Poor fiscal management main cause of slowing growth, sticky inflation

By R K Pattnaik & Preeta George
The Indian economy in the post-crisis period has been characterised by deceleration in growth and persistent inflation. The main contributing factor to such economic malaise is poor fiscal management.

Even under the given Fiscal Responsibility and Budget Management ( FRBM) Act, the Indian authorities were unsuccessful in adhering to the golden rule of government finance, that is, the elimination of the revenue deficit. Thus, the borrowings by the government are pre-empted for meeting current consumption expenditure. The continuation of revenue deficit has adversely affected growth through dissaving of the government. Furthermore, this has led to a lower provision for capital outlay. Inflation management is difficult as the expenditure pattern of the government fuelled the demand side, thereby making monetary policy ineffective. It has also constrained the scope of fiscal space.

Markets have cheered recent policy reforms announced by the government. These measures have the potential to mitigate downside risks of macroeconomic management but growth and inflation risks remain. The announcement of disinvestment of PSUs will ease the fiscal situation a little. FDI reforms will brighten up sentiments and help the rupee appreciate a bit. Nevertheless, the major threat leaning on the fiscal side remains, as the growing revenue deficit is alarming.

The arithmetic of fiscal sustainability: Our empirical exercise reveals that the tax buoyancy for the Centre is around 1.35 and the total revenue buoyancy is 1.17, whereas the expenditure elasticity is 1.22. This indicates that an elimination of revenue deficit in the medium term looks difficult unless tax buoyancy is further increased with emphasis on minimising the structural component. In non-interest revenue expenditure, the structural component predominates. However, the share of development expenditure in this category is lower than the non-development components.

The persistence of revenue deficit accentuates the vicious cycle of deficit and debt. The current debt GDP ratio at around 50% for India seems to be lower in comparison to European economies, US and Japan. However, a sheer low number is meaningless until the sustainability factor is suitably addressed by elimination of revenue deficit.

Federal finance and fiscal management: In a federal set-up like India, the analysis of fiscal sustainability is incomplete without addressing underlying issues in state finances. Evidence suggests that fiscal consolidation in terms of reduction in revenue deficit has been more encouraging in case of state governments. However, our technical analysis suggests that this improvement has been achieved to a large extent by the Finance Commission awards. Thus, the indicative ceiling on overall transfer to states on the revenue account is set at 39.5% of gross revenue receipts of the Centre on the basis of the recommendation of the Thirteenth Finance Commission. Thus, the elimination of revenue deficit will have implication for state finances in terms of the tax devolution to states as well as grants-in-aid to states. For example, the share of grants in the total transfer has come down from 18.9% to 15.1% from the Twelfth to Thirteenth Finance Commission. What are the options before the Fourteenth Finance Commission (2015-20)?

First, revisit the fiscal consolidation process to recommend a revised fiscal architecture emphasising the structural component of both revenue and expenditure. In this context, the Fourteenth Finance Commission may consider an exercise of decomposing the fiscal deficit into its cyclical and structural components for both the Centre and states. This facilitates policy clarity to address structural rigidities and reduce the conventional dependency on the business cycle model of fiscal management. It will also make headroom for fiscal space.

Second, re-examine the tax devolution formula keeping in view the goods and service tax ( GST) model.

Third, examine the end-use of grants given by the Centre to the states. This is important because the government of India has introduced a concept called effective revenue deficit (revenue deficit minus capital grants to state governments) claiming that a large part of grants to states are for capital expenditure. In the present Budget accounting practice, these grants are classified as non-tax revenue of the state governments, giving a wide scope for flexibility in spending. It is for the consideration of the Fourteenth Finance Commission to prescribe an inbuilt mechanism like that of 'capital budgeting' to check the end-use of these grants.

Fourth, non-adherence to FRBM has not been accompanied by any penalty. The Fourteenth Finance Commission may consider examining the pros and cons of making FRBM a constitutional necessity.

To conclude, fiscal sustainability through FRBM could be instrumental in generating the required fiscal space to address the inflation growth trade-off.

The authors are professors at SP Jain Institute of Management & Research