Why policymakers should not use fiscal deficit as a guide to public policy

By Arindam Banik & Paromita Mukherjee

According to economic theory, fiscal rules can help governments build a reputation for fiscal discipline. This, apparently, mitigates the bias towards higher budget deficits and debt accumulation that characterises the political process of budgeting. This may also positively impact a country’s sovereign rating and benefit the corporate sector in case it decides to borrow externally.

According to the latest Budget, the fiscal deficit was 3.5% of GDP in 2017-18. This is estimated to be reduced to 3.3% in 2018-19. Policy entrepreneurs are worried. But they support tax cuts and, in the process, this may add to the deficit.

But, arguably, large deficits won’t wreck the nation’s finances. The question is whether India invests crores to firm up its substandard infrastructure and offer universal healthcare medical benefits, or shed tears demanding fiscal prudence. The idea of deficit is to spend more on the provision of public good that may lead to increase in future revenues, as spending on structural reforms and productive investment have a multiplier impact on growth.

The plight of the rural poor in eastern India, for example, may be explained by issues related to water management. Agriculture in the high rainfall and flood-prone eastern Gangetic plains area is largely rain-fed, with limited supplementary irrigation. The region also became economically disintegrated due to Partition in 1947. The region is desperately looking for public investment in water management.

Here, policymakers should not use deficit as a guide to public policy. Instead, they should be concerned about delivering investments in water management. The same argument holds for education, technology and infrastructure. This will sensitise both manufacturing and services demand and, in the process, spur employment generation.

Some may argue that many desirable structural reforms — such as tax, welfare, public investments projects, labour and product market reforms — may be required and lead to higher deficit and, therefore, are in conflict with the requirements of tight budgetary rules. China provides a model.

Economic liberalisation in China in 1978 brought radical changes, with large sections of the population benefiting with a significant decline in poverty. Reforms in agriculture led to a large growth in the sector, which, in turn, led to a large reduction in rural poverty. How was that possible?

When government spends more than it earns in taxes, a deficit is generated in the official balance sheet. But this is only part of the story. Typical double-entry book-keeping portrays the rest of the picture.

The expenditure of, say, Rs 100 by a government comes from, say,  Rs 90 as tax collection. Another Rs 10 is borrowed from other sources. That implies that the Rs 10 deficit is always harmonised with Rs 10 from other sources.

There is no contradiction due to adding up and the balance sheet, well, balances. Policy entrepreneurs will still find mystery in this. No private entity in India can commit to large-scale infrastructural investment unless it has the labour, machinery, steel and concrete.

We have resources and may use local currency, bonds or sovereign debt instruments to meet the financial challenges. This may create demand-driven inflation. Hence, hackles will be raised.

So, the key question becomes: how can macroeconomic institutions be designed in India so that the outcomes of these complex interactions will result in welfare-enhancing macroeconomic performance? Not that we forgo these institutions altogether to feed the bogey of deficit.

The writers are director and academic dean, respectively, International Management Institute, Kolkata

DISCLAIMER : Views expressed above are the author’s own.

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