Modi’s fiscal masterclass

The following post is contributed by @saiarav from X or Yajnavalkya from Medium

Fiscal management has been one of the most critical parameters for evaluating the central government’s economic governance as far back as I can remember — and I have been a amateur observer of the Indian economy for more than two decades. And not without reason. In the Indian context, fiscal management goes well beyond the classical approach of fiscal as a countercyclical force — i.e. government spends more during economic downturns and dials back when the economy is doing well. For India, there has been a strong case for a structural reduction in the government’s fiscal deficit primarily for the following reasons:

A) The most obvious reason — uncontrolled fiscal deficit can result in a debt trap. The Indian government has already been spending between one-third and half of its total receipts towards interest payments since 2000.

B) The fiscal deficit is funded by borrowings in the domestic market. This in turn, crowds out investment by private sector who are competing for the same funds.

C) High fiscal deficit risks macro-economic instability — high inflation and a Balance of Payments (or foreign exchange) crisis . High government spending flows into higher income for households which drives higher consumption demand. If there is not enough supply, it leads to inflation. If you think about it, it is related to B). It boils down to the fact , in many instances, government spending is not economically efficient and therefore is not generating commensurate economic output.

Indeed, we saw the macro-economic instability play out in UPA 2 as high fiscal deficit contributed to persistently high inflation, an out-of-control trade deficit (imports less exports of goods and services).

That being said, economic theory is not like the laws of physics. There are those who have argued that both During the Vajpayee and Modi years, the governments missed a trick by being too fiscally conservative and thereby stifling growth. But even most of these critics argue only about the scale of fiscal tightening, not the principle itself that fiscal tightening is a good for the long term.

As is to be expected, the ideal amount that any government would prefer to spend is…….infinite. The more a government spends, the more popular it will be with the voters, in the near term at least. Fiscal management for a ruling party, therefore is a tightrope walk between preserving one’s political capital and an economically optimal fiscal policy.

In these series of posts, I plan to analyse Modi’s record of fiscal management during his second term. I posit that Modi has delivered a masterclass in fiscal management — he has achieved the near impossible of following a disciplined fiscal policy while not just maintaining his political capital, actually expanding it. All this, amidst times of high economic turbulence globally. In good part, this is because we have, arguably the most incompetent and out-of-touch opposition since independence. But this is also a story of how a politician put his popularity at stake and took the more difficult economic path and the average voters’ willingness to look past their near term pain due to their abiding faith in the man’s intention (the Hindi word is neeyat, I think) and ability to deliver in the long-term**. That is what it is all about — because let us be honest, Modi has, after all, not delivered all that well in terms of the promise of acche din so far.

**Critics will argue this is because voters are prioritizing Hindutva over economic development. There is some truth to it as well and as a Hindutva supporter, I see it as a good thing. But I believe they are exaggerating the Hindutva factor but that is a separate debate.

Fiscal deficit is simply the difference between the total expenditure of a government and its total receipts. This is typically measured as a percentage of GDP.

Both expenditure and receipts are classified as revenue and capital. A capital expenditure is something which results in the creation of a long term asset — a road, a railway track, a port and so on. Spend which does not result in a long term asset is revenue expenditure — things like salaries for government employees, fertilizer subsidy given to farmers, interest on borrowings etc. Revenue receipts are primarily either taxes or dividends from government-owned companies or from RBI. Capital receipts are inflows from divestment of government companies, sale of telecom spectrum etc.

Revenue deficit is the revenue expenditure less revenue receipts. Again, this is measured as a % of GDP.

Total debt as a % of GDP is another key measure of fiscal management, which is self-explanatory.

Internal and Extra Budgetary Resources (IEBR): The government can also spend money outside its budget books via the companies that it owns. For example, if NHAI takes a Rs. 1 lakh crore loan to build roads, that borrowing will not be reflected in the government’s books. But ultimately the government is responsible for the debt, so it needs to be factored in.

Quality of spend — revenue vs capital expenditure

It is generally understood that, in the Indian context, the government should be spending more on capex considering how deficient we are in terms of infrastructure. And on the other hand, contain revenue expenditure which is a less efficient use of fiscal resources. But this is just a high-level view and I will have to warn upfront that not all revenue expenditure is bad and not all capex is good. For example, this government is spending 70K crores this year on Jal Jeevan Mission — all of this is revenue spend. On the other hand, the government has allocated over 50k crores as capital infusion to BSNL. Difficult to argue that this is actually for the creation of productive assets and not just covering the losses an inefficient public sector operator.

But for a big picture view, we assume that capex spend is qualitatively better and then as I drill down further, we look more closely at the specific areas of spend.

What is good fiscal management?

Tax revenues, which constitute the bulk of total receipts, are generally a function of the economic cycle. The government can, of course, raise or lower tax rates. Further, in the Indian context, growth in tax revenues also reflects on the effectiveness of the government’s taxation policies and administration in bringing in greater formalisation of the economy (what is called bringing black money into the tax net, in popular parlance).

Most of the revenue expenditure is either non-discretionary or semi-discretionary. Whether the economy grows 8% or declines 6% (like in 2020–21), one will have to pay the salaries, service the debt and so on. Even spend that is discretionary on paper, is de facto non-discretionary. No political party will touch the fertlizer subsidy, for example. Further, there is constant political pressure to increase revenue spend because that is an easier way to reap political dividends. On the other hand, while capex is discretionary, it is also critical for the long term.

