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Wednesday, June 29, 2022

Budget reveals a new fiscal situation

Neelkanth Mishra writes: Government now has more funds than it can allocate

Written by Neelkanth Mishra |
Updated: February 2, 2022 9:23:59 am
A labourer carries vegetables for a vendor for sale in a wholesale market, Thursday, Jan. 27, 2022. (AP Photo/Anupam Nath)

For all of the last decade, the primary metric for evaluating budgets was the fiscal deficit. How much would the government target to bring it down by, and how credible were the numbers? The source of that stress was the massive stimulus set in motion by the government well before the global recession showed up, as it was inundated by taxes in the 2006 to 2008 period. The challenge with that stimulus was that it was hard to roll back, much of it being a large increase in state and central government salaries and pensions.

The narrative after the recent economic downturn could not have been more different. It is now “how much can the government really spend”?

Tax collection is surprising positively, and should be more than 1 per cent of GDP higher than before the Covid-19 lockdowns (though assumptions are lower). Further, financial markets appear to be expecting both central and state governments to incur large fiscal deficits for several years, with the anchor shifting higher by 3 per cent of GDP. Let us assume that GDP being below where it was supposed to be if the pandemic had not happened means an extra per cent-and-a-half of costs for the government. Interest costs have risen as governments borrowed to bear a large part of the economic loss during the lockdowns. Further, some government expenses, like salaries and pensions, keep rising irrespective of the level of GDP. This still leaves 2.5 per cent of GDP of space for governments to increase spending.

Even for governments, it is difficult to spend such large sums productively at short notice. Struggling to spend, the central government has been clearing arrears and bringing into the budget expenditures that were earlier off the budget. Last year, it did so with the fertiliser and food subsidies, and this year, the use of extra-budgetary resources has dropped to nearly zero. Further, more than Rs 50,000 crore of export incentives were paid, in addition to a similar amount for the debt write-off for Air India. While the transparency this brings is commendable, and clearing of arrears is prudent, they do not add to aggregate demand.

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In any case, despite these efforts, government cash balances with the RBI are now at a record high of Rs 5.5 trillion; for perspective, this number should be around half a trillion in normal times. We estimate that more than half of this is cash parked by state governments.

The challenge for the next year remains much bigger. During the pandemic, the distribution of free grains, higher demand for MGNREGA work, and free vaccinations necessitated significant government spending. The surge in fertiliser prices also meant higher fertiliser subsidies. However, nearly none of this is required next year (fertiliser prices should normalise going forward). How, then, can the spending be maintained, or, to stretch things a bit, boosted?

The sharp increase in capital expenditure from Rs 5.45 trillion to Rs 7.5 trillion shows the intent of the government is to stay away from distributing freebies (commendable, given the upcoming state elections), and focus instead on productive spending, which may be rolled back if necessary. However, half of this increase is an allocation for interest-free loans to state governments for capital expenditure, and some of the rest is the inclusion of off-budget provisions in last year’s budget in the budget numbers this year. There are increases in the allocation for defence (particularly once adjusted for the lower spend on aircraft purchases this year), the Nal se Jal scheme, and for roads and railways, but these are incremental rather than substantial.

Allowing state governments more fiscal space (deficits up to 3.5 per cent of GDP are allowed, with another half a per cent if the state undertakes power sector reforms), and dangling the carrot of more funding if they undertake capital expenditure is the right approach in theory. Much of the necessary investments need to occur at the state level: Like in health, education, urban infrastructure, water supply, sanitation and power distribution. However, the gap between states’ intent to spend and their execution has widened substantially during the pandemic, and their total spending is far lower than budgeted, despite increases in non-discretionary expenses like interest costs, salaries and pensions.

The budget also seems to have built significant buffers in tax receipts. Growth in gross taxes has been north of 40 per cent for the first nine months of this fiscal year, and 21 per cent in the last three months, including in December. Yet, assumptions in the revised estimates for this year imply a decline in taxes in the last quarter. On this low base, the assumed growth for next year is small as well. The 11.1 per cent growth assumed for nominal GDP is below consensus, which itself needs substantial upgrades, in our view.

The reluctance to increase permanent expenditure heads for the government is prudent, for one never knows when the narrative may change. However, keeping deficits high without meaningful expenditure means the worst of both worlds: Large headline deficit numbers push interest rates higher for borrowers, whereas the benefits of higher government spending are missing. The delay in clarity on India’s inclusion in global bond indices, which needed some clarity on taxation, is also a concern for bond markets. A premature rise in interest costs is as much a monetary as a fiscal issue, particularly given elevated sovereign debt levels. This can delay fiscal consolidation.

This is a new fiscal situation for governments (the Union as well as states) — having more funds than one can spend. But this may not be the last year of such a challenge. If the tax-to-GDP ratio continues to climb, as it appears likely to, fiscal space may continue to expand, even if headline deficit ratios fall as planned over the next four years. While a permanent increase in government spending may be unwise until we are sure this trend will last, a surge in unused sums also runs the risk of some governments getting tempted into wasteful expenditure. During this year, if government cash balances keep rising, and states are unable to scale up spending even after lockdowns are lifted, the government having to reduce its borrowing targets remains a possibility.

This column first appeared in the print edition on February 2, 2022 under the title ‘The struggle to spend’. The writer is co-head of APAC Strategy and India Strategist for Credit Suisse

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