Large fiscal deficits have a variety of adverse consequences: reducing economic growth, lowering real incomes, and increasing

the risk of financial and economic crises of the type that we recently witnessed in several countries of Asia and Latin America and fiscal deficits can also lead to inflation. Even if a central bank prevents such inflationary consequences , the other adverse ';real'; effects cannot be avoided. And under some conditions budget deficits can lead to higher inflation despite the attempt of the central bank to pursue a sound monetary policy. A budget deficit implies that the national debt is increasing. But since the GDP is also rising, the ratio of the national debt to GDP may or may not be increasing. That depends on whether the growth rate of the national debt is more than or less than the growth rate of GDP. A continually increasing ratio of debt to GDP runs the risk that the debt will get on an unsustainable path leading to national insolvency. Even if the debt ratio is not explosive in this way, a high ratio of debt to GDP has serious adverse consequences. It is important therefore to understand what drives the ratio of debt to GDP and, if it is converging to some equilibrium level, what determines that level. Fiscal Policy vs Monetary Policy for Economic Stabilization Economic analysis has thus come full circle back to the traditional case that sustained budget deficits in peacetime are harmful. This does not however deal with the original Keynesian contention that budget deficits can play a useful role in managing economic fluctuations. Current thinking on that subject is much less supportive of discretionary fiscal policy than was true in the past. Although automatic stabilizers like unemployment insurance and income tax withholding which respond quickly to an economic downturn may be helpful, explicit discretionary policy is generally the wrong tool for demand management. Since most economic downturns are relatively short term the average time from peak to trough in the U.S. has been only 10 months in the past seven recessions it is difficult to provide a discretionary fiscal stimulus before the economy recovers. Attempts to use discretionary fiscal policy are hampered by lags in recognizing that a downturn has begun, by lags in designing simulative legislation and getting it enacted, and potentially by more lags before households and firms respond to the fiscal stimulus. In contrast, monetary policy is a much more flexible tool. Interest rates and money growth rates can be changed frequently and can reverse direction. A potentially countercyclical monetary policy within a framework committed to price stability is therefore a preferred strategy. Fiscal policy is generally best designed to provide a long-term context that removes distortions and encourages saving, risk-taking, and individual effort . There are times, however , when expansionary monetary policy cannot be used because the interest rate is already at or very close to zero. This has been true in Japan for some time and has been true in the United States since the Federal Reserve cut the fed funds rate to one percent. Under such circumstances, an expansionary fiscal policy is an appropriate way to avoid continued stagnation or outright economic decline. I believe that was true of the recent use of expansionary fiscal policy to accelerate the U.S. economic recovery in 2003.

Why India survives high fiscal deficits For years, the World Bank, IMF and Indian observers (including me) have warned that Indias fiscal deficit is too high and will soon lead to disaster. Yet disaster has stubbornly refused to arrive for so long that it seems a case of crying wolf. How droll, a Wolf crying wolf. When oil prices shot up during the 1991 Gulf war, it proved the last straw for an Indian economy burdened by a 10% combined fiscal deficit for the Centre and states. Today, another Gulf war has raised oil prices, and Indias fiscal deficit is back to 10% of GDP after dipping briefly in the mid-1990s. But today India has a current account surplus, forex reserves of $75 billion, low inflation and low interest rates. Now, fiscal deficits of even 5% of GDP have bankrupted countries like Argentina. How does India survive, indeed thrive? What makes India different from other countries, and even from the India of 1991? The main reason is the flood of invisibles in the 1990s. That makes India really different. High fiscal deficits typically cause three problems a balance of payments crisis, high interest rates (because of crowding out) and high inflation (with currency depreciation being a key contributor). India suffered all three problems in 1991. Indias high fiscal deficit has indeed created a huge trade deficit as conventionally measured. Indias merchandise trade deficits in the 1990s have been 3 to 4 % of GDP, often higher than the 3.2% that emptied Indias forex reserves in 1991. But an influx of net invisibles of 4% of GDP has converted a record trade deficit into a current account surplus. Instead of a crisis we have equanimity. Next, consider the impact of the fiscal deficit on interest rates. A high deficit should crowd out private investment and so raise interest rates. This is exactly what happened in the investment boom of the mid-1990s, when corporate bond rates soared to over 20%. This was unsustainable, led to uncompetitive production, and was followed by an investment bust that cooled interest rates. These were then pushed down even further by the flood of invisibles. The flood greatly increased money supply, despite the RBIs sterilisation efforts. The Economic Survey says that forex reserves now exceed 100% of currency. The inflow of invisibles has been augmented by FDI and FII investment. The net effect is that corporates today can float 5-year bonds at 7%, the lowest rate for decades. Reliance, which once borrowed abroad to save on interest costs, now finds Indian borrowing cheaper. As Surjit Bhalla has remarked, globalisation has forced down Indian interest rates via invisibles. What about inflation? Typically, high fiscal deficits drive down the real effective exchange rate. Currency depreciation plus high interest rates typically cause high inflation. But in India invisibles have kept the rupee steady, and steady import prices have meant low inflation. As India opens up, domestic inflation is increasingly determined by global inflation. Many people think the rupee was weak in the late 1990s because it depreciated against the dollar. In fact other currencies depreciated even more, and Indias real effective exchange rate was pretty steady. Ever since the Asian financial crisis, global inflation has been modest. So too has Indian inflation.

