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|| आ नो भद्राः क्रतवो यन्तु विश्वतः || Let nobel thoughts come to us from everywhere, from all the world || 1.89.1 Rigveda ||
Section : Economics

It’s Not The Fiscal Deficit, Mr Jaitley!
The Seventh Pay Commission report is due around September, how the government deals with its recommendations will put it to test on how serious it is about putting a lid on the revenue deficit.

By Seetha,a senior journalist

Finance Minister Arun Jaitley is committed to achieve the fiscal deficit target of 4.1 per cent of GDP. He should, instead, focus on a more important thing: the revenue deficit.

So Finance Minister Arun Jaitley is determined to somehow achieve the fiscal deficit target of 4.1 per cent of gross domestic product (GDP). Speaking at an award function in Mumbai on Friday, he said that all efforts will be made to stick to this target as it is a question of the country’s credibility.

Arun Jaitely along with Reserve Bank of India (RBI) governor Raghuram Rajan
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Arun Jaitely along with Reserve Bank of India (RBI) governor Raghuram Rajan

At one level this is a very positive statement. During the 10 years of United Progressive Alliance (UPA) rule, we have seen fiscal consolidation rules, codified in the Fiscal Responsibility and Budget Management (FRBM) Act being breached in a cavalier fashion (well before the 2008-09 global recession, when a relaxing of the rules would not have been grudged).

At another level, it is also an unnecessary statement. It was widely known that the 4.1 per cent fiscal deficit target that Jaitley’s predecessor P. Chidambaram set in his last budget in February 2014 was not a credible one.

Since that was just an interim budget, Jaitley should not have accepted that figure as a challenge, but instead exposed it for the charade that it was and then put in place credible fiscal consolidation path. The rating agencies would have understood; none of them believed the 4.1 per cent figure anyway.

But the real problem in the deficits discourse is the almost exclusive focus on the fiscal deficit, with the revenue deficit—the main reason for public finances going out of kilter—slipping under the radar.

The revenue deficit is the gap between the government’s revenue receipts and running expenses (interest payments, salaries, subsidies, maintenance expenditure, sundry grants). Revenue expenditure does not involve spending on creating capital assets.It is this which is the real indicator of how a government is spending beyond its means. It is this which forces the government to borrow more for consumption, crowding out borrowing by the private sector, pushing up interest rates and fuelling inflation.

According to the Mid-Year Economic Analysis, the revenue deficit in the first half of this fiscal (April-September) was 91.2 per cent of the budget estimates, which was not only higher than the 84.8 per cent figure of the first half of the previous fiscal (2013-14) but was much higher than a five years’ moving average of 63.5 per cent. By November, it was 103 per cent of the budget estimates.

But it isn’t just about this year alone. The revenue deficit has been pushing up the fiscal deficit (the gap between the government’s total earnings and total expenditure) for over a decade. Its share in the fiscal deficit increased from around 60 per cent in the early 2000s to 81 per cent in 2009-10.

This was perhaps partly due to revenue losses from excise duty cuts given as part of the stimulus package to counter the 2008-09 recession, but ground has not been recovered sufficiently. The budgeted revenue deficit for 2014-15 is 72 per cent of the fiscal deficit. This is worrying.

The FRBM Act, 2003, mandated eliminating the revenue deficit completely by March 2008, through a minimum annual reduction of 0.5 per cent of GDP. But barely had the Act got notified in 2004 than the UPA government relaxed the revenue deficit target in its very first budget.

The next major dilution was the introduction of the dodgy concept of effective revenue deficit by Pranab Mukherjee, during his stint in North Block. Defined as the difference between the revenue deficit and grants for the creation of capital assets, effective revenue deficit was really a thinly disguised attempt to show a better revenue deficit number than was actually the case (for example, a 3.3 per  cent revenue deficit in 2010-11 translated into a 2.1 per cent effective revenue deficit). The elimination target was applied to this lower number. But even this lower revenue deficit is still 50 per cent of the fiscal deficit.

A logical question is, will the focus on containing the fiscal deficit not inevitably and automatically involve trimming the revenue deficit as well?

Ideally and technically, yes. When cutting expenditure, the initial focus should be on non-productive spending. But that is not what actually happens.

The focus on fiscal deficit relative to revenue deficit invariably involves cutting back on capital expenditure, and not revenue expenditure. If not an actual reduction, the increase in capital expenditure over the budgeted estimates has always been less than that of revenue expenditure.

In 2009-10, revenue expenditure was 1.6 per cent higher than budget estimates, while capital expenditure was 8.8 per cent less. In 2010-11, revenue expenditure exceeded budget estimates by 8.5 per cent, but capital expenditure was higher by just 4.3 per cent. In 2012-13, revenue expenditure was 3.3 per cent less than budget estimates; capital expenditure was 18.5 per cent less. The trend continues in this financial year as well. Revenue expenditure up to November 2014 was 60.7 per cent of budget estimates; capital expenditure was 53.5 per cent.

To be fair to governments, cutting revenue expenditure, which accounts for nearly 80 per cent of total expenditure, is not easy. Close to 60 per cent of revenue expenditure is committed expenditure – interest payments (around 25 per cent), defence (15 per cent) and salaries and pensions (18 per cent). There can be no cutting back on any of these. Together, they gobble up nearly 80 per cent of revenue receipts.

The government has only 40 per cent of revenue expenditure it can play around with, of which subsidies (hovering around 15-18 per cent of revenue expenditure) are a political hot potato. It would be wrong to term all revenue expenditure as non-productive – maintenance of capital assets are as important as creating them and there is a limit to how much such spending can be pruned.

But that does not mean Jaitley and his team should throw up their hands in the air and give up the battle against the revenue deficit. Creative solutions will have to be found to get around this conundrum. A start has already  been made to trim the subsidy bill and this effort needs to continue without succumbing to populist pressures.

The Seventh Pay Commission report is due around September, how the government deals with its recommendations will put it to test on how serious it is about putting a lid on the revenue deficit.

The amendments to the FRBM Act in 2012 gave statutory status to the effective revenue deficit and made it the target of reduction. While reporting this number in the budget documents will have to continue, Jaitley can decide that he will target the real revenue deficit for reduction. That will send out a powerful message of this government’s commitment to fiscal consolidation. Yashwant Sinha did something similar –he decided to follow some of the prescriptions of the FRBM Act even before it was passed.

Rating agencies certainly keep a hawk’s eye on the fiscal deficit. But it would be wrong to presume that they will be okay with a low fiscal deficit in which the revenue deficit is nearly 70 per cent as against a slightly higher fiscal deficit caused by more capital expenditure, which is what the country needs today. The size of the fiscal deficit does matter, but so does its quality. Team Jaitley has to pull off this tightrope walk.

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