Growth must go on: Going slow on stimulus rollback: Mint 28th February 2011

The government appears to be firm on rolling back the fiscal stimulus at a time when the investment climate looks shaky.

The Economic Survey in a way sets the prelude for the Union Budget in so far as it broadly provides the goals to be targeted. While talking of sustainable growth and stable inflation are metaphorical bromides in any document, they are significant this time as the circumstances are singular.

We now have a situation where growth has been maintained in fiscal year 2011 at 8.6%, but inflation remains a worry. The fact that core inflation—which is non-food, non-fuel inflation—is increasing has implications for monetary policy, which will remain hawkish. The government appears to be firm on rolling back the fiscal stimulus at a time when the investment climate looks shaky. The survey talks of the cost that we have to bear in terms of higher inflation when we speak of sustained growth. Are we to infer that growth would be the priority this year? If so, what should we expect from the Budget to ensure that growth is on course?

The survey talks of 9% growth in FY12, while most experts, including the International Monetary Fund, have forecasted a slower pace than the one in FY11. In any case, the 9% figure is based on an academic exercise—juxtaposing the FY10 capital formation number with an incremental capital output ratio (ICOR) of 4.1. Curiously, the Central Statistical Organisation’s number for capital formation in FY11 is lower than that in FY10. But, as we are talking of 9% gross domestic product (GDP) growth, let us see what the Budget can do.

For the Budget to influence growth, one has to take a Keynesian expansionary stance, which is difficult if we have the shadow of a stimulus rollback behind us. Therefore, we have to work within the confines of the rollback, which means a declining fiscal deficit to GDP ratio. The Survey has lowered the fiscal deficit for FY11 to 4.8% from 5.5%. This is because the denominator (GDP at current market prices) was revised upwards due to high inflation and new wholesale price index base year prices. Therefore, for the fiscal deficit ratio to be lower in FY12, there has to be a downward adjustment in the numerator at a time when the denominator will have a downward inflation bias.

This is the crux because if the deficit has to be lower, then either tax collections must increase or expenditure must decrease. Tax collections will increase on their own if growth takes place, thus offering a higher taxable base under unchanged tax conditions.

On the other hand, to bring about growth in GDP, we will have to lower tax rates. But there are limitations here, given our commitment to the goods and services tax and the direct taxes code, which have set the perimeter for policy. If rates are lowered, we can expect the Laffer theory to come into effect, wherein lower taxes stimulate investment and production, which leads to higher growth, which in turn leads to better tax collections. With inflationary pressures being exacerbated by high oil and metal prices, lowering excise rates selectively is an option to boost specific sectors and control inflation. Also, tax benefits on investment are pragmatic at a time when investment appears to be stagnant. One must remember that this year we will not have the buffer of 3G collections or higher disinvestment.

The other option is to work on expenditure, which is more direct and effective. But even here, there are constraints. A large part of expenditure is committed, such as interest payments and subsidies. These, for all practical purposes, cannot be rolled back. The government must make its expenditure work more efficiently so that it leads to higher productivity and growth. Here, the way would be to refocus the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) to more productive areas where capital is created. Considering that the government has to make agriculture more resilient, a prudent move would be to direct the Rs. 40,000 crore allocation to MGNREGS in FY11 to the creation of facilities such as warehouse chains, improved farming and so on. The wage-materials ratio for MGNREGS can be changed to wage-capital in the new scheme of things. This way, fixed revenue expenditure can be capitalized partly without changing the overall expenditure level, but by making it work more efficiently.

Any other capital expenditure to stimulate growth has to go beyond the existing framework and increase the deficit as investment expenditure has a lagged effect on output. Last year, the government had targeted an increase of 35% in its capital expenditure, which should be sustained. Focus on rural and general infrastructure will provide backward links to industries such as basic, capital and intermediate goods to propel growth.

The economic environment today is challenging for growth, with high inflation, interest rates, rising current account deficit and subdued capital markets acting as barriers. To maintain growth, the government has to take the lead, because monetary policy will remain cautious as long as inflation lingers. Private sector investment will remain subdued until economic conditions improve. Therefore, selective Keynesian prime pumping through tax incentives, probably capital expenditure expansion and capitalization of revenue expenditure should be done to make money work better. This may compromise the fiscal deficit a bit. But if it enables higher growth, the outcome will be worth the effort. The momentum will be maintained, which will finally matter.