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January 23, 2023

Indian Economy|Capital Markets

What the Budget should explain

By Nitin Desai


What the Budget should explain

Nitin Desai

FM's speech must highlight its impact on money supply, demand and investment- factors that influence inflation and growth

The formal responsibilities of the Ministry of Finance for the management of the Union government’s Budget have a deep effect on the economy because of the high scale of public spending as a proportion of gross domestic product or GDP; the demands of the Union government on savings; and the impact of decisions about taxes and subsidies on private concerns about consumption, savings, investment, exports, and imports. Hence, the primary aim of the Budget must be to design these formal responsibilities in such a manner that:

(a) Macroeconomic impact is consistent with short- and medium-term objectives about inflation and growth.

(b) The allocative and distributional effects made in the Budget about expenditure allocation, taxes and subsidies move these in a chosen direction.

The Budget as presented to Parliament and the public is fairly comprehensive in providing information about the details of public finances. However, the explanation of the choices made is generally presented in the Budget speech of the finance minister that should focus at length on the likely macroeconomic, allocative, and distributional effect of the choices made rather than on a tedious narration of specific projects, which are designed and implemented by other ministries.

When it comes to macroeconomic impact, the usual focus is on the gross fiscal deficit (GFD), which is the excess of total expenditure (including net loans) over revenue receipts (including external grants) and non- debt capital receipts. A simple way of assessing its potential macroeconomic impact is to examine the statistical correlation, (which can range from -1 to 0 to +1 ) between the Budget deficit and the two principal macroeconomic goals — the rate of inflation and the GDP growth.

However, the correlation does not prove the direction of causation. For instance, low deficits could lead to high growth because the lower demand on private savings provides more resources for private investment, or high growth can lead to low deficits because of the positive impact of high GDP growth on tax collections.

Using the data from the post-liberalisation period, 1991-92 to 2019-20, makes sense as it covers the period when the economy became more market and private-sector oriented. In this period, one finds that the correlation between the deficit ratio (gross fiscal deficit as a percentage of GDP) and the growth rate of the wholesale price index for manufactured goods (WPI-MG) is 0.27, modest but significant. The reason for excluding primary articles from the WPI growth variable in the correlation is that items like food and fuel are heavily influenced by supply-side factors rather than demand-side ones. However, what is more important is the correlation between the deficit ratio and a growth rate of broad money supply (M3), which is 0.30 and the correlation between M3 growth and WPI-MG, which is 0.48.

Turning now to the impact on growth, the correlation of the deficit ratio with GDP growth is negative and amounts to -0.51. This negative impact could be because in this time period an increase in the deficit ratio may well have been because of rising revenue expenditures rather than a higher public capital expenditure. This rise in the government’s demand on savings could lead to a slowdown in private sector investment growth. This hypothesis is consistent with the negative correlation — (-)0.31 — between the deficit ratio and private corporate investment.

The correlation between broad money (M3) growth and GDP growth is slightly negative, which is understandable given the correlation between the deficit ratio and M3 growth. However, M3 growth seems to be linked indirectly to GDP growth in a positive way. This can be seen in a fairly high correlation, amounting to 0.57, between M3 growth and the growth in commercial credit by banks, and this credit growth also has a significant correlation, amounting to 0.35 with private investment growth and 0.47 with the growth rate of total investment. And, as is expected, the correlation of the growth rate of investment (GFCF) to the GDP growth rate is also fairly high and amounts to 0.57.

Correlation, as stated earlier, is not a sufficient measure of causation. But it does mean that the correlated items have a substantive connection, perhaps sharing a common causal process. Hence the finance minister’s explanation of the Budget should include some assessment of how the deficit and the government’s borrowing programme could affect the growth in the supply of broad money (M3), the flow of banking finance to the commercial sector, and the potential impact on private investment. Since the growth in broad money (M3) supply is also greatly influenced by the Reserve Bank of India, the Budget could present some indication of the assumed direction of monetary policy as the budgetary parameters can only be partially relevant.

Private sector investment in growth is dependent on what is happening to demand. The expenditure side of the Budget matters because public spending in infrastructure and other activities is a major source of demand growth. Private sector and household demand growth will also depend on other elements in the Budget, particularly the changes in tax and subsidy provisions.

One crucial element here is the degree of variability of the private sector items of demand growth. One way of assessing this is to work out the absolute extent of departure above and below the mean and compare it with the mean as a measure of variability. From 1991-92 to 2019-20, the average absolute difference from the mean for private consumption was 1.6 per cent on a mean rate of growth of 5.6 per cent. The corresponding figures for private investment (corporate plus household) are 7.6 per cent and 8.7 per cent, and for exports 7.7 per cent and 11.0 per cent, which shows how much more variable and unpredictable their growth rates are. This clearly suggests that influencing consumption demand is more predictable and most useful as a domestic measure for GDP growth. Investment growth may be more affected by such demand growth and the Budget’s impact on credit sources than by corporate tax rate adjustments in the Budget.

The real requirement for the finance minister’s explanatory speech is to explain the measures taken in the Budget to influence inflation and growth not just through the announcement of a deficit goal, but more broadly through the impact on money supply, consumer demand, foreign trade and investment. In the occasional case of the Budget including significant measures to influence income distribution or environmental protection, the Budget speech should certainly explain these clearly from an overall economic perspective and not just by a long description of specific projects.


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