ISSN: 1391 - 0531
Sunday, November 12, 2006
Vol. 41 - No 24
Columns - The Sunday Times Economic Analysis

Fiscal consolidation and long-term economic growth

By the Economist

There are two publications those interested in the economy must read: The Central Bank's Annual Report and the Institute of Policy Studies' State of the Economy. The two reports differ in style and content.

The Central Bank Annual Report is focused on the developments of the past year and comment is mostly confined to developments during the year. It focuses on the pressing problems in mild and guarded ways, stresses on the healthy developments in the economy and criticises some aspects of the economy in a muted manner. Euphemisms downplay the less favourable developments of the economy. There is often a glossing over of the fundamental problems. Yet the facts are there and some critical comment is hidden in the pages of this large volume. It is undoubtedly the best source of data on the economy and essential reading.

Fuel subsidies and heavy defence expenditure are two areas that affect govt. expenditure

Those interested in a more interpretative account must turn to the IPS report State of the Economy. This discusses the most recent economic developments and gives a longer-term perspective. Apart from this it selects several key issues in the economy for in-depth analysis and comment. In fact State of the Economy 2006 has sections on agricultural reform, leading issues in the development process and policy briefs on four issues. These sections of the report constitute the bulk of the report and give an in-depth understanding on these issues.

For sometime both reports have drawn attention to the country's most serious economic problem: the imbalance in the public finances. The Central Bank annual Report has pointed out in its mild and discreet manner that there is a fiscal problem. Yet the wording hardly brings out neither the gravity of the problem or the urgency of it. Most readers dipping into the report are hardly likely to be impressed by its prognosis. The Annual Report describes the fiscal problem in these cautious words: "Though the debt to GDP ratio declined in 2005, the relatively higher level of debt poses a threat to long-term debt sustainability. Further improvements are needed to lower public debt to a manageable level, contain the primary deficit and the current account deficit and thereby generate surpluses needed for debt sustainability, containing monetary expansion and building up external reserves. The required strong and sustainable fiscal adjustment process is implied in the medium-term targets of the Fiscal Management (Responsibility) Act (FMRA)."

The most important and pertinent comment in the Annual Report is that "Fiscal consolidation paves the way for monetary policy to operate effectively in containing monetary expansion and maintaining price stability." This is the most fundamental issue in the public finances of the country that impacts on the economy and produces inflation, reduces the supply and availability of credit and increases its cost and prevents the state playing its vital role of developing the country's economic and social infrastructure.

In contrast the IPS State of the Economy 2006 report is more interpretative and forthright on the fiscal problem. It characterise the problem as a serious constraint to development and points out that despite the rhetoric of attaining fiscal consolidation, the performance has been in the opposite direction. The IPS Report states:

"While it has been encouraging that despite political pressures, the government has not embarked on large populist public spending schemes, the criticism is that budget policy is doing too little to ensure sustained growth in the long term. The deficit in 2005 was contained not by streamlining government spending but primarily by reaping the extra revenue that comes with growth. There were big rises in spending in some areas - adding workers to the government pay-roll where payments on salaries and wages increased from 5.2 per cent of GDP in 2004 to 5.9 per cent of GDP in 2005 - that do little to strengthen long-term growth prospects. Current transfers and subsidies over time have increased from 4 per cent of GDP in 2003 to 5.4 per cent of GDP in 2005. "

The country has got itself into a straitjacket where government finances are concerned and redeeming itself from it is indeed a formidable task. The capacity to reduce government expenditure is extremely limited. As the IPS State of the Economy points out:

"Most expenditure is hard to cut. The spending goes largely on interest payments, defence, and public sector wages and pensions, leaving little room for big capital investments. Given the limited room for manoeuvre, curtailing expenditure in non-productive areas is critical. But most importantly, if the government is going to make a difference, it needs to raise more revenue."

The report then goes on to suggest some means by which government revenue could be increased and also indicates some measures that have been taken that may not augur well for good fiscal management. It comments that "one of the most pressing tasks here will be to raise tax revenues without discouraging investment. Tax increases effected on an ad hoc basis - and with limited regard for the overall structure and incentive implications of the tax system - can prove counterproductive if it undermines the predictability and consistency of the policy regime. Many 'temporary' taxes - such as the imposition of excise duties on select 'luxury' goods and cesses - introduced for short-term fiscal consolidation also tend to become entrenched in the system over time." The Report also focuses attention on what it calls "waste in the budget", these relate to the "ill-directed fuel subsidies.” It points out that "Fuel subsidies in theory are aimed at the poor but benefit the rich disproportionately. The non-alignment of fuel prices could heave further burdens on the government budget. The report is emphatic in its unpalatable prescription. "Given the steady upward rise in oil prices, overhauling energy policies - cutting subsidies and raising domestic prices - are inevitable to curb demand and allow government budgets to be maintained."

The fiscal problem remains unresolved. In fact there has been little serious effort despite the ad infinitum budget speech rhetoric that it must be reduced. The irony is that everyone would agree with the views of the IPS State of the Economy observations but little would be done to reduce the deficit. The fiscal problem is likely to get worse this year owing to further unwarranted government expenditure and the likely huge increase in defence expenditure.

We cannot but agree with the Institute of Policy Studies observation that there has to be a qualitative improvement in government expenditure. "The quality of fiscal consolidation needs to be improved by re-orienting expenditures to priority and growth enhancing areas. Given the strong growth performance of the economy and the risk of a further widening of the external current account deficit, the authorities should resist any temptation to loosen the fiscal stance and use the additional revenues from higher growth for debt reduction.

Fiscal consolidation would also reinforce monetary policy in controlling inflation. The failure to rein in the fiscal deficit saw the economy grappling with rising inflation in 2005. And it goes on to state, "high inflation has a far higher cost to the economy in terms of its potential to disrupt steady growth."

Unfortunately these observations are not likely to be taken seriously enough to lead to any meaningful action, especially on the side of government expenditure. The public debt is likely to grow, the deficit in the current account would climb further and the country would have to cope with the short-term impacts of inflation and a credit squeeze and forego higher growth in the future.

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