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Caging the fiscal deficit: quality of expenditure matters

and , February 8, 2015, 0 Comments

op views monetary policy rbi MarketExpress-inAs the government gears itself   to present a full-fledged budget in a few weeks, the policymakers will have to do the balancing act of giving a boost to the economy along with getting  the budgetary arithmetic right.

In the last budget of 2014-15 the Modi government had  promised to abide by targets laid by resurrected FRBM Act   which once long forgotten by the UPA was again resurrected in its way out.

The fiscal prudence   which was adhered to between 2004-08 went awry   year after year when fiscal bonanza in form of loan waiver, pay commission compensations and huge subsidies set the fiscal targets off track. These were notable failings and had a cascading effect on inflation and eventually growth.

In the current fiscal the government has budgeted to collect Rs 13.6 lakh crore as tax revenue. This requires a 16 per cent growth in direct taxes and 20 per cent growth in indirect taxes. Direct tax collection, during the first nine months of the current financial year, increased by 12.93 per cent, which is still short of the annual target of 16 per cent.

To adhere to the fiscal deficit target of 4.1 per cent, the government will have to critically depend on two non tax revenue sources, namely revenue from dis-investment and revenue from telecom spectrum auctions. Tax revenue collections so far indicate a shortfall in likely achievement of targets. The government had targeted a revenue from dis-investment exceeding Rs 40,000 crore. While this target is difficult to achieve a lot depends on possible revenue from stake sale in Coal India Ltd. and ONGC.

The fall in international price of crude oil came as a major bonanza for the government. This has reduced the government’s subsidy bill by a huge margin. The savings have come primarily on account of fuel subsidies. Similar success is still beyond reach in the matter of food and fertilizer subsidies.

During the last few budgets presented by the UPA government attempt was made by the government to achieve fiscal deficit targets through expenditure compression. In the process an attempt was made to reduce plan expenditure which was the only item that appeared downward flexible while non plan expenditure like those on salaries was downwardly immobile. One option available to the new government also is to follow the previous government’s strategy of expenditure compression. It is here one encounters the concept of quality of government expenditure.

More than caging the deficits it is   important to get the composition of expenditure and buoyancy in revenue receipts right. The impact of fiscal deficits on GDP depends on the nature of each expenditure. The expenditure profile of the government finances can be dissected as revenue and capital expenditure. Within each of these, some expenditures   increase assets by capital formation (infrastructure investment) or lead to a transfer of purchasing power (MNREGA). Since different types of expenditure have different multiplier effects on GDP, the   composition of expenditure profile needs to be assessed to generate the right response of GDP growth.

The real driver of growth are the development expenditures that impact and result in capital formation. As per the budget estimates of 2014-15 nearly five trillion rupees  make up   plan expenditure. The outlays on development spending such as Bharat Nirman, agriculture, rural roads, national highways infrastructure, railway network expansion and so on result in asset creation. They   go a long way in not just  improving the quality of fiscal expenditure but also have a   strong multiplier effect   on output.

As per empirical estimates (an NIPFP study) the value of capital expenditure multiplier, transfer payments multiplier and other revenue expenditure multiplier are 2.45, 0.98, and 0.99 respectively. When we use the capital expenditure multiplier the planned expenditure of   Rs 113049 crores   on development should translate into 2.45 times increase in output, i.e., Rs 276970 crores   whereas   non development expenditure of Rs 442273 crores should translate into   GDP worth Rs 437850 crores .

The fiscal deficit of 4.1 per cent translates into an outlay of Rs 531177 crore. We can consider three scenarios – one where development expenditure is 25 per cent of fiscal deficit, second where development is 50 per cent of fiscal deficit and third where development expenditure is 75 per cent of fiscal deficit. A fiscal deficit of 4.1 per cent result in incremental growth in GDP of Rs 456812 crore under scenario one, growth of Rs 913624 crore under the second scenario and growth of Rs 1370437 crore under the third scenario. In percentage terms this translates into incremental growth of 0.86 per cent, 1.72 per cent and 2.58 per cent under the three scenarios.

With an aim to restrict fiscal deficit to 4.1 per cent of GDP in 2014-15 and kick start growth, Modi government unlike its predecessor should not tweak with development expenditure. Any attempt at fiscal prudence should be adhered to by slashing items from non development expenditure and promoting development expenditure. The moral of the story is that what matters is not merely the quantum of fiscal deficit but the quality of government expenditure it promotes.