Subject: Economics

Context

Many states are pursuing the freebie culture, which raises several questions.

About freebies

• Why do governments give freebies? The obvious motivation for States in expanding freebies is to use the exchequer to build vote banks.
• Electoral calculations tempt them to place short-term gains ahead of long-term sustainability.
• Case in which it is necessary? A certain amount of spending on transfer payments to provide safety nets to the most vulnerable segments of the population is not only desirable but even necessary.
• What is the problem? The problem arises when such transfer payments become the main plank of discretionary expenditure, the spending is financed by debt, and the debt is concealed to circumvent the FRBM targets.
• Opportunity cost: The more States spend on transfer payments, the less they have for spending on physical infrastructure such as, for example, power and roads, and on social infrastructure such as education and health, which can potentially improve growth and generate jobs.

Questioning the logic of freebie culture

• Sustainability: Is borrowing and spending on freebies sustainable?
• Best use: Is this the best possible use of public money?
• Opportunity cost: What is their opportunity cost — what is it that the public are collectively giving up so that the government can fund these payments?
• Checks and balances: Should not there be some checks on how much can be spent on them?

Where should government spend the borrowed money?

• Ideally, governments should use borrowed money to invest in physical and social infrastructure that will generate higher growth, and thereby higher revenues in the future so that the debt pays for itself.
• On the other hand, if governments spend the loan money on populist giveaways that generate no additional revenue, the growing debt burden will eventually implode.

But what is the problem with freebies if states are confirming to the FRBM targets?

• Any analysis of State Budgets by the Reserve Bank of India shows that State finances are in good health and that all of them are conforming to the Fiscal Responsibility and Budget Management (FRBM) targets.
• This is a misleading picture.
• Off budget borrowing: Much of the borrowing that funds these freebies happens off budget, beyond the pale of FRBM tracking.
• The typical modus operandi for States has been to borrow on the books of their public enterprises, in some cases by pledging future revenues of the State as guarantee.
• Effectively, the burden of debt is on the State exchequer, albeit well concealed.
• The Comptroller and Auditor General of India (CAG) had in fact pointed out that in respect of some States.
• Huget cost: The costs of fiscal profligacy at the State level can be huge.
• The amount States borrow collectively every year is comparable in size to the Centre’s borrowing which implies that their fiscal stance has as much impact on our macroeconomic stability as does that of the Centre.
• The need, therefore, for instituting more effective checks that can make wayward States fall in line is compelling.

What are the institutional checks and balances? What are the reasons of their failure?

• 1] Legislature and opposition: In theory, the first line of defence has to be the legislature, in particular the Opposition, whose responsibility it is to keep the Government in line.
• But the Opposition does not dare speak up for fear of forfeiting vote banks that are at the end of these freebies.
• 2] Lag in CAG reports: Another constitutional check is the CAG audit which should enforce transparency and accountability.
• In practice, it has lost its teeth since audit reports necessarily come with a lag, by when political interest has typically shifted to other hot button issues.
• 3] The market: The market is another potential check.
• It can signal the health or otherwise of State finances by pricing the loans floated by different State governments differently, reflecting their debt sustainability.
• But in practice this too fails since the market perceives all State borrowing as implicitly guaranteed by the Centre, never mind that there is no such guarantee in reality.

Suggestions

• 1] Amend FRBM Act for complete disclosure: First, the FRBM Acts of the Centre as well as States need to be amended to enforce a more complete disclosure of the liabilities on their exchequers.
• Even under the current FRBM provisions, governments are mandated to disclose their contingent liabilities, but that disclosure is restricted to liabilities for which they have extended an explicit guarantee.
• The provision should be expanded to cover all liabilities whose servicing obligation falls on the Budget, or could potentially fall on the Budget, regardless of any guarantee.
• 2] Centre should impose conditionalities: Under the Constitution, States are required to take the Centre’s permission when they borrow.
• The Centre should not hesitate to impose conditionalities on wayward States when it accords such permission.
• 3] Use of financial emergency provision: There is a provision in the Constitution of India which allows the President to declare a financial emergency in any State if s/he is satisfied that financial stability is threatened.
• This provision has never been invoked so far for fear that this will turn into a political weapon.
• But the provision is there in the Constitution for a reason.
• After all, the root cause of fiscal irresponsibility is the lure of electoral nirvana. It will stop only if the political leadership fears punishment.
• 4] Course correction by the Centre: The Centre itself has not been a beacon of virtue when it comes to fiscal responsibility and transparency.
• To its credit, it has embarked on course correction over the last few years.
• It should complete that task in order to command the moral authority to enforce good fiscal behaviour on the part of States.

