Limited fiscal consolidation - was the centre on to something?

One of the biggest disappointments of the Union Budget 2012-13 is the limited moves on fiscal consolidation. In fact, even the consolidation suggested in the budget might be a challenge to achieve. However, things are always clearer on hindsight, and there is a possibility that the centre might actually have been on to something with its measured steps.

Why? Consider the most dominant suggestion that was put forward to ease the fiscal deficit – easing the subsidy burden. Fuel subsidy is one of the most difficult of subsidies for the government to sustain. However, decreasing the burden of fuel subsidy in effect means that fuel prices will rise. Remember that we are coming out of a year when India’s central bank, the Reserve Bank of India (RBI) has waged a pitch battle against high inflation.

If, the subsidies had been cut, resulting in higher fuel prices, the battle would have come to nought. Globally, crude prices have been on the rise. With the Middle-east continuing to be unsettled, sustained high crude prices will be a safe assumption to make. It also implies that sooner rather than later, the government would have had to hike fuel prices in any case. If we now compound this pressure to withdraw subsidies, in effect, we are saying that the battle against inflation is irretrievably lost.

Already, the government has increased indirect taxes in the budget, which of course have a direct impact on inflation. Higher excise duties and service taxes essentially hikes prices across products and services. From the looks of it, inflation is unlikely to recede significantly through this year in any case, and higher fuel prices plus a hike in tax rates would have compounded this situation further. 

Higher inflation in turn results in sustained high interest rates. As an aside, high interest rates are effective in curtailing demand driven inflation, hence, it might not be the most appropriate policy mechanism at the present point in time. However, in so far, as the central bank will look to keep interest rates elevated (as it has over the past year despite signs of softening growth), it is not good news for growth. Lower growth also means lower tax collections.

In other words, a cut in subsidies would put an upward pressure on inflation, which in turn keeps interest rates elevated resulting in soft growth and lower tax collections. So we are back to square one. Of course, it is a matter of deep consideration how much of a net impact a subsidy cut will have and it cannot be said without a thorough analysis what it would be. But it could be a thought.

Interestingly, if we remove monetary policy as tool for dealing with inflation from the mix, the link between spending cuts and lower growth can be broken (with or without subsidy changes). The question then is, what are the other policy measures that can counter inflation?

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