Dont loosen the purse strings

Written by Ila Patnaik | Updated: Oct 10 2006, 05:30am hrs
The first-quarter 2006 GDP growth figure of 8.9% is higher than what most people expected. However, while the GDP numbers are great news, they should not set the stage for unsustainable government spending. Instead, they must alert us to the need for a stabilising fiscal policy.

Part of the UPAs belief that it can spend more comes from the view that high growth rates are here to stay. High GDP growth would provide higher tax collection. Higher taxes would support higher government spending, be it on the employment guarantee programme or on government employees through another pay commission.

Why should we believe that India has touched a higher growth trend This requires more investment and more efficiency. It is believed that if Indias savings rate rises from the present 29% by another three to four percentage points, this will add one percentage point to the GDP growth rate. While it is correct to think that the household savings rate will rise because of the ongoing demographic shift which is reducing the dependency ratio, the shift could take about a decade.

The overall savings rate will also depend on the public savings rate. The fiscal adjustment programme does not suggest that the government will be able to the reduce fiscal deficit to allow India to increase the gross domestic savings rate by three to four percentage points in the next 4-5 years.

The second assumption is that efficiency improvements will raise GDP growth. This can happen only if there is progress on economic reforms. The current productivity increases, the mainstay of Indias high growth, have come from economic reforms that unleashed forces in the private sector. India can continue to ride the gains from reforms of the past.

But unless the government pushes further on this front, it will not give the economy higher efficiency growth. For example, privatisation will increase efficiency and raise GDP growth, but will the UPA government be able to deliver this Across a host of areas, the weaknesses of economics under the UPA make one gloomy about the outlook for efficiency improvements.

The first quarter growth figure of 8.9% is great news, but we must remain alert to the need for a stabilising fiscal policy
The most important flaw in the UPAs sanguine outlook, however, is the issue of the business cycle. The growth seen in the last three years is a combination of two factorsone, a step-up in the trend growth rate, and two, the high of the business cycle. The global cycle could see a downturn. US housing data is already showing a downturn. Some see the fall in global oil prices as a sign of a slowdown in demand. The large US current account and fiscal deficits would need adjustments not only in the US economy, but the world over. India may not be insulated against a downturn in the global business cycle and may witness a slowdown.

In recent years, there has been a sharp rise in corporate tax collections in India, which have high buoyancy. So, when GDP goes up by one percentage point, corporate income tax goes up by 1.6%. When a downturn hits the economy, this is among the first sources of revenue to be hit.

When tax collections are high, a government aiming to merely meet its Fiscal Responsibility and Budget Management (FRBM) targets can spend more. This means higher public spending when the going is good. Conversely, when there is a downturn and tax revenues fall sharply, the government will be forced to cut expenses to keep within the FRBM. It would be better for the government to have a stable and affordable expenditure profile and run surpluses when times are good, while abiding with the FRBM when the times are bad.

A well-designed employment guarantee programme would fit well within such a framework. When times are good, very few workers should want to be in the National Rural Employment Guarantee (NREG) Programme. That should free up public money, which should induce surpluses. When the business cycle has a downturn, more workers would rush into the NREG. Government spending would go up and should be calibrated to achieve FRBM targets under such circumstances.

In summary, the high GDP numbers are worth celebrating, but may not be here to stay. The higher trend cannot be taken for granted. In addition, India has yet to incorporate business cycles as part of its reality as a modern economy and frame policies, accordingly. The UPAs interest in big spending is setting up a dangerous situation for the next downturn.