Issue

Context

As India’s economic slowdown has intensified, so has the debate on whether the government should stick to fiscal consolidation or run a higher deficit to push growth. We examine here the fiscal situation of the economy, and understand recurring concepts like off-budget liabilities.

Background

• Slowing economy: India’s economic growth decelerated to a six-and-a-half-year low of 4.5% in the September quarter.
• Manufacturing sector growth has contracted.
• Core sector growth has contracted.
• Growth in non-food credit is slow.
• Employment data is dismal.
• Many agencies have downgraded India’s growth forecast.
• Tight fiscal situation: Government had reduced its fiscal deficit target to 3.3 per cent of the GDP for 2019-20 from the initial estimate of 3.4 per cent of the GDP in the interim Budget presented in February.
• However, the fiscal deficit overshot the budget estimate for the entire year.
• Even after taking into account the windfall gains in non-tax revenue, following the transfer of surplus reserves from RBI, and even without accounting for any off-budget liabilities, the fiscal deficit could be between 3.9 - 4.2% of the estimated GDP.
• This number can be higher if the off-budget liabilities are included.

Basic economic concepts Growth stimulus: An economic stimulus is the use of monetary or fiscal policy changes to kick-start growth during a recession. Governments can accomplish this by using tactics such as lowering interest rates, increasing government spending, and quantitative easing, to name a few. Fiscal deficit: The difference between total revenue and total expenditure of the government is termed as fiscal deficit. It is an indication of the total borrowings needed by the government. Gross Domestic Product: It is the monetary value of all finished goods and services made within a country during a specific period. Recession: An economy that is seeing negative growth rate or shrinking GDP for two consecutive quarters may be considered to be in a recessionary phase. A recession may be the outcome of tight monetary and fiscal policies aimed at controlling inflation. Depression: When recession is severe in terms of the contraction in GDP and extends over a longer period of time, it turns into a depression. Stagflation: Stagflation is a period of high inflation in a period of slow economic growth. Typically, costs push inflation, caused by supply side issues, or excessive liquidity in the system cause such inflationary conditions. Higher prices affect demand and further aggravate economic slowdown. Policy prescriptions in a situation of stagflation can be tricky since increasing interest rates to control inflation will make it difficult for the economy facing slowing growth to recover. At the same time, keeping rates low to support recovery may exacerbate the inflationary situation. Tax buoyancy: Tax buoyancy refers to the responsiveness of tax revenue growth to changes in GDP. When a tax is buoyant, its revenue increases without increasing the tax rate. Multiplier effect: The multiplier effect refers to the proportional amount of increase in final income which results from an injection of spending. Easy monetary policy: An easy money policy is a monetary policy that increases the money supply usually by lowering interest rates. It occurs when a country's central bank decides to allow new cash flows into the banking system. Counter-cyclical fiscal measures: These are policy measures which counteract the effects of the economic cycle. For example, when the economy is slowing it includes increasing government spending or cutting taxes to help stimulate economic recovery.

Analysis

Industry’s demand for fiscal stimulus

• Industry demand: Businesses are clamouring for a government stimulus to restart the investment cycle.
  • Private sector itself is not able to drive growth in the economy due to liquidity crunch on account of crisis in the non-banking financial company (NBFC) sector that is acting as a hurdle for private investment.
  • The demand for fiscal stimulus by industry is more by way of higher government spending on infrastructure sectors such as roads and railways that could have a multiplier effect on downstream industries and the economy as a whole.
• While businesses are clamouring for a government stimulus, the government has very little fiscal space for any significant growth stimulus.

Reasons for small fiscal space

• Economic slowdown: The spike in deficit numbers is largely on account of a pronounced slowdown in revenue, exacerbated by economic slowdown. Total revenue receipts are short of the budgeted amounts.
• Low GST collections: As the economy has slowed, so have tax collections. GST revenue collection has been slow owing to operational difficulties.
  • Estimated shortfall is more than ?1 trillion.
• Low direct tax collections: Government’s net revenue growth from direct taxes has decelerated sharply reflecting low tax buoyancy in the wake slowdown in economy.
• Low disinvestment receipts: Disinvestment receipts are likely to fall short of the target this fiscal year.
• Compensation cess gap: With state goods and service tax (SGST) collections also taking a hit, the compensation cess collections of the government is falling short of compensation requirement of states.
  • And union government may have to use its own exchequer to make up for any such shortfall, and fulfil its constitutional guarantee to the states.
• Corporate tax cut: The effective corporate tax rate came down from around 35% to 25%. While it was done with the intension to revive demand, it did not happen. It in fact further tightened the fiscal space of the government because of shortfall in corporate tax revenue.

