Chapter 4

Macro perspectiveon fiscal consolidation

Chapter3 hasarguedthatin the‘baselinesce-nario’, there is a needof a substantial fis-cal correctionin orderto achievecompliancewith the FRBM Act. This chapterbringsmacroeconomicperspectives to bearon thequestionsandmajorpolicy choicesconcern-ing thetrajectoryto theFRBM targets.

4.1 POLICY A LTERNATIVES

The broadgoal of macroeconomicpolicy isto find the mosteffective trajectorythroughwhich the FRBM goals can be achieved.There are two main questionsabout theimplementationof thefiscalcorrectionwhichis requiredby the FRBM: (a) The questionof anearlyor a lateadjustment,and(b) Thequestionof how adjustmentshouldbesharedbetweentaxation and expenditure. In thischapter, weseekto bringeconomicprinciplesto bearon thesetwo key choices.

4.1.1 Early versusdelayedadjustment

Figure 4.1 shows alternative paths for therevenuedeficit. One thing is clear, that therevenuedeficit hasto go to zeroat theendof2008-09. Thereis room for flexibil ity whenit comesto theintermediateyears.

However, there are alternative trajectorieswhich can achieve this. It is possibleto have a ‘front-loaded adjustment’,whichemphasisesfinishingthebulk of therequiredfiscalcorrectionin theearlyoneor two years.Alternatively, there can be a ‘back-loadedadjustment’,whichemphasisesachieving thebulk of the requiredfiscal correctionin thelateyears.

In addition,thereis an importantdistinctionbetween front-loaded policy reforms andfront-loadedfiscal adjustment. It is possibleto conceive of policy decisionstaken earlyin the adjustmentperiod, which generateasustainedimpactover thefollowing years.

4.1.2 Cutting expenditure versusraisingtax revenues

The secondkey question about the fiscalcorrection concerns the relative role ofrevenue expenditure and revenue receipts.Going by the requirementof the FRBM,by 2008-09, the revenue deficit has to beeliminated.However, in termsof adjustment,many alternative pathscanbe envisaged.Forexample:

1. The existing ratio of revenuereceiptsto GDPcould stay unchanged,and expenditurecouldadjustdownwards,soasto be equal torevenue

38 Macro perspectiveon fiscal consolidation

Figure4.1Alternativepathsto eliminationof therevenuedeficit

1998 2000 2002 2004 2006 2008

01

23

4

Pe

rce

nt

to G

DP

Front−loaded

Back−loaded

receiptsaspercent ofGDPby 2008-09.

2. Alternatively, theadjustmentof 3.6 percentagepointscouldbesharedin half betweenthetwo.

3. Alternatively, revenueexpenditurecould stayfixedaspercent ofGDP, andthe taxGDPratiocouldriseby 3.6percentagepointsby 2008-09.

4. Alternatively, we could actuallyhave arise inrevenueexpenditureas per cent of GDP. Forexample,revenueexpenditurecould rise fromthe presentlevel of 13.17%of GDP to a levelof 14.17%of GDP. Thiswould requirea riseof4.6%of GDPon thepartof revenuereceipts.

4.2 BUSINESS-CYCLE CONSIDERATIONS

Reducing expenditure or raising taxes, inthe quest for the FRBM targets, can becontractionary. At thesametime, oneof thegoalsof fiscalpolicy is to becountercyclical.

There is a need to reconcile these twoobjectives. This requiresa closerappraisalof questionsaboutthebusinesscycle,andtheimpact of taxationor expenditureproposalsin termsof thebusinesscycle.

4.2.1 Closedeconomymultipliers

In the standardKeyenesianframework ofa closed economy, raising governmentexpenditure G or cutting tax revenuesT

have a‘multiplier effect’, with the followingmultipliers:

∆Y

∆G=

1

1 − MPC∆Y

∆T=

−MPC1 − MPC

4.2Business-cycleconsiderations 39

Here,∆Y is the changein GDP associatedwith a changeof ∆G in governmentexpen-ditureor ∆T in taxes. Thesizeof bothmul-tipliers is relatedto the marginal propensityto consume(MPC).These‘multiplier effects’aremostusefulasa guidefor understandingsituationswherethere is excesscapacityinthecountry, andrecessionaryconditionspre-vail.

Sincethesavings ratein India is high, whencomparedwith most OECD countries,weexpectthat themultipliers in India would becorrespondinglysmaller.

