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With a huge informal economy, government should increase spending, not worry about deficit

To get the engine of the economy revving, an expansionary fiscal policy that harnesses the energy of the informal sector to boost aggregate demand is the order of the day.

economy slowdown, gdp growth, development, demand, National Sample Survey, National Statistical Office Fiscal pessimists and hawks are underestimating the role of the informal sector.

That India is in the midst of a serious economic slowdown is no longer in question. The debates are now mostly about what to do about it: Whether to opt for a fiscal expansion to boost demand or to carry out deep reforms to raise productivity and the growth potential of the economy. As per the recent release by the National Statistical Office (NSO), the growth rate of the GDP in real terms is now 5 per cent, the lowest in more than a decade, and that ofthe nominal GDP is 7.5 per cent — the lowest in four decades. Technically, this is being called a slowdown and not a recession, since in absolute terms GDP has not fallen.

Yet, the leaked National Sample Survey (NSS) consumer expenditure data — a report that was withheld and now has been officially withdrawn — shows that real monthly per capita expenditure has in fact fallen in absolute terms between 2011-12 and 2017-18. In rural areas, consumption expenditure decreased by 8.8 per cent, while in urban areas it increased by 2 per cent, leading to an all India decline of 3.7 per cent.

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This is a striking fact as there has never been a decrease in the average level — a contraction rather than growth — in all the NSS consumer expenditure surveys since liberalisation. If average consumer expenditure is down, then where is the GDP growth coming from? After all, according to National Accounts Statistics (NAS) that produce the estimates for national income, consumer expenditure is around 60 per cent of the GDP. Investment (or gross fixed capital formation, to be precise) is about 30 per cent of the GDP, and its growth rate has plummeted to less than 1 per cent according to latest estimates. And while government expenditure has grown at a high rate (around 10 per cent), it is only about 10 per cent of the GDP. Accordingly, growth in investment and government spending contribute 1.3 percentage points to the overall GDP growth rate, and so to get an overall 5 per cent growth rate, consumer expenditure should be growing at higher than 5 per cent.

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This is a genuine puzzle: How can consumption expenditure be going down in absolute terms according to the NSS estimates and be growing at more than 5 per cent according to the NAS? That these two types of estimates of consumption expenditure do not match is well-known, and that is the case in other countries as well. However, as has been noted in a recent column by C Rangarajan and S Mahendra Dev, it is a puzzle as to why the gap between the two estimates has widened so much over the last few decades in India. In the very latest round, they note, the discrepancy had reached alarming proportions: In the 1970s, consumer expenditure according to NSS estimates was around 90 per cent of consumer expenditure according to NAS, but in 2017-18 it was only 32.3 per cent. It is as if we are looking at data from two different countries, one where consumption expenditure growth is positive and propping up the GDP growth rate and the other where it is actually falling.

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There is scope for criticism of both data sources and to get to the bottom of this issue making the NSS report available in full is a first step. However, a few inferences can be drawn that pertain to the debate around the state of the economy and the policy options.


First, as is well-known, the presence of a large informal sector plays a big role in the discrepancy between the NSS and NAS estimates. It accounts for nearly half of the GDP and employs 85 per cent of the labour force. Yet, in national income accounts, growth in the informal sector is estimated by extrapolating from the performance of the formal sector. As the newly appointed chairman of the Standing Committee on Statistics, Pronab Sen, put it in a recent interview, it is largely guesswork.

Second, because of the presence of the informal sector, expansionary fiscal policy will be more effective than what would appear from official statistics, as a big part of its impact will be felt in the informal sector. Indeed, the expansionary effect will be larger than what can be guessed from the formal sector expansion. The reason is that a big segment of the population is located in the informal sector; they are poorer and tend to spend a much higher fraction of their income on consumption. This group has been seriously affected by the economic slowdown. Calculations by S Subramanian, based on the draft NSS report, confirm that there was a rise in the rate of poverty between 2011-12 and 2017-18, with a pronounced spike in rural areas.

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Third, it is true that the fiscal space is quite tight for an expansion, given the size of the existing deficit and the limited scope for raising more tax revenues or borrowings. However, the effect of an expansionary policy on the budget deficit will look much worse than what it would be since the estimates of its effect on income expansion and tax collection will be largely based on the formal sector. But, some of the income generated in the informal sector will boost demand in the formal sector through consumer demand for mass-consumption items (for instance, biscuits, as opposed to automobiles). Therefore, in the medium term, once the engine of the economy starts moving, the income expansion and deficit numbers will look better.

Finally, policies such as personal and corporate income tax cuts, which are being talked about, will achieve precious little. To start with, they will affect barely 3-5 per cent of the adult population. Also, income tax revenues amount to around 2.5 per cent of the GDP and corporate income taxes around 3.3 per cent. So, irrespective of the number of people affected, and even if they spend the entire increase in their income as a result of the tax cut, the overall economic impact will be small relative to the GDP. Moreover, most of the tax is paid by the richest among these groups (the top 5 per cent taxpayers contribute 60 per cent of individual income tax revenue), and the rich tend to spend a smaller fraction of their income (and save more). Also, leveraged firms and households will possibly use the money to save or repay loans rather than consume. Therefore, a tax cut for the rich would be less effective in raising spending compared to an equivalent amount being given to poorer groups who spend a much higher fraction of their incomes.

To sum up, fiscal pessimists and hawks are underestimating the role of the informal sector. To get the engine of the economy revving, an expansionary fiscal policy that harnesses the energy of the informal sector to boost aggregate demand is the order of the day.

This article first appeared in the print edition on January 23, 2020 under the title ‘Where demand has gone.’ The writer is professor of economics at London School of Economics 

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First published on: 23-01-2020 at 12:02:21 am
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