Fiscal Policy

Fiscal policy deals with government spending, taxes and government debt. The key points to keep in
mind regarding this module are the following:

a. Structure of government budget: Revenue and Capital budget. Former deals with current
income and expenditure of the government while the latter looks at asset creating expenditures
and receipts from disinvestment proceeds along with loans.
b. Budget is further divided in to Planned and Non-planned where the first one is expenditure
earmarked for specific ministries to carry out their programs in consultation with the Planning
Commission of India. Non-planned expenditure on the other hand is accounted for by interest
payments, subsidies (mainly on food and fertilizers), wage and salary payments to government
employees, grants to States and Union Territories governments, pensions, police, economic
services in various sectors, other general services such as tax collection, social services, and
grants to foreign governments, defense, loans to public enterprises, loans to States, Union
Territories and foreign governments.
c. Over time this distinction has become problematic. Still in India Non-planned expenditure has
had a much higher share compared to the planned expenditure on account of high interest and
transfer payments.
d. Main points as far as the fiscal policy in India are concerned are the following:
a. High level of Revenue deficit difference between the Revenue receipts and Revenue
expenditure on account of very high interest payments and subsidies. This is bad as this
implies that the government expenditure is being used for consumption of unproductive
nature. So when time comes to repay government debt used to finance this deficit,
government will either have to increase taxes that will hurt growth or it will have to
resort to inflation to bring down the real value of debt which again is not good for the
economy.
b. From the tax side the problem has been heavy reliance on indirect taxes. Indirect taxes
are distortionary in nature as they change relative prices of competing goods and
services and they are also regressive since poor spend a larger share of their income on
consumption hence they share relatively higher burden of indirect taxes.
c. During 2003-2007, government did manage to achieve fiscal consolidation riding on high
growth rate and hence high tax collections, slow growth in capital expenditure along
with some accounting jugglery (oil bonds!).
d. However, with the onset of financial crisis, the need to provide fiscal stimulus implied
that the process of fiscal consolidation went off track and deficit (particularly revenue
deficit,) shot up. In the absence of a well-defined `exit` strategy from expansionary fiscal
policy (many of the fiscal changes in the wake of crisis such as 6th pay commission,
MGNREGA etc. were permanent in nature and actually unrelated to the crisis) and
absence of meaningful reforms that could increase the potential growth rate of Indian
economy implied that the fiscal `headroom` was exhausted after the crisis with no gains
in productive capacity. Now, with slowdown in growth , high inflation and weak global
 economy India is not in a position to provide counter-cyclical fiscal stimulus and has to
work to achieve fiscal consolidation in the midst of a slowing economy.
e. With a high share of revenue receipts going towards servicing existing debt stock, India
is in the danger of getting in to a `debt trap` where in it will have to keep on borrowing
more and more just to service the existing stock of debt. A high debt to GDP ratio
(above 85-90 percent) can further bring down growth by adversely affecting investor
and consumer sentiments. That would make the situation even worse as far as
government debt is concerned.
f. Bottom line: Important to keep the `Fiscal powder` dry (have healthy fiscal position) in
normal times in order to be able to help the economy during adverse periods.
g. Some pluses for India are that Public debt is largely domestically held and is of longer
maturity. Same cannot be said about the private sector debt though.
e. In general, following points need to be kept in mind when analyzing the fiscal policy of any
country:
a. What is its composition - `C` or `I`. Except for merit goods and public goods, very high
`C` component is not good.
b. Even if government engages in `I`, long gestation periods for the infrastructure projects
could mean that the economy could see overheating in the interim (no increase in
productive capacity in the short run but high aggregate demand due to government
spending). At the same time expectations of sustained expansionary fiscal policy stance
might fuel inflationary expectations.
c. Second important consideration is the state of the economy in terms of liquidity and
investor sentiments as well as `excess capacity` in the economy. If liquidity is tight,
government spending will crowd out private spending. If investor sentiments are very
low so that interest rate reductions fail to boost investment spending then government
expenditure might help by boosting aggregate spending and expectations of future
growth. On the other hand, persistent and high level of government debt used for
financing populist schemes such as cash transfer might actually crowd out private
investment. If there is little excess capacity in the economy, fiscal deficit will fuel
inflation without boosting growth (vertical AS)
d. Mode of financing is also important, though ultimately it is the productivity of the
expenditure that will determine whether government deficit has an adverse impact on
growth or a positive impact.
i. High domestic borrowings to finance government deficit tend to push up
interest rates
ii. Higher taxes are likely to have an adverse impact on disposable income as well
as incentives to invest and work
iii. Printing of more money (Monetization) likely to fuel inflation in the absence of
productivity growth
iv. Higher external borrowing likely to widen trade deficit and put domestic
currency under pressure unless government uses the money to enhance
productivity and export capacity of the economy
e. Sustainability of government debt: Simple view - b = b(r g) z. If r<g or interest rate on
debt less than the growth rate of the economy then debt to GDP ratio will not be
growing even if z ==0 (primary surplus = 0)
f. In reality, a lot of things matter such as the maturity structure of the debt, its currency
composition, is it domestically held or externally held.
g. Ultimately, government debt is like any other asset and an important determinant of its
sustainability is investors confidence. As long as investors continue to believe that
government will not default on its debt (it will be able to repay interest and principle in
a timely manner) people will continue to finance it. This may be true even when
government is simply borrowing more and more to service its existing debt (US for
example!). As long as investors believe that there is a market for a countrys debt they
will continue to fund it. However, when that confidence is lost (as in the case of Greece
and other periphery Euro zone countries), there is trouble. The country is then forced to
default explicitly or implicitly through `debt restructuring` (second one is more likely). It
then becomes difficult for the country to get back to the international capital market
without external support either from a multilateral agency like IMF or ECB or another
country which can bail out the sovereign in trouble. It is therefore a matter of
conjecture when a countrys sovereign debt will become unsustainable. Japan is one
example of a country that has had a very high level of sovereign debt and yet has no
problems financing that debt through fresh issues of Japanese Government Bonds (JGB).
Whether this can continue indefinitely is however anybodys guess.