The problem with government spending

Political parties must be upfront about how they plan to finance the additional spending promised in their manifestos

The one certainty about the next government, no matter which party helms it, is that it will spend more than its predecessor. Political parties may have differences in spending priorities — Congress may spend more on redistribution, the Bharatiya Janata Party more on infrastructure — but even a cursory look at the manifestos for 2019 shows that there is unanimity on the need for the government to spend generously. In a country which is still poor (per capita income of only $2,000) and where market failures may exist (particularly in the social sector), there may indeed be a case for government interventions. But political parties must be equally upfront on how they plan to finance this spending, because that has consequences for economic growth.

The obvious way to finance more government spending is to raise taxes. Some US-based advisers to the Congress have already hinted at that. In the Indian context, two points should be noted on the perils of such a strategy. First, the direct tax base remains extremely narrow so raising rates amounts to squeezing the minority which is complying with tax laws. If anything, higher income tax rates/corporate tax rates would incentivise people to drop out of the tax net rather than come in to it. Needless to say, it also discourages wealth creation which is the only way to power growth in the long term. Second, any attempt to raise resources through indirect taxes is regressive (because everyone pays the same rate regardless of income) and unlike most advanced economies, India already raises much more revenue from indirect taxes than direct taxes. 

An alternative strategy would be to increase government borrowing. This may be a more sustainable strategy for spending on productive investment than on redistribution which generates no return. Regardless of that, higher government borrowing has real negative consequences for the rest of the economy. It crowds out the more efficient private sector from the resources available in the economy. It puts upward pressure on interest rates which is a deterrent to private investment. And, in the end, it pushes the burden of repayment on to a future generation which will have to pay higher taxes.

The best way for the government to finance its spending is by the economy achieving double-digit growth. For this, the government should actually contemplate lowering tax rates — the top rate of corporate and individual tax should be no more than 25 per cent, including cess; top rate on goods and services tax should be no more than 18 per cent — and lower borrowing requirements, which would boost private investment.

But how does that square up with increasing government spending? Governments need to realise that the way forward isn’t about spending more or less, but spending better. There are some parts of government spending that need to be cut. 

Does the government really need to spend on loss-making public sector companies? There is no economic justification for the government to spend tens of thousands of crores on Air India, BSNL and MTNL (and several others). There is no market failure in the aviation or telecom sectors. In fact, a competitive private sector has taken both telecom and air services to sections of the population that were never serviced in the era of government monopolies. The next government must either sell or close these companies, through the National Company Law Tribunal route, if necessary.

Illustration: Binay Sinha

Public sector banks, many of which are drowned in non-performing assets, should also be freed from government control. Not only would it save significant spending by the government, it would also bring efficiency to the economy. There is no need to divest these banks to a single promoter. The aim should be to create listed, widely-held entities which are managed by independent boards and professional management. 

The government needs to abolish some large centrally-sponsored or central sector schemes which either duplicate effort or are very leaky. Since both the major political parties have philosophically accepted income support interventions via direct benefit transfer, it would be possible to end mega, leaky schemes/subsidies like MGNREGA and the public distribution system. In fact, the government should identify three or four schemes it must run, say in education, health and nutrition/childcare and ramp up spending in these while cutting down on other schemes. In any case, state governments are far better placed than the Centre to run most welfare schemes which must be designed to cater to specific local problems.

The first 100 days strategy of the next government must be headlined by a “Spend Better” plan which is not just a routine bureaucratic exercise but backed by full political support, possibly steered by a group of ministers. Its mandate should be to achieve the “impossible” — tax less, spend more (only on some things).

The author is chief economist, Vedanta