Don’t cut capital expenditure while chasing fiscal target

December 23, 2014

(Any opinions expressed here are those of the author and not necessarily those of Thomson Reuters)

In the last three years, budget deficit has been reined in from 5.7 percent to the targeted 4.1 percent. Much of the decline came from a cut in capital expenditure because tax revenues were less than budgeted and current expenditures proved too sticky. Finance Minister Arun Jaitley is again faced with the same problem and a cut in capital expenditure is most likely if the government is to achieve its 2014/15 fiscal target.

It is not often appreciated that most of the government’s tax revenue comes from industry, whether it is from corporation tax, income tax, excise or import duties. A minimum of 8 percent growth in industry is necessary for the finance minister to have the freedom to implement projects without any fear of increasing the budget deficit.

But industry has been stagnant for the past three years and unable to generate the expected revenue. In the current year, the shortfall in tax revenue is likely to be 1.05 trillion rupees despite the fall in international oil prices and resources to be mobilized from disinvestment.

Jaitley has to make a choice between achieving the deficit target or maintain capex and let the deficit jump slightly. A similar choice confronted his predecessor P. Chidambaram, who opted for a lower deficit by cutting outlay.

Should Jaitley do the same? Certainly not, even though rating agencies may temporarily downgrade India’s credit rating. The reason is that the government’s first priority should be to get industry back on its feet to enable it to generate tax revenues, because this alone can reduce the budget deficit. And the first step in this direction is to implement stalled capital projects which can create demand for industry and kickstart recovery.

A budget deficit emerging from capital expenditure is much less harmful than when it emerges from current expenditure, because the latter means the government has to borrow capital to fund consumption. This reduces the total savings in the economy and puts pressure on prices. Borrowing for capex does mean that the government’s over-presence in the debt market will push up interest rates, but there is no reduction in savings and no pressure on prices. The government should try and bring the revenue deficit to zero, but not by cutting capital expenditure.

The revival of industry due to higher capital expenditure will open up sources of tax revenue for the government in subsequent years. For instance, if the budget deficit in the current year is 4.5 percent but ensures industrial recovery in 2015-16, there will be buoyancy in revenue which will reduce deficit in future. But the need to cut current expenditure to reduce fiscal deficit to zero still remains.

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