Conclusion

The state governments, as well as the Central government, need to avoid the freebies that harm financial health and cause long-term harm. For that, there is a need to implement the suggestions mentioned above.

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Back2Basics: FRBM Act

• The FRBM is an act of the parliament that set targets for the Government of India to establish financial discipline, improve the management of public funds, strengthen fiscal prudence and reduce its fiscal deficits.
• It was first introduced in the parliament of India in the year 2000 by Vajpayee Government for providing legal backing to the fiscal discipline to be institutionalized in the country.
• Subsequently, the FRBM Act was passed in the year 2003.

Context

The five-year transition period after the adoption of the Goods and Services Tax (GST) on July 1, 2017, came to an end on June 30, 2022. With this, the era of GST compensation that the state governments were entitled to has ended.

High estimated loan issuance

• Many state governments have asked for the compensation period to be extended by a few years.
• To tangibly assess the near-term outlook for state finances, we have to rely on the states’ own estimates for their market borrowing requirements for the second quarter of 2022-23.
• The indicative calendar of market borrowings by 23 state governments and two Union territories for the second quarter has pegged their total state development loan issuance — the primary source of financing state government deficits — at Rs 2.1 trillion.
•  This projected issuance is 29 per cent higher than the same period last year, and at an eight-quarter high.
• This high level of issuance projected by states reflects concerns that some of them might rightfully have regarding the uncertainty of their cash flows in the post-GST compensation era.
• High dependence on GST compensation: Of these 23 states, Tamil Nadu, Andhra Pradesh, Haryana, Punjab and Gujarat have indicated large increases in borrowings.
• Most of these states have an above-average dependence on GST compensation.

Implications of discontinuation of GST compensation

• Alter the revenue compensation: The discontinuation of the GST compensation flows would alter the revenue composition of some states adversely, particularly those with a relatively larger share of such receipts in their overall revenue streams.
• Increase in debt level: To offset a portion of the associated revenue loss, such states are likely to enhance their borrowings and/or to undertake some expenditure adjustments in the quarters ahead.

Adjustment of borrowing limit of the States by the Centre

• At the time of communicating to states their annual borrowing limits for the ongoing year, we understand that the Centre had informed state governments that their off-budget borrowings for the past two years (2020-21 and 2021-22) would be adjusted from their borrowing ceiling this year.
• Data on off-budget borrowing: It appears that the calculation of the adjusted borrowing limit required the submission of detailed data by the state governments related to their off-budget borrowings for the last two fiscal years, followed by a thorough assessment of the same by the Centre.

Need for early step up in tax-devolution

• On the whole, though, states appear to have entered the year with a comfortable cash flow position.
• This follows from the back-ended release of the tax devolution to states for 2021-22 — nearly half of the full-year amount was released in the fourth quarter.
• Additionally, the total amount was also well above the revised estimate, providing an unexpected gain to states.
• This may have allowed them to temporarily withstand the changes related to their borrowing permission.
• Subsequently, the release of the GST compensation grant of Rs 869 billion for several months in May is likely to have further eased their cash flows.
• If the government does decide to step-up tax devolution to the states in the near term, instead of back-ending it as was done in the last year, it may reduce the size of state borrowings in the second quarter.
• But more significantly, such revenue certainty, despite the end of the GST compensation era, may embolden states to ringfence their capital spending, providing a positive impulse to the economy.

Conclusion

The discontinuation of the GST compensation flows would alter the revenue composition of some states adversely, tax devolution to the states in the near term could cushion the blow of the discontinuation.

