By Aurodeep Nandi

Central spending has increased by around Rs 2 trillion from last year. How much did India’s GDP increase as a result? If your answer is Rs 2 trillion, read on.

Suppose, on February 1, finance minister Arun Jaitley announces an extra Rs 100 to be spent on highways. This Rs 100 note will travel from North Block to the road contractor. He will keep some of it, and pass on the bulk of the remaining to his staff, labourers and subcontractors as payment to build the road. Each of them will save a bit, and then spend the rest to buy goods and services from other citizens.

The citizens will also save, and pass on the remaining and so on till the Rs 100 finally sunsets into the economy.

Also, increased government spending on highways could give confidence to other private players to increase their operations and investments — aprocess known as ‘crowding in’.

So, the Rs 100 the government recordsin its books as expenditure will end up multiplying several times over and ultimately could impact the economy by an amount higher than Rs 100, say, Rs 105. The extra Rs 5 is being generated from thin air: simply by the process of government spending circulating in the economy. Economists call this the ‘fiscal multiplier’.

Of course, it is not a given that government spending will always ‘multiply’ the economy’s overall growth. It can very well happen that Rs 100 of government spending can lead to Rs 95 worth impact on the economy. When governments spend more, they have to borrow that amount from the public.

Increase in public borrowing will increase overall interest rates, and can make it difficult for private companies to borrow from the market.

As a result, they might cut their operations, leading to ‘crowding out’ and causing a fall in GDP. High inflation accompanying increased government spending can also corrode growth eventually. So, when the FM announces a litany of sops, yojnas and tweaks in tax rates in his Budget, will the GDP multiply or fall? Unfortunately, to answer this literally trilliondollar question, there isn’t much economic research done in India. This creates a dangerous policy pothole.

Spend Shrift

Governments everywhere are tempted to respond to a fall in growth by raising expenditure. The global financial crisis led to a massive avalanche of public spending across the world. In India, fiscal deficit was yanked up from 2.5% of GDP in 2007-08 to nearly 6.5% of GDP by 2009-10. Assisted with this steroid, growth accelerated to 10% levels, and India became one of the fastest-growing economies in a world languishing under recession.

But by end-2012, growth came crashing down to 5%, inflation was refusing to abate, while an inexorably high level of current account deficit had sent the rupee tumbling. As credit-rating agencies were threatening to cut India’s rating to junk, in hindsight, the government splurge of a 6.5% of GDP worth fiscal deficit seemed myopic. The process of stabilising the fiscal ship from that period continues to haunt FMs till date.

The handful of studies on fiscal multipliers in India, however, offer an interesting insight. A study by the National Institute of Public Finance and Policy (NIPFP) states that the fiscal multiplier is around 2.5 for capital expenditure, while it’s less than 1 for revenue expenditure. This means that for every Rs 1 the government invests in capital goods like roads and railways, the GDP is likely to end up increasing by Rs 2.50.

But the overall impact of spending an extra Rs 1 on revenue expenditure, like salaries and subsidies, will end up having an overall impact of less than Rs 1on the overall GDP.

Other studies come up with different figures, but the conclusion is broadly the same: that capital expenditure creates more multiplying effect in the economy than revenue expenditure.

However, India spends around 88% of its budget on revenue items, and hardly 12% on capital expenditure. While this may reflect the reality of millions of Indians stuck at different levels of social and financial vulnerability, it is also true that politicians hate cutting populist spending.

So, when push comes to shove, FMs are known to cut fiscal deficits by further slaying the golden goose of capital spending, instead of economising consumption spending.

However, fiscal trends over couple of years give hope. This government can boast of better quality of fiscal consolidation: reducing revenue expenditure while pushing the pedal on capital expenditure.

Scream: Saver!

For instance, subsidy spending has been reduced from 2.3% of GDP in 2013-14 to around 1.7% through better targeting. The savings have been used to increase public investments to resuscitate a fall in private investment.

As always, the coming Budget will put these to a stress test.

On the revenue side, GoI will be facing higher interest payments, a gradual rise in commodity prices affecting the subsidy burden, obligations of pay revisions, and a need to offer financial platitudes to the rural and micro, small and medium enterprise sectors. The real litmus test will be how well the government can deliver itself from the temptation of not compromising on capital expenditure.

The writer is a senior economic adviser at a foreign mission in New Delhi