[Editorial] A New Fiscal Situation

What is fiscal deficit?

  • Fiscal deficit is the difference between the total revenue and total expenditure incurred by the government. The total revenue part doesn’t include the government’s borrowings.
  • It indicates the borrowing required by the government.
  • Fiscal deficit happens due to:
    1. A situation of revenue deficit
    2. A major increase in capital expenditure
  • It has been the primary metric used for evaluating budgets in the last decade i.e.
    • How much the government seeks to reduce it by?
    • How credible are these targets?
  • This stress has been caused by the massive stimulus introduced by the government, even before the global recession, as it was inundated by taxes between 2006 and 2008.
  • One of the challenges with this stimulus was that it was difficult to roll back as a large part of it went towards increasing government (both central and state) salaries and pensions.

How is the current situation different?

  • Following the economic downturn in the recent times, the question is now ‘how much can really be spent by the government?’
  • Currently, the tax collection is positive i.e. 1% of GDP higher than what it was pre-lockdown.
  • Financial markets seem to expect the governments at the centre and states to witness large fiscal deficits for several years.
  • If it is assumed that the GDP is lower than what it could have been if the pandemic hadn’t occurred, it would mean an extra 1.5% of costs for the government.
  • During the lockdowns, the governments borrowed a lot to compensate for the large economic loss. As a result, the interest costs have risen.
  • Some expenses, such as salaries and pensions, continue to increase irrespective of the GDP levels.
  • Inspite of all this, a space of 2.5% of GDP still remains for the government to increase spending.
  • The government’s cash balance with the RBI now stands at 5.5 trillion INR– a record high. In normal times, this figure should be around 0.5 trillion INR. Over 50% of this is cash parked by state governments.

Most probable and repeated topics of upsc prelims

Why is this a challenge?

  • Productively spending such large sums of money at short notice is a difficult task for the governments.
  • The central government has been tackling arrears and including those in budget expenditure. Earlier, such expenses were off the budget.
    • In 2021, the central government did this with fertilizer subsidies and food subsidies.
    • This year, there is almost no use of extra-budgetary resources.
    • Over 50,000 crore INR worth of export incentives were paid.
    • A similar amount was paid to write-off the debt over Air India.
  • This inclusion improves transparency and the clearing arrears is a prudent move, but they don’t add to aggregate demand.
  • For the next year, the challenge is bigger. During the peak of pandemic, the governments spent significantly to cater to:
    • Distribution of free food grains
    • High demand for work under MGNREGS
    • Free vaccination
    • Higher fertilizer subsidies necessitated by increase in fertilizer prices
  • However, this year, almost none of it would be required. For instance, the fertilizer prices are expected to normalize moving ahead.
  • The bond markets have been concerned about the lack of clarity on India’s inclusion in global bond indices, which need clarity on taxation.

How is the government responding?

  • The government seems intent on staying away from freebies and instead focusing on productive spending. This can be gathered from the significant increase in capital expenditure to 7.5 trillion INR (from 5.45 trillion INR).
  • Allocation for interest-free loans to state governments account for half of this increase in capital expenditure. Another part is due to inclusion of some off-budget provisions in 2021 budget in this year’s budget numbers.
  • The government has also increased allocations for: (however these are incremental increases, rather than substantial)
    • Defence
    • Nal Se Jal Scheme
    • Roads and Railways
  • In theory, allowing more fiscal space (fiscal deficit of up to 3.5% of GDP and another 0.5% if power sector reforms are undertaken) and incentivizing capital expenditure with extra funding is the right approach.
  • A lot of the necessary investments have to occur at state level– such as investments in education, health, water supply, sanitation, urban infrastructure and power distribution.
  • However, the gap between the states’ intent to spend and their actual execution has increased during the pandemic. States’ total spending is much lower than what was budgeted. This is despite the increase in non-discretionary expenses such as salaries, pensions and interest costs.
  • The budget has built in significant buffers in tax receipts. Growth in gross taxes has been above 40% for the 1st 9 months of this fiscal year. In the last 3 months, it has been 21%. Yet, revised estimates for this year indicate a decline in taxes in the last quarter. Given this low base, the growth assumed for next year is small.

What is the way ahead?

  • The governments at the centre and states are facing a new fiscal situation where more funds are available than what one can spend. If the tax-to-GDP ratio continues to increase, the fiscal space would continue to expand. This could happen even if headline deficit ratios decline over the next 4 years.
  • It is prudent to be reluctant about increasing permanent expenditure heads for the government. However, letting the deficit remain high without any meaningful expenditure leaves the country with the worst of both worlds:
    • Large headline deficit (i.e. cyclical deficit + structural deficit) would mean higher interest rates which would discourage borrowers
    • Benefits of larger government spending would be missing too
  • A premature increase in interest costs is both a monetary as well as a fiscal issue. This is especially so given the high sovereign debt levels. This could delay fiscal consolidation (i.e. reduction in fiscal deficit and debt accumulation).
  • A permanent increase in government spending is unwise. However, an increase in unused sum would increase the risk of some governments undertaking wasteful expenditures.
  • If the cash balances keep increasing and the state governments are unable to scale up productive spending, even after lockdowns are lifted, the government may have to pare down its borrowing targets.
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