Finance Commission got it right: GDP grows better when state govts spend more

yv reddyThe 14th Finance Commission led by former Reserve Bank of India(RBI) governor, Dr Y V Reddy, has recommended that the states’ share of central taxes be increased to 42%, from the current 32%. As the report points out: “increasing the share of tax devolution to 42 per cent of the divisible pool would serve the twin objectives of increasing the flow of unconditional transfers to the States and yet leave appropriate fiscal space for the Union to carry out specific purpose transfers to the States.” 

The Narendra Modi government has accepted the recommendations of the Finance Commission. In a letter to the chief ministers Modi said: “This Government is…committed to the idea of empowering states in all possible ways. We also believe that states should be allowed to chalk out their programmes and schemes with greater financial strength and autonomy, while observing financial prudence and discipline.”
“It is in this context that we have wholeheartedly accepted the recommendations of the 14th Finance Commission…The 14th FC has recommended a record increase of 10% in the devolution of the divisible pool of resources to states. This compares with the marginal increases made by previous Finance Commissions. The total devolution to states in 2015-16 will be significantly higher than in 2014-15,” the Prime Minister wrote.
The recommendations of the Finance Commission are in line with one of Modi’s pet themes of “cooperative federalism”. Also, giving more money to the state is only fair given that the taxes also come from the states.
Having said that, it also makes more sense for state governments to spend money rather than the central government.
When state governments spend money the multipliers are higher in comparison to when the central government spends money. What this means is that expenditure carried out at the state government level is more efficient and adds more to the gross domestic product (GDP) than in comparison to the central government.
In a September 2013 research paper titled
Size of Government Expenditure Multipliers in India: A Structural VAR Analysis, Rajeev Jain and Prabhat Kumar of the Department Of Economic And Policy Research of the RBI, make this point. As they write: “In the case of India, one per cent increase in total spending by the Central government leads to 0.04 per cent increase in GDP…In contrast, one per cent increase in aggregate expenditure by the State governments has an incremental impact of 0.11 per cent…Higher expenditure multipliers found in case of State governments than the Central government may reflect the quality of expenditure which is found to be better in case of former than the latter.
The RBI researchers also point out a reason for this: : “Lower expenditure multiplier at the Central level perhaps confirms the argument made in the literature that local government spending generates higher expenditure multiplier as investment projects are of relatively smaller scale, and are managed locally and, therefore, have lower gestation lags than projects of higher level of government.” Further, it is easier to keep track of projects at the local and state levels, than from New Delhi.
What helps further is the fact that expenditure happening at the central level is “thinly spread over a large number of programmes and large areas of the country.” On the other hand expenditure happening at the state level is more focussed.
The researchers also found that when states carry out capital expenditure, it is more growth inducing than when the central government does the same. But ironically, “even though the States’ capital outlay has the highest multiplier effect on GDP, its share in combined expenditure is only 6.7 per cent (an average of 1980-81 to 2011-12).” Hopefully, this anomaly should be set right in the years to come. The multiplier is also higher at the state level in case of development expenditure. What all this tells us is that there is a clear case of decentralization of government expenditure. The Modi government accepting the recommendations of the Finance Commission is a right step in that direction.

The column originally appeared on on Feb 26, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Stimulus and reforms don’t go together: Jaitley should have kept his fiscal deficit promise