The performance should therefore broadly be judged on the following parameters:

A) What is the overall level of fiscal deficit? With the caveat that it should be seen in the changed global context due to a once-in-a-century pandemic.

B) Receipts growth and especially tax buoyancy — ie how much has tax collection growth out/underperformed economic growth?

C) Quality of expenditure — Ability to keep revenue expenditure in check and focus resources on capex.

But I cannot emphasize enough that good fiscal management is the ability to balance the above political vs economic imperatives in an optimal way. A good example of how not to do it was provided by the BJP government in Karnataka which went to polls last year boasting of a disciplined fisc and record capex allocation, only to be swept away by the voters who chose the opposition party which announced a slew of pro-poor welfare measures (or freebies or revdis, as critics would call it).

Alright, now we get down to the numbers. Here, I analyse Modi’s fiscal management at a high level for the period 2019–20 to 2023–24. Keep in mind that we had a major global pandemic which dramatically pulled down economic growth the world over and this also meant governments had to expand their fiscal spend substantially. So fiscal metrics go awry — higher numerator and lower denominator (i.e. GDP).

Fiscal deficit expands, as pandemic hits growth

Modi started his second term with a fiscal deficit of 3.4% (2018–19), which was quite moderate then, but looks like an unreal number in a post-pandemic world. The number is also low because a good part of the spending was done via IEBR (ie outside the budget books). He will end the term with a fiscal deficit of close to 6%, which is a pretty good performance overall, considering how the pandemic has ravaged public finances worldwide.

GDP during the period grew at just 4.2% annually. If expenses grow faster than GDP growth, it leads to a widening of fiscal deficit while if it is slower, it leads to a reduction. The converse is true in case of receipts. As you can see in the table below, receipts grew only modestly faster than GDP, so the widening of the fiscal deficit is largely attirbutable to higher expenditure.

Note: 2018–19 GDP has been indexed to 1000 and all figures are based on real growth (i.e adjusted for inflation)

Budgetary capex spend grows sharply

Next, we drill down to the expenditure. What do we find? Both revenue and capital expenditure has outpaced GDP growth but it is capex which has grown at a furious pace. But since revenue expenditure accounts for more than 4/5 of total spend, it contributes to 100 bps (100 bps = 1%) of the widening in fiscal deficit while capex contributes to 170 bps.

Capex spend trend solid even after factoring in IEBR

But wait, the capex growth is not as dramatic as it sounds. A large part is simply because Modi government moved from IEBR to budgetary support for road and railway capex. Combining both budgetary capex and IEBR spend, the numbers still look pretty solid though. Optically, it increases only by 20 bps to 5.0% but 2018–19 was also an extremely strong year for capex spend. If one compares the overall capex spend for Modi’s first and second term, the trend of improving capex spend is clear. And this is during a period of aneamic revenue growth.

The fiscal masterclass — strong discipline in revenue spend (ex-interest)

Drilling down further into revenue expenditure, we find that the increase in spend has been entirely driven by higher interest expense. This is because, like most other governments, India had to suffer big fiscal deficits in the first two years of the pandemic — so higher overall debt levels. This was further exacerbated by rising global interest rates.

Excluding interest expense, revenue expenditure has actually been a net positive for the fiscal deficit, moving down by 40 bps. This forms the crux of the fiscal masterclass that I keep referring to. In a period of economic turmoil, Modi government has been able to hold the line on revenue spend, amidst immense political pressure for populist measures. Revenue expenditure (ex-interest) annual growth was contained at just 3.2% — we will drill down further on this later but this low growth is despite significantly higher outlay for food subsidies and the Kisan DBT (2019–20 was first full year of the program).

Receipts — modest growth supported by high fuel taxes

Receipts have only modestly outperformed GDP growth though we are finally seeing signs of a turnaround in private sector profits as the sector comes out of the twin balance sheet crisis (high bad loans in banks and high debt levels in businesses). Meanwhile, Modi has held the line with high fuel taxes, inarguably an unpopular decision politically. While it was easier to do when oil prices had collapsed in 2020, to continue those taxes even as oil has moved back to $80/bbl shows great political fortitude. And he has maintained those high taxes with just a few months to go for the national election.

(On a tangent, I have written about why fuel prices should be reduced and it has no impact on the fisc)

Higher fiscal deficit but fiscal internals and outlook positive

To summarize, fiscal deficit widened by 250 bps during Modi’s second term but this was driven by a 170 bps increase due to capex and 150 bps increase due to higher interest expense. Revenue expenditure (ex-interest) actually came down by 40 bps.

Admittedly, a fiscal deficit of 5.9% is still quite high but the government has set itself up pretty well for a meaningful reduction in the medium term. For one, there are clear signs of a corporate profit recovery and strong bouyancy in personal tax collections. Two, the burden of interest expense should keep progressively coming down given an exapnding GDP base. Three, the government has the option of flexing down on capex spending over the next couple of years contingent on a revival in private capex spend.

Counterfactual — what if it was UPA-3 instead of Modi-2

One way to think of the scale of Modi’s achievement is to think where the fiscal deficit would have been if we had a UPA-3 in 2019 instead of Modi-2. How much higher would the revenue expenditure spend have been? And how much lower would the fuel taxes have been? And what that would have translated into in terms of fiscal deficit, inflation and growth. Admittedly, the difference between a UPA-3 and Modi-2 does not just boil down to Modi — a large part is simply because BJP has a majority while UPA would have been an unstable coalition. But, again Modi deserves a lot of credit for running the first non-Congress majority government.