Acorn | How the government will keep its entitlement commitments

You won’t like any of them

No one really knows how much the Food Security Bill (or Act, if it becomes law) will cost the exchequer. Given the way the legislation is framed, it is impossible to make an accurate assessment of its costs. That doesn’t mean we are short of proponents who argue that it should be (or, worse, normatively must be) affordable. We also have a few opponents who argue that it’s more expensive that what the proponents suggest. We’re talking about numbers whose order of magnitude is in the range of single-digit percentages of GDP.

The scheme is open-ended: there’s no expiry date, no sunset clause. It covers around two-thirds of the population—even those who are not really needy. This means that the outlays will have to increase as the population grows.

Obviously, finding the money to keep this scheme going year after year will be a big problem. There’s worse news though—this programme is over and above other open-ended spending commitments like the NREGA, fuel and fertiliser subsidies which are in the vicinity of 2%-3% of GDP. These are the explicit subsidies. We will not even attempt to calculate the implicit subsidies and opportunity costs in this post.

Many of these schemes are pro-cyclical—which means that the subsidy load will increase when growth slows down. In other words, subsidies as a fraction of GDP will increase—tightening the government’s budget constraints and reducing the fiscal space.

The nature of these schemes is such that governments will be scared to cut them during times of distress, forget ending them altogether. So how will the Indian government finance the gargantuan entitlement economy and what might be the consequences?

First, through new and higher taxes. This has already happened. Didn’t you notice the ‘education cess’? Didn’t you notice the higher marginal taxes on high income earners? Expect more of the ‘Good Cause Cesses/Surcharges’, a fiscal sleight of hand to raise new taxes by citing a plausible good cause. (See this post on education cess for more). As the economic and fiscal situation gets worse, expect higher tax rates lower down the income pyramid. Corporate profits are also an easy target—so they too will be taxed in increasingly creative and extortionary ways.

The consequence of higher taxes are lower investments and higher tax evasion. Lower investment means lower growth. Higher taxes when you are already in a low growth phase is a recipe to stay in the low growth phase longer than otherwise.

The second way for the government to raise resources is through borrowing. It can borrow money abroad (and incur foreign debt) and borrow money from the domestic market. The former puts the Indian government at the mercy of its foreign lenders to the extent of its borrowings. If you do not recall the days of the 1960s-80s, when India was mired in foreign debt, ask someone who does.

The Indian government can borrow from Indian citizens and corporates through the bond market and other instruments (a new -Vikas Patra can be invented quite easily). While it transfers money into the government’s budget, it crowds out the private sector. Interest rates will rise because of the large government demand for funds, making it harder for entrepreneurs and businesses to raise funds to expand their economic activity. This too puts the brakes on economic growth. Higher interest rates during an economic slowdown will prolong it.

The third way for the government to raise resources is to get the Reserve Bank of India to print more money. This has the effect of increasing inflation and depreciating the value of the rupee vis-a-vis other currencies. Higher inflation makes people poorer. It makes poorer people even more poorer (because they do not own assets like real estate, shares or foreign exchange that can weather inflation). A drop in the value of the rupee will make it tougher to service foreign debt, both for the government and for private firms. If the rise in exports on the account of a cheaper currency does not outpace the higher cost of imports, the current account deficit will grow. It could even result in a balance of payments crisis, like the one seen in 1991.

The fourth way is what is termed an “austerity drive”—for the government to cut expenses. Because politics will not allow cutting back on salaries, pensions, subsidies and entitlements, the government will cut two things: office expenses and capital expenditure. So you’ll probably get to see ministers photographed coming to work on bicycles and civil servants working without air-conditioning. Other than schadenfreude, these measures achieve nothing substantial. Cutting down on capital expenditure—roads, power plants, defence equipment—does create fiscal space, but at the cost of future growth.

Where does this leave us? Well, at the edge of a vicious cycle of low growth, high inflation, low investment, higher unemployment, higher taxes, greater evasion and higher out-migration of talented individuals and firms. We’ve been there before. It’s unconscionable that we are being taken there again.

The only way to avoid this vicious cycle is to suspend entitlements and rekindle growth. It is unlikely that growth can be rekindled without sustained pro-growth measures: greater liberalisation, simpler taxation and coherent economic governance. The Delhi Straitjacket must be dismantled.

Related: INI9 Conversation with V Anantha Nageswaran on the falling Indian Rupee.

DISCLAIMER: This is an archived post from the Indian National Interest blogroll. Views expressed are those of the blogger's and do not represent The Takshashila Institution’s view.