What can be done? What can be done to reduce the budget deficit, the ratio of debt to GDP, and the risk of insolvency? There are only three basic ways to reduce the fiscal deficit and one additional way to reduce the equilibrium ratio of debt to GDP and the risk that the debt ratio will reach an unstable level. The three ways to reduce the budget deficit are to Cut non-interest government outlays To increase tax or other revenue To reduce the rate of interest on the government debt.

A faster rate of economic growth would also reduce the equilibrium ratio of debt to GDP and the risk of a shift to an unstable path of debt to GDP. Let me consider each of these options in turn. Reducing non-interest outlays is always politically difficult but it is not impossible. Fortunately, what matters is not the absolute level of government outlays but the ratio of outlays to GDP. It is necessary therefore only to slow the growth of noninterest spending to less than the growth of GDP. Despite the difficult of doing this in a democracy, the United States did succeed in reducing the ratio of noninterest outlays to GDP during the eight years of the Ronald Regan presidency from 20.8 percent of GDP in 1980 to 19.4 percent of GDP in 1988. Nondefense discretionary spending i.e., spending excluding defense and the so-called entitlements that are not subject to annual Congressional appropriations (like Social Security pensions, Medicare benefits, etc) fell one-third from 4.7 percent of GDP in 1980 to 3.1 percent of GDP in 1988. Spending reductions must of course be made program by program even if overall spending goals and limits help to achieve that aggregate spending reduction. In many emerging market countries, stopping support for money-losing state owned enterprises by imposing a hard budget constraint or by privatizing the entity can be a major source of spending reduction. Raising revenue is the alternative way to reduce the primary deficit. The way in which that revenue is raised in very important. An increase in the tax on labor income or investment incomes can entail large deadweight losses. That form of tax can also reduce the rate of economic growth, raising the ratio of government outlays to GDP, increasing the equilibrium ratio of debt to GDP, and increasing the likelihood that the economy will shift to an unstable path. Taxes are not the only source of non-debt government revenue. Charges for government services can be an important source of revenue, especially in an economy like India where the government provides such a wide range of public services. Charging for some public services may also make it possible for private providers to offer these services, covering their own costs with charges and making a profit as well. Reducing the interest rate on the government debt is of course another way in principle to reduce the budget deficit and the equilibrium ratio of debt to GDP. Although the government cannot reduce that interest rate directly, it can do so indirectly by actions that makes the debt less risky.

A sound monetary policy that reduces inflation risk can reduce the real interest rate. Budget policies that reduce expected future primary deficits can also reduce the real rate of interest. Finally, an increase in the rate of economic growth would lower the equilibrium ratio of debt to GDP and reduce the risk of an unstable rising ratio of debt to GDP. Since a lower primary deficit permits more investment and therefore faster economic growth, any policy that reduces the primary deficit brings an extra benefit in this way, creating a virtuous circle. There are of course many other things that a government can do to raise the rate of economic growth: increasing market flexibility, improving infrastructure, reducing regulations, and removing financial and legal barriers to individual entrepreneurship. India is clearly engaged in a wide variety of such pro-growth policies. If they are successful, they will reinforce sound fiscal management to achieve lower budget deficits and to reduce the relative size of the national debt. It is important that such pro-growth policies as well as explicit deficit reduction initiatives be adopted in the years ahead.