We see that the expenditure multiplieris larger; that the contractionary effectof cutting expenditure is larger than thecontractionaryeffect of raising taxes. Thisis an argumentin favour of placinga largershareof the requiredfiscal adjustmentuponthegrowth of revenuereceipts.

We may note that FRBM targetscould alsobemetwhile increasingexpenditure,whereitwouldberequiredthattheTax/GDPratioriseby morethan3.6%. In this scenario,raisingexpenditure would have an expansionaryeffect, which would partly counteractthecontractionaryeffectsof raisingtheTax/GDPratio.

4.2.2 Attenuation of fiscal multipliers inan openeconomy

It is important to emphasisethat the aboverelationships are for a closed economy.In an open economy, characterisedby acombinationof tradeflows,capitalflows,andaflexible exchangerate,thesemultipliersareconsiderablyweakened.

Whenthereis adomesticfiscalcontractioninanopeneconomy, theweaknessin domestic

demandis counteractedby a depreciationof the currency, which improvesnet exportsandaggregatedemand.Giventhe increasingopennessof the Indian economy, the fiscalmultipliers may be smaller, and fiscalconsolidationmay have a lesserimpact onaggregatedemand.

4.2.3 Wherearewein the businesscycle?

The timing of fiscal consolidationhas tobe closely interwoven with the domesticand international business cycle. Forexample, if India had embarked on astrong fiscal correction in 2001-02, thewelfare consequenceswould have beenhighly negative.

Asof early2004-05,weappeartobestandingat a relatively high point in the domesticand internationalbusinesscycle. Businessconfidenceis high. Investmentdemandhasgrown well, with imports of capital goodshaving grown by 31% in the period fromApril 2003 to February 2004, comparedwith the previous year. Thereis heightenedinterestin India asa destinationfor FDI, andin integrating India into global productionchainsfor manufacturingandservices.

In 2002 and early 2003, there were globalfearsof slow economicgrowth anddeflation.However, the international businesscyclehasturnedaround,with a distinct pickup ingrowth in the US and Japan. Commoditypricesaresharplyon theupswingin 2004.

This environmentconstitutesanargumentinfavour of front-loading.As JohnF. Kennedyargued, the time to fix the roof is whenthesunis shining. At this moment,the welfarecosts of the fiscal adjustmentwill be themost muted. Furthermore,if India is able

40 Macro perspectiveon fiscal consolidation

to obtain substantialprogressin the fiscaladjustmentin 2004-05and2005-06,thenthiswill ‘recharge the guns’ of fiscal policy forpossibleusein countercyclical fiscal policy,which may be requiredif the domesticandthe world businesscycle turnsaroundin thefuture.

The US is an important casestudy in thisregard (Figure 4.2). The US achieved adramatic fiscal consolidation in the yearsafter 1992,at a time whenthe US economywasgrowing strongly. This createdthefiscalspace for countercyclical fiscal policy, inthe form of the enormoustax cuts whichwere implementedin recentyearsin orderto counteractthedownswingof thebusinesscycle. If the fiscal consolidationhad nottaken placein the US over 1992-2000,thenit would not have beenpossibleto usefiscalpolicy asa tool for tackling the recessionofthefollowing years.

4.2.4 Investment-ledgrowth

In the mid 1990s, India experienced aboom in investmentuntil 1995. After this,investmentdemandhas beenweak, exceptfor the spurt in investmentwhich was alsoobservedin 1999-2000.

This has been a period of consolidation,wherefirms were improving efficiency, andoptimally utilising existing capacity. Largelyspeaking,after1995,growth in consumptionplayed a prominentrole in obtaining GDPgrowth.

This period of better utilising existingcapacitynow seemsto bebehindus,andthenext waveof GDPgrowth in India is likely tobebasedoninvestment.Someevidenceof anupsurge in investmentis visible in the early

monthsof 2004for whichdatais available.

From the viewpoint of macro policy, ourgoal shouldbe to bestharnessthis cyclicalrevival of investment,to prolong the periodof positive expectationsandhigh investmentrates,andto maximisethe impact thattheseinvestmentshaveuponGDPgrowth.

The fiscal reforms processneedsto fosterthis processof investment-ledgrowth, byestablishinganon-distortionaryandeffectivetaxsystemto raiserevenues,andby pursuingexpenditurepolicieswhichyield anadequatequantityandqualityof publicgoods.