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010Vivek Kaul

Promises are meant to be broken, especially in politics. In the budget speech he made in July 2014, the finance minister Arun Jaitley had said: “My Road map for fiscal consolidation is a fiscal deficit of 3.6 per cent for 2015-16 and 3 per cent for 2016-17.” Fiscal deficit is the difference between what a government earns and what it spends. A little over seven months later he has gone back on his earlier promise. In the budget presented on February 28, 2015, Jaitley said: “I will complete the journey to a fiscal deficit of 3% in 3 years, rather than the two years envisaged previously. Thus, for the next three years, my targets are: 3.9%, for 2015-16; 3.5% for 2016-17; and, 3.0% for 2017-18.” The extra space that this creates will allow the government to incur an extra capital expenditure of Rs 70,000 crore during the next financial year. The thing is that just ramping up spending is not enough. At the end of the day what matters is not the quantity of spending but the quality. As Taimur Baig and Kaushik Das of Deutsche Bank Research had pointed out in a recent research report: “Recent budgets have routinely allocated close to 5% of GDP in capital spending, a non-trivial amount by any measure. But these generous allocations have not materialized in a discernible pick up in the investment cycle…If the authorities aim at high quality, high multiplier projects worth 4-5% of GDP as opposed to simply ramping up the rate of spending, they will handily achieve the goal of providing a boost to the economy, in our view.” This postponement of the fiscal consolidation by a year comes at a time when the Bhartiya Janata Party(BJP) has a majority in the Lok Sabha. The National Democratic Alliance(NDA) which the BJP heads, has close to 60% members in the Lok Sabha. The BJP has more than 50% members in the Lok Sabha. Given this, Jaitley and the BJP do not have to pander to the idiosyncrasies of multiple allies like the Congress led United Progressive Alliance(UPA) had to, before them. This is the first time India has had a single party stable government in the last quarter century. Over the years, one item that has wrecked the government finances is the subsidy on oil. Jaitley has been very lucky on that front since taking over. The price of the Indian basket of crude oil on May 26, 2014, the day the Modi government was sworn in, was $ 108.05 per barrel. It had fallen by around 60% to $43.36 per barrel by January 14, 2015. The oil price has risen since then. On February 26, 2015, the price of the Indian basket of crude stood at $59.19 per barrel. While prices have gone up over the last six weeks, they still are very low in comparison to where they were in May 2014, when the Modi government came to power. So, there is not much pressure on government finances when it comes to offering oil subsidies. Further, the government has used this opportunity to increas-e excise duty on petrol and diesel and garner revenue in the process. In fact, the finance minister has budgeted just Rs 30,000 crore for oil subsidies in 2015-2016, against the Rs 60,270 crore that will spent during this financial year. The consumer price inflation has also been brought under control by the Reserve Bank of India(RBI) and in January 2015 was at 5.1%. In fact, this is under the 6% inflation that the RBI will now have to work towards maintaining. As Jaitley said in his speech: “We have concluded a Monetary Policy Framework Agreement with the RBI, as I had promised in my Budget Speech for 2014-15. This Framework clearly states the objective of keeping inflation below 6%.” So, things are looking well on this front as well. The one big ticket item that Jaitley had to deal with were the recommendations of the 14th Finance Commission which increased the states’ share of central taxes from 32% to 42%. Jaitley chose not deal with another big ticket item in this budget. The public sector banks need a huge amount of capital in the years to come. The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.” The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.” In the next financial year’s budget Jaitley has committed just Rs 7,940 crore towards this. So, he has more or less given this a complete miss. Also, as Jaitley said in his speech: “uncertainties that implementation of GST will create; and the likely burden from the report of the 7th Pay Commission.” This will only make things more difficult when it comes to controlling the fiscal deficit in the years to come. Long story short—controlling the fiscal deficit this year and ensuring that it was at 3.6% of GDP and not 3.9% of GDP was important. Also as Ruchir Sharma of Morgan Stanley pointed out in a recent column in The Times of India: “When the state spends in haste, it will repent at leisure…A stimulus mindset is the opposite of a tough reform mindset, and governments can rarely do both as the contrasting experience of the 1990s showed. By the end of that decade, most emerging nations had no money to burn, no lenders they could turn to.” So, stimulus and reforms don’t go together. Let’s see if Jaitley and the Modi government are able to prove that wrong. Only time will tell. But with 282 members in the Lok Sabha, Jaitley should have kept his promise to bring down the fiscal deficit on 28/2.

The column originally appeared on on Mar 2, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)