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Back2Basics: Compensation under GST regime

• The adoption of the GST was made possible by the States ceding almost all their powers to impose local-level indirect taxes and agreeing to let the prevailing multiplicity of imposts be subsumed under the GST.
• While the States would receive the SGST (State GST) component of the GST, and a share of the IGST (Integrated GST), it was agreed that revenue shortfalls arising from the transition to the new indirect taxes regime would be made good from a pooled GST Compensation Fund for a period of five years that is set to end in 2022.
• This corpus in turn is funded through a compensation cess that is levied on so-called ‘demerit’ goods.
• This GST Compensation Cess or GST Cess is levied on five products considered to be ‘sin’ or luxury as mentioned in the GST (Compensation to States) Act, 2017 and includes items such as- Pan Masala, Tobacco, and Automobiles etc.

Context

The monumental indirect tax reform, the Goods and Services Tax (GST), has completed five years in existence. The article analyses the impact of GST on inflation.

Background

• Before the implementation, it was said that it would be a boon to the economy in terms of higher revenue buoyancy, lower inflation, higher revenue, higher growth etc.
• During the 12 months preceding GST implementation, the Consumer Price Index (CPI) inflation was 3.66%, while it increased to 4.24% post-GST in the next 12 months.
•  A similar pattern was observed in Australia, New Zealand, and Canada.
• An Australian Competition and Consumer Commission study showed that GST initially increases inflation.

How GST can affect prices

• In theory, implementing GST should not lead to a change in overall inflation.
• The revenue-neutral rate (RNR) is calculated so that it would not cause higher inflation.
• But revenue neutrality does not mean that prices would not go up or down in the economy.
• This is because the weight of goods in the consumption basket and their contributions to indirect tax collections are not the same.
• Importantly, the effect of GST on the prices of certain goods and services depends on the structure and design of taxation.
• The RBI, in a 2017 report, showed that about half of the groups of items that GST covers are not in the CPI basket.
• So, the effect of GST on prices was expected to be small.
• Finally, prior to the GST implementation, it was expected that prices would go down because GST harmonises indirect tax rates and eliminates the cascading effect.
• Thus, whether GST has any effect depends on how different factors affect each other.

So, how can we ascertain whether GST has had an inflationary impact in India?

• Inflationary impact can be assessed by turning to statistical modeling?
• Statistical results provide us with an interesting picture of the impact of GST on price levels.
• First, we look into the overall price index (CPI).
• Here, the actual CPI growth in the study period is 4.61%, whereas the counterfactual estimate of inflation is 3.24%.
• This implies that without the GST implementation, the CPI inflation would have been 3.24%.
• This indicates that with the implementation of GST, CPI increased by 1.37 percentage points (pp).
• Second,  CPI core inflation (which strips off volatile components such as food and fuel from the headline inflation) increased by 1.04pp in the post-GST period (actual inflation was 4.57%, counterfactual inflation was 3.53%).
• Third, GST is found to have a significant positive impact on inflation of commodity groups such as paan, tobacco and intoxicants, clothing.

What explains rise in inflation post GST?

• Rise in tax rate of some goods: The rise in inflation post-GST implementation could be due to the rise in the tax rate of some goods and services, the inclusion of business activities that were not taxed earlier, or the market structure.
• The average weighted GST rate was designed to be neutral, so it might not have contributed much to the observed higher inflation.
• Coverage of business activities under GST not taxed earlier would result in higher prices since the firms would pass on the cost to the consumers.
• Market power: There is another possibility which would cause result inflation after the GST implementation.
• As Joseph Stiglitz opined, rising market power is bad for the economy as it raises economic inefficiency and inequality and lowers the economy’s resiliency.
• Further, taking advantage of market power, it is possible that most firms would have passed the taxes to end consumers.
• With the existence of market power, firms’ price includes a significant mark-up over marginal costs.
• Some results point out the possibility of profiteering in select segments after GST.
• To pre-empt this possibility, the government set up National Anti-profiteering Authority (NAA).