4.3 OTHER CONSIDERATIONS

4.3.1 Lags in policy

Fiscal consolidation is about reforms inrevenuesandreformsin expenditure.Thereis aninnatetimedelaybetweendecisionsandtheir full impactupontherevenuedeficit.

We may outline the sequenceof eventsthatmight unfold. First, a new policy would beadopted. After this, therewould be a timedelayrequiredfor implementationin termsofprocessesandIT systems.Therewould thenbea timedelayfor thesesystemsto stabilise.

Finally, there are time delays before thefull impact of new policies is seenin termsof behavioural impact. A central plankof tax reformsconsistsof finding strategieswhich give firms and householdsincentivesto behavein adifferentway, andin awaythatis compatiblewith a reductionin therevenuedeficit. This would require some time tofall into place, as firms and householdsgraduallyshift awayfrom traditionaldecisionprocesses,whicharerootedin adistortionary

4.3Other considerations 41

Figure4.2Fiscaladjustmentin theUS in the1990s

Therearenumerousinternationalprecedentsof comparableadjustmentstakingplacein ashorttime. Oneprominentexampleof asubstantialfiscal adjustmentwasthatof theUnitedStatesin the1990s,which is shown in thechart.A striking fact about this period was the accelerationof GDP growth that took place along with this fiscalconsolidation.This phenomenonof ‘expansionaryfiscal consolidation’ hasalsobeenexperiencedby many othercountrieswhichhaveembarked onfiscalconsolidation.

1988 1990 1992 1994 1996 1998 2000

18

19

20

21

22

23

24

25

Pe

rce

nt

to G

DP

Expenditure

Revenue

GDP growth (right scale)

1988 1990 1992 1994 1996 1998 2000

fiscal system, and shift into new ways ofthinking.

Throughthesechannels,therewill innatelybe somelag betweenpolicy decisionsandtheir full impact on therevenuedeficit. Thisconstitutesan argumentin favour of front-loading of decisions. At the same time,this suggeststhat while decisionsshouldbefront-loaded,their full impactshouldonly beexpectedwith a lag. The full impact of adecisionon reformsin 2004-05will only beseenin 2005-06,2006-07andbeyond.

4.3.2 Flexibility on capital expenditure

It is important to emphasisethat the focusof the FRBM is on ensuringthat revenuereceiptsexceedrevenueexpenditure.FRBMdoes leave government with flexibility inengagingin capitalexpenditure.1

1Increasedcapital expendituresdo impinge uponthe calculations required by the FRBM, if theyare financed by bond issuance. For example, ifcapitalexpendituretakesplacein 2004-05usingbondissuance,then the interestpaymentson thesebondswould serve to increaserevenueexpenditures from2004-05onwards,andwould requirea consequentialincreasein revenuereceiptsin orderto ensurethattherevenuedeficit is eliminatedby 2008-09.

42 Macro perspectiveon fiscal consolidation

Hence,if thereare strongfearsof the con-tractionaryeffectsof increasingtaxrevenues,or cuttingexpenditures,thenincreasingcapi-tal expendituresremainsavailableasapolicytool.

From a debt dynamicsperspective, capitalexpenditurescanbe safelyundertaken whenfuture userchargesand the incrementaltaxrevenues from the increasedfuture GDP(causedby the new capitalgoods)are largeenough. In technical terms, governmentcan confidentlybuild a railway line costingRs.1000crore, financedby issuing a bondworth Rs.1000crore, when the NPV of theincreasedtax revenueson theincreasedGDPin thefuture,coupledwith theNPV of futureusercharges,exceedsRs.1000crore.

If this condition is not met, then capitalexpenditureswhich are financedby issuingbonds serve to raise the Debt/GDP ratioand are not fiscally sustainable. Thisdifficulty posessignificantconstraintsuponthe ability of governmentto easily rampupcountercyclical capitalexpensesin awaythatdoesnotadverselyaffectdebtdynamics.

This approach emphasisesthe need toacute care in the institutional design ofthe processesthrough which debt-financedcapital expendituresare undertaken. Thisaspectalso links up to the issue of lagsin policy discussedin Section4.3.1, sincecreating new institutional mechanismstoachieve high quality capital expenditure(inthe sensesketched above) is difficult andtime-consuming.

