Government spends, at what cost?

Government spending, when it exceeds its income can reduce growth through inflation, tax distortions, and lowering private investment. India's fiscal deficit (excess of government spending over its income) is currently close to 5.1 per cent of GDP. While a scientifically “acceptable” rate of fiscal deficit does not exist, most economists are comfortable with 3-4 per cent of GDP (more as a convention). Evidence show that countries running large fiscal deficits experience slower economic growth in the medium and long term, and India may not be an exception to this phenomenon. 

Fall-out of government spending

When government spends, say to build highways, it generates employment, which creates income for people. Increase in income leads to increased demand for goods and services, and thus stimulates economic activity. Then, why not keep doing this? Hold on! There is no free lunch in economics.

The Government's usual sources of revenues are taxes, borrowing, and inflation, each of which comes with its own demerits.

Typically, taxes are insufficient to cover expenditures. Borrowing entails repayment of a larger amount than what was borrowed because of interest rates applied to the borrowed sum. This amount is typically sourced from additional taxes.

People, in general, are resistant and averse to paying taxes because a) they are left with less money to spend or save after paying for taxes, and b) the amount collected is not effectively and efficiently used by the government.

For instance, in India, poorly maintained roads, public schools, or hospitals, do not reflect immaculate use of tax money.

The Government can also source its funding by printing money, which leads to inflation. To counter inflation, the interest rates are raised, which increases the cost of borrowing, leading to a fall in private investment.

Long-term growth

Tax distortions and inflation create uncertainties in the business environment, which deter private investments. Displacing private with government investment is not always a zero-sum game. Unlike government investment, private investment is undertaken on a profit-motive, which ensures that resources are more effectively and efficiently utilised.

Consequently, a fall in private investment is typically associated with a fall in efficient and effective allocation and utilisation of resources.

Moreover, excess borrowing can affect the repaying capacity of the borrowing country, and force credit rating agencies to downgrade the credit standing of the country. Such quandary send negative signal to investors, and may lead to a further fall in investments.

Debt and economic growth

Every time the Government runs a fiscal deficit, it adds to the public debt — the sum of internal and external borrowings (or the accumulated borrowing by the government). In India, internal debt that is largely caused by fiscal deficit accounts for 80-90 per cent of public debt.

Different economists project different numbers for the effect of public debt on economic growth.

An International Monetary Fund paper published in 2010 estimates that, on an average, a 10 percentage point increase in debt-GDP ratio decreases the ensuing five-year GDP growth by 0.3 to 0.4 percentage points in developing countries.

Countries that have debt-GDP ratio of 30- 60 per cent experience a decline of 0.11 percentage points growth. India, with a debt-to-GDP ratio of about 60 per cent, falls under both the categories — so conservatively, let us assume the decline in growth rate is the average of 0.4 and 0.1, that is, 0.25.

Reducing poverty

This reduction of 0.25 per cent of our GDP (averaged over the last five years) roughly amounts to $9509769 per day! According to the liberal definition of poverty-line by the World Bank, which is fixed at $1.25 per day, the amount above is sufficient to move 7.6 million people out of poverty.

Looking at it differently, India fails to move 7.6 million poor people out of poverty because of its current debt-GDP ratio.  It is the government's lack of accountability in policy implementation that creates wastefulness in its spending. However, the fact is that government's expenditure has been constantly rising over the last few years.

Recognising its inefficiencies, the government can actively provide a favourable environment in which private investment can flourish.

Public-Private-Partnership is an arrangement that internalises both social and economic motive, and is proven to be very effective. With the outlook on credit rating for India being downgraded from safe to negative, it is time India focuses on tightening its belt, and paves way for the more efficient private investment to take the lead.

ramaprasad@thehindu.co.in

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