Strategic thinking on fiscal policy

Business Standard, 2 February 2024

What is a fiscal crisis

Given the limitations of GDP measurement in India, measures such as the interest payment to revenue receipts (IP/RR) ratio are desirable. About 40% of revenue receipts now go to interest payments. In the world of corporate finance, the term `operational leverage' is used to convey the pressure of locked-in payments that are akin to debt servicing obligations. Indian public finance faces overt leverage (which demands debt servicing) and operational leverage (commitments to pay wages and pensions), which limits the room for maneuver.

Every borrower runs the risk of falling into a `debt trap': where debt is repaid through borrowing. A `fiscal crisis' is a short period in which the debt dynamics becomes adverse, where debt grows dramatically compared with tax revenues. In countries with a fiscal crisis, the debt/GDP ratio surges over a few years. Governments have limited room to maneuver by way of cutting spending, because of the inflexibility of interest payments and operational leverage, so when debt servicing costs surge, this creates extreme pain.

Diagnosing fiscal stress

A good tool for understanding debt dynamics is the `primary deficit' (PD). As long as there is a primary surplus (i.e. a PD that is negative), the debt/GDP ratio will decline. It helps that the primary deficit is a fact measured out of public finance accounting, and does not require observation of GDP. We just have to know whether it's a primary surplus or a deficit. When a small primary surplus is obtained, the debt/GDP ratio declines, regardless of the problems of GDP measurement.

The primary deficit was above 3.5% of GDP for all the years from 1983-84 to 1990-91. This worked out poorly. Things worked better from 1991-92 onwards. There was a good period -- 2003-04 to 2007-08 -- where four out of the five years had primary surpluses. This gave a nice reduction in total debt, from 62.6% in 2002-03 to 57.3% in 2008-09. Small primary surpluses kick off gains in the debt/GDP ratio.

The pandemic gave a period of greater difficulty. While the union government (in my opinion, correctly) resisted calls for vast spending, tax revenues suffered thus creating fiscal stress. The primary deficit was back up to 5.74% in 2020-21 and is now at values of about 2 per cent. The RE for 2023-24 is 2.3%: well above zero.

Long term objectives: Chronic small primary surpluses

Looking into the next decade, it would be a great step forward for India if a fiscal adjustment of about three percentage points were obtained, so that we get to prudent public finance, the state of affairs where in a normal year, there is a small primary surplus. This would create the space to occasionally run primary deficits, in response to events like a war, a global financial crisis or a global pandemic. The power of policy makers would be enhanced because, when faced with such crises, they would have the ability to put multiple percentage points of GDP into additional spending.

So far, we have engaged in conventional fiscal reasoning, where the numerical values in budget documents are taken at face value, with the mandatory surgeon general's warnings about GDP data. The algebra underlying the need for small primary surpluses is impeccable.

Long term objectives: Borrowing from voluntary lenders

The second structural problem of Indian public finance, which gets less attention, is the means used for borrowing. When a corporation or an individual borrows, the financial system has the right to refuse the debt, and the financial system sets the required interest rate. This is not how the Indian state borrows. The bulk of the borrowing of the Indian state comes from financial firms who are forced to buy government bonds. This is called `a financial repression' system.

From the viewpoint of economic efficiency, this constitutes a tax on formal finance. Every user of the Indian financial system -- of insurance companies, pensions and banks -- is being taxed in the form of an inferior return on account of the forced mobilisation of their resources by the state. In public finance, we know that any tax on one industry is an inefficient tax. It is better to have broad based taxes -- such as personal income tax and GST -- where no excessive burden falls on any one kind of commercial activity.

Finance is the brain of the economy; it's a particularly important industry. It would be good to not distort this industry. The financial repression tax reduces the size of Indian formal finance, in favour of three alternatives: non-intermediated capital, overseas intermediation and informal finance. Each of these imposes a cost upon the economy when compared with a properly working financial system.

Dialing back on forcible resource mobilisation will foster economic growth. It will also enhance Indian strategic depth because the government will then build something new: A cadre of private voluntary lenders. This becomes the foundation for enhanced borrowing when faced with a crisis, where higher interest rates can be paid and more resources can be obtained. In contrast, under present conditions, the forced lenders are price insensitive and have not learned to think about the risk and reward of lending to the Indian state as a business proposition.


The strategic sense for Indian public finance, then, runs in two parts. To rise from a world of forced borrowers to voluntary lenders. And to go from chronic fiscal stress to a world of normally having small primary surpluses. These two prongs would create a healthy environment for high growth for the people, and enhance strategic depth in the state by opening up to vast resourcing when faced with a crisis.

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