No free lunches here

Record high tax revenue collections have allowed the government to raise expenditure without there being a big increase in deficits. However, high revenue growth has come from both better efficiency in collection and high growth of GDP. In the coming year, if Indian industry witnesses a slowdown, signs of which are already visible in the latest two months of IIP data, it might mean bad news for tax collection. Customs duties, which have yielded high indirect taxes collections, will also slow down with lower import growth.

There are those in the Left and even in the Congress who do not support the idea of fiscal consolidation. It seems to be a good idea to borrow and spend if it gets votes. However, if it was such a good idea, why would the UPA have even tried to talk about carrying through with the FRBM and trying to implement it when it came to power? Should it not have gone for the borrow-and-spend strategy right from day one? Large fiscal deficits could have supported even bigger expenditures on roads, schools, debt relief, free power, subsidies and many populist measures along the way. There have, after all, been many state elections during these years.

There are many reasons why borrowing and expanding government expenditure is not a good idea. The higher demand that it generates puts upward pressure on inflation. The government already pre-empts a large share of household financial savings. More borrowing puts upward pressure on interest rates. Not only do domestic borrowing costs go up with large deficits, as India8217;s fiscal deficits increase, its country credit ratings go down, and even external finance for Indian corporates becomes more expensive. High domestic and external cost of capital puts downward pressure on profitability and investment.

These unpleasant elements of the deal put pressure on the government not to borrow large amounts. Given the economy8217;s performance in terms of growth and inflation, the government is comfortable in borrowing only up to a certain amount. Hence, budget deficit numbers are usually a talking point when the budget is announced.

Moreover, interest payments reduce the flexibility of the government to spend on other items. Debt holders have to be paid first, before anyone else. Interest payments on government borrowing have been rising over the last few years as the public debt has grown bigger. In 2002-03, interest payments were 80 per cent of the fiscal deficit. By 2007-08, they were estimated to rise to 105 per cent of the deficit. So for example, in 2006-07 the Central government borrowed Rs 1.5 lakh crore. Out of this Rs 1.46 lakh crore was used up in making interest payments. In 2007-08, however, the budget estimate was that not only would the entire borrowing of Rs 1.5 lakh crore be used for making interest payments, interest payments would also dig into tax revenue. Interest payments in the year were budgeted to be nearly Rs 1.6 lakh crore.

I suspect that revised estimates for interest payments in 2007-08 will be even higher due both to the rise in interest rates and a larger spend on MSS Market Stabilisation Scheme interest payments.

The budget had underestimated the increase in bond issuance for the MSS, a mechanism devised in 2004 to sterilise RBI8217;s foreign exchange intervention. It expected to add Rs 10,000 crore to the stock of MSS. During the year, however, RBI aggressively pursued a policy of intervening in foreign exchange markets, pushing up liquidity in the system, and then mopping it up by selling MSS bonds. Nearly Rs 1 lakh crore of MSS bonds have been sold this year. This is likely to have cost the government at least Rs 10,000-15,000 crore in interest payments. Indeed, we are now at a point where the annual MSS issuance is almost bigger than the fiscal deficit itself.

Interest payments on MSS are, as yet, a small part of the overall problem. But the stock of MSS bonds is growing very rapidly and will increasingly start mattering in the overall interest burden. In other words, interest payments are already very high, and rising. A large borrowing programme will be unwise.

The above arguments indicate that a large borrow and spend budget is bad in the long run. How about in the immediate run-up to the election? Here again the Congress and the Left appear to be ignoring one of their most important political constraints: inflation. Given the voter aversion to inflation, the Congress cannot risk an expansionary budget. Last month in Davos Finance Minister P. Chidambaram said, 8220;I will not be politically in trouble if my growth rate slows down to 8.5 to 8 per cent. I will be in greater trouble if my inflation rises to 6 per cent this year.8221; Considering that consumer price inflation in December was already at 5.5 per cent, he clearly has a tightrope walk on Friday.

The writer is senior fellow, National Institute of Public Finance and Policy

ilapatnaikgmail.com