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Reshaping India’s Fiscal Policy

India is already a highly decentralised country, but it is not meeting its goal of promoting more inclusive growth. It needs to promote fiscal democracy and a shift from a top-down to a bottom-up approach to promote inclusive growth

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Two key drivers of macroeconomic policy and economic growth include monetary policy and fiscal policy. Monetary policy has taken the lead in this global downturn, with successive outbursts of interest rate hikes. It seems that monetary policy may have run its course, and it is now the turn of fiscal policy to take the lead. 

A more active fiscal policy is needed not only to protect against the global downturn, but also because young fast-growing economies like India can run deficits, sustain high growth, and establish a virtuous cycle for macro stability with fast economic growth. An active fiscal policy will also prevent the mistakes of the Great Recession of 2008-09.  

A key drawback of India’s fiscal policy is that it has focused more on fiscal targets rather than fiscal objectives like promoting economic growth. The amendments made to the Fiscal Responsibility and Budget Management Act are an early transition towards shifting the goal post, and this needs to be accelerated.  

Fiscal objectives should be aimed at achieving two key goals- maximising infrastructure investments needed to promote sustainable economic growth, and a transition from a top-down to a bottom-up approach to promoting fiscal democracy. 

It is now well established that infrastructure investments promote entrepreneurship, economic growth, and job creation. A successful example of this is the Golden Quadrilateral Highway which unleashed growth of new enterprises and job creation. Scaling up infrastructure investments will enable India to sustain high growth, benefit from its demographic dividend, and its large youth bulge. Infrastructure expenditures give a bigger boost to economic growth and job creation compared to tax cuts and current expenditures. 

Given rising concerns on climate change, India also needs to decarbonize, fast. Green growth calls for improving the efficiency of resource use to reduce the carbon intensity of growth. Improving efficiency will be more challenging compared to scaling up investments, but not impossible.  

India is still at an early stage of development, and this has opened the door to make an early transition towards green growth. India is well endowed with resources for renewable energy and scaling up infrastructure investments towards green growth will reduce the cost of making a transition towards green growth. 

India is already a highly decentralised country, but it is not meeting its goal of promoting more inclusive growth. India needs to promote fiscal democracy, and a shift from a top-down to a bottom-up approach to promote inclusive growth. 

Scaling up infrastructure investments 

India ranks low in most global rankings on infrastructure, and its infrastructure financing gap is huge, estimated at more than USD one billion a day and growing exponentially. A more active fiscal policy can close the infrastructure financing gap.  

To scale up infrastructure investments, and accelerate the pace of preparation of bankable projects, India needs to break the silos that currently exist across 16 central ministries, centres and states, and the public and private sectors. The potential for bankable projects is huge because the rate of return on infrastructure projects in India is much higher compared to Europe and USA. 

The high return on infrastructure projects reflects India’s young demographics, high savings rate, the rise of the middle class and a large domestic market. Global investors have already started to view India as one of their top destinations for infrastructure projects. 

There are many instruments that can be used to tap into new sources of financing, including scaling up public-private partnerships (PPPs), multilateral and bilateral financing, South-South alliances, and improving the credibility of the regulatory regime. The traits of infrastructure projects, such as its market size, long-term steady revenue stream, and investment returns that exceed inflation, make these projects attractive for promoting PPPs, and in sharing risks and responsibilities to close the infrastructure financing gaps.  

Fiscal risks associated with scaling up infrastructure investments through PPPs is also minimal, as fiscal costs of bailing out PPPs remain low (one to two per cent of GDP), compared to bailing out state-owned enterprises (5 per cent of GDP) and bailing out banks (ten per cent of GDP). An active fiscal policy with a well-structured PPP can also help to turn around loss-making state-owned enterprises into generating a surplus. India has already made a good start with PPPs, like building airports through PPPs in Mumbai and Delhi

The next frontier for infrastructure investments should be in the rural areas and in tier two and three cities. Infrastructure investments in rural areas have a greater potential for future growth compared to urban areas. India’s manufacturing sector is rapidly de-urbanising and moving out of costly and congested cities into rural areas. 

However, the pace of expansion of manufacturing growth in rural areas has been constrained by poor infrastructure. Increased rural infrastructure investments will accelerate the pace of India’s industrialization and also make growth more inclusive, as 60 per cent of India’s population lives in rural areas.  

A more active fiscal policy requires scaling up coordination between the Ministry of Finance and the line ministries, state governments, and the private sector. Problems of moral hazard and adverse selection in projects can be overcome by reducing the opaque structures of projects and by providing the information required to improve the risk-return profiles that match investors’ expectations. Integrating the preparation, design, and execution of investment projects also matters a great deal. This will need to be combined with a shift from top down to a bottom-up approach.  

Improving fiscal democracy 

Decentralisation has long been recognized as an efficient instrument for development. It builds institutional capacity at the grassroots level, improves the delivery of economic and social services to meet people’s needs, and prevents sectarian violence.  

A strong state is not always associated with a centralized state. Decentralization and democratic suppleness at the grassroots level reduces the threat of conflict. Trade-offs between the centre and local favour increased decentralization. Large countries like India and the US are too big to be governed efficiently from the centre. 

There is room for improving fiscal democracy in India to create a more level playing field and reduce the wide variation that currently exists between lagging and leading regions. Some fiscal transfers from the Centre to states are still tilted towards the richer states. 

Economic and social progress continues to be uneven across states and geographic areas.  

There is a huge potential for using administrative decentralisation to improve service delivery outcomes by taking advantage of better local information and monitoring. India needs to deepen and unbundle the decentralisation agenda to promote economic and social democracy and provide budget responsibility to local governments.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

Ejaz Ghani

Ejaz Ghani is currently a Senior Fellow at the Pune International Center. He was previously the Lead Economist at the World Bank and has worked on Africa, East Asia, South Asia, Corporate Strategy, and Independent Evaluation Unit.

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