The debate in the US highlights the need to be realistic about the impact of a stimulus package, says Abheek Barua.
There is some confusion about what today’s interim budget will contain. Legal experts suggest that there is no constitutional bar on announcing either tax or spending changes in an interim budget. Precedent would however suggest that it will be silent on tax policy and prefer to continue the status quo. They could and are likely to, this time, contain significant changes in expenditure. The consensus view seems to be that apart from increasing allocations for ‘maintenance’ expenditure for the day-to-day running of government (until a new government tables its budget), today’s vote on account is also likely to contain more ‘stimulus for the sagging economy.
If there is indeed a stimulus package in today’s mini-budget, it would be the third in the past three months. The question then is: can these stimulus packages really reverse an economic downturn? If they are indeed effective, how soon can we observe some of the change in economic growth rate that they seek to bring about.To answer these questions, it might make sense to look at the mother of all stimulus packages — the new US administration’s whopping $800 billion fiscal package which the President is due to sign into law today.
The current avatar of the US fiscal package has its share of critics. While few Americans (barring some cranks in the ultra right-wing think tanks) who would argue that not doing anything at this stage is an option for the US government, there is a lively debate on the size, structure and contents of the package. Governments across the world that are thinking of cranking up their fiscal machines would do well to pay careful attention to some of the key issues in this debate.
But first, let’s get some basics out of the way. The American stimulus programme is not a one-off infusion of cash into infrastructure projects. It is a smorgasbord of tax cuts (roughly a third) and spending initiatives. Although it is heavily frontloaded with the bulk of the stimulus coming in 2009 and 2010, the stimulus continues until 2019. The increase in government spending will be on a diverse and somewhat befuddling range of programmes. While infrastructure gets the lion’s share of allocations, there is money earmarked for benefits for the jobless, a re-structured medical care programme, income support for distressed mortgage-holders and a whole lot of other things.
The US administration also has a plan to stimulate credit by cleaning up banks’ and other financial institutions’ balance sheets .This runs parallel to the fiscal initiative but should not be confused with it. Its price-tag seems a little high — the last figure mentioned by Treasury Secretary Geithner added up to $1.5 trillion. However a large part of this would be funded by creating money (not from taxpayers’ incomes) with the central bank lending heavily to the private sector against a wide range of collateral.
The key debate on the fiscal package revolves around the share of tax cuts or rebates offered in the stimulus. Republicans want more tax breaks; Democrats want less and are pushing for more public spending. While this does represent an ideological divide, there is some hard economics involved. Those who argue against tax breaks fall back on the predictions of conventional consumption theory — consumers smooth the spending increase, reserving most of it for future consumption, by saving it or using it to pay down debt. Households also tend to increase ‘precautionary’ savings during period of uncertainty like a recession — the US personal savings rate has incidentally shot up from 0.4 per cent in Q407 to 2.6 per cent in Q408. To cut a long story short, income tax cuts might put more money in people’s hands but there is no guarantee that this will translate into higher spending.
The other contentious issue pertains to the temporal pattern of spending. While the US fiscal stimulus package is indeed front-loaded, expenditures peak in 2010, not 2009. This implicitly acknowledges that things like infrastructure spending take a while to plan and implement. This is all too familiar a problem for Indian policymakers who can ramp up allocations but have to reconcile to problems of implementation. Critics of the US package argue that since the recession is likely to get worse in 2009, government spending has to be ramped up earlier and waiting for 2010 might prove a trifle too late.
If income tax cuts don’t necessarily work and project spending is vulnerable to planning and implementation delays, do policymakers have an option then? Economists argue that reducing sales tax or value added taxes is perhaps the quickest and most potent way to provide a quick stimulus. An influential paper by James Poterba, Julio Rotemberg and Lawrence Summers in the American Economic Review in September 1986 demonstrated the high potency of a sales tax (or VAT) cut as a stimulus. They studied the reverse situation, where a big increase in the British sales tax caused a severe recession. The problem with the US is that it does not have a national sales tax or VAT. However, most states have sales taxes and these could be reduced with the federal government compensating states for revenue losses.
What are the implications for Indian policy? If Messrs Poterba, Summers and Rotemberg are right, more cuts in CENVAT are warranted. The reduction in central excise in December for a number of products has been passed on to consumers and seems to have pushed up the demand for products like cars. One could perhaps even make a case for a cut in state sales taxes with the central government providing offsetting fiscal transfers.
Finally, the debate in the US highlights the need to be realistic about the impact of a stimulus. The projections that the US government has made about the impact of its policy initiatives are premised on a set of ‘multipliers’ computed by Council of Economic Advisers head Christina Romer and her colleague Jared Bernstein. These estimates have come in for criticism for being a trifle too optimistic. To know for sure whether Ms Romer or her critics have the correct set of numbers, one will unfortunately have to until the end of 2010.
The author is chief economist, HDFC Bank. The views here are personal
