September 17, 2015

Concept of fiscal policy



There is always a risk in simplifying economics beyond an extent: the risk of ignoring the nuances. Probably this is the reason why fiscal policy is often clouded in figures and jargons. However, fiscal policy is damn simple to understand and comprehend. Fiscal policy, in fact, follows from some elementary mathematics and accounting.


Say, a family of six members - Father, Mother, Ram, his wife Sita, his brother Hari, and his daughter Geeta - constitute an organisation. The organisation may be called a Hindu Undivided Family (HUF). Ram earns an income, so does Hari. No one else earns an income from any source outside the family. But there are expenses: medical expenses, daily ration, rent, studies of Geeta etc. At the end of the year, an accountant states that the HUF is in surplus if its income is more than expenses. The HUF is in deficit if its income is less than expenses.


Now substitute the HUF with a country, say Pakistan. Pakistan is in surplus if its revenue is more than its expenses. It is in deficit if its revenue is less than its expenses. What are the sources of revenue for Pakistan? Pakistan does not get salary like Ram or Hari. It gets its revenue from taxes, profits from PSUs, aid from US, UN etc, donation from middle east to spread terrorism etc. Its expenses are on the army, defence, terror funding, and to some extent, in education, health (allegedly), and running terror camps.


REVENUE = TAXES + NON-TAX REVENUES


Naturally, the revenue of Pakistan would not be sufficient to meet the expenditure requirements of the country. Same is the case with most countries. The expenses tend to be more than revenue. As a result, the country has a deficit. This is called the fiscal deficit.


Now, how does a country finance its deficit? Continuing with the earlier example, if Geeta cracks the CAT examination and gets an admission into an IIM, her father has to shell out some 30 Lakhs for her studies. Till now (say), the family consumed all that it earned. There was neither a surplus nor a deficit. But in order to get Geeta a MBA degree, Ram and Sita have to spend more than they earn. How? By taking a loan. Hence, deficit in HUF account is financed by debt. Similarly, fiscal deficit of a country is funded by debt.


EXPENSES - REVENUE = FISCAL DEFICIT


TOTAL DEBT = SUMMATION (FISCAL DEFICITS of all FYs) + INTEREST - REPAYMENTS

Debt and deficit are two primary concepts in understanding fiscal policy. Debt is a liability on the nation. It has to pay back the debt with interest one day or the other. More the deficit, more the cumulative debt. Then the next question arises, why can't a country exercise fiscal discipline and restrict government spending? If government spending is restricted, deficit won't be there. If deficit won't be there, there will be no debt. Isn't it?


Government expenditure


In order to appreciate the importance of deficit, we need to revisit the HUF we discussed earlier. Geeta can not get her MBA degree from IIM without a loan. The family does not have enough cash to pay for her degree. But if a loan is taken for her education, she would study for 2 years and earn ten times more than the loan amount in the next decade or so. The loan is used for productive purpose. Similarly, my personal observation about middle class families is that they are of three types:


Type 1: The couple is too conservative and spends only within its means. Such a couple keeps savings in the form of bank deposits. 


Type 2: This couple is spendthrift. The family has a habit of spending on high life, fashion, movies, and other items of conspicuous consumption. This family takes loans for luxury items such as AC, fridge, flat screen TV etc


Type 3: This couple also takes loan like Type 2. However, the couple uses the loan to purchase gold or land or flat or other wealth-generating assets.


On analysis, Type 1 family has a surplus. Type 2 and Type 3 families have a deficit at the end of the year. However, on making an economic analysis, Type 3 outshines the other two. Type 2 family is doomed to fall into a debt trap, and hence is unsustainable. Type 1 family is just sustainable. It makes a surplus and keeps it in bank. Bank pays an interest rate of 6%. Inflation is (say) 5%, thus eroding the value of money kept in bank by 5%. Hence net actual interest is merely 1% (6% - 5%). Type 1 family got fooled by the advertisements of banks boasting of 6% interest rate, whereas real interest rate is just 1%.


