If the fiscal deficit is a problem, it is because of its high revenue deficit component, which crowds out creation of productive capacity as well as private investment.

Many in India believe that reduction in subsidies (to bring down fiscal deficit) will further raise the already high prices of day-to-day household consumption items such as food, fuel or electricity, and be detrimental to the interest of the common people.

Is it really so? Is the relation between reduction in subsidy and increase in the prices of essentials so straight? Is high fiscal deficit (caused by burgeoning subsidy burden) contributing to the problem of inflation in India? On the eve of the upcoming Union Budget, it would be pertinent to examine the implications of high fiscal deficit for the (growth of) productive capacity of the economy.

Subsidy accounts for roughly 2.5 per cent of India’s GDP. If one adds bonds issued to oil marketing companies (in lieu of subsidies) to compensate for under-recoveries, it will be another 2 per cent of India’s GDP. Thus, subsidy — covert and overt — is blocking roughly $90-100 billion annually and is a major cause of high levels of fiscal deficit.

India’s fiscal deficit (Centre and States taken together) of 8-9 per cent of the GDP is high by any standard. It far exceeds all other BRIC nations — China (1 per cent), Brazil (2.9 per cent) or Russia (1 per cent). The combined fiscal deficit of the States stands at 2.5 per cent of India’s GDP, which is well below the limits set by the Thirteenth Finance Commission. Clearly, the Centre seems to be more responsible for India’s fiscal mess.

Revenue deficit

Fiscal deficit in itself is not a problem, but if one looks at the constituents of India’s fiscal deficit, one finds that revenue deficit accounted for 76 per cent of gross fiscal deficit in 2011-12. Only 24 per cent of deficit went for the creation of additional productive capacity i.e. will add to the future supply of goods and services.

Besides, 24 per cent of the resources must generate enough returns to service 100 per cent of the additional public borrowings (i.e. fiscal deficit), which is not feasible. The result would be more borrowings or imposition of additional taxes in future to service past debts. That will reduce domestic (household) savings, and ultimately investment, as domestic savings is the pre-dominant source of investment in India.

High fiscal deficit also crowds out private investment by raising the cost of capital for private sector. On the other hand, the Government, with access to cheap finance (through SLR mechanism that mandates investment of 23 per cent of bank deposits in government securities), uses the funds to fill its revenue gap, which does not lead to any increase in supply of goods and services. This would lead to more inflation in future with negative consequences for the economy.

Sustained inflation induces switchover from financial assets to physical assets such as gold and real-estate as a hedge against low or negative returns on savings.

Inflation makes the exports of a country expensive, leading to trade deficit and depreciation of its currency. That, in turn, increases the rupee cost of imported items (e.g. crude), adds to subsidy burden and, in turn, fiscal deficit in a controlled price environment.

Subsidy and Food Inflation

The major causes of rise in food prices are increasing urbanisation, disposable income and change in consumer preference towards protein-rich food items (milk, eggs, pulses) and fruits, while the government policy still focuses on input subsidy or price support to boost production of cereals.

Deregulating non-urea fertilisers, while keeping urea regulated (and heavily subsidised) has increased the relative price gap of urea and non-urea fertilisers. The result is unbalanced use of fertilisers, wastage of nutrients, soil degradation and lower return on per unit of fertiliser use.

The way subsidies on food and fertilisers are being administered, food inflation will continue to haunt Indian consumers for a long time and for the simple reason that the supply of non-cereal, protein-rich food items is not keeping pace with their increased demand. Lack of post-harvest infrastructure only adds to the problem.

The solution lies in replacing ‘predominance of input subsidy’ by ‘predominance of investment’ aimed at improving agri infrastructure as well as intensifying R&D for better yield in non-cereal segment. It also calls for improving post-harvest infrastructure. Hopefully, FDI in retail will fill this gap.

Electricity

The major cause of the increase in electricity prices is increasing coal price. Since domestic production of coal is constrained (despite India possessing huge reserves of coal) by regulatory impediments, electricity producers have to rely on expensive imported coal that increases their cost. Alternative sources of electricity, in particular hydro, wind and solar, together, account for less than one-third of the country’s electricity generation.

Fuel Subsidy Issues

India imports more than three-fourth of its crude oil. Its rupee cost is dependent upon international price and exchange rate. If any of these two becomes unfavourable, the landed price of crude in India goes up, thereby increasing the subsidy burden and fiscal deficit. Using subsidy to keep the price of Petro products low promotes their sub-optimal use. Launch of diesel variants of luxury cars and SUVs is the unintended consequence of subsidy on diesel.

The Farm sector consumes only 12 per cent of the subsidised diesel. The transport sector takes the largest chunk (67.6 per cent), and there is not much justification for maintaining diesel subsidy for all categories of consumers.

Indian rupee remains under pressure because of high current account deficit in the range of 4 per cent of GDP — caused mainly by import of crude and gold. To maintain overall balance on external account, India needs FII and FDI inflows equivalent to 4 per cent of its GDP. Of the two, FII is highly volatile and its net inflow depends on expected risk-weighted return in equity markets. FDI inflows, on the other hand, depend upon the overall attractiveness of India as an investment destination of which macroeconomic stability is a key determinant and maintaining fiscal deficit at low levels, a key component of that. Without cutting subsidies, bringing fiscal deficit down to 2.5 per cent or so is not possible.

Deregulating fuel prices will induce their efficient and economic use and promote development of fuel-efficient technologies. That, in turn, will reduce import requirement and pressure on the rupee exchange rate will ease. That will reduce landed cost of crude and requirement for subsidy will automatically go down. However, cutting subsidies alone will not be enough. Revenue augmentation measures, such as recovery of direct tax arrears (which currently stands at two-third of direct tax revenue), will also be needed.

Inflation in India is primarily a supply-side problem and needs supply-side solutions. Fiscal deficit (because of rising subsidy), by crowding out private investment, only adds to the supply constraints. Subsidy, at the most, is a temporary solution with many negative side effects, fiscal deficit being just one of them — the less we depend on this, the better.

(The author is Group Economist of a top corporate house. Views are personal.)

(This article was published on February 25, 2013)
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