Long road to fiscal consolidation

Union Budget-related commentaries are usually focused on the potential economic and financial market impact during the year. Since the economy has just recovered from an unprecedented shock, which dealt a mighty blow to public finances, it is important to assess medium-term possibilities for government finances and their implications as well. This is also essential because the government did not present medium-term fiscal projections, owing to continued global uncertainty. The government, however, has given itself a target of reducing the fiscal deficit to under 4.5 per cent of gross domestic product (GDP) by 2025-26.

As things stand, the government clearly has a challenging fiscal path ahead and will need to make sustained efforts over many years to attain Fiscal Responsibility and Budget Management (FRBM) Act targets. Let us first consider the target of 4.5 per cent of GDP. The target for 2023-24 is to reduce the fiscal deficit to 5.9 per cent of GDP from the current year’s level of 6.4 per cent, a reduction of 0.5 percentage points. The implicit target for the next two years thus is to reduce the fiscal deficit by at least 1.4 percentage points, or 0.7 percentage points per year. This would be difficult, at least because of three reasons. First, growth is expected to slow. The government has assumed a nominal growth rate of 10.5 per cent for the next fiscal year, which seems reasonable, though some analysts expect it to be lower. Lower growth affects tax collection and makes it more difficult to contain the deficit. As the global economy is expected to expand at a slower pace, growth in India may not pick up significantly in the coming years.
 

Second, a sharper fiscal consolidation could prove difficult in an election year (2024-25). Despite its commitment to consolidation, the ruling party may have to respond to the promises made by other political parties in the run-up to the Lok Sabha elections. The fiscal position in 2024-25 and beyond will also depend on the outcome of the 2024 elections. Third, recent history is not in favour. The Union government has been able to cut the gross fiscal deficit by 0.7 percentage points or more only four times since the FRBM Rules were adopted in 2004. One such year was 2021-22, when the government reduced the fiscal deficit by 2.46 percentage points, though on a very high base of Covid year. Notably, the government has not been able to attain consolidation worth 0.7 percentage points or more for two consecutive years.
 

It was, therefore, advisable to frontload consolidation in high-growth or recovery years. To be sure, the government did not target faster fiscal consolidation, partly because of its push to capital expenditure. Even though India needs large infrastructure investments, the government should have prioritised fiscal consolidation for at least two important reasons. One, large debt-financed infrastructure spending may not lead to the desired multiplier effect at a time when the economy is growing close to its potential. Two, it would anyway have to compress capital expenditure to achieve the desired level of consolidation in the coming years, simply because there are clear limits to the extent revenue expenditure, which is largely committed, can be reduced.
 

Further, even after reaching the 4.5 per cent mark, the government would need to continue on the consolidation path. This would be necessary mainly for two reasons. First, lower borrowing would be crucial for reducing the overall debt stock, which was estimated to have increased to about 90 per cent of GDP in 2021-22. In fact, the Centre’s debt stock is expected to increase marginally in 2023-24. A lower level of debt would help the government save on interest costs, which are absorbing over 45 per cent of the Centre’s net tax revenue. A lower interest outgo will allow the government to spend more on developmental needs.
 

Second, higher government borrowing crowds out the private sector. It is worth noting, unlike widely believed, the fiscal deficit target under the FRBM Rules (2004) was effectively based on available savings in the economy. The combined fiscal deficit of 6 per cent, split equally between the Centre and the states, was predicated on estimated available savings of about 12 per cent of GDP — household financial savings of about 10 per cent and the current account deficit worth 2 per cent of GDP. The available savings were divided equally between the public and the private sectors. Given the decline in the available household financial savings, the FRBM Review Committee (2017) argued in favour of a combined fiscal deficit of 5 per cent of GDP, again divided equally between the Centre and the states.
 

Since the government is expected to run a much higher level of deficit in the foreseeable future, it would restrict expansion in the private sector and might affect longer-term growth prospects. A significant revival in private-sector investment would thus have to depend on imported capital, which will affect external balance and increase financial-stability risks. Therefore, it is important to contain the fiscal deficit at reasonable levels. The biggest obstacle in attaining this objective will be the

stagnant tax-to-GDP ratio — 10-11 per cent for the Centre. Sustained expenditure compression, which is anyway difficult, could also affect growth. Since some of the big-ticket tax reforms, such as goods and services tax and the rationalisation of

corporation tax, have already been done, it is not clear what will push up the tax-to-GDP ratio. It is perhaps time for a comprehensive review of India’s fiscal position.