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 “3rd 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.
[iii]
Do listen to this very informative podcast: http://www.seenunseen.in/episodes/2019/7/22/episode-130-demystifying-gdp
