On February 1, 2017, the big
news dominating the headlines was the fiscal deficit target number: 3.2% of GDP. It seemed the government was well on track
with experts expressing their satisfaction over the budget’s focus on fiscal
consolidation and the hope that it would comply with the FRBM target of 3% of
GDP by 2018-19. For once, even rating
agencies like Standard & Poor and Moody’s “lauded India’s commitment to
improve fiscal performance, but said a rating upgrade is still sometime away.”[1]
And then some eleven months
later the outcome emerging is something quite different; the government is
likely to breach its 3.2% fiscal deficit target stoking “fiscal worries”[2],
a dreaded disease that inflicts most mainstream macroeconomists and experts. Before you get drowned in all the numbers
being thrown at you in lakhs of crores and trillions, I attempt to give readers
a heterodox economics view drawing upon the tenets of Modern Money Theory (MMT)
that allays many unnecessary fears about the fiscal deficit and instead shift
focus to what should be the center of discussion.
Fiscal policy consists of two
elements; government expenditure and taxes.
The first part of the budget is a statement of government expenditure
decided upon at the beginning of the financial year. Why does the government need to spend? To achieve its political, economic and social
objectives, the government must transfer real resources from the private sector
to itself. It does this by “spending” or
literally “buying” goods and services from the private sector using its money
or IOUs (I Owe You). This leads to the
most important question in MMT; why does the private sector accept the
government’s money or IOUs? To pay
taxes; the private sector must discharge its tax obligations to the state only
in the IOUs issued by the government or what we call as legal tender. Taxes drive (state) money. This is a critical feature of modern fiat
money; the state does not need our money to spend. Instead, we need the state’s money – that is
created when it spends – to discharge our tax obligations to it.
But there is another crucial
reason for imposition of taxes – controlling inflation[3]
– which brings us to the second part of the budget. When the government spends
its money into the economy, more of it will be available with the private
sector which may drive up demand for goods and services, resulting in rising
price levels or inflation. To prevent
this taxes are imposed on private sector entities in order to drain the economy
of excess money injected through government spending. But the government does not fix the amount of
taxes that has to be paid by private agents.
For example, it cannot stipulate that a grocery store will have to pay
Rs.100,000 in taxes every year. What if
sales of the grocery store falls drastically during the year? The government therefore fixes the tax rate as a percentage of incomes,
profit or sales. Ideally income and
corporate taxes are considered the most fair especially with progressive rates
as well as non-distortionary (in terms of its low impact on relative prices).
Unfortunately, in a country
like India where the tax base is abysmally narrow it becomes difficult to drain
out government money from this small section of people without recourse to high
tax rates – which then has a significant negative impact on incentives. Instead, the government must resort to
indirect taxes – like GST – which obviously has a wider tax base but is
unfortunately regressive in its impact on the poor. But that’s a compromise we have to live with perhaps
partial offsetting by a lower tax rate on essential goods and services.
As the economy progresses
through the year, the government’s policies as well as a multitude of other
factors from private sector sentiments to international trends determines
output produced, sales, incomes and profits that directly influence actual tax
collections. Unfortunately, when the
economy does not perform as expected, tax collections turn out to be lower too
while the deficit widens for any given amount of government expenditure
undertaken. This property of fiscal
policy is called an “automatic stabilizer”; the deficit widens during times of
poor economic growth and narrows when growth is strong.
At this point, let me digress briefly
into what constitutes state money or its IOUs.
When the government buys goods and services from the private sector,
your account in a commercial bank will be credited with a certain amount; these
are simply tokens or numbers in the books of accounts of all stakeholders. But the government does not do this transaction
directly; instead, its banker (the central bank or the Reserve Bank of India)
will credit “reserve money” into the account of the commercial bank which then
credits your account with this sum. This
reserve money is the liability of the central bank or what it owes to the
private sector. If the private sector
entity wants cash, the “reserve money” is printed on pieces of paper and
delivered through the commercial bank so that it is easily exchangeable by
private sector agents for transactions between themselves. What about taxes? Taxes must be remitted back to the
government’s account at the central bank only with “reserve money” or “cash”
(printed slips of reserve money). When a
private sector entity pays taxes the commercial bank debits its account and
then transfers the same amount of reserve money (which it had earlier received
when the government undertook spending) back to the central bank. Government spending creates reserve money, taxes
destroy the same. There is nothing physical about this money; it is essentially
a grand bookkeeping system.
In the good ol’ days, the government could ask the central bank to credit
its account with as much reserve money it wanted it to in exchange for
government promises to pay back later or what is called, government securities
or bonds. The government/central bank
would also sell these bonds to the public (and even promise to pay them
interest on them) to mop up excess state money floating around in the private
sector (untaxed spending) to prevent inflation.
