The missing political cycle in fiscal management

Economists have long observed and discussed the phenomenon of the opportunistic political business cycle, in which output and inflation rise and unemployment falls, induced by expenditures undertaken prior to an election.

To the extent that such expenditures run up against supply constraints leading to inflation, the government in power after the election may be forced to contract expenditures to rein in prices.

This could trigger a growth slowdown or a recession, generating an economic cycle that corresponds to the electoral cycle.

Is there evidence that the UPA II government at the Centre acted according to the expectations generated by such models of political behaviour? If the revised estimates for financial year 2013-14 provided in the budget are an indication, this does not seem to be so.

On the contrary, unless figures undergo major revision or much more than anticipated expenditures occur during the period between February 17, 2014 (when the Interim Budget was presented) and the end of March 2013, the fiscal stance at the Centre appears to have been contractionary.

In fact, there has been a 0.2 of a percentage point reduction (from 14.1 per cent to 13.9 per cent) in the ratio of aggregate expenditures to GDP, when compared with the actuals for the previous financial year (Chart 1), and a larger 0.8 of a percentage point reduction (from 14.7 per cent to 13,9 per cent), when compared with the budgeted figure for the financial year ending March.

Finance minister Chidambaram has not even spent the ₹14,36,169 crore he had allowed himself in budget 2013-14, touching only ₹13,99,540 crore, in nominal terms.

The final figure marks a nominal increase of just 12.5 per cent relative to 2012-13. Taking inflation into account that would amount to near stagnation in real aggregate expenditure.

It is clear that this reduction in expenditure was necessitated by two factors. The first was a declared commitment to reduce the fiscal deficit to GDP ratio.

To recall, even though it concerned the financial year that was to just precede the general elections, in budget 2013-14, the finance minister had drawn for himself a “red line” that he would not cross, marking a 4.8 per cent fiscal deficit to GDP ratio.

Deficit reduction can occur in two ways: either through an increase in revenues or a curtailment of expenditures. In budget 2013-14, Chidamabram had provided for the former, with the revenue to GDP ratio budgeted to rise from an actual of 8.8 per cent in 2012-13 to 9.3 per cent in 2013-14.

In practice, however, Chidambaram failed to deliver on this promise. He has not been able to realise his own revenue projections.

The ratio of revenue receipts to GDP has risen only by 0.2 of a percentage point relative to 2012-13 as compared with a budgeted half of a percentage point.

What is more, non-tax revenue increases rather than tax revenue mobilisation has accounted for even the meagre increase in revenues. Clearly, measures such as extracting surpluses from public sector corporations through the payment of special dividend has helped the Finance Minister. But yet total revenues have fallen short of the conservative projection even he made.

In the circumstance, it is the reduction in expenditure recorded in 2013-14 that has helped him do better on “fiscal consolidation” than even he projected, with the deficit down to 4.6 per cent in the revised estimates as compared with 4.9 per cent in 2012-13 and the 4.8 per cent estimate in the budget.

What needs noting, however, was that this 0.2 percentage point reduction in the deficit relative to the budget estimate (BE) was made possible by a large 0.8 percentage point reduction in the expenditure to GDP ratio relative to the budget estimate, at a time when growth was slowing.

As far back as November 2013, Chidambaram had declared that the government would make cuts in expenditure to ensure that it sticks to fiscal deficit targets.

His problem was that by the end of the first six months of 2013-14, the absolute value of the fiscal deficit amounted to three-fourths of the target for the full financial year.

India had just come out of a period when, in the wake of an announcement by Ben Bernanke that he would start the process of tapering down the $85 billion-a-month bond buying policy of the US Federal Reserve, foreign financial investors had begun exiting from India.

In the event, the rupee collapsed around mid-2013, revealing India’s vulnerability.

That background made the Finance Minister focus attention on the rating agencies that were threatening to downgrade India to junk status if the fiscal deficit target was not achieved.

A downgrade could mean capital flight and a currency collapse. Realising that the faster than projected rise in the deficit was the result of rapid expenditure increases and lagging revenues, the finance minister had decided that it was time to rein in the former.

“Every rupee lost in revenue will be met by one rupee cut in expenditure,” Chidambaram reportedly said.

The distribution of the shortfalls reveals the circumstances facing and measures adopted by the government. On the revenue side, the shortfall in corporation tax (₹25,843 crore) and customs and excise duties (₹30,268 crore) explains the bulk of the total shortfall (₹76,964 crore) relative to budget. On the expenditure side, austerity seems to have focused on capital expenditures.

The finance minister’s expectations that he would, in an election year, be able to reduce aggregate subsidies by close to ₹26,000 crore relative to fiscal 2012-13 have been belied.

To make up for this and ensure the additional expenditure reduction need to meet the deficit target, the budgetary support for the plan had to be cut by as much as ₹62,575 crore or 15 per cent.

Thus, fearing the responses of rating agencies and foreign financial investors, economic decision makers in the UPA government have chosen to behave “abnormally” and cut expenditures in a year that just precedes an election.

This would, of course, have adverse implications for growth in the short run.

But it could have worse implications for the UPA in the coming elections, since many schemes that voters were expecting to be implemented would have remained incomplete or been dropped.

The consequent reduction in voter support is the price the party may have to pay for having steered policy in a neoliberal direction, opened up India’s economic borders and celebrated the inflow of foreign finance.

The whims of finance rather than the demands of the people and politics appears to have tied the government’s hands and constrained policy.

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