Why the fiscal package is ineffective
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Home General

Why the fiscal package is ineffective

Archive Manager by WEB DESK
Mar 22, 2009, 12:00 am IST
in General
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The fiscal package implemented by the Government does not appear to be delivering. The rupee has declined to an all-time low of Rs 52 to a dollar. The sensex is down to 8k. Quarterly growth rate is in the dumps at five per cent. This situation cannot be wholly attributed to loss of export markets due to global recession. The share of foreign trade in our GDP is small by global reckoning. Further, exports declined by 16 per cent while imports declined by 18 per cent in January. Therefore, the loss of export markets was more than made up by gain of domestic markets.

The problem is due to inherently faulty design of the fiscal package. The alleged purpose of the package is to rev up domestic demand to make up for the loss of export markets that has taken place earlier. The Government has implemented the Sixth Pay Commission award and topped it with a hefty four per cent increase in DA. This has put more money in the hands of government employees. But these outgoes do not much translate into effective demand. The propensity to consume among government employees would be rather less. They would invest a good part of the additional income in gold, fixed deposits or in the purchase of imported goods. Only a small part of the additional government expenditure, therefore, translates into effective demand. Similarly, the additional demand generated from increased expenditures on infrastructure such as power plants is partly transmitted to foreign countries.

Even this small increase in demand does not come free of cost. The higher fiscal deficit leads to devaluation of the rupee and erodes the purchasing power of the people. The fiscal package, therefore, has two opposite effects. It directly leads to some generation of demand from increase in expenditures. But it also leads to a parallel decline in demand from rest of the economy due to debasement of the currency. Now, if the propensity to consume of rest of the economy is high then the net impact of the package would be negative. More demand will be lost from the decline in purchasing power due to debasement of the currency and, relatively speaking, less increase in demand will be created from the government expenditures.

Time factor is involved as well. The decline in purchasing power due to debasement of the currency will take some time to manifest while the increase due to increased government expenditures would take place immediately. Even this benefit is not being reaped by us. This short run gain is cancelled by the immediate outflow of foreign investment. Foreign investors peer into the crystal ball and they see a devaluation of currency coming. They have exited our markets immediately. Hence the short term gain that would have accrued from adoption of Keynesian strategy of spend now – tax later is not working.

The reduction in rates of excise duty progressively from 16 to 10 per cent also faces the same dilemma. This move is basically in the right direction. It helps our producers face competition from cheap imports. However, the loss of revenue from this source has to be made up by increase in fiscal deficit, debasement of the currency and that, in turn, leads to a reduction in purchasing power of the people. The reduction in price of cloth from, say, Rs 20 to Rs 18 per meter due to reduction of excise duty is cancelled by an increase in price of other inputs like cotton and electricity of like amount. In the result there is not much to show. The largesse given by the Government from the right hand through reduction of excise duty has been taken away by the left hand though debasement of the currency.

The fiscal package would have been effective if reduction of excise duty had been accompanied with reduction in government expenditures that do not generate much domestic demand. For example, reduction in expenditures on foreign embassies and purchase of defense equipment from foreign suppliers would not lead to reduction of domestic demand. In fact, a reduction in excise duties along with a parallel reduction in salaries of government employees would have jump-started the economy. The final impact depends upon the difference in the propensity to consume of those getting relief and those bearing the burden. If the propensity to consume of the government employees is less than rest of the economy, then transfer from government employees to rest of the economy will generate more demand.

A similar situation prevails with respect to the increase in welfare expenditures. The outlay on Employment Guarantee Programme, for example, has been increased. This programme places purchasing power directly in the hands of the poorest who have the highest propensity to consume. So far so good. But there are leakages. Sarpanches have told this writer that about 20 per cent commission has to be paid. Then there is loss of purchasing power from debasement of the currency. The net positive impact may be small.

The correct formula for dealing with the slowdown would be to tax those with lower propensity to consume and give more income in the hands of those who have higher propensity to do so. That is not the case with the present package hence its failure.

(Author'saddress: [email protected])

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