Type 3 family, on the other hand, took loan to create assets that appreciate at a rate of 20% to 50%. Also, assets like houses and flats will generate more income once completed. Type 3 family also spends on kids' education, so that they grow up to become qualified professionals and generate more income. Type 3 makes more sense than Type 2 or Type 1. This classification has been termed by economists as smarak swain's elementary economics of Indian middle class


Narcissism apart, this classification has important ramifications to understand the salaried class. It helps you identify which middle class families become upper middle class in a generation, and upper class in few generations. It helps you explain why some middle class families remain stagnant in their social class. It also explains reverse social mobility, i.e. why some middle class families become lower middle class, and may even reach to bottom of the social pyramid in few decades.


Hence, taking loans is good. Its not always good, but under certain conditions. Same is the case with government expenditure. After all, government expenditure is a vital part of GDP (refer my discussion on GDP). Government expenditure in Pakistan can be both productive and unproductive. The massive spends on maintaining salaries and perks on army officers - virtual rulers -is unproductive. The excessive expenditure in stealing nuclear and propulsion technologies from the West are unproductive, as India has better things to do than engage in a conventional warfare with it. The expenditure in running terror camps, on the other hand, is productive. Pakistan trains its citizens in suicide bombing, cyber crimes, piloting aircrafts and bulldozing buildings etc. Such training enhances the human resources of its trainees. These trainees then get gainfully employed in the terrorism industry, not only in Pakistan but also in other countries under the Global Jehad banner, thus contributing to national domestic product.



When is debt good?


By now it is clear that debt is a double-edged sword. Debt can be good for a country at times, and bad at other times. How exactly can debt be good for a country? The answer to this question should be guiding light of public policy and every budget. In his book The death of money, James Rickards mentions three conditions:


  1. The benefits of government spending must be greater than the cost incurred
  2. Government spending should be directed at projects the private sector cannot do on its own
  3. Overall debt level should be sustainable
These three tests, says Pickards, must be applied independently and all three should be satisfied. I believe these three conditions provide an analytical tool to examine any government scheme. Lets make an attempt (statutory warning: economics is definitely more complex than this; so the conclusions drawn may be erroneous):

  • NREGA: The benefits of government spending are definitely less than the costs incurred. Rather than make an attempt at providing social security to the poor, the government merely increased expenditure. Minimum wages were set, due to which rural labour became idle and incompetent. NREGA did help some who were living below subsistence level. But on an overall, it promoted people making a meaningful living to sustain on NREGA wages. Hence it was wasteful spending, and could have been avoided to reduce fiscal deficit.
  • Midday meal scheme: Any scheme meant to support and promote education is welcome. The benefits are more than costs. One may criticise such a program on its implementation, but government spending cannot be criticised.
  • Government schools & hospitals: Government spends a vital amount in running schools and hospitals. It makes sense. Benefits are more than costs in terms of citizen welfare. Also, pribate sector cannot do it on its own. Government schools can be found in remote villages, villages where private sector would not find it profitable to open schools. Schools and dispensaries for the poor are again the responsibility of government as private sector cannot do it on its own
  • Running Indian railways: Indian railways are running at a heavy loss consistently. Significant innovations in logistics, goods carriages, and luxury class travel could be made by the private sector. Government may need to remain only to facilitate general class travel for the poor. Hence a major part of railways should be outsourced to the private sector. Significant expenditure incurred by government on maintaining railways could be cut this way
  • Running Air India: By the above logic, Air India should also be privatised. Many columnists are voicing this opinion these days. But I beg to differ. A government-run airlines is necessary to prevent cartelisation by the private sector. Without a government-run airlines, private airlines may collude and increase costs to the detriment of customers. There is also a security angle involved here. See... economics is not as simple as I projected it above. This argument is also valid for state-run power companies.
One of the three conditions mentioned above is that 'overall debt should be sustainable'. Sustainable debt is another topic altogether and I will deal with it in a separate blog post. I have quite a few back-to-back book readings of my book, THE LEGEND OF YUCK-MAN, lined up this weekend (the fact that I am getting only 'yucks' and brickbats for writing the book has not tempered my publicity drive). I shall make an attempt to explain debt-to-GDP ratio and consequences of unsustainable debt levels after the weekend. 


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