Columns - The Sunday Times Economic Analysis

Fiscal consolidation: imperative but difficult

By the Economist

Many of the problems of the economy arise due to the fiscal weaknesses of the government. The high inflationary pressures, the disincentives for economic enterprise, poor performance in exports, the drain on foreign exchange reserves through large trade deficits are some of the problems whose root cause lie in the imbalance between government revenue and expenditure. The fiscal imbalance has ballooned over the years to such massive magnitudes that its management is a formidable task. The current IMF loan would no doubt have stringent conditions on cutting down the fiscal deficit that has been over 7 percent of GDP for several years and in certain years reached 8 percent of GDP.

There is no doubt whatsoever that fiscal consolidation is essential for stabilisation of the economy and its future growth. Yet it is easier said than done. The core cause for the economic crisis is the dire state of public finances. The current predicament in the economy permits little opportunities for fiscal adjustment and yet that is essential. It is a clear case of how unresolved economic problems grow into dimensions when its resolution becomes intractable. Yet, fiscal consolidation is a must and the current crisis should awaken the country from its stupor into a frame of mind that creates a political will to introduce fiscal discipline.

Fiscal consolidation means initially the bringing down of the fiscal deficit to manageable proportions that ensures lesser inflationary pressures and lessens the debt burden that is crushing the country’s economy. As we said earlier, this is easier said than done for several reasons. The public debt has grown to such an extent that it is itself at the root of the problem. The debt servicing costs absorb nearly the entirety of the country’s revenue. It may shock readers of this column to know that in 2008 as much as 90.5 percent of the revenue collected went towards servicing debt alone.

What is then left is a mere 10 percent or less of revenue for all other expenditures such as defence, education, health, salaries to public servants and pensions, money for loss making public enterprises and welfare expenditure. Since this 10 percent or less is inadequate, the government must borrow to meet these current expenditures and the capital expenditure. Hence the government has for several years run fiscal deficits of over 7 percent of GDP. In 2006 the budget deficit turned out to be 8.0 percent of GDP, followed by a deficit of 7.7 percent in 2007 and 2008. The fiscal deficits in the last three years are indicative of this recurring problem.. What’s more these deficits were far in excess of the original estimates provided to parliament, as there were revenue shortfalls on the one hand, and expenditure overruns on the other.

The budgeted deficit in 2008 was 7 percent of GDP; it turned out to be 7.7 percent of GDP. The pious expectation in budgets has been to reduce the budget deficit. Year-in-year-out we listen to the Finance Minister announcing that the fiscal deficit would be brought down to a lower figure than in the previous year. The outturn is just the opposite. It is now a general expectation that the outturn would be an overshooting of the budgeted fiscal deficit. The budgeted deficit for 2009 is 6.5 percent of GDP. It would probably reach almost 8 percent as revenue collection is falling quite sharply this year.

Debt servicing cost has been the single biggest expenditure.. This is the cumulative result of recurring budget deficits. Since the country has been fighting an expensive war one of the most significant reasons for the recurring high fiscal deficits has been the war expenditure. In 2008 the expenditure on defence increased sharply. However placing the difficulties on the war alone is insufficient. There are other committed current expenditures that cannot be curtailed. What is worse is that most of these expenditures have risen rather than decreased to offset the rising debt servicing costs and the increasing defence expenditure.

The expenditure on salaries and pensions in particular increased with more persons employed in the public sector. All these meant that it was inevitable that the fiscal deficit had to be large and the government had to borrow to meet these costs. Cutting down of any of these expenditures is a difficult, almost an impossible task. Yet what has happened is that the costs of salaries have risen in recent years owing to an increase in the numbers recruited to the public services. Similarly expenditure on maintaining a large cabinet with its paraphernalia of security personnel offices, costs of transport etc have added to the burden. Costs of elections and foreign travel of ministers have all been items that may not seem large by themselves, but add up to a significant amount in a situation of inadequate revenue.

In as much as the task of fiscal discipline is difficult there is no option for the country and the government. There would have to be thrusts on both sides of government expenditure and on government revenue. It is most likely that the IMF would insist on a promise to curtail government expenditure though it may not specify where such cuts should take place. However, in their discussions the IMF would have no doubt indicated their displeasure of certain expenditures and indicated the need to cut these wasteful expenses. The curtailment of these may be inadequate and cuts in even development expenditure and welfare services may be needed to meet the targets set by the IMF. The release of the first tranche would be on promises by the government to reduce expenditure and increase taxes. If these are not met the government runs the risk of not getting the subsequent instalments.

Unfortunately it appears that the possible increased taxation would fall very largely on the poor, as indeed the first indication of taxes on sugar and dhal illustrate. This would be particularly so as the recessionary conditions in the country are hardly conducive to corporate and other taxes that would fall on the rich. In fact on the revenue side the problem is more intractable as revenues have been falling this year owing to the downturn in economic activities. The realistic course to follow is to bring down the deficit to about 7 percent by cutting wasteful expenditure and then aim at cutting defence expenditure and increasing revenue next year to achieve a fiscal deficit of around 6 percent of GDP.

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