Table 4.1 summarisesthe experiencewithonesuccessfulexperienceof capitalexpendi-tureby theCentre:thatof NHAI. TheUnionBudgetfor 1998-99hadprovidedfor thefuelcess,and1998-99canbe viewed asthe firstyearof the highway-building effort. As the

Table 4.1 Buildup of capital expenditureofNHAI

CapitalexpenditureYear (Rs.crore) (Percent to GDP)

2 1999-00 746 0.043 2000-01 1,261 0.064 2001-02 3,997 0.185 2002-03 6,584 0.216 2003-04 9,525 0.33

table shows, it was only in year 4 that thecapitalexpenditurereachedalevel of roughly0.2% of GDP, and in year 6 that it reached0.33%of GDP.

This suggeststhat if there is an intent ofengagingin countercyclical capitalexpendi-tures in the period 2007-2009,institutionalmechanismsthrough which thesewill takeplaceneedto becreatedwell aheadof time.

4.3.3 Expansionaryeffectsof tax reforms

Theabovediscussionhasfocusedonthecon-tractionaryeffectsof thefiscalconsolidation,andhow thiscanbedirectly counteracted.

At the sametime, therearemany importantchannelsthroughwhich fiscal consolidationis expansionary. In many countries, therehave been experiences of ‘expansionaryfiscal consolidation’, which underline theimportanceof thesechannelsof influence.

In India’s case,the most importantpositiveimpact isrootedin tax reformsthemselves.Tax rationalisation,removal of exemptions,andmodernisationof tax administrationwillinnately reduce deadweightcosts, reducethe extent to which resourceallocation isdistorted in the quest for tax evasion, andthusraiseproductivity. Theseimprovementscanbe viewed aspositive productivity gainswhich will be causedby tax reforms. They

4.3Other considerations 43

will fuel GDPgrowth in theyearsthatfollowthe taxreforms.

Thesecondchannelliesthroughinterestratesand the bond market. To the extent thatthe fiscal deficit goes down, Governmentwould make a smaller claim on resourcesthroughbond issuance. This would reducethe crowding out of the privatesector, makegreater resourcesavailable to the privatesector, foster reducedinterest rates and alower costof capitalfor equityanddebt,andfostereconomicgrowth.

Tax reforms would give greatersupport toentrepreneurship,support relatively labour-intensive small andmediumenterprises,andreducethe cost of capital for risk capital.Throughthesechannels,resourceallocationwouldbeimproved.

Credit rating agencies have focused onIndia’s fiscal problemsas the defining issuewhich hasled to near-junk ratingsfor Indiandebt.2 WhenIndia is visibly seenasmakingprogresson thefiscalquestion,India’s creditratingwould improve. Thiswould reducethecostof capitalfacedby firmswhenborrowingabroad,andthusfurtherspurinvestment.

Domestic capital markets and businessconfidence would improve, when it is seenthatGovernmentis seriousaboutestablishingprudentgroundrules.

Thus, there is a strong link betweenfiscalconsolidationandanexpansionof investment

2Using ratings by S&P, the median values forthe centralinterest/ revenuesratio for variousratingcategories were as follows: BBB (8.68%), BB(19.21%), B (16.68%). The medianvaluesfor thecentralgovernment Debt/GDPratio for variousratingcategories were as follows: BBB (29.98%), BB(55.95%), B (70.8%). By S&P scales, investmentgraderunsfrom AAA till BBB-. Below that,startingfrom BB+, is speculativegrade.

and thus employment in the economy.Conversely a failure to make progressonfiscalconsolidationwouldleadto acontinuedpreemptionof investibleresources,andlowerjob creation.

4.3.4 Positive impact on statefinances

In the last decade, the finances of stategovernmentshavebeenfacingextremestress.This hasmanifesteditself in poorproductionof local public goods, most of which arecontrolledat the statelevel. Weaknessesinhealth, education,water and sewage, localroads,etc. areall importantproblemswhichhold backGDP growth. Thereis an urgentneedto improve expenditureson healthandeducation.

At present, many state governmentshavesignedMemorandaof Understandingwhichrequireeliminationof the revenuedeficit by2005-06. The accomplishmentof this targetis acentralissue that isshapingpoliciesatthestatelevel.

This constitutesa strongargumentin favourof front loading. If the centre is ableto improve the Tax/GDP ratio in 2004-05and 2005-06, then roughly 30% of theseincreased proceeds will go to the stategovernments,where they will substantiallyalleviate the statefiscal crisis, help achievethe targets agreedto under Memoranda ofUnderstanding, leadto improvedproductionof local public goodsandthusstrengthenthedevelopmentprocessat thegrass-rootlevel.

