Public investment can transform economy

The new government that will take over in a month has to tackle some serious challenges on the economy, many of which require long-term solutions. These include environmental degradation and the woeful state of public services.

The people realise that these are unlikely to be sorted out soon. But they are no longer as patient as they used to be. Especially the younger generation, which expects a newly-elected government to attend to these issues with alacrity and resourcefulness.

The most urgent matters are growth and inflation. In the past decade, high growth with low inflation has been replaced by low growth with high inflation. This has to be reversed, and quickly.

With productivity languishing, increasing the investment rate is absolutely essential if India is to return to the high growth rates of five years ago. Investment in the right quarters is essential to maintain stable prices. Thus observers are right to emphasise that the investment climate is crucial, and that the government has to be conscious of incentives to the private investor.

The question, though, is how to alter the investment climate favourably. In fact, this is the challenge for the government. A ready answer to the question is “more reforms”, but this solution often stays on paper.

Beyond the proposal for a Goods and Services Tax, there is no major pending macroeconomic policy reform with the potential to reverse the growth slide. For instance, the tariff rate and corporate tax rate are by now quite low by international comparison, and a round of private issue of bank licences has only just been completed.

Sector-specific liberalisation that increases profits and, maybe, even the profitability of private players will help, particularly in the financial sector, though these, in themselves, may not lead to a higher private investment rate.

In the virtual stagnation of economy-wide investment over the past five years, fixed capital formation in the public sector actually fell since 2008. Household investment, however, grew faster than before. Private investment may have dipped a couple of years since but has, on average, grown.

Public investment, on the other hand, actually collapsed, recording in 2012-13 a level less than half of what it was in 2007-08. It is this that led to the growth slowdown in India, just as its steady rise had fuelled rapid growth in the five years from 2003-04. Once it is recognised that the public sector invests more in infrastructure than the private, it is easy to see why public investment is so important to the country’s growth dynamic today.

The investment climate for the private sector is defined by the expectation of profits to be realised entirely in the future. A firm’s forecast revenues are related to the demand for its product which, in turn, depends on the expected state of the economy.

This itself, as we can see from the experience of the past decade, is at least partly dependent on public capital formation. Public capital formation both enhances aggregate demand and transforms the supply side. Private investment too adds to aggregate demand but is relatively less transformational. This is because public investment, at least in principle, creates, public goods that are open to other producers — think “bridges and roads” or even just pavements, which are in such short supply in our cities that they hold back economic activity. Therefore, the investment climate for the private sector is, in some part, determined by public capital formation. So, from a macroeconomic point of view, the first task for the new government would be to step up public investment substantially.

Also, as the fiscal deficit is quite large, space will have to be made by cutting subsidies to the same extent. This will not really impact growth, as growth has been hit even amid burgeoning subsidies. On the other hand, increasing subsidies may well have crowded out investment by the government in the past. And so, any proposed increase in investment may be expected to speed up growth.

A plan for enhancing public investment does not in any way mean restraining the private sector. Actually, public investment enables the private in two ways: It generates demand for the latter’s products and enables the expansion of private production by providing the necessary physical infrastructure.

Much of this infrastructure is in the nature of public goods and the private sector has no incentive to produce them, as it cannot ration their use by the public.

The political left, heavily invested in the language of rights and the practice of distributivism, does not adequately recognise the importance of public infrastructure for any meaningful empowerment of the poor, leave alone the ultimate elimination of poverty. In fact, the poor are left seriously disempowered by the absence of access to infrastructure that is vital to their survival. After all, they are empowered less by airports than by producer services such as rural roads and urban water supply.

What has been set out here is a programme of fiscal action that makes up for the deflationary stance of monetary policy in the recent past. The RBI claims that it is engaged in ‘anchoring inflationary expectations’. This it has done by raising interest rates. The result has been declining manufacturing output with inflation having yielded little. Private investors cannot but remain pessimistic of the future in such a situation.

Unless the government steps in to invest, by its inaction it would have ended up ‘anchoring stagflationary expectations’.

The writer is a professor, Centre for Development Studies, Thiruvananthapuram

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