These sale of bonds accumulated over time becomes the infamous and much
feared public debt – what we, however, often fail to realize is that the other
side of public debt is private sector (financial) assets. Government bonds are the safest income
yielding security that the private sector can hold – would we feel safe parking
all our wealth in physical assets (land or gold) or in private sector financial
assets (equity shares or commercial paper of companies)? Obviously not; every individual would aspire
that at least a part of his/her wealth be held in government securities or
financial assets not backed by any
physical asset (the latter could depreciate or at any time, turn bad). In fact, the curtailing of public debt would
force the private sector to save in private sector financial assets – the
insecurity may even force the savings rate up and cause a contraction in
consumption spending.
Does the government need to
borrow in order to spend? Obviously not;
it could simply raise taxes or let inflation accelerate. Moreover, the fact that the government does not need to borrow before it spends can easily be seen from the fact that bonds
must be purchased from the government in exchange for reserve money only. Just like taxes, spending (injection of
reserve money) must precede bond issues (draining of reserve money).
Ever since the rise of
neoliberal macroeconomics in the 1980s that sought to restrict the influence of
the state in the free market system, fiscal policy was “proven” impotent. The quantifiable target of government
intrusion was the fiscal deficit and it had to be curtailed. Governments were convinced (or perhaps forced
to under the influence of structural adjustment programs of the IMF) that
fiscal policy more than anything caused accelerating inflation that threw the
free market system out of gear. Low and
stable inflation was made the center of macroeconomic policy so that market
forces would propel the economy to full employment. For this, fiscal deficits
had to be restricted and if not, “independent central banks” (under the charge
of a professional economist) were given the power to set interest rates to
mitigate the dangers of rising inflation from fiscal profligacy. Rating agencies that imbibed and propagated this
neoliberal worldview kept nation-states in-check and against deviating from
this model. After all, a de-rating could
mean lower foreign exchange inflows (from FDI, ECB and FII flows) and a balance
of payments crisis.
A further offshoot of
neoliberal macroeconomics was pressure of governments to impose constrains on
themselves – like the Fiscal Responsibility and Budget Management (FRBM) Act of
2003 – whereby the government must not let the fiscal deficit rise above 3% of
GDP and more importantly, it cannot engage in “deficit financing”. This means that unlike the good ol’ days the government can no
longer borrow or get an overdraft from the RBI but has instead to borrow in the
market (from the private sector) before
it spends. In other words, there must be sufficient money in the
government’s account at the central bank before it signs cheques on the private
sector.
Does this self-imposed
constraint by the government really mean that the government cannot increase
its expenditure if required? Not really;
a system[4]
Primary Dealers (PDs) and Bank-PDs has been put in place wherein governments
will be able to obtain the required amount through mandatory participation of these
entities in the bond auctions. The
central bank, however, stands by to provide reserve money to PDs to meet their
obligations. In fact, it can be shown
that “the end result is exactly
the same as if the central bank had bought directly from the Treasury.”
(Tymoigne 2014[5]).
So what I have attempted to
show here is that the fiscal deficit or public debt target number is really not
important; it cannot and must not be the objective of macroeconomic policy. All this, however, does not mean there is no big deal on account of the widening fiscal
deficit. In fact, there is a critical question that needs to be posed; what
went wrong with government policies that brought down the growth rate sharply?
And this even as the world is witnessing a kind of economic boom with robust
growth, low unemployment and low inflation (although poor real wage
growth). Have the twin shocks of
demonetization and GST implementation derailed the economy? Or is the
unresolved NPA problem along with low private sector business sentiment suppressing
growth?
Deflection from these
questions into breaching of fiscal deficit target numbers is fraught with a
greater danger – the imposition (with a little encouragement from rating
agencies) of austerity measures – which as MMTers have long argued, is bound to
take the country down a spiraling path – lower government spending, lower GDP
growth, lower tax collections, widening fiscal deficits and therefore the need
for even greater austerity!
[3]
Taxes are also used to achieve other objectives; sectoral allocation of
resources, curb negative externalities, redistribution of income and wealth,
etc. In this article, we consider the
purely financial aspect of taxes.
[4]
Master Circular – Operational Guidelines for Primary Dealers, Reserve Bank of
India, July 1, 2015, https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=9841#8
[5]
Éric Tymoigne, Modern Money Theory and
Interrelations between the Treasury and the Central
Bank: The Case of
the United States, Levy Economics Institute of Bard College, Working Paper #
788, March 2014, http://citeseerx.ist.psu.edu/viewdoc/download;jsessionid=89DEA9B2158162AA06
B4840477ABF6D8?doi=10.1.1.640.4425&rep=rep1&type=pdf
