Indian Economics & Politics: September 2019

Introduction

The flurry of reforms unleashed in the last few weeks suggests that the Government has finally accepted that the Indian economy is in trouble. The changes have been so dramatic that the Economic Times called it the “3^rd Budget in 8 months”.[i] Of course, there is a disconnect between what the government says and what it does: even as the Finance Minister Nirmala Sitharaman announced changes to the FDI policy in August, she claimed that the Indian economy was doing very well.[ii] Never mind. The ruling BJP has its compulsions: it needs to keep its flock together and, hence, needs to paint a rosy picture of how well the economy is doing.

For months, economists and other responsible analysts had been pointing to the alarming state of the economy. Despite all the misgivings about the GDP especially after the base change and after numerous revisions,[iii] I use quarterly growth rates of GDP in Figure 1 below to capture in summary form the problems facing the economy.

The growth rate in 2019-20Q1 at 4.89% is the worst that the economy has performed since 2012-13Q4 when it was 4.21%. The BJP might still find solace in the fact that its worst performance is still better than the worst performance during the UPA rule. However, just the fact that one has to search for the worst performance of the UPA to make the latest growth rate look good shows the magnitude of the problem. In addition to the falling growth rate, analysts have drawn attention to other grave problems: (a) unemployment[iv] [v] (b) stagnant rural incomes[vi] (c) falling consumption[vii] (d) falling investments.[viii] The combination of stagnant rural incomes, stagnant consumption and investment levels coupled with low inflation suggests that the primary cause of the slowdown in India is inadequate demand.[ix] Combating such a slowdown in the economy requires demand-side policies, such as, increases in government expenditure. This might well have an adverse effect on the quantum of fiscal deficit but, if the economy revives and GDP increases at a faster rate than it currently is, the fiscal deficit to GDP ratio may not experience too large an increase.

Flurry of Reforms

In response to the slowing down of the economy the government has announced a series of measures:

Merger of banks, which has reduced the number of public sector banks from 27 to 12.[x]
Foreign Direct Investment: On 28 August 2019, the Finance Minister announced changes in the FDI policy which would now permit single-brand retail to commence online retail trading prior to opening of physical stores provided physical stores begin operations within two years of commencement on online operations.[xi] This is a major change since single brand retail FDI has been a “political hot potato” which no government had embraced so far.[xii]
Loan Melas: The Finance Minister has urged public sector banks to hold “loan melas" (loans festival) in 400 districts across the country.[xiii]
Tax Rates: The biggest announcement has been the reduction in corporate tax rate from a highest rate of almost 35% to about 25%.[xiv]

The important question is whether there is a correspondence between the problems facing the Indian economy and the policy measures that have been announced. As stated above, the problem facing the economy is one of inadequacy of demand. Do the policies that have been announced address the problem of demand deficiency? I have my doubts especially because the measures announced are in the nature of supply-side policies.

Supply-side policies

Supply side policies are designed to increase the potential output of an economy.[xv] In general, such policies affect an economy’s long run economic growth. Supply side policies typically involve reduced government expenditure, tax cuts for labour and business and policies designed to increase competition. Of course, the approach to supply-side policy has to be nuanced; for example, which type of government expenditure is reduced matters.

Considering the various measures that have been introduced in the recent past one could identify the following:

Merger of banks: supply side measure to increase competitiveness
Foreign Direct Investment: supply side measure to increase competitiveness
“Loan melas": assuming that loans are actually given out, this is likely a demand side measure
Cut in corporate tax rates: standard supply side policy

Barring “loan melas” all the others are supply side policies which are expected to increase long run economic growth. No doubt this is important but does it address the problems that the economy is facing? The hope of the supply side policies – especially FDI and tax cuts – that have been introduced is that foreign and domestic investment will revive which will lead to more employment and which will result in higher production which in turn will lead to more investment, more employment and so on in a virtuous cycle. The question is whether investment will work as an autonomous driver in a demand deficient economy. If producers are not confident about selling their products – remember the problems being faced by Parle-G biscuits as well as other FMCG products[xvi] and Maruti Suzuki cars?[xvii] – would they take the risk of investing? The tax cuts that have been announced will have immediate beneficial effect only if the money is spent on additional investment. In the absence of that, it is merely a bonanza for companies and huge strain on the public finances.

Fiscal Multipliers

A change in fiscal policy (change in government expenditures or change in taxes) has an impact on GDP. The size of this impact is measured by the multiplier.[xviii] It may be noted that a change in taxes or a change in expenditure has an impact on the fiscal deficit which is defined (in simple terms) as:

Fiscal Deficit = Government Expenditure – Government Revenues

Expenditures include both capital and current account expenditures while government revenues include tax revenues, non-tax revenues and other non-debt-creating revenues (e.g. disinvestment proceeds).

The recent reduction in corporate taxes is expected to reduce tax revenues by Rs. 1.45 lakh crore. Keeping government expenditures constant, fiscal deficit will rise by the same amount. However, if the government wishes to keep fiscal deficit constant, expenditures must be reduced by the same amount that taxes have gone down. It may be noted that a reduction in taxes and increase in expenditures are said to be expansionary i.e. they are designed to expand the economy. The question is, by how much? This is computed by reference to the multiplier. Denoting government expenditures as G and tax revenues as T, the relationship between GDP and G or GDP and T is given by:

Change in GDP = (expenditure multiplier)*(change in G)
Change in GDP = (tax multiplier)*(change in T)

It can be shown that the tax multiplier is smaller than the expenditure multiplier. Hence, for a unit change in expenditure, the change in GDP will be greater than for a unit change in taxes. Bose and Bhanumurthy of NIPFP have estimated that the multiplier associated with capital expenditure is as high as 2.45. [xix] If instead of cutting taxes to the extent of Rs. 1.45 lakh crore, the same amount had been spent of capital expenditure, GDP would have risen by Rs. 3.55 lakh crore. Bose and Bhanumurthy estimates for the multiplier associated with the corporate tax indicate that for the Rs. 1.45 lakh crore cut in taxes, GDP will increase by the same amount. Clearly, you get more bang for the bucks with a unit change (i.e. increase) in expenditures than for a unit change (i.e. decrease) in taxes.

Conclusions

In conclusion, I will summarise my evaluation of the recent policy changes:

The problems facing the Indian economy have arisen due to a deficiency of demand and, hence, solving these required that demand-side policies be enacted
Unfortunately, the government has enacted supply-side policies which will be beneficial in the long run by raising India’s potential output. However, it may not do anything to reverse the slowdown in the economy.
Reducing taxes as an expansionary measure does not have as much of an impact as raising government expenditures due to the much smaller multiplier effect.
If government expenditures are reduced to keep the fiscal deficit at its announced level, the economy will face a further problems. Note that the expenditure multiplier works in reverse as well and a reduction in expenditures will reduce GDP. In the current context, if expenditures are cut by Rs. 1.45 lakh crore, GDP will fall by Rs. 3.55 lakh crore. Coupling this with the increase in GDP due to the tax cut, the net effect on GDP will be a fall of Rs. 2.1025 lakh crore. This is bound to worsen the economic situation in India.