Non-tax revenue options for the government

• Slowing revenues prompt the government to tap non-tax revenue options.
• Dividends and surplus: Given that tax revenue side appears bleak, among the non-tax revenue options, dividends and surplus from the RBI, banks and financial institutions and public sector enterprises are crucial to meet revenue requirements.
• Issuance of overseas sovereign bonds in foreign currency: Unlikely to be implemented due to criticism.
• Expenditure cuts: Expenditure cuts can help government meet fiscal targets, but it could be detrimental for the already slowing economic growth.
  • Government has incurred a lower capital expenditure (capex) as revenues declined.
  • Decline in investment activity evidenced by a nearly 30 per cent drop in capex in June 2019 quarter.
• Transfer of surplus reserves from RBI: In line with recommendations of the Bimal Jalan Committee RBI transferred ?1.76 trillion to the government this fiscal year.
  • Some of these funds were used to recapitalize public sector banks.
  • Excess money was reserved to meet the expected shortfall in tax revenues.
  • This will help contain any fiscal slippage in FY20.

Operation twist: Lately RBI launched operation twist to bring down long term yields, help government borrow cheap money against its bonds, and thereby induce demand for private sector loans (read PT article on Operation Twist).

Off-budget liabilities

• Off-budget financing: It refers to expenditure that’s not funded through the budget. Off-budget liabilities are basically ‘withheld payments’.
  • Deferred payments are not considered as expenses, and the government takes advantage to defer these payments to one of its ‘own’ firms.
  • It may also undertake borrowing which are not included in government’s debt.
• Why is it done: Comptroller and Auditor General (CAG) of India have many times pulled up the government for increased use of off-budget financing for schemes and subsidies in order to comply with the Fiscal Responsibility and Budget Management Act.
  • Since it remains outside the budget, there is little parliamentary control on such spending.
• Budget implications: Off-budget financing by its nature isn’t taken into account when calculating fiscal indicators. Such financing tends to hide the actual extent of government spending, borrowings and debt and increase the interest burden.
  • If the government’s off-budget liabilities are taken into account the ‘real’ deficit of current fiscal would shoot up to 5.5% of GDP.
• Examples: Off-budget liabilities are basically payments withheld by the government; Examples include:
  • National Small Savings Fund (NSSF) loans to public entities (as FCI, NHAI, and IRFC) and government-serviced bonds.
  • Unpaid food subsidy bills to FCI (avails NSSF loans to run operations).
  • Covering the fertilizer bills through special banking arrangements.
  • Borrowing from NABARD under the Long Term Irrigation Fund to implement Accelerated Irrigation Benefits Programme.
  • Creating special purpose vehicle (SPV) to construct a bridge (or other activities). The SPV will likely borrow money on the strength of a government guarantee.
• CAG suggestions: A policy framework for off-budget financing that should include disclosures to parliament about the amount, rationale and objective of such funding.

Should India opt for fiscal stimulus?

• Empirical results: During episodes of systemic banking crisis in advanced and emerging market countries during 1980-2008, timely countercyclical fiscal measures contributed to shortening the length of banking crisis episodes by stimulating aggregate demand.
• Fiscal consolidation: But given India’s high debt situation, it should stay the course on fiscal consolidation path. It is important that the deficit stays within target.
• There is also a risk of inflationary pressures building up.
• Avoid fiscal stimulus, opt for easing policy: According to the IMF Indian government should avoid a fiscal stimulus to boost the sagging economy and, instead, opt for an easier monetary policy.
• Given cyclical weakness of the economy, in near-term, monetary policy should maintain an easing bias, at least until the projected recovery takes hold.
• Fiscal stimulus should be avoided, given that the fiscal space is at risk.
• Temporary fiscal stimulus: In the event of a more severe economic slowdown than currently envisaged, any fiscal stimulus should be temporary, focusing on measures to boost near-term growth, such as immediate investment or public infrastructure spending.

Policy suggestions

• Reformative budget: Taking government borrowing together with public sector borrowing, there is there is little space for any fiscal expansion. It is important to do policy changes, focusing on ease of doing business, and structural reforms that catalyse private investments.
• Increasing government consumption: Stimulus packages that rely mostly on measures to support government consumption are more effective in shortening the crisis duration, than those based on public investment.
• Reducing consumption taxes: Reducing the share of income taxes is less effective than reducing consumption taxes; as the later can help boost consumer spending, increase investment sentiments and thereby ease the banking crisis.
  • IMF said that personal income tax collections could be increased by ending exemptions, reducing the minimum threshold for taxpayers, and by raising contributions of top earners (Ex. Surcharging their income).
• Medium term measures for fiscal consolidation:
  • Subsidy-spending should be rationalized.
  • Tax-base should be enhanced.
  • Revenue projections should be more realistic.
  • Fiscal transparency and budget coverage should be enhanced.