Case for targeted & temporary fiscal profligacy

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By Anish Tawakley
Head of Research, ICICI Prudential AMC
April 18,2017
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Fiscal policy should be counter-cyclical, which means deficits should be small in economic booms and large when economy is sluggish


Fiscal deficits are in focus again.While the central government is being commended for sticking to its fiscal targets, rising state government deficits are a cause of worry.This is a wrong time in the economic cycle to focus on containing the fiscal deficit. Fiscal policy should be counter-cyclical. This means deficits should be small in economic booms and large when the economy is sluggish (has low capacity utilisation). A counter-cyclical fiscal policy does not target a constant fiscal deficit at all times. Simply put, austerity is not always a virtue. The time for austerity is when the economy is booming. A temporary fiscal stimulus, targeted so to maximise the multiplier effect on Aggregate Demand delivered within a timely (i.e. quick) manner actually helps the economic recovery.


The anatomy of economic slowdowns and fiscal deficits


There are three fundamental aspects of the relationship between the fiscal deficit and the economic cycle. One, the fiscal deficit widens automatically in a downturn. This happens even when there is no increase in expenditure. Two, cutting expenditure (or raising tax rates) to contain the automatically widening deficit makes the downturn worse. It is necessary, therefore, to monitor not the actual fiscal deficit but the “cyclically adjusted fiscal deficit“ i.e., what the fiscal deficit would be if the economy was operating at normal capacity utilization. Three, it makes sense to make more of the spending explicitly cyclical (i.e., so that it automatically increases in the downturn).


Why does fiscal deficit automatically widen in the downturn?


A downturn is characterised by weak demand, idle capacity and low corporate sector profitability. In such an environment, tax revenues drop below normal (mid-cycle) levels. So, even if expenditure remains normal (at mid-cycle levels) the drop in tax revenues means the deficit is larger than it would be if the economy was operating at normal (mid-cycle levels). Note, the widening of the deficit is not because the government is being profligate. In fact, the government expenditures are at normal levels, but the deficit is wider because tax collections are abnormally low. In fact, state government deficits are larger today because taxes from the real estate sector are at cyclical lows.


Why restraining the automatic widening of the deficit worsens the downturn?


As the deficit widens in the downturn, a reasonable response is to cut expenditures (or raise taxes) to bring the deficit back in line. This, however, only makes matters worse. The basic thing to remember is that one entity's spending is another entity's income. So, if the government cuts its spending, it correspondingly reduces another person's income in turn forcing this person to cut his spending. The government spending cut, therefore, sets off a recursive cycle of spending cuts. The total negative impact on Aggregate Demand, and correspondingly GDP , is a multiple of the initial expenditure cut by the government. An increase in taxes has a similar effect of setting off a cycle of expenditure cuts. Given that balancing the fiscal deficit in the downturn is counter-productive, it is better to monitor not the actual fiscal deficit but the “cyclically adjusted“ fiscal deficit i.e., what the deficit would be if the economy was operating at normal capacity utilisation. So, if we target a constant cyclically adjusted fiscal deficit of 3%, the actual fiscal deficit would automatically be higher than 3% in a downturn and lower than 3% in a boom.


Why it makes sense to have more expenditure explicitly cyclical


Just as expenditure cuts have a multiplier effect and lead to an even larger contraction in Aggregate Demand, expenditure increases also lead to larger expansion.Hence, there is a case for not just holding spending constant but actually increasing it in a downturn.In developed economies with unemployment programmes, this happens automatically ­ expenditures on unemployment-related programmes shrink in a boom and expand in the downturn. This helps moderate both booms and busts. In India, spending on social programmes, such as MNREGA, can be explicitly linked to economic growth. Spending on such programmes can be enhanced when growth in industrial activity and construction activity is low and moderated in boom times.


This isn't a carte blanche for any and all expenditures at all times


The primary objective of a fiscal stimulus is to stimulate demand.The fiscal measures should have a strong multiplier effect on aggregate demand during the down turn. If done smartly , they can also build capacity ­ but capacity creation is an additional benefit and not the primary criteria on which a stimulus should be judged. When viewed from this perspective we reach some counter-intuitive conclusions about what makes for a good stimulus. Let us look at some specific cases: Infrastructure spending is great if the money is spent on shovel-ready projects. Sanctioning projects that have a long approval cycle before construction starts is not helpful from a stimulus perspective. By the time the spending starts, the downturn may well be over.


One-off direct transfers to the poor (i.e. handouts) or work creation are actually a good option. The poor generally have a high marginal propensity to consume so money transferred to the poor ends up being spent rapidly (which is better than it being saved). In contrast, waiving loans that only have to be repaid 2-3 years later is less useful because the relief is delayed. Loan waivers, of course, also damage credit discipline.


Creating permanent expenditure commitments that extend beyond the downturn (e.g. salary increases for government employees) is the biggest risk in designing a stimulus package. Such expenditures damage long-term growth potential.


Larry Summers has given the most succinct description of an effective fiscal stimulus ­ it should be “timely , targeted and timely“. The former chief economist, World Bank, said: “ As with any potent medicine, stimulus if misadministered, could do more harm than good by increasing instability and creating long run problems."


This article was first published in The Economic Times on April 18,2017.

 

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