Martin Feldstein, while addressing the Reserve Bank of India in 2004, remarked, Fiscal deficits are like obesity. You can see your weight rising on the scale but there is no sense of urgency in dealing with the problem. And, also like obesity, the more severe the problem, the harder it is to correct. The question that arises is what weight loss strategy should be adopted the quick-fix easy solution of slimming pills or the more arduous route of exercising regularly? The finance minister, while presenting the budget for 2010-11, has chosen the more arduous path and clearly spelt out the message of fiscal discipline to the nation.
The budget deficit of the central government stands at 6.8 per cent of GDP in 2009-10 and, this rises to about 10.5-11 per cent of GDP if deficits of subnational governments are included. The combined government debt is 82 per cent of GDP. Given these worrying figures, the decision to act on the fiscal problem was imminent and necessary. And, it is apparent that the finance minister has done so. Importantly, the fiscal consolidation exercise has not been done by cutting spending on social sector schemes and capital expenditure. Government spending on social sector programmes increased by 22 per cent to Rs 1,37,674 crore, or about 37 per cent of the total planned outlay of budget 2010-11. Non-plan expenditure, on the other hand, has been held down. The government expects to spend 66 per cent of total expenditure on non-plan activities during 2010-11 compared to 70 per cent in 2009-10.
To ensure fiscal discipline, the FM has cut subsidies and hiked duties in a manner that will imply an additional cost for consumers in the short run. There has been an increase in excise duty, which is a part of the exit strategy from the stimulus package that was put in place to combat the global slowdown. Continuing to keep these duties low would have meant a huge burden on public finances through government borrowings. The one measure, which has drawn the most criticism, is the increase in customs and excise duties on petrol and diesel, which in turn has led to a hike of Rs.2.71 and Rs.2.55 per litre respectively. The fuel price hike is being criticised for being inflationary.
This will lead to a slight increase in inflation in the weeks to come, but if this exercise had not been undertaken now and fiscal deficits were allowed to run high, inflation would have been even higher in the long run. Governments have two ways of meeting deficits. They can either issue bonds and raise money from the market or they can print money. Their ability to issue bonds is limited by their ability to service debt and the market appetite for government bonds. Monetising the deficit has a severe inflationary impact. The question, therefore, is should we tolerate slightly higher inflation today or be prepared to put up with much higher inflation in the future. Of course, there is a trade-off involved here. It could be argued that higher inflation today could well entrench inflationary expectations, but it is also the case that greater fiscal profligacy today signals that government may wipe out debt through higher inflation in the future.
Another important concern is the impact of fiscal deficits on private investment. In the aftermath of the crisis, it is mainly government and private consumption, boosted by the fiscal stimulus packages, that have driven growth. However, this cannot continue indefinitely and investment is imperative for growth. If the government keeps borrowing to fund its deficit, it will crowd out private investment and the RBI would run a tighter monetary policy, increasing interest rates. This will also widen current account deficits. Though increased interest rates may well attract more capital flows, for emerging economies on the path to recovery, there are challenges emanating from increased capital flows with ramifications for monetary growth, inflation and exchange rate stability. Controlling fiscal deficits in a timely manner will offer more scope for the RBI to run a looser monetary policy and make more credit available for the private sector.
The oil price hike will raise an additional Rs25,000 crores in revenues, and while some might argue that this may not make a very significant dent in fiscal deficit, this exercise signals that the government is serious about containing the fiscal problem. The success of fiscal consolidation depends, to a large extent, on the credibility of the government and people’s perception of the government’s commitment to fiscal discipline. It is, therefore, imperative that the budget involves some element of fiscal signalling. This budget does so by laying out a clear path of medium and long-term fiscal correction. It also outlines fiscal consolidation targets such as reducing government debt to 68 per cent of GDP by 2014-15 as recommended by the Thirteenth Finance Commission and promises to introduce the direct tax code and the good and services tax from April 2011.The decision to bring the subsidies through cash above the line brings greater transparency in fiscal accounting.
In conclusion, the finance minister needs to be applauded for moving towards fiscal prudence without jeopardising the country’s growth prospects. While this might lead to a slight increase in inflation in the weeks to come, it will save us from much higher inflation in the future and provide a more conducive environment for investment and growth.