Confusion continues to prevail on what the stance of fiscal policy is this year, as revealed by a slew of analyst reports on the subject over the last fortnight. Where is the confusion emanating from?
The Union budget was clear enough. With the private sector struggling under a mountain of debt, the government slowed the pace of fiscal consolidation to engineer a public investment thrust. This makes eminent sense. Public investment multipliers are large and, to the extent that it would help crowd-in private investment, the supply-side would finally get some traction. One would have hoped that the infrastructure thrust could have been accommodated within the envelope of the original fiscal road-map, but that was a difficult task given that tax revenues are struggling as the government has lost access to the inflation tax. As it turned out, however, both the budgeted fiscal consolidation and the intentioned capex thrust surprised slightly to the downside. The central government fiscal deficit was budgeted to narrow from 4.05% of GDP in FY15 to 3.94% of GDP—a consolidation of about 0.1% of GDP. Furthermore, asset sales should be placed below the line because, unlike taxes and duties, they are not contractionary and instead simply constitute an exchange of assets between the public and private sector. Adjusting for that, the central fiscal deficit actually increases modestly by 0.1% of GDP. Furthermore, non-defence capex is budgeted to rise by only about 0.2% of GDP. So, why was the government not able to deliver a larger capex thrust or commensurately reduce the deficit more? Because, by virtue of accepting the recommendations of the 14th Finance Commission, net transfers to the states went up sharply this year—about 0.4% of GDP. In a sense, therefore, the central government budget did the best it could, given the constraints is was facing.
The question then becomes what are the states doing with these transfers? The Centre’s legitimate hope is that part of the additional transfers would be saved and part spent on capex such that, from a consolidated perspective, there would be both more fiscal consolidation and more capex spending.
So, did this happen? We examine the state budgets of 17 states in India—which together account for 90% of gross state domestic product (GSDP)—to understand their consolidation. And what do we find? That there is very little budgeted fiscal consolidation at the state level this year. Specifically, the budgeted-fiscal deficit for FY15 (weighted by GSDP) for these 17 states was 2.7% of GDP, whereas the budgeted deficit for FY16 is 2.6% of GDP—a consolidation of only 0.1% of GDP. Since the Centre’s deficit widens by a similar amount (net of asset sales), this implies that the consolidated fiscal deficit is the same across both years, or that the fiscal stance is neutral.
These numbers compared the budgeted estimate (BE) across both years. Shouldn’t we compare the revised estimate (RE) in FY15 to the budgeted estimate in FY16—to get a sense of the targeted consolidation at the state level? Doing so reveals a consolidation of 0.3% of GDP. But this is only valid if one believes the actual out-turn in FY16 will be the same as what is budgeted. But this did not happen last year. The budgeted deficit across these 17 states was 2.7% of GDP, and the actual out-turn was wider, at 2.9% of GDP. What was underpinning this? Large slippage that was narrowly concentrated among a few states, whose track-record is not particularly encouraging. For example, in FY14, West Bengal’s budgeted deficit was 1.8% of GDP. The actual out-turn: A whopping 3.6% of GDP. The same thing happened in FY15—the budgeted deficit was 1.9% of GDP while the actual out-turn was 3% of GDP. Unsurprisingly, this year, too the budgeted deficit is 1.7% of GDP. In other words, the state government is targeting an unprecedented consolidation of 1.3% of GDP, and that too in the year before the state election.
Rajasthan’s is a similar story. In FY14, budgeted targets were missed by 1.1% of GDP. In FY15 they were missed by 0.5% of GDP despite not targeting any fiscal consolidation. This year, Rajasthan is targeting a sharp consolidation of 1% of GDP. So, the likelihood of slippage is commensurately higher. Maharashtra, too, is targeting a sharp fiscal consolidation, despite meaningful fiscal slippage last year when no consolidation was targeted. In other words, if the recent fiscal dynamics in just these three states—with a less-than-encouraging recent fiscal history—plays out again this year, the actual out-turn for states as a whole in FY16 would be 2.8% of GDP, a slippage of 0.2% of GDP. Then, comparing the actual out-turn from FY15 to FY16 would only reveal a fiscal consolidation of 0.1% of GDP—exactly what we get by comparing the budgeted estimates across both years. Put differently, the apparent consolidation from comparing the RE in FY15 to BE in FY16 only exists because states that have seen meaningful slippages in recent years continue to budget aggressive consolidations in FY16. Given this pattern, we believe comparing budgeted estimates across years is a more apples-to-apples comparison. Realistically, therefore, the consolidation at the state level is likely to be 0.1% of GDP, giving rise to a neutral combined fiscal stance. Furthermore, if you believe that output gaps are closing this year, the cyclically-adjusted fiscal impulse is expansionary—but that depends on one’s subjective view of the output gap.
So, what’s going on? Why isn’t there more consolidation? There are two competing explanations: Either some states did not internalise the finance recommendation when preparing their budgets, or they are spending the extra transfers (hopefully, on capex!). We test both, in turn. We look at the 10 states that presented their budgets post the Union budget and clearly internalised the higher transfers. Unfortunately, the picture does not change. In the case of these 10 states, the budgeted fiscal consolidation across the two years is just 0.15% of GDP—almost identical to that of the full sample of 17 states. So, even the states that explicitly acknowledge the transfers have very modest consolidation.
Why is this? Surely, this is because they are spending on it higher capex? Not really! For eight of this group of 10—for which we have hard data on capex allocations from their budgets—the budgeted capex in FY16 at 2.9% of GDP is lower than the 3.0% of GDP budgeted in FY15! Even comparing the RE in FY15 to the BE in FY16, shows capex allocation remains flat at 2.9% of GDP. Therefore, for the sample of states that have clearly internalised the transfer, deficits are only modestly lower and, very surprisingly, capex allocations are, in fact, lower—suggesting the resources are being spent on current expenditures.
None of this is meant to be a criticism of fiscal policy this year. For one, budgets are dynamic and will evolve as the year goes on. More fundamentally, a neutral fiscal stance is perhaps what the doctor ordered this year when output gaps are negative, demand appears depressed, and external and internal imbalances are under control. In fact, the Union budget scored highly on institutions and focusing on a public investment thrust. The point of this piece is to simply point out that a detailed read of the state budgets reveals neither much consolidation nor a greater capex thrust.
All told, a neutral fiscal stance is understandable this year. But the extra fiscal space thereby created should be used to augment supply (capex expenditures) not demand (current expenditures). It is therefore imperative that not only must the Centre execute its capex plans to the fullest, but prod states (and public sector enterprises) to use extra resources towards greater public investment than their Budgets have revealed thus far. Else, we risk ending up in no man’s land—higher deficits and lower capital expenditures.
SajjiD Z Chinoy & Toshi Jain
Chinoy is Chief India Economist and Jain is Economist, JP Morgan