From UPSC perspective, the following things are important :
Prelims level : Not much.
Mains level : Paper 3- Role of informal sector in Indian economy, How expansionary fiscal policy can help more than represented in the official data.
That India is in the midst of a serious economic slowdown is no longer in question. The debates are now mostly about what to do about it.
Where is the GDP growth coming from?
Fall in consumption expenditure in absolute terms: The leaked National Sample Survey (NSS) consumer expenditure data -shows that real monthly per capita expenditure has in fact fallen in absolute terms between 2011-12 and 2017-18.
- 8 % decline in a rural area: In rural areas, consumption expenditure decreased by 8.8 per cent.
- 2% decline in an urban area: While in urban areas it increased by 2 per cent, leading to an all India decline of 3.7 per cent.
- Where is the growth coming from: If average consumer expenditure is down, then where is the GDP growth coming from?
- Consumer expenditure contribution: After all, according to National Accounts Statistics (NAS) consumer expenditure is around 60 per cent of the GDP.
- And given the other contributors to GDP-investment and government spending- are not growing spectacularly, consumer expenditure should be growing rather than decreasing.
- So, to get an overall 5 per cent growth rate, consumer expenditure should be growing at higher than 5 per cent.
- NSS vs. NAS- a genuine puzzle: How can consumption expenditure be going down in absolute terms according to the NSS estimates and be growing at more than 5 per cent according to the NAS?
- Variation in data a norm: That these two types of estimates of consumption expenditure do not match is well-known, and that is the case in other countries as well.
- The discrepancy at alarming proportions: In the 1970s, consumer expenditure according to NSS estimates was around 90 per cent of consumer expenditure according to NAS, but in 2017-18 it was only 32.3 per cent.
- Data from two different countries: It is as if we are looking at data from two different countries.
- One where the consumption expenditure growth is positive and propping up the GDP growth rate and the other where it is actually falling.
A few inferences that pertain to the state of the economy and the policy options.
- Reasons for the discrepancy between NSS data and NAS data.
- First- Presence of large informal sector:
- 50% contribution to GDP: Informal sector accounts for nearly half of the GDP and employs 85 per cent of the labour force.
- Guesswork on performance: In national income accounts, growth in the informal sector is estimated by extrapolating from the performance of the formal sector. Which is largely guesswork.
- Second- Making effects of the expansionary policy less pronounced:
- Expansionary fiscal policy more effective than appear to be: Because of the presence of the informal sector, expansionary fiscal policy will be more effective than what would appear from official statistics, as a big part of its impact will be felt in the informal sector.
- Why is it so? The reason is that a big segment of the population is located in the informal sector; they are poorer and tend to spend a much higher fraction of their income on consumption.
- This group has been seriously affected by the economic slowdown.
- Third-Results of expansionary policy would be apparent after a delay
- Apparent effects of policy much worse than what it would be: The effect of an expansionary policy on the budget deficit will look much worse than what it would be since the estimates of its effect on income expansion and tax collection will be largely based on the formal sector.
- Informal sector boosting the formal sector: Some of the income generated in the informal sector will boost demand in the formal sector through consumer demand for mass-consumption items (for instance, biscuits, as opposed to automobiles).
- Good medium-term pictures: Therefore, in the medium term, once the engine of the economy starts moving, the income expansion and deficit numbers will look better.
- Final-Tax cuts will achieve little
- Only 3-5% population affected: The tax cut will affect barely 3-5 per cent of the adult population.
- Contribution of taxes in GDP: Income tax revenues amount to around 5 per cent of the GDP and corporate income taxes around 3.3 per cent.
- Rich tends to save more: Most of the tax is paid by the richest among these groups (the top 5 per cent taxpayers contribute 60 per cent of individual income tax revenue), and the rich tend to spend a smaller fraction of their income (and save more).
- Little impact on GDP: Irrespective of the number of people affected, and even if they spend the entire increase in their income as a result of the tax cut, the overall economic impact will be small relative to the GDP.
- The futility of tax cut: Therefore, a tax cut for the rich would be less effective in raising spending compared to an equivalent amount being given to poorer groups who spend a much higher fraction of their incomes.
The government should not underestimate the role of the informal sector in the economy. To get the engine of the economy revving, an expansionary fiscal policy that harnesses the energy of the informal sector to boost aggregate demand is the order of the day.