This constitutesone of the most importantchannels through which expenditures onhealth and education, which are statesubjects,canbesharplyincreasedin thenearfuture.

44 Macro perspectiveon fiscal consolidation

4.3.5 Needfor pre-announcedtrajectory

Governmentis presentlyengagedin mediumterm fiscal planning, leading to a removalof the revenuedeficit by 2008-09. Theseplansnecessarilyinvolve many actors,willbe phasedin over a period of years, andwill have a considerableimpact upon theoptimisingdecisionsof individualsandfirms.

Thesedecisionsof economicactorswill bebest undertaken under conditions of fullerinformation, and sound expectationsaboutthe future. The changesin policy willundoubtedlyaffecttheeconomy, but they willhave the smallesteffect if economicagentshavesoundexpectationsaboutthefuture,andareableto well anticipatethechangesthatareunderway.

This suggests a need for good qualitydisclosure by government about the pathto 2008-09, to ensure that there is fulltransparency aboutthepath,andto minimisethe shocksto the economythat comeaboutfrom policy announcements.

4.4 PROPOSALS

To summarise, there are a number ofarguments favouring fiscal consolidationthrough higher tax revenues rather thanreductionin expenditure:

• Raising tax revenues helps state financesthroughthe devolution of resources,and thusfuels GDP growth through better resourceflows into local public goods. In contrast,cuttingcentralexpendituredoesnotaddresstheproblemof localpublicgoods.

• The expenditure multiplier is larger thanthe tax multiplier, hence the businesscycleimplicationsof cutting expendituresare more

onerousthanthebusinesscycle implicationsofraisingtax revenues.

• Tax reforms, which move towards a simpletax system, yield positive productivity gains:they eliminate deadweightcosts and reducedistortions in resourceallocation. Throughthis, they serve to boost GDP growth andemploymentgrowth.

Thereareseveralreasonsthatindicatethede-sirability of front-loadedfiscalconsolidationcomparedwith back-loadedfiscalconsolida-tion:

• Swift and decisive actions would greatlystrengthen the credibility of the country’seconomicpolicy making.

• Thedomesticeconomyandtheworld economyare faring well in terms of businesscycleissues. Fearsof deflation have receded,andthereappearsto belittle slackcapacity. Hence,a front-loaded fiscal consolidation may notadverselyaffectdemand.

• An early fiscal consolidationwill ‘reload theguns’ for countercyclical fiscal policy twomovesahead.

• An early fiscal consolidationwill quickly freeup resourcesfor investment by the privatesector. It will quickly improve India’scredit rating, improve investmentflows, andaccelerateGDPgrowth.

• An early improvementin the centralTax/GDPratio will swiftly easethe difficulties of statefinances,andthushave apositive impacton thedevelopmentprocessat thestatelevel.

• Owing tolagsin policy, decisionstaken in2005will fully yield fruits in termsof higher GDPgrowth andsoundfiscaloutcomesby 2006and2007. It is henceimportant to take decisionsearly about reforms in tax and expenditurepolicies, so as to benefitfrom the full impactof these decisionsby 2008-09. The idealsequencingis thusonewherea comprehensiveexercisein reformingtax policy is put in forceearly. The full impact of this upon fiscaloutcomeswould comeover a two to threeyearperiod,reflecting thetime taken tobuild sound

4.4Proposals 45

tax administration,for behavioural changestotake place amongfirms and householdswhowould then shift out of their existing distortedstates,and for higher GDP growth rates tomaterialise.

• FRBM also places obligations on theDebt/GDPratio. A slow fiscal consolidationwill give agreateraccumulationof debt.

In the light of this analysis, the fourfundamentalprinciplesfor anIndianstrategyin achieving fiscal consolidation may bearticulatedasfollows:

I. Fiscalconsolidationshouldberevenue-led.

II. Fiscalconsolidationshouldbefront-loaded.

III. Capitalexpenditure shouldbeenhanced,whilesimultaneouslyengagingin institutionalreformto ensurean adequatetranslation of capitalexpenditureinto anincreasedflow of GDP.

IV. The reforms efforts on revenue expenditureshouldbefurtherintensified.

46 Macro perspectiveon fiscal consolidation