The Illogic Of Expecting Growth To Soar When Policies Are Mildly Deflationary

We keep wondering when growth will pick up when we have lost track of one of the most important macroeconomic questions that will tell us what is going on: are we following an expansionary, contractionary, or neutral fiscal and monetary policies?

My answer is simple: both monetarily and fiscally, we are following mildly deflationary policies in the aggregate – policies that were begun in the closing years of the United Progressive Alliance government. This will allow for only a slow revival of growth. The pain is being frontloaded, the gain backloaded.

That the Reserve Bank of India (RBI) has been following a wayward policy of chasing non-existent inflationary potential is a point this writer has discussed earlier. Suffice it to say that given super-low current retail (1.54 per cent) and wholesale price inflation (0.9 per cent), the RBI’s refusal to cut rates is simply inexplicable.

But here’s the point: the overall situation is not too different with fiscal policy, whether at centre or states.

The headline we keep seeing frequently is the high infrastructure spending being done by the central government since 2014-15, with the latest budget announcing that Rs 396,135 crore will be spent on creating and upgrading infrastructure this fiscal (2017-18). That number looks good, but only because the railway budget has been added to the general budget this year. The country’s total infrastructure spends are far from adequate considering that private spending is down to a trickle.

A Mint study recently showed that nearly 68 per cent of infrastructure spending is now government-led, with infrastructure spend being defined as investment in transport, power, telecom, irrigation, storage and distribution of water, gas, etc. Recent telecom and power woes have only added to the angst.

In theory, it should not matter much for growth as long as someone is spending. If the government sector is taking the lead, so be it.

The real issue: public spending will boost growth only if fiscal policies are overall reflationary in nature. But this is far from being the case. Overall public spending policies have, if anything, been mildly deflationary and pro-cyclical. If high public spending on infrastructure is counter-balanced by high taxation, the overall economic impact cannot be expansionary or reflationary.

Here are some numbers: between 2013-14 and 2016-17, central taxation on petroleum products has risen by more than 150 per cent from Rs 106,090 crore to Rs 273,502 crore.

States, which were already taxing petro-goods to their limits, also boosted taxes by 23 per cent, from Rs 152,460 crore to Rs 188,618 crore, according to data available with the Petroleum Planning and Analysis Cell.

Taking central and state taxes, and other amounts transferred from the oil companies to government (like dividends or subsidies paid by the oil companies), there has been a 70 per cent rise in revenue collections from just this one sector in three years.

How can you expect investment and growth to pick up when the level of taxes collected has substantially picked up?

This is not to say that pricing petroleum products high is wrong strategy for a country that is over-dependent on imports, and usually cannot afford to raise prices steadily when global crude prices rise. The point is that higher taxation of oil products amounts to a deflationary policy.

Then, consider another item that is potentially deflationary. The UDAY Scheme of the Power Ministry is one of the biggest reforms initiated by Power Minister Piyush Goyal. UDAY essentially transfers state electricity boards’ and distribution companies’ (discoms’) liabilities to state governments, thus making the former viable again. But as things stand, states had issued Rs 232,163 crore worth of UDAY bonds, and another Rs 269,056 crore of bonds will be issued to clear discom dues. Rs 5 lakh crore of discom bonds means a huge annual outgo in the range of Rs 35,000-40,000 crore for states in interest payments. (See the details at the wonderful UDAY portal)

This will automatically crimp their infrastructure outlays, which means cuts in spends. Add new expenses like farm loan waivers, for which the demands are politically peaking, where will states have the money to make investments in infrastructure or health?

On the other hand, while 16 states have accepted UDAY financial rejigs, 25 states have also increased power tariffs. Increases in power tariffs across India constitute another deflationary force.

Put simply, energy price trends, whether through higher taxation or rising consumer prices, are among the biggest deflationary forces now in action. The government’s own spending on infrastructure may not be doing enough to counter this.

Then we need to come to the goods and services tax (GST). Leave aside short-term blips like discounting in June to clear inventories and the adjustment period in the July-September quarter, the basic point of GST is to expand the tax base and increase collections. If that happens, higher tax collections again will have a small and short-term deflationary impact on growth.

And we haven’t even listed other deflationary forces now working their way through a slowing economy, including demonetisation and excess debt.

If we accept that a large part of fiscal policy is deflationary, it follows that India is following pro-cyclical macroeconomic policies just when growth is sluggish. We are doing the opposite of what economic theory suggests – that when growth is low, the government must spend more; and vice-versa.

An important caveat: this is not to suggest that the policy is wrong, for fiscal prudence is always going to pay off at some point. Two years down the line, as banks work off their bad loans hangover, and companies reduce their debts, and lower interest rates start kicking in, the economy will take off vertically, driven by a virtuous cycle of growing investment and consumption.

But what is clear is that our current policies are growth-neutral or even mildly deflationary in the aggregate. Hence the delayed revival of animal spirits.