Let’s get fiscal

Budget day will test the reformist credentials of the Manmohan-Montek-Chidambaram team. One of the big fears caused by the Common Minimum Programme (CMP) is that there will be a sharp increase in public spending on various social programmes. At the time of the July budget, no one had demanded that higher expenditure be financed out of higher deficits. The CMP supports the Fiscal Responsibility and Budgetary Management Act that seeks to bring down the level of deficits. But things have changed since. The Left has been asking for higher spending even at the cost of higher deficits. For example, it would like the spending for EGA to come not from cutting expenditures on subsidies but from government borrowing.

This populism is very dangerous. Fiscal deficits have undesired side effects. The ’80s witnessed high growth rates with high fiscal deficits. This led to higher imports and a current account crisis. The ’90s did not see that happen because of a sharp rise in household savings. But the routing of household savings into government bonds through the banking system meant that the government borrowed the bulk of additional savings. Today, when the economy is on the upswing of a growth cycle, the pre-emption of household savings by the government will put an upward pressure on interest rates. It is argued that if the government borrows more to create infrastructure then it will increase the productivity of private capital. Unfortunately, the Indian bureaucracy, which is expected to undertake this public investment, does not have a good track record. The state of roads, government schools and hospitals are a sad commentary on the efficiency of public investment. The mechanism of public spending needs to be fixed instead of more money being pushed into existing vehicles of spending.

Further, the argument for additional government borrowing ignores the fact that India has already built up a debt-GDP ratio of 85 per cent. As this ratio has increased, the cost of servicing the debt has risen. The preemption of resources by interest obligations on past public debt has had a disastrous effects on the provision of public goods. Since half of government spending goes into servicing this debt, less money is available at all levels of government for provision of public goods. Law and order, enforcement of contracts, health and education are important determinants of growth. While India has seen significant economic growth, improvements in public services and infrastructure has not kept pace. They are today severely constrained by the availability of resources. If interest payments use up the bulk of revenue collection, little is left for provision of public services.