Exercise in inertia

Published : Mar 27, 2009 00:00 IST

WHY do they not get it? In periods of economic downturn, tax cuts simply do not solve the problem of reviving the economy. The reasoning is so simple that it should be kind of obvious: when economic activity and employment are coming down, something has to be done to kick-start markets and increase effective demand. And there are several reasons to say that increased government spending is the simplest, most direct and effective way of increasing demand in such a situation.

The argument that tax cuts can help create more demand is based on the idea that when people retain more income (because of income tax sops) or find that goods are cheaper (because of indirect tax cuts) they buy more, which would push up demand and revive the economy. But the first mechanism need not work, especially in situations of economic uncertainty, when people are worried about the future and about their own future income streams and therefore simply save more out of the additional income. This is especially so in countries like India because direct tax payers are already a small and relatively well-off minority that does not need to consume the additional income in order to survive.

The second mechanism is even more problematic. To begin with, indirect tax cuts reduced rates of sales and excise duties need not be fully passed on by producers to consumers, so that actual price falls may not be as much as suggested by the tax cuts. But the more significant problem is that relatively minor price declines are unlikely to motivate higher rates of consumption when consumer confidence is anyway down for the reasons outlined above. Indeed, when animal spirits are particularly subdued, tax cuts that are associated with falling prices can even have an effect that is the opposite of what is intended. As was found in Japan in the 1990s, falling prices simply made potential consumers even more worried about the future and their own possible unemployment and made them reduce their consumption even further.

It has been known for at least seven decades now that tax cuts are not the most useful fiscal policy weapon against deflation. Instead, the much more sensible thing to do is to increase public spending because that is a direct injection into the economy. While such spending will necessarily have positive multiplier effects that will generate a wider expansion in economic activity, the value of this multiplier effect depends on the marginal propensity to consume in the economy.

So, how the money is spent that is, how employment-generating it is or how much of it goes to the poor who need the resources for essential consumption is also likely to have an impact in terms of determining the positive multiplier effects of the spending.

In such a context, it is clear what the Indian government needs to do to combat the torrent of bad news that is pouring in about falling export demand, declining manufacturing production, job losses and agricultural stagnation. It must engage in proactive countercyclical macroeconomic policies. Simply put, it must spend, and spend in ways that directly create more employment and more indirect demand.

There are many ways that public expenditure could be usefully increased, which would meet both the demands of the immediate economic crisis and longer requirements of development in India.

There is a strong case for immediate expansion of the National Rural Employment Guarantee Scheme (NREGS) to ensure not just that it reaches every rural habitation in the country but to provide for individual entitlements rather than being household-based as at present. It would also be good to lift the arbitrary limit of 100 days of employment specified in the Act, but since hardly any households in the country are getting that at present, this is not the immediate concern and providing individual entitlements would be more productive. Extension of the employment guarantee to urban areas which was promised in the United Progressive Alliance (UPA) governments Common Minimum Programme also needs to be expedited.

Second, the continuing problems in agriculture require urgent attention, not least through price stabilisation schemes for farmers facing very volatile international prices and significantly enhanced public expenditure in agricultural research, sustainable irrigation practices, and improvement of soil fertility and related areas. Given that the majority of our workers (and our population) still depend on agriculture for basic livelihood, such public spending directed towards agriculture should be one of the first charges on the national budget.

Third, much more public expenditure on ensuring a vibrant and efficient Public Distribution System (PDS) for food is required. The food crisis continues unabated as inflation in retail food prices in India continues to rule high. India already has the dubious distinction of topping the international hunger charts, with the latest Report of the United Nations World Food Programme estimating that 230 million Indians are undernourished, more than people of any other country and accounting for 27 per cent of the total number in the world.

Other nutrition indicators, such as anaemia and protein deficiency, are also appalling, especially for Indian children. And there is evidence that food insecurity is on the rise it is certainly likely to worsen with the combination of rising food prices and higher unemployment. This is clearly time for the government to expand and universalise the PDS and provide better access to all citizens to affordable food.

Fourth, social expenditure needs to be stepped up, especially in health, sanitation and education. Some of this can be done directly through central schemes (the so-called flagship schemes of the UPA government). Since State governments are primarily responsible for such spending, it makes more sense immediately to ensure that the States are not strapped for cash for such essential items, by directly transferring Central resources to them. Social spending has the added advantage that it is generally employment-intensive, and therefore also has high multiplier effects.

Fifth, spending on infrastructure and public housing, especially in rural and urban areas that have hitherto been hugely deprived, would serve the manifold purposes of reviving the construction industry, generating more employment, easing infrastructure bottlenecks and generally improving the quality of life of the citizenry.

So, there is clearly no shortage of useful avenues for increased public spending, which could have a range of benefits along with immediately reviving the economy.

So is the Indian government doing any of these very obvious things, which are simply crying out to be done? Remarkably, no. Instead, the Interim Budget presented by the Centre was almost an exercise in inertia, compounded by denial about the severity of the effects of the crisis in India. The excuse provided for the lack of decisive action was the sense of propriety apparently felt by the government that is shortly to face general elections.

But all such considerations of propriety vanished just a few days later when the government, in its response to the discussion on the Vote-On-Account Budget, announced a slew of tax-cut measures, mostly benefiting certain consumer durable industries and financial activities. These tax incentives which are estimated to cost the exchequer as much as Rs.30,000 crore make little economic sense. Surely, no one can believe that many more consumers will rush to buy an automobile worth Rs.4 lakh simply because its price has been brought down by Rs.4,000 by tax concessions. And providing more tax incentives to the finance sector at this point is laughable.

While these tax concessions have high opportunity cost because they represent money that could have been spent in so many more productive ways, the only clear beneficiaries of these are the industries concerned.

Clearly, industry and corporate lobbies have been successful in getting their way with the government when many more deserving constituencies have been ignored.

The very next day, the Central government announced an additional handout of dearness allowance to its employees, involving an additional outgo of more than Rs.5,000 crore.

Once again, this decision defies logic. Why not provide such money to enlarge the Centrally sponsored schemes that will directly benefit ordinary people? Why not reduce (at least temporarily) the requirement for State governments to provide matching grants, to enable such resources to be used quickly? Or better still, why not simply provide the resources directly to States for their own plans?

State governments that have begged desperately for a few hundred crores more from the Planning Commission to meet essential development expenditure have been turned away without anything but the suggestion that they borrow more on their own.

For example, the Centres Plan Assistance to Bihar (with a population of nearly 90 million) is less than Rs.3,000 crore for the current fiscal year, and nothing more has been provided to it notwithstanding the current fiscal exigency. But more than Rs.5,000 crore was quickly found to provide additional dearness allowance to those who are already the best-paid civil servants in the country.

The UPA government, in its final lap, has therefore created a genuine sense of bemusement about its intentions on tackling the crisis. The chances of making a real difference through proactive fiscal policy that would lift economic activity and generate employment have all been wasted.

And the flurry of fiscal changes that were announced just before the electoral code of conduct came into force suggest nothing more than obeisance to corporate lobbies and preferred interest groups, without any serious regard for the macroeconomic implications. Surely the country deserved better.

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