BackOpinion | Let data on fiscal multipliers guide budget allocations
A boost in capital outlays to help attract private investment is what India’s economy needs
PremiumWhat should the government do to kick-start the economy, which has been slipping further and further? The question itself has been contentious, with opinions often based on which side of the economic fence you sit on. Thus, there are economists blaming the demand side for the current morass and calling for measures to prop the economy by bolstering aggregate demand. There are others who attribute the mess to supply-side factors, and hence suggest structural reforms.
In a scenario like the present, where the inadequacy of disposable income and, more importantly, consumer confidence may restrict consumption demand, demand side theorists recommend an increase in government expenditure as a means of driving up aggregate demand. There are others who recommend cuts in personal income taxes to support consumption and thus aggregate demand.
The moot question for deciding macroeconomic policy is: Which fiscal policy instrument is the most effective? The effectiveness of fiscal policy can be measured through fiscal multipliers, defined as the ratio of change in output to exogenous changes in fiscal variables—government expenditure or taxation, or both. The basic choice within government spending itself is between revenue and capital expenditure.
Revenue expenditure includes transfer payments such as major subsidies, pensions etc., as also direct spending by the government on goods, services and wage payments. While direct spending increases public consumption expenditure, transfer payments fuel private consumption by transferring purchasing power from the government to the rest of the economy, and thereby putting more money in the hands of the people. Capital expenditure, on the other hand, leads to public investment in the economy. However, revenue and capital expenditure are negatively related, given the fiscal targets and the budget constraint, in the sense that an increase in revenue expenditure will lead to a cutback in capital expenditure.
Such fiscal multipliers have been estimated by the Reserve Bank of India in its Monetary Policy Report . The revenue expenditure multipliers for both the central and state governments are at less than unity—0.45 and 0.82, respectively. This means a ₹1 increase in revenue expenditure by the government will lead only to a 45-paise or 82-paise increase in output. As governments increase revenue expenditure, they cut capital expenditure, which could result in a decline in private investment and hence gross domestic product (GDP) growth.
On the other hand, the capital expenditure multipliers for the central and state governments are 3.25 and 2, respectively. This means a larger impact on GDP for the same ₹1 rise in government expenditure, albeit on the capital side of the budget.
However, the central government fiscal indicators show a decrease in the budgeted capital expenditure from 1.7% in 2018-19 to 1.6% of GDP in 2019-20, even as revenue expenditure was increased from 11.2% to 11.7%, thereby increasing the overall budgeted government expenditure to 13.3% of GDP in 2019-20.
Such capital expenditure, it must be borne in mind, comprises not only of capital expenditure on acquisition of assets like land, buildings etc., but also loans and advances by the Centre to state governments and Union territories, government-owned companies, etc. The budgeted Gross Capital Formation for 2017-18, leaving aside such loans and advances, was a mere 6.7% of the central government’s total expenditure. Most of the cuts in the budgeted capital expenditure would likely have come from a reduction in such gross capital formation. State governments too have mimicked such capital expenditure cuts to achieve fiscal consolidation, even as there has been an increase in non-developmental expenditure and a cut in spending on roads, bridges, irrigation and energy.
That cutback in capital expenditure was worsened by tax collection shortfalls, especially of the goods and services tax (GST), and a consequent increase in the gross fiscal deficit (GFD). Faced with a lower tax intake and the spectre of a rising GFD, the Centre cut back capital expenditure, which contracted by 7.8% in 2018-19, as against a growth of 20.3% envisaged in its revised estimates.
The proposal to reduce personal income tax rates should be based on a correct estimation of tax multipliers, as also the corresponding tax base. Such tax multipliers estimated for the GST, corporate tax and income tax in India in 2013 by Sukanya Bose and N.R. Bhanumurthy were found to be around -1. The (reverse) personal income tax multiplier was only -1.01, while the GST multiplier was -1.08. The tax base for personal income taxes is also low, with personal income taxes accounting for a minuscule 2.6% of India’s GDP. Thus, the effectiveness of personal income tax cuts on growth seems fairly limited.
What the government broadly ought to do in the forthcoming budget for 2020-21 is fairly clear. Pay attention to fiscal multipliers. Reject populist revenue expenditure measures, as also ineffective personal income tax cuts, given their low multiplier values. A boost in capital outlays, with its positive impact on “crowding in" private investment, is the direction the economy needs amid all the gloom in the air.
Tulsi Jayakumar is professor of economics and chairperson, Family Managed Business, at S.P. Jain Institute of Management and Research (SPJIMR), Mumbai. These are the author’s personal views
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