Exercise to reduce fiscal deficit and limit external debt

- Low government spending weakens economic growth in the short run

In the interim budget presented earlier this month, the government laid renewed emphasis on controlling the fiscal deficit and limiting external borrowing. The fiscal deficit is targeted to be limited to 5.1 percent of gross domestic product (GDP) in FY25, representing a consolidation of 71 basis points over the actual 24 (revised estimate). The tax-GDP ratio also increased from 10.1 percent in FY24 to 11.7 percent in FY25 (budget estimate). Tax revenue generation has also improved. This controlled increase in revenue expenditure, combined with the stimulus provided to capital expenditure, indicates that a large proportion of debt is now directed towards financing capital expenditure. It is noteworthy that the decline in capital allocation and revenue expenditure ratio indicates that the government is trying to improve the quality of expenditure while at the same time it wants to stay on the path of fiscal consolidation.

In this context, a recent paper published by the Reserve Bank of India examines sluggish growth and fiscal consolidation in greater detail. Interestingly, this paper redefines capital expenditure and looks at development expenditure. Its scope is broad as it includes social and economic costs that also cover health, education, skills, digitalization and climate risk. It aims to include those components of revenue expenditure that can actually result in physical and human capital formation. Also, setting aside that portion of capital expenditure that does not promote growth. While capital expenditure has been targeted at 3.4 per cent of GDP in FY25, development expenditure is estimated at 4.2 per cent of GDP.

It is generally believed that low government spending weakens economic growth in the short run. But fiscal consolidation can boost growth in the long run. This can be done by reducing interest rates for the long term. This will bring in private investment and at the same time create fiscal space for more productive spending. The measures suggested in the letter in this regard include reskilling the labor force, investing in digitalization and achieving energy efficiency, using a macroeconomic framework. The paper said that a one percent increase in real development spending can have a cumulative multiplier effect and increase GDP by five percent over four years.

A five per cent annual increase in employment including training and skills in high labor productivity sectors (such as chemicals, financial services and transport etc.) could lead to a one per cent increase in GDP over the period 2020 to 2031. Similarly, digitalization and lower energy intensity could boost growth in the medium term as technological advances support labor and capital.

There may be problems in the short term. We have seen this in the form of an increase in the debt-to-GDP ratio, but long-term benefits will offset this. A rebalancing of government spending towards development spending would reduce the general public debt-to-GDP ratio to 73.4 percent by 2030-31, while the International Monetary Fund said it would cross 100 percent of GDP in the medium term.