Budget time is very significant for an economy. It gives an opportunity to take stock of how the economy fared during the previous year and setting targets for the coming year. These targets are fixed on the basis of expectations or assump-tions of certain variables. The proficiency of the government is reflected on how accurately it makes the expectations of these variables. More often than not, the government is tempted to give a very rosy picture about the coming fiscal year by presenting the Budget basing on unrealistic expectations about the functioning of the economy. However, with the passage of the year, these unrealistic expectations stand exposed and they inflict an irreparable damage on the credibility of the government. This, in turn, has a great negative influence on the expectations of the investors about the functio-ning of the economy thereby discouraging them to invest in the economy.
Nothing can explain this better than the Budgets of the last two fiscal years. For example, not a single target fixed in the last Budget (2012-13), be it fiscal deficit as a ratio to GDP revenue collection as ratio to GDP or absolute etc., came true. This was simply because all these targets were set on the expectation of a highly unrealistic growth rate (over eight per cent), whereas the economy is recording merely five per cent growth rate this fiscal as per the recent estimation of the CSO. This implies that the government cannot revive the investment activities by just painting a rosy picture of the economy through the presentation of a Budget based on unrealistic assumptions. One cannot befool the investors in a market economy. They have their own methods to make assessments about the variables that are significant for investments. The most significant variables in the Budget for the investors are the corporate tax structure, indirect taxations and fiscal deficit target. The corporate and indirect taxes are not a source of worry for the investors because they are almost stable or would change on expected lines. What worries most to investors is the fiscal target. The new Finance Minister has prepared the roadmap for fiscal consolidation by the year 2015 and taken many measures in that direction by increasing the prices of petroleum products (including diesel), capping the LPG cylinder, enhancing rail fares etc. However, these are very small steps in comparison with the mammoth task ahead. Although the Finance Ministry is betting on its plan to well-target the various subsidies through the UID card, its implemen-tation has yet to overcome many technical and administrative glitches. The impending national Food Security Bill is another programme which is capable of offsetting all the gains coming from the UID card scheme. It will be more problematic especially in the face of the election UPA II has to face in the year 2014.
The fiscal deficit has two roles to play in an economy. First, it has a short-term role to fuel the demand in the economy. Second, in the long run, it might hamper the growth by discouraging private investments through an adverse impact on the expectations of the investors about one significant economic variable for investment—real interest rate, besides the crowding-out effect. It is especially good if the economy is operating below the potential level of the GDP. This was the prescription given by Keynes during the Great Depression in the 1930s. How-ever, once the economy is hitting the potential level of the GDP, there is a chance of overheating of the economy. That would start the inflationary spiral in the economy by triggering expectations of the economic agents.
In fact, after reaching close to the potential GDP, the difficult task for the government is to roll back the counter-cyclical measures initiated at the time of slowdown of the economy. This requires a lot of political guts. Often, at this juncture, the monetary tools are used frequently to contain the inflationary pressures. This has happened in India in the recent past as well. It delays the revival of the economy on its natural path. In fact, the economy starts slowing down again in the absence of the investment activities owing to the high interest rates and high inflation. It also works to adversely influence the expectations of the investors about the real interest rate in the future.
Recently the author conducted the adaptive expectation econometric analysis with regressing industrial production index on the real interest rate and fiscal deficit. The quarterly data on the Indian economy after the year 1991, a watershed year in the economic history of India, was used for the purpose. It was found that expectations work in the case of the entrepreneurs' decisions for investments to the real interest rate in India. The fiscal deficit, when used in the model, bears a negative sign. However, when it is used in a simple model, it has a positive sign. It might be that when the investors make expectations about the economic variable (real interest rate) in future, they take into account the level of fiscal deficit also into consideration. This has a negative impact on investment activities, especially by private players, even in the short run. This could be because a high fiscal deficit leaves little policy space for the monetary policy to reduce the interest rate in the economy.
Dr Anshuman Gupta is the Head, Economics and IB Department, University of Petroleum and Energy Studies, Dehradun.