Is The Fiscal Deficit Excessive Or Not?

Consider this quotation from the recent book by Vijay Joshi and IMD Little, India's Economic Reforms 1991-2001: Present fiscal deficits will very soon bring debt to levels that threaten stability and a loss of creditworthiness. Not only that, they are currently threatening growth. In order to contain inflation, the government is borrowing heavily on the market rather than printing money. This forces up interest rates to levels which must reduce investment. There is too much monetary restraint because there is not enough fiscal restraint.

This presents the hard-line argument in a nutshell. Joshi and Little forecast that, because of unsustainably large fiscal deficits, India is heading for another major crisis, although they do not spell out how they see such a crisis unfolding. They argue that the fiscal deficit should be reduced to 4 per cent of gross domestic product (GDP) from 5.9 per cent in fiscal 1995-96, that the revenue deficit should be zero instead of 3 per cent and that the primary account (fiscal deficit minus interest payments) should be in a surplus of 1 per cent of GDP instead of a deficit of 1.1 per cent last year.

 

A broadly similar, though less alarmist, view was presented in the Country Economic Memorandum of the World Bank, published last week. It said that the consolidated public sector deficit, at around 10 per cent of GDP, was an excessively high deficit which threatens the achievements of the last five years, constitutes a major destabilising force to the financial sector, and may deprive the country of the high growth that the reforms of the past five years could generate.

The Bank has hardened its position considerably since last year, and this apparently was deliberate. It wanted to warn the government to avoid complacency. Perhaps it also was seeking to assure the industrialised countries which provide official aid "" for whom the memorandum is written "" that it was keeping up the pressure on India's new government for further reform. This would bolster the Bank's argument that official aid should continue to be granted in spite of India's relatively comfortable economic and external position.

The common thread of the argument for further fiscal compression is that high real interest rates are both a harbinger of problems and a problem in themselves. At present the marginal real interest rate that the government pays on its domestic debt is close to the economy's growth rate itself, the bank says. Therefore, unless fiscal imbalances and thus real interest rates are significantly reduced, India will be in a debt trap and will not be able to maintain the current mix of low inflation and relatively high growth.

Still, the Bank is not presenting nearly as bleak a picture as those who see the need for even more urgent action on the fiscal deficit. In spite of its warning of a debt trap, it does not seem to forecasting a new crisis. It is essentially saying that inflation will rise and growth will slow unless the fiscal discipline is tightened, and therefore that enormous opportunities provided by the past five years of reform would go to waste.

High real interests rates, however, could be used to support the case for more rapid fiscal action. It could be argued that, while real interest rates are high, the risks are entirely on the up-side. Almost anything that could happen is likely to push them higher and to increase the likelihood of a debt trap. Economic growth has not yet run into the infrastructural barriers and capacity constraints which have been generally forecast "" although this is difficult to quantify, since it could be argued that growth would be much higher if India had better infrastructure. But if such barriers did become apparent, they could push up inflation and put pressure on the government to restrain demand "" through higher interest rates. Equally, any trend towards above target money supply growth, or any exchange market worries about the rupee, would produce pressure for higher rates. Since a high real interest rate regime is inevitable and creates high risks for the economy, then why not eliminate the fundamental reason which causes them to be high in the first place "" that is, the high level of public borrowing? This would create a benign instead of a vicious circle.

The argument against all this has its devotees on this newspaper. They say that, with the primary deficit eliminated and the fiscal coming down to 5 per cent this year and perhaps 4 per cent next year, what's the worry? At current levels of interest rates and growth, they deny the existence of a debt trap, but they do agree that the revenue deficit must be tackle: what fiscal compression there has been since 1991 has been primarily at the expense of necessary capital expenditure, and this needs to be corrected. They do not deny the need for fiscal discipline, better direction of public spending, continued tax reform, and revamping of Centre-state fiscal relations. But they also argue that it will be extremely hard to produce a big change in the fiscal balance given that a good deal of expenditure is spoken for (interest payments, defence, wages and salaries) and it will be hard on both political and economic grounds to bring any significant increase in revenue.

This is where the Joshi and Little school take strong issue. The two authors say that: We think there is considerably more room for manoeuvre..which is not to say that there are not substantial political difficulties in doing so.

On taxation, there is plenty of scope for increasing the yield of taxation further without compromising efficiency. They note that only about eight million people pay income tax "" less than one in a hundred when the middle class is estimated at between 100 and 200 million. It is to be hoped that much better administration, fiercer penalties for evasion, and a broadening of the tax base by closing legal loopholes will eventually result in a large rise in the revenue from direct taxes, say Joshi and Little.

They also argue for less reliance on excise duties and the introduction of VAT for cutting of subsidies, through the withdrawal of universal entitlement to food subsidies and better targeting, and reduction of fertiliser subsidies which in any case do not reach the very poor. Joshi and Little seek a freeze on new public employment and pay restraint in the public sector, the removal of massive hidden subsidies such as on electricity and water, and sale of public enterprises and land, with the proceeds to be used as retire debt "" automatically reducing interest payments which force up the fiscal deficit so much.

The political obstacles to all this are of course enormous. Perhaps the last option "" extensive disinvestment "" might in fact be the least problematic and would have the fastest effect on the deficit. Even if you think the deficit level is comfortable, it would still be no bad thing to reduce it.