Post crisis- political paralysis and current and recent reforms

Triggered by higher oil prices and political uncertainties, the balance of payments crisis of 1991 led to economic liberalisation. The reform of the tax system commenced with direct taxes increasing their share in comparison to indirect taxes. The fiscal deficit was brought under control. When the deficit and debt situation again threatened to go out of control in the early 2000s, fiscal discipline legalisations were instituted at the central level and in most states. The deficit was brought under control and by 2007-08 a benign macro-fiscal situation with high growth and moderate inflation prevailed. The global financial crisis tested the fiscal policy framework and it responded with counter-cyclical measures including tax cuts and increases in expenditures. The post-crisis recovery of the Indian economy is witnessing a correction of the fiscal policy path towards a regime of prudence. Deficit financing to meet escalating expenses has been an important policy instrument in a developing country like India where the government fails to generate sufficient revenues. The reduction of fiscal deficit from 5.91 percent of GDP in 2002-03 to 2.69 percent in 2007-08 on basis of FRBM guidelines proved vital during the crisis. It generated the space for expansionary fiscal stance to boost aggregate demand to counter the crisis. Government announced several fiscal stimulus packages between Dec. 2008 and Feb. 2009 which included reduction in indirect taxes and sector specific measures. Apart from these measures, increase in government expenditure because of National Rural Employment Guarantee scheme, debt relief to farmers, expenditure on General Election(2009), payment of arrears and increment in salary after 6 th Pay Commission and higher procurement prices around the crisis played a major role in sustaining demand especially in rural areas. In response government increased its expenditure by 36 percent in third quarter of 2008-09. This had led to an increase in the fiscal deficit from 2.6 percent of GDP in 2007-08 to 5.6 percent in 2008-09 and 6.5 percent in 2009-10.

Indias challenge is to stimulate further unilateral trade and FDI liberalisation related to domestic structural reforms. That means tackling non-border, but still trade-related, regulatory barriers. These are second -generation reforms whose politics can be more challenging than the politics of first -generation reforms. The latter involve the reduction and removal of border barriers. They demand a minimum of capacity across government, especially for implementation and enforcement. Above all, they are politically very sensitive, as they affect entrenched interests that are extremely difficult to dislodge. Nevertheless, the case should be made to take on these reforms so that they can be pushed through when political opportunities present themselves.

The most important explicit challenge is subsidies administered through the Central Government budget are food and fertilizer subsidies, and until recently, export subsidies. These subsidies account for about 30% of the total central subsidies in a year and have grown at a rate of approx 10% per annum over the period 1971-72 to 199697.The relative importance of different explicit subsidies has changed over the years. E.g., food subsidies accounted for about 70% of total Central explicit subsidies in 1974-75. Since then, its relative share fell steadily reaching its lowest of 20.15% in 1990-91. The relative share of the food subsidies has been rising although in a cyclical pattern. According to the Budget proposals, the government's subsidy bill on food, petroleum and fertilisers is estimated at Rs 1,79,554 crore for the 2012-13 fiscal as against Rs 2,08,503 crore in the revised estimates for this fiscal. The revised estimate for this fiscal is higher by 55 per cent compared to the budget estimate of nearly Rs 1,34,211 crore.

The poor economic outlook and successive quarterly GDP growth rates of 5.3 per cent and 5.5 per cent confirm the prolongation of a slowdown in the economy. An almost flat growth of 0.1 per cent in industrial output for July 2012 highlights the stagnation in manufacturing and infrastructure. As the only economy in the BRICS group of emerging market economies facing the possibility of a major downgrade in credit rating, the cost of inaction was becoming increasingly onerous for India. It was evident that without a big push economic revival over the next few quarters would not be possible. The low growth rate is a reasonably good excuse for the government to take tough measures. Signaling the end of the claimed policy paralysis in India several policy reforms were announced. The first intent to move ahead was correcting retail prices of domestic petroleum products slashing subsidies on diesel and LPG. Second was to allow majority foreign equity in domestic multi-brand retail operations. Also, the restriction on single-brand foreign retailers to procure at least 30 per cent of their requirements from domestic small and medium enterprises was amended. The decisions in retail were followed by the decisions to increase permissible ceiling of foreign equity in domestic aviation services to 49 per cent, allow similar foreign equity levels in power trading exchanges. The Kelkar committee has said that the proposed reduction in deficit could be achieved through a combination of share sale of state-owned companies, pruning petro-product subsidies and raising prices of diesel and LPG or cooking gas and implementation of the Goods and Services Tax or GST. Administrative reforms including beefing up of IT infrastructure have been suggested to improve compliance.