Good inflation? Current levels provide a conducive environment to increase spending

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Anuj Agarwal

Consumption in the area would take a big hit, leading to a lower demand for manufactured goods, and this vicious cycle might spill over to other sectors and industries.Consumption in the area would take a big hit, leading to a lower demand for manufactured goods, and this vicious cycle might spill over to other sectors and industries.

The latest estimate of India’s growth for fiscal 2020, at 5%, is at a 11-year low. With every passing day comes a new anecdote of India’s slowing growth. The most recent one was that of liquor sales taking a hit. Another one was Surat’s diamond merchants and polishers suffering amidst the slowdown, and Nirav Modi’s PNB scam case. Some interesting ones relate to innerwear sales and biscuits. A recent visit to a manufacturing facility made the ground-level impact of the slowdown clear—macro having a bearing at the micro level.

Amidst the ongoing slowdown, construction was banned in Delhi NCR to keep a check on air pollution. As a result, the demand for the product of this manufacturing plant took a hit. The plant was operating at around 60% capacity utilisation, and daily dispatches were down nearly 90%. As a result, some causal labourers (about 20% of the total workforce) were laid off. One can argue the very essence of casual/contact labour is to help the plant in tiding over highs and lows, nevertheless this meant loss of livelihood. The ancillary businesses that the plant supported in the vicinity had also taken a hit. Other industries in the area, too, were in a similar plight. Consumption in the area would take a big hit, leading to a lower demand for manufactured goods, and this vicious cycle might spill over to other sectors and industries.

Now, how do we revive demand and growth in such a scenario? While RBI is doing its bit by lowering policy rates and asking for a transmission, there is also a need for an expansionary fiscal policy. Breaching the fiscal deficit target (within acceptable limits) is not too big a sin, if it helps the economy tide over tough times. Some even question the sanctity of the 3% benchmark. On the fiscal front, the government has two levers to play with—expenditure and revenue. One way to provide stimulus is for the government to forego revenue by lowering taxes and duties. It has already announced corporate tax cuts, and there are expectations of concessions on personal income tax as well. Savings from reduction in corporate taxes aren’t as huge as government estimates them to be, and there is no guarantee that these savings will translate into investment spending or increased payouts. The other option to provide fiscal stimulus is to increase spending. The quality, however, is crucial—increased spending should be focused on capacity creation and should ideally be capital expenditure.

Consider the case of the manufacturing plant. A reduction in government taxes both for the business as well as the individual employee won’t be of any help. For the business, the demand for its output is weak amidst the slowdown. Employees of the plant are also witnessing this slowdown, and won’t be too positive about future incomes and employment. For the workers who have been laid off, a reduction in income tax means nothing when there is no income. In such a scenario, increased demand/spending whether by the business or by individuals is unlikely. On the contrary, if the government decides to spend more on infrastructure projects, the demand for plant’s output will increase. Employees will be confident about their future economic prospects. The plant will start to operate at a higher capacity utilisation rate. With increased demand, the business may be willing to hire more people to meet the increasing needs. In such a scenario, new investment by the business seems likely. Confident individuals are also likely to spend more.

The effectiveness of fiscal stimulus as increased spending versus tax cuts has been long debated by academicians. In a broad sense, with tax cuts, increase in revenue expenditure is assumed to precede and lead to increase in capital expenditure. Fiscal expansion via increased spending on infrastructure will lead to increased capital expenditure driving the increase in revenue expenditure—increased demand for capital goods, increased incomes for the people in those industries, and increased consumption spend. The advocates of lower taxes argue that tax cuts are self-financing by way of increased economic activity and higher tax collections in the future. In a similar way, increased fiscal spending of capital nature will lead to capacity creation and facilitate increased economic activity in the future. In the current scenario, fiscal expansion via increased government spending seems to be better suited. The effectiveness of tax cuts to stimulate demand and investments remains doubtful in a scenario of weak confidence. Moreover, direct tax cuts will have a limited impact given the following facts: With a population of around 1.3 billion, India has only 80 million individual taxpayers. Of this, around 22 million pay zero tax.

While the latest numbers suggest that fiscal deficit had reached 4% until November 2019, perhaps it is time to let go of the fiscal discipline and put faith into the Keynesian economic theory. Government consumption spending accounted for nearly a quarter of the growth in fiscal 2020—clearly, government spending is what is keeping the economy going. Public sector also accounts for nearly a quarter of capital formation. Current low levels of inflation, especially core inflation, provide a conducive environment to increase spending. The government must use the Budget for the next fiscal as an opportunity to jump-start the economy and revive all sectors, be it undergarments or auto.

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via FinancialExpress

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