Wednesday, April 07, 2021

Indian fiscal policy: should we switch to primary deficit as the sole target?

India has missed its fiscal policy targets mandated under the FRBM Act more often than one cares to recall. Arvind Subramanian and Josh Felman argue  in an article in the Indian Express that India needs a new fiscal framework that focuses simply on one indicator: the primary deficit. 

The authors say that India's primary deficit (PD) has been more than offset by negative interest rate -growth rate differentials (IRGD). However, we can't bank on this:

If the interest-growth differential consequently turns unfavourable, as occurred during the previous period of high debt in the early 2000s ..., then debt sustainability could only be preserved by shifting the primary balance into surplus. 

Such a shift would be hugely disruptive and hence not easily accomplished. So what is the way to protect ourselves against the IRGD turning unfavourable? We need to rein the primary deficit. They propose (based on a paper that has Olivier Blanchard as co-author) that the Centre commit to reducing the  PD by half a per cent of GDP on the average each year (the average would be calculated over buoyant years for the economy and lean years). 

There is a corollary suggestion that is worth noting:

...any future framework should not be fixated on specific numbers. Around the world, countries are realising that deficit targets of 3 per cent of GDP and debt targets of 60 per cent of GDP lack proper economic grounding. In India’s case, they take no account of the country’s own fiscal arithmetic or its strong political will to repay its debt.

This is, of course, an acknowledgement that the targets advocated by successive Finance Commissions and mandated under the FRBM Act were misguided, to put it mildly.

What do we make the proposal on primary deficit? 

Take a look at Chapter 2 in the Economic Survey for 2020-21. The Survey examines the sustainability of India's debt after factoring in the PD. The PD for 2020-21 is estimated at 6.8 per cent. It is pegged at 2.2 per cent thereafter. It is assumed to reach 1.5 per cent in FY 24 and stay at that level thereafter. In other words, there is a steep reduction of 4.6 percentage points in PD in FY 22 followed by an average reduction of 0.35 percentage points in the next two years. 

Under this assumption (and suitable assumptions about inflation and interest rates), India's debt remains sustainable even  if real growth averages a mere 4 per cent in the next 10 years! In other words, we need, at the most, to bring PD down to 1.5 per cent and no more. At growth rates of over 4 per cent, PD can be higher than 1.5 per cent. It makes no sense to keep driving it down to zero, as Subramanian- Felman seem to imply.

India's IRGD, as the Survey points out, has been the lowest among the major OECD economies. It averaged -3.9 per cent in the period 1990-2018. At this average, India can tolerate a higher PD than 1.5 per cent. However, a target of 1.5 per cent would provide safeguards against any adverse turn of events.

In short, if we go by the simulations of the Economic Survey, the Subramanian- Felman  prescription of an annual reduction of 0.5 per cent in PD looks onerous and uncalled for. To make the case for such a reduction compelling, they need to challenge the projections of the Economic Survey.

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