An expansionary consolidation

The Budget can generate an expansionary fiscal impulse even as it consolidates the headline deficit

At the best of times, budget-making has to carefully balance fiscal sustainability with the needs of the business cycle. In a post-Covid world, however, these trade-offs will get much more acute for emerging markets. They must simultaneously grapple with unwinding — often large — crisis-induced fiscal support while still staring at incomplete recoveries down the line.

In the case of India, the recovery is proceeding faster than previously envisioned because India has been able to successfully break the link between mobility and virus proliferation, and we expect this to be complemented by stronger government spending in the second half of the fiscal year. Alongside that, however, exist signs of discernable scarring in the labour market. A more bifurcated recovery, in turn, — with smaller firms and workers at the bottom of the pyramid disproportionately impacted — raises questions about the sustainability of demand once pent up pressures are exhausted. Of the many insidious fallouts of Covid, perhaps the most economically salient is the relative income shift from the bottom of the pyramid to the top that is playing out globally. Inequality concerns apart, this is demand-impeding in the steady state, given the higher propensity to save at the top. Against this backdrop, can India’s consumption growth go back to its 7 per cent pre-Covid average sustainably? To be sure, the global backdrop will improve with more US fiscal stimulus and progressively-vaccinated developed economies. But will an export pick-up, if juxtaposed against uncertain domestic demand, be enough to stoke a private investment revival in India, given that manufacturing utilisation rates were sub-70 per cent pre-Covid? Or will firms look through the next few quarters and remain cautious given the prevailing uncertainty? 

It’s against this backdrop that fiscal support cannot be withdrawn too quickly in 2021. Monetary policy was the prime mover last year but will eventually face diminishing returns, remains a blunt instrument and, to the extent it fuels more asset price inflation, can exacerbate inequalities. The baton must therefore pass from monetary to fiscal in 2021.

Central government spending rose from 12.2 per cent of gross domestic product (GDP) in FY19 to 13.2 per cent in the pre-Covid year, and we expect it to rise to about 15 per cent of GDP in FY21. To be sure, some of the increased share in FY21 is simply because the denominator (nominal GDP) contracted even as the numerator is likely to grow about 8-9 per cent this year. In FY22, it will be crucial to sustain this level of central spending (15 per cent of GDP) and, ideally, increase it, thereby imparting an expansionary fiscal impulse. Doing so won’t be easy, though. If nominal GDP grows 15 per cent in FY22 off a depressed base, as is widely expected, then government spending will need to grow by that amount — almost twice the rate of FY21 — just to preserve its share of GDP. To be sure, non-interest spending rose 20 per cent in the pre-Covid year as a counter-cyclical response to a slowing economy, and it’s important to repeat that effort. Instead, if expenditure/GDP declines, that would impart a contractionary fiscal impulse, and potentially impede an incipient growth recovery.

Where should the spending be directed? Apart from ensuring enough funds for vaccine procurement and rollout, and adequate allocation to meet still-elevated MGNREGA demand, the leitmotif of the Budget must be a concerted public investment push — physical infrastructure, health and education. Not only would this boost demand, crowd in private investment, and improve medium-term competitiveness, but it will create much-needed jobs. It’s only the income certainty from job creation that is likely to reduce precautionary savings in the aftermath of Covid.

Illustration: Binay Sinha

Maintaining and raising spending, however, is only one half of the challenge. The other half is to do so while simultaneously reducing the headline deficit. Public debt/GDP is expected to rise to 85 per cent of GDP in FY21. The immediate sustainability imperative must therefore be to ensure debt/GDP first stabilises at these levels and then gradually asymptotes lower. In the coming years, the trajectory will matter more than the level. This, in turn, will require achieving a deft balance between reducing the primary deficit but not choking growth potential in the process. If India’s medium-term real growth settles at 5 per cent, even a rapid fiscal consolidation will not be enough to prevent debt/GDP rising for the rest of the decade. In contrast, medium-term growth of 7 per cent in conjunction with a gradual consolidation to pre-Covid levels (say, over the next three years) would ensure a declining debt/GDP path for the rest of the decade. Consolidating too quickly, if at the cost of medium-term prospects, can counter-intuitively be counterproductive for fiscal sustainability.

That said, primary deficits will still need to come down to pre-Covid levels. The new global fiscal orthodoxy that debt is sustainable as long as nominal GDP growth (g) exceeds borrowing costs (r), is only true when primary deficits disappear or are very modest, and therefore not yet applicable to India.

The question therefore is how to impart an expansionary fiscal impulse (increase expenditure/GDP) while reducing the headline deficit from an expected 7 per cent of GDP this year to about 5.5 per cent of GDP next year? By relying on a potentially-strong automatic stabiliser response from tax revenues along with doubling down on asset sales. Gross tax/GDP — net of excise duties on petroleum products and the effects of the corporate tax cut — has declined by almost 1.5 per cent of GDP since FY19 on account of the slowdown. Given the observed non-linearity between taxes and growth (we expect non-excise taxes to decline about 13 per cent this year on a nominal GDP contraction of 3-4 per cent), a sharp rebound in nominal GDP next year, is likely to pull up the gross-tax GDP ratio by 0.8-1 per cent of GDP, especially given the increased formalisation that Covid is triggering. If this can be complemented by a big push on asset sales (disinvestment, strategic sales, infrastructure monetisation) which garners an extra 1 per cent of GDP, then the headline fiscal deficit can be brought down by 1.5 per cent of GDP, even as expenditure/GDP is increased.

One unappreciated wildcard is rising crude prices. The increased excise duties on gasoline and diesel will generate a hefty 0.7 per cent of GDP in revenues in FY21. But if crude prices continue to climb, this will create unenviable choices between continually passing the price increases to consumers — and impinging on household purchasing power — or cutting duties and complicating the fiscal math.

All that said, unprecedented crises create unprecedented opportunities. A big public investment push financed by asset sales will allow the Budget to drive an expansionary consolidation, thereby nurturing the recovery without compromising on stability.

The writer is chief India economist at J P Morgan. All views are personal