The role of the finance minister in a new government is hugely challenging. The first challenge is the immediate task — the presentation of the union budget within just a couple of months of taking charge. This involves taking decisions about taxes, expenditure and borrowing.
Along with this huge task, which has to be done in a very short time as the budget has to be presented in July, the finance minister is also expected to understand the long-term challenges facing the economy that are outside the mandate of the budget. Departments and economic advisors and experts often give one side of the picture, and the solution that they are convinced of, and these represent various viewpoints and stakeholders.
Making of the budget
Understanding the trade-offs involved for different policy options requires listening to different views of both the minister’s team and others, understanding the potential general equilibrium effects for the economy, and finally taking a call on what to do. This is a complex and involved task and having to do it in the first two months of the term makes it even more challenging.
The actions taken by the finance minister are critical for the success of government policies. While the party leadership can convey broad policy directions to the finance ministry, the role of the finance minister and team in translating these into proposals, schemes, and a coherent direction for the economy is immensely important.
As government departments focus on trying to solve the problems they face, they lose sight of the bigger picture. Civil servants are typically biased toward solving problems on their watch. Thus, an officer with a one or two-year horizon may not give advice which would help the economy over a five-year period.
The minister is a politician with a five-year term and a long horizon. The minister has to think long term and ensure the consistency of various proposals with the longer-term policy framework of the government. Yet, she or he cannot afford to ignore the short term.
One such trade-off between the short and long-term is imminent. In an economy that appears to be facing a demand slowdown, there is a temptation to spend to more to spur economic activity.
Higher public spending can certainly push up demand and economic growth in the near term. Moreover, it can be argued that public expenditure on infrastructure has positive externalities and raises growth and investment. Ministries responsible for power, roads and railways would argue for higher spending. Similarly, social sector spending on houses, cooking gas, employment guarantee, health, education, pensions, farm income support and many other scheme have social benefits. Spending on these can also push up demand.
How should this spending be financed? The government can either tax more or borrow.
Higher fiscal deficit
An increase in government borrowing can crowd out private investment. Lesser domestic savings will be available for the private sector to borrow and invest. Higher fiscal deficits can spill over into a higher current account deficit. There may be an increase in borrowing from abroad. Expansion of external debt may pose new risks. Credit rating of India’s sovereign debt may fall, and foreign commercial borrowing by Indian companies may become more expensive, increasing dollar interest payment outflows. There may be inflationary pressures.
In other words, while at first look it may seem like a good idea to borrow more, in the long run, it may not be. It may lead to lower growth of output and jobs.
How is the minister to decide how much more to spend and how to finance that spending? Should the government borrow more? How much will be good and at what point do the costs outweigh the benefits?
Higher tax rates
In an attempt to keep the fiscal deficit in control for the higher budgeted expenditure, the minister could consider the option of increasing tax revenue. How should this be achieved?
One way would be to increase tax rates and the other to increase compliance. The revenue department may advise the finance minister to raise tax rates. This would make sense for it as its need to meet tax targets, and raising tax rates is a stroke of the pen action — much easier than raising compliance, which cannot be done by an announcement.
There have been many debates for years about how the tax department needs to use multiple data sources from credit cards, travel agents, lifestyle choices, assets, and even the social media to reduce tax evasion.
There have also been many debates on how agricultural income needs to be taxed at some level as it provides loopholes for tax evasion.
These kind of options, often advocated by economists, are all politically difficult choices. What officials often suggest as a means to raise revenue is an increase in tax rates.
Again on the other hand, the finance minister has to keep in mind the investment climate. If higher tax rates reduce investment spending and lower GDP growth, they may end up being counterproductive. Investment may decline because higher taxes affect post-tax profits. The net effect could be a lower return on investment and lower growth of income and jobs.
So how much should the finance minister listen to the advice of the revenue department to raise tax rates?
The challenges to the new finance minister in an economy that is on the brink of a long-drawn slowdown are many. How to trade between the short and the long term, and how to achieve long-term goals through short-term changes are all part of the routine work of the finance minister, along with the immediate goal of the upcoming union budget.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.
Also read: Indian economy makes a weak start in 2019
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