Public deficits and the public interest

Published : Nov 10, 2001 00:00 IST

In India, all economic indicators point to the need for higher public expenditure in order to revive economic activity.

NOW that the economy is clearly in recession, it becomes more and more obvious to most players that the government must move quickly to pump prime the system and increase expenditure in order to revive economic activity. And indeed, the other features of the economy at present - such as the existence of huge surplus foodgrain stocks in the public sector and a comfortable level of foreign exchange reserves ensure that such moves would not be inflationary but rather expansionary.

The present situation is one that calls so clearly for Keynesian style increased public expenditure that even the Confederation of Indian Industry (CII), which is anything but an advocate for more government spending in most circumstances, has asked for it. Nevertheless, despite the overwhelming arguments in favour of an expansionary fiscal stance at this stage, neo-liberal economists who advise the government tend to remain unmoved.

Thus the Prime Minister's Economic Advisory Council has cautioned against using fiscal stimuli even in this context. Recently it has actually been argued by some neoliberal economists that fiscal deficits are disastrous not only because they "crowd out" private investment through higher real interest rates, but because they apparently lead to lower aggregate savings and investment rates in the economy. And therefore, curbing the fiscal deficit by cutting state expenditure becomes the primary goal for such economists, regardless of the state of aggregate demand in the economy.

There are several important fallacies in such an argument. One set of fallacies relates to the actual effects of fiscal deficits in particular economic contexts, as considered below. And another area of confusion stems from the fact that the very processes of economic and financial liberalisation that are advocated by such economists are actually responsible for worsening the fiscal position of the government.

Consider first of all the effects of a fiscal deficit. It is typically argued that large deficits create macroeconomic instability in the form of inflation or external imbalance. But the size of the fiscal deficit, which shows the net demand arising from the government, does not necessarily have anything to do directly with such instability, since both of these depend upon ex ante excess aggregate demand. In fact, if there is a positive private savings balance (that is, private savings is more than private investment) then this would finance the public deficit. A classic example is that of Italy, where until 1997 the government ran huge fiscal deficits amounting to around 9 per cent of GDP for more than a decade, and this was entirely financed within the country by the private sector's savings surplus in the fast growing economy.

Secondly, while large revenue deficits (which reflect the excess of current non-capital expenditures over current revenues) can be problematic, there is nothing necessarily wrong with borrowing to meet investment requirements. In fact, there is a strong case for a fiscal deficit composed entirely of public capital investment, as long as the social rate of return from such investment exceeds the rate of interest.

Thirdly, a reduction in the revenue deficit or in the fiscal deficit can be brought about in a number of ways besides expenditure cuts, the most obvious method being an increase in direct tax revenue. Indeed in any developing economy where glaring poverty coexists with offensive opulence, increased revenue from direct taxes is urgently called for anyway as a means to reduce inequalities. But policies of liberalisation or the new-style economic reforms invariably underplay or even completely disregard this avenue of deficit reduction and emphasise cuts in investment and welfare expenditures.

So the theory underlying such expenditure cuts is completely invalid. But even apart from this, it is the case that the various economic measures that are undertaken as part of the neoliberal "reform" agenda actually operate to worsen the fiscal deficits which are invoked to justify expenditure cuts in the first place. There are several ways in which this occurs.

FIRST, since inviting direct foreign investment becomes an overriding objective of economic policy, the rates at which they are taxed get reduced in competition with other countries. This, for reasons of symmetry, means that direct tax rates on the rich as a whole are lowered. Since customs duties are cut as part of the import liberalisation package, and excise duties, again for reasons of symmetry, cannot be raised as a consequence, indirect tax revenues too suffer. This is aggravated by the sluggishness in output growth that cuts in government expenditure may engender. Liberalisation has an adverse impact on tax revenues for three reasons. First, since trade liberalisation has as an important component the reduction of the maximum and average rate of tariffs imposed on commodities, revenue trends can be adversely affected even if liberalisation leads to an increase in the import bill. Second, since liberalisation is expected to spur private sector demand and encourage the growth of private industry, Finance Ministers have through the liberalisation years provided a range of excise duty concessions in order to revive or spur demand in individual sectors. Finally, with the liberalisation-driven objective of improving private incentives to save and invest, the government has been providing a range of direct tax concessions as well.

It is not surprising, therefore, to find that the tax to GDP ratio in the Indian economy fell over the decade of neoliberal reform from more than 11 per cent at the start to around 9 per cent at the close - an abysmally low ratio by international standards.

While tax revenues cannot be raised to lower budget deficits, the higher real interest rates, resulting in a larger interest burden on the government, add to the expenditure side. Increased interest rates on public sector borrowing are typical results of the financial liberalisation process. Two features are particularly significant in this process: first, various measures which increase interest rates in the economy; and second, the raising of norms on statutory liquidity ratios and other such compulsory holding of government securities, which forces the government to take recourse to open market borrowing to finance deficits.

Thus this type of economic strategy, which aims to restrict the fiscal profligacy of the state, in effect contains within itself processes that work to aggravate the fiscal situation, through lower taxes on the rich and higher interest rates.

OVERALL, therefore, economic reform has had damaging consequences for the fiscal position of the Central government. Nothing reveals this more than the fact that, through the 1990s, while capital expenditures as a proportion of GDP have fallen sharply and revenue expenditures net of interest payments have stagnated, the government's effort to hold down the fiscal deficit has been completely unsuccessful.

All this, of course, in no way undermines the basic Keynesian argument for increased state expenditure. In a situation of unutilised capacity and low demand, increased spending will generate positive multiplier effects which will increase economic activity, reduce slack and thereby add to future public tax revenues because of the economic growth that will result. So all increased state expenditure does not necessarily mean higher public deficit, since some of this will come back as higher tax revenues.

Then there is the issue that such expenditure, by generating more economic activity and employment, would directly benefit workers and small-scale producers. However, failing to engage in such expenditure simply benefits a small group of rentiers who are obsessed with the chimera of controlling fiscal deficit and tries to pander to their interests. And by allowing low levels of employment and economic activity to persist, by allowing foodgrains to rot instead to going in for public food-for-work schemes, by allowing valuable domestic manufacturing assets to be run down because of lack of demand, by depressing the incentives for technological change and productivity increases, this strategy commits a major crime against the more general public interest.

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