The Indian growth story is facing a rapid slowdown and the government seems to be considering various policy options—including tax cuts—to get back to a healthier growth path. This has led to two important questions. First, is there any fiscal space for the government in the current scenario? Second, what should be the focus of any fiscal policy in such a situation and how would it help us get back to a healthy growth trajectory?
There is a lot of scepticism from conservative commentators in the Indian media, who feel that there is very little fiscal space for the government in the current scenario. Is this scepticism justified? The argument made against fiscal expansion is that the combined deficits of the central and state governments have reached such large proportions that they use up all the savings that are available to fund them. These deficits are close to 7 percent of GDP and need to be supported by borrowing from the excess savings of the private sector. Since the current financial savings of the household sector is close to 7 percent as well, higher deficits would have to be funded by excess savings in the corporate sector, which can only happen by pushing down private investment. So any increase in government deficits in this scenario will crowd out private investment. Since this is definitely not an outcome the Indian economy wants, it would seem that we are out of any more fiscal options.
This is, however, an incorrect understanding of the current economic situation. For the first time in many years, we have an economy where growth rates are falling because demand is collapsing. The export demand has collapsed due to domestic and international factors. Next, private investment demand has collapsed due to problems in the financial sector and due to policy uncertainty. And now, even the growth in consumption demand has started falling due to a number of reasons, including problems in the NBFC sector. As a result, we’re far from our true potential output due to two important reasons. Firstly, falling private investments have resulted in our current productive capacity falling below potential capacity creation. And secondly, the overall slowdown in demand means that we are producing even less than this suboptimal capacity.
In such a situation any increase in the fiscal deficit will lead to a more than proportional increase in output due to the effect of fiscal multipliers.
The Case For Fiscal Expansion
Clearly, any increase in the fiscal deficit will increase demand and output in our economy. But what about the lack of savings needed to fund this higher fiscal deficit? Actually, the increased output will also automatically increase the total volume of savings. As income goes up, the household sector will be saving more. The corporate sector will be making more profits and their savings will also be going up. Even the dissaving in the government sector due to larger deficits will be brought down by higher tax revenues that will result in an increase in output. Furthermore, higher growth will also encourage more foreign savings to flow in as well.
So in a demand-constrained economy, macro equilibrium is restored not by falling private investments but by rising savings. Clearly, there is enough fiscal space for the government in such a situation.
Why then has the argument—that there is no fiscal space—been so pervasive? The main reason for this is that it has largely been true for our economy in the past. For most of the post-reform period, the Indian economy has been largely capacity-constrained with small deviations due to demand shocks. In such a situation an increase in fiscal deficit left total output and savings largely unchanged and hence large increases in government expenditures would lead to a fall in private investment. Since this was the predominant macroeconomic condition in the last decades, this argument of crowding out continues to capture our imagination even today. But the current situation is very different from those previous periods and so the fears of lack of fiscal space are unfounded in this situation.
Setting The Stage For Deeper Reform
So can this fiscal space be used to return to the higher growth path that we had achieved in the past? Here, it must be understood that fiscal expansion is not a panacea for India’s current troubles. Government expenditures by themselves will not get the Indian growth story back to a healthy trajectory. Increased demand can bring back some growth, but it is not going to solve the problems in the banking sector, the NBFC sector or the real estate sector that are the real impediments to long-run growth in demand. For healthy and sustainable growth, we also need to focus on the supply side by reforming the factor markets, which include labour and land markets. If these bottlenecks are not cleared, a fiscal stimulus by itself will only give us a limited reversal of slowdown, followed by another and more protracted slowdown in the future.
There is, however, an important reason why this fiscal space could be crucial for India’s attempt to get back from the current slowdown to a healthy growth path. The fact is that all the bottlenecks, both on the demand and supply side described above, need the return of growth momentum, in order to be tackled effectively. There are two important reasons for this.
The first is that most of these bottlenecks are prone to self-fulfilling prophecies where pessimistic expectations of the future actually exacerbate these problems. Without growth momentum, it will be impossible for people to again trust our financial institutions or the government’s ability to implement its policies. This will make it really hard for these problems to be solved.
The second reason why growth revival is crucial is that most of these policy reforms will need significant resources.
The low-hanging fruits of policy reforms that gave us high growth rates after liberalisation in the 1990s are no longer available.
The current bottlenecks will not go away simply by changing the relevant rules and laws. We will need substantial additional institutional capacity and governance capability in order to deal with an economy that is transitioning to higher levels of economic complexity. This will need substantial additional resources and that will only be available when we have a minimum growth momentum in the economy.
Influential research by Dani Rodrik of Harvard University has shown that in most developing countries, growth booms and recoveries are rarely the outcomes of major economic reforms. Rather, successful developing countries trigger such booms by taking care of some immediate constraints and then use the growth momentum to bring deeper reforms. India needs to learn from these experiences. The government has to bring back a growth momentum by using the fiscal space that is available because of the current collapse in demand. At the same time, it needs to make sure that the resultant growth and the resources made available by it are not frittered away on populist programs. It needs to invest such resources in institutional capability and governance capabilities. Only then will India be able to return to a high and sustainable growth path.
Sabyasachi Kar is a professor at the Institute of Economic Growth, University of Delhi.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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