Overall fiscal position can increase risks
The fiscal deficit numbers announced in the Union Budget have surprised almost all analysts. According to the revised estimates, the fiscal deficit at Union level will expand to 9.5 per cent of gross domestic product (GDP) in 2020-21. The government is aiming to contain it at 6.8 per cent in the next fiscal year and to below 4.5 per cent of GDP by 2025-26. The expansion in the Budget deficit is not very difficult to justify. First, the economy is expected to contract by 7.7 per cent in the current fiscal year, which has not only resulted in a significant loss of revenue, but also requires government support to recover the lost ground at the earliest. Second, the government has made a big shift towards improving transparency and has brought off-Budget items related to subsidies on its books, pushing up the headline fiscal deficit.
These steps have been lauded by most commentators, but India’s overall fiscal position needs greater attention because it can lead to both growth and financial stability risks. The overall fiscal expansion is likely to take the stock of public debt to perhaps over 90 per cent of GDP in the current year and it is unlikely to come down in a hurry. The Fifteenth Finance Commission’s (FFC’s) projections suggest that the general government debt will only moderate to about 86 per cent of GDP by 2025-26. However, there could be risks. The FFC has assumed a gradual return to a trend GDP growth rate of 7 per cent, which may not materialise in the stated period. India’s potential growth is said to have come down significantly, partly because of the pandemic-related disruption. To be sure, elevated levels of debt and deficit will not allow India to take any countercyclical measures in the case of a shock in the medium term. If GDP growth falters, higher interest payments, along with a higher debt stock, could create a vicious cycle and increase risks to financial stability.
To avoid such an outcome, India needs to address its inherent fiscal management weaknesses. According to the FFC’s estimates, the gap in India’s tax collection is over 5 per cent of GDP, compared to its potential. Further, overall tax collection at about 17 per cent of GDP in 2018-19, for instance, was roughly at the same level as in the early 1990s. Differently put, all the reforms over the years and the formalisation of the economy have not resulted in a higher tax-GDP ratio. India’s revenue collection (tax and non-tax) is also very low compared to other emerging economies. Effectively, this means that India is not in a position to take fiscal risks like other countries.
Additionally, higher government spending could increase risks to inflation. Although the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is expected to leave the policy rate unchanged on Friday, the accompanying commentary would be worth watching. The MPC will need to make sure that higher government spending does not end up fuelling inflation expectations. Besides, the RBI will not only have to manage a large borrowing programme — even in the next fiscal year — but also protect financial stability more vigorously. In the given context, the government should revisit the fiscal management framework to address the inherent weaknesses and impending challenges. It will help minimise risks.