Way forward

•  NAA should monitor the prices of critical or essential goods and services to see the price impact of GST.
• Similarly, the Competition Commission of India should observe anti-competitive producer behaviour that hurts consumers via excessive price increases.
• These measures may ensure that producers do not take advantage of the GST.

Conclusion

Statistical results suggest that GST implementation has resulted in a decrease in inflation of food items and raised inflation of non-food items.

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Context

All emerging markets (EMs), including India, are facing outflows of foreign portfolio investment as the US Fed tightens.

Inflatioon and exchange rate

• Exchange rate as response to capital flow: Canonical inflation targeting wants exchange rates to float as the correct response to capital flows.
• Policy should respond to exchange rate fluctuations only after they affect inflation or output.
• Any interest rate defence of the exchange rate would reduce the focus on inflation.
• But most EMs intervene in foreign exchange (FX) markets in order to reduce volatility.
• A research paper by Edward F Buffie and co-authors indicate that  FX intervention greatly enhances the efficacy of inflation targeting.
• Two instruments for two targets work better than trying to do everything through the interest rate.
• Excess depreciation of currency can raise inflation.
• Other researches such as from the IMF, argues for the use of prudential capital flow management techniques and finds reserve accumulation and its use reduces risks and crises in EMs.

Policies followed by RBI to reduce volatility

• Not fully convertible: RBI’s sequenced approach to capital account convertibility, where, for example, debt inflows are only allowed as a percentage of domestic markets, saved it from the kind of interest rate volatility Indonesia experienced during the taper tantrum and is helping it now.
• More liberalisation measures can be taken when needed.
• India’s large foreign exchange reserves have allowed rupee depreciation to be lower than most other countries as the dollar strengthens.
• The cost of holding foreign exchange: There are costs of holding large reserves and of too much intervention.
• The central bank ends up supporting the US and not its own government borrowing and it sacrifices interest income.
• But holding reserves and then not using them when required is the most costly.
• Again use of multiple instruments can mitigate over-reliance on intervention.
• Much research and recent experience suggest that all available instruments should be used to moderate volatility in nominal variables.

Why increasing interest rates will be ineffective in reducing capital outflow

•  A common suggestion is to raise policy rates to maintain a historical gap with US Fed rates.
• But such an interest rate defence did not prevent outflows during the taper tantrum or in 2018 and only triggered a slowdown.
• It forgets that interest-sensitive flows are only about 8 per cent of India’s foreign liabilities.
• There have been no debt outflows in 2022 despite a narrowing interest differential.
• Equity outflows also seem to be tapering.
• Monetary tightening that dampens expectations of growth, induces more outflows as country risk-premiums rise.

Issues with less intervention

• Some want less intervention and more rupee depreciation in order to improve the current account deficit.
•  But less intervention can lead to a chaotic fall and jittery markets as we saw in 2011.
• It is best for policy to prevent over-depreciation due to global risks.
• After about 4 per cent nominal depreciation, India’s real effective exchange rate against a basket of 40 countries is approaching 100.
• That implies the real exchange rate is too depreciated since India has had relatively more structural reform and productivity growth.
• Future corrections toward equilibrium will require a rise of the rupee.
• High oil prices are a risk for India’s balance of payments, but multiple types of adjustments have the best chance of succeeding.

Why sometimes policy changes are introduced as surprise?

• Market participants want clear communication and no surprises for markets.
• Forward guidance is an important part of inflation targeting. But when markets tend to overreact and are influenced more by the US than by Indian policy, the best way to introduce a policy change may be by surprise.
• Thus markets had priced in excessive rate hikes after the US Fed began tightening.
• The steep surprise hike in Indian repo rates prevented additional rate hikes from being priced in as domestic rate-rising began.

Conclusion

Inflation targeting is an art that requires skill, attention to context and an open mind.

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Back2Basics: Real Effective Exchange Rate

• The real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies.
• The weights are determined by comparing the relative trade balance of a country’s currency against that of each country in the index.
• An increase in a nation’s REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper.
• It is losing its trade competitiveness.