, which emphasises maintainable debt and expenditure as the vehicle of development as opposed to increased tax burdens. Therefore, there appears to be a contradiction between the government’s announced fiscal policy stance and the fiscal regime it is actually running. But then, Professor Blanchard’s argument requires the growth rate to exceed the rate of interest, which was not the case in FY 2020-21.

Dipankar Dasgupta is former Professor of Economics, Indian Statistical Institute, Delhi and Kolkata

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Printable version | Oct 28, 2021 6:21:19 PM |

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