The quantum and composition of government expenditure has, in recent years, fuelled inflation

India faces the prospect of inflation remaining high and volatile in the coming years. The push for persistently high inflation in recent years has come from the quantum and composition of government spending. Government expenditure has two outcomes?the expenditure that pushes up wages and incomes leads to rising consumption demand, and investment spending raises the supply capacity of the economy to meet the growing demand. The overall quantum of government spending and its composition?consumption versus investment expenditure?determines its impact on the economy. Of late, not only has the government expenditure risen sharply but its composition continues to favour consumption expenditure accounting for around 75% of total expenditure. The result of such a policy is for all to see?persistently high inflation.

The Union Budget 2012-13 did not announce any decisive reform measures to increase investment spending and, thus, raise the economy?s supply capacity, barring a few proposals to boost infrastructure and agriculture investment. While the Budget aims to raise capital expenditure by R480 billion in 2012-13, this would be an ambitious target to achieve; past experience shows that actual spending tends to be lower than the budgeted spending. The revised estimates for 2011-12 suggest that the government?s capital expenditure rose by only R2 billion versus the previous year.

More importantly, by failing to lay out a concrete and credible plan to reduce the government?s consumption expenditure, the Budget has not helped the cause of inflation control. In fact, on the back of two years of nearly 9% inflation, the government itself has factored in inflation of nearly 6.4% for 2012-13, significantly above RBI?s comfort level of 5%. While the situation demanded a transparent government spending review to cut the size of ballooning subsidies, this year?s Budget did not initiate such a process, also partly constrained by lack of political consensus.

Instead of curtailing consumption expenditure, the Budget tries to reduce fiscal deficit?the difference between government expenditure and revenue?via increases in indirect taxes. The overall impact of a rise in indirect taxes on inflation depends on the extent to which companies are able to pass on tax increases to consumers, depending on the demand strength. In any case, rather than reducing demand, the fiscal policy needs to focus on raising the supply capacity of the economy if we wish to get back to 8-9% sustained growth.

The only way to achieve low and stable inflation without lowering growth potential is to raise the productivity of land, labour and capital in line with wage growth. Our recent study?Putting the lid on inflation*?provides evidence of near-simultaneous wage growth in urban and rural India for both skilled and unskilled labour in recent years. Urban and rural wages rose by 12-14% over 2004-05 to 2009-10, versus an increase of 7% in the previous five-year period. Increases in rural income were especially sharp and higher than the inflation rate after 2007-08.

The rapid rise in wages, which has not always been aligned to productivity growth in recent years, is a result of various factors. The reasons include sharp increases in the minimum support price to farmers, income transfers under the national rural employment guaranteed scheme, public sector salary hikes and rising skilled premium in the private sector due to skill shortage.

All-round wage growth is what determines persistent inflationary pressures. If incomes of only a section of households rise, it cannot generate persistent inflationary pressures. For example, assume that wages of only people employed under MGNREGA rise. This will result in higher demand for primary food articles relative to the existing supply, thus leading to higher prices. This will imply that all consumers will have to spend more if they want to purchase the same quantity of these goods as before. This is possible only if majority of consumers? incomes either rise adequately or their existing incomes are high enough to accommodate higher prices.

If the supply of these commodities does not rise sufficiently over time while demand continues to surge, inflation will be determined by how much the majority can afford to pay. In fact, if the supply shortage continues, it is likely that the rural poor, who drove the demand growth to begin with, will be forced out of the market by other consumers.

As inflation takes hold, people revise their expectations about inflation upwards. This leads employees to demand higher wages as they seek to maintain their purchasing power. Firms pass on this cost increase to consumers by hiking output prices. This is called the wage-price spiral, which makes inflation persistent as people do not have to cut back on their spending.

The wage-price spiral in India has strengthened since last year, since wages in the rural economy are now automatically rising in line with inflation. The government linked wages under the MGNREGA to inflation in February 2011. As MGNREGA wages have become the benchmark floor for rural wages, wages of other rural workers too now increase along with inflation. Reducing the budgeted expenditure on MGNREGA will not stop this process. In addition, wages in the public sector have always been linked to inflation.

The solution to this problem lies in ensuring wage growth in line with productivity growth. This would entail raising farm productivity via improved irrigation and seed technology, stepping up efforts to accelerate skill development in sectors where acute skills are required and devising mechanisms to link wages to productivity in the public sector, including employment under employment guarantee schemes.

The Union Budget of 2012-13 did not propose path-breaking initiatives on any of these solutions.

Putting the lid on inflation, Dharmakirti Joshi, Vidya Mahambare, Dipti Saletore, CRISIL Insight, March 2012

The author is senior economist, CRISIL. These are her personal views