View: Don't shy away from running a larger fiscal deficit

Last week’s Union budget for 2021-22 targets a fiscal deficit of 6.8%. It might sound counterintuitive, but this target is too conservative. With GDP growth projected to be 14.4% as the economy rebounds from the Covid-19 economic shock, India has a rare opportunity to run a larger fiscal deficit without pushing the debt-to-GDP ratio higher.

India’s fiscal deficit zoomed from 4.6% of GDP in 2019-20 to 9.5% in 2020-21. The International Monetary Fund (IMF), rating agencies and India’s own Fiscal Responsibility and Budget Management (FRBM) Act, 2013, all may advocate a figure in the vicinity of 3.5%, which would suggest India is being reckless with a projected deficit almost twice as large with no end in sight. Against this backdrop, a fiscal deficit of about 12% of GDP is more appropriate for the country next year.

A target figure for a country’s fiscal deficit cannot be arrived at in a vacuum. A nation’s economic growth rate, current level of indebtedness — debt-to-GDP ratio — and target fiscal deficit are all interrelated. India’s debt-to-GDP is currently about 85%. It had held steady at about 68% for the previous 10 years, rising last year when the economy shrank and the fiscal deficit soared due to the stimulus, an understandable response. This new 85% debt-to-GDP proportion is a sound target for India for the next decade. Many G20 nations, including the US, Japan, Britain, and Brazil have debt-to-GDP ratios at, or above, this threshold.


With that target, and taking at face value finance minister Nirmala Sitharaman’s Covid-rebound GDP growth rate of 14.4%, we arrive at a fiscal deficit of 12.2% — equal to 85% debt-to-GDP times 14.4% GDP growth — that will leave the debt-to-GDP ratio unchanged. The principle behind this calculation is simple to follow and economically intuitive.

Private Spend, Public Good
Robust economic growth creates room for additional borrowing without jeopardising financial health. This is the same counsel financial advisers offer to individuals. Promotions and salary increases create an opportunity to invest in a bigger home, or better schooling for one’s children, without worrying about facing financial ruin.

Even if India desired to revert to its historical 68% debt-to-GDP, it could afford a fiscal deficit next year of about 9.8%. That leaves room for considerably more investment in a country starved of essential infrastructure.

Of course, debt-financed increased public spending raises the spectre of higher inflation and interest rates. Here, what matters is not the increased spending per se, but rather what the spending is for. Compared to developed economies with near zero or negative interest rates, India’s rates are high, about 6-8%, in good measure because of high inflation and high loan default rates. High interest rates increase debt servicing costs, which discourages additional borrowing. Unless government expenditures enhance productivity, they only fuel inflation. And, therefore, how the government spends is crucially important.

With new public spending, the temptation is there to crowd out private spending on short-term consumption goods with various subsidies and redistributive entitlement programmes because these are politically popular. While these increase consumption demand, they rarely yield productivity growth, and the result is higher inflation.

Sidestep the Inflation Trap The way to avoid the inflation trap from deficit financing is to direct the new public spending to areas where the private markets underspend because benefits are hard to capture or the operating cycle is long. For India, the big areas to target for public spending are critical public works — to allow, for example, for more stable electricity and faster transportation — and soft infrastructure. Examples of the latter include education, and legal and (de)regulatory infrastructure that facilitates the ease of doing business.

Expenditures designed to remove infrastructure and regulatory bottlenecks would spur the economy. Routing these expenditures through a competitive private sector would be even better as they would be helpful in realising efficiency gains.

To improve legal infrastructure, for instance, a good place to invest, with low risk of triggering interest rate rises, is in expanding the judiciary. Indian courts are notoriously backlogged and inefficient, slowing the timely settlement of contracts. According to one retired Supreme Court justice, there are about 33 million cases pending in Indian courts. A July 2014 Law Commission of India report, ‘Arrears and Backlog: Creating Additional Judicial (Wo) Manpower, suggested doubling the size of the judiciary by adding about 20,000 new judges. A bold public investment in the judiciary would unclog regulatory and contractual bottlenecks, and unleash private investment, domestic and foreign.

High forecasted GDP growth for 2021-22 creates an extraordinary occasion to be more aggressive with deficit financing. But how the additional financing is expended will determine the success of this strategy. Now is the time for India to be bold and invest to create conditions that will stimulate further economic activity.

(Kothari is professor of accounting and finance, MIT Sloan School of Management, US, and former chief economist, US Securities and Exchange Commission. Ramanna is professor of business and public policy, Blavatnik School of Government, University of Oxford, UK.)