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Are we overestimating the fiscal boost to the economy?

Let’s assume it takes a tonne of steel to build half a kilometre of road. Let’s also assume steel costs 1,000 a tonne and there is a tax of 10% on steel. Now, if steel prices doubled in a year, then government spending and taxes from steel will also double, although the length of road remains the same. Prices do not typically double in a year, but this hypothetical example shows that in years of abnormal inflationary movements, fiscal waters can easily get muddied. The 2021-22 financial year could be one such year for the Indian economy. Here are four charts that explain why.

Nominal growth component of the GDP has been increasing

Gross domestic product (GDP) statistics are released at both current and constant prices. The latter discounts inflation (more on this later) from the base year of the current GDP series. While real GDP matters to track the growth of actual output, nominal numbers are important on at least two counts: government finances and terms of trade, or ratio of prices, between sectors. A look at quarterly GDP statistics shows that the nominal growth component, or the difference between current and constant price growth, has increased sharply in the current fiscal year that ends in March 2022. At 11.6 and 9.1 percentage points in the June and September quarters, the nominal growth component was the highest since September 2011.

Nominal growth component of GDP is more aligned with Wholesale Price Index

It could be a surprise to some that nominal growth was higher the the Consumer Price Index (CPI). On an annual basis, CPI growth was just 5.6% and 5.1% in the June and September quarters. However, nominal GDP growth is more aligned with the Wholesale Price Index (WPI) than the CPI. This is explained by the fact that the CPI is designed to measure average household budgets and, therefore, has a high food component (39%). The share of agriculture in gross value added (GVA) is just about 15%. The WPI, on the other hand, is the best proxy for producer prices in the economy, even though it does not take into account the price of services, which have the largest share in GVA. A simple comparison shows that nominal growth has a higher correlation with WPI than CPI. Neither WPI, nor core inflation – the non-food, non-fuel component of the CPI – have come down significantly in the recent period. Most analysts expect them to stay at elevated levels compared to historical standards. This implies that nominal growth for the entirety of 2021-22 could be close to levels seen in the first half of the current fiscal year.

What does this mean for the budget’s fiscal math?

The most important number in the budget is the nominal growth projection for the financial year. This is because nominal GDP is the denominator for revenue collections. Taxes are collected on nominal, not real, incomes. The 2021-22 budget assumed a nominal GDP growth of 14.4% in 2021-22. Eight months into the fiscal year, the budget’s nominal growth projection appears to be an underestimate. At 8.4%, GDP growth in the September quarter positively surprised analysts and the consensus around the the central bank’s projection of real GDP growth being 9.5% for the full financial year has become bigger. If WPI growth for the fiscal year ends up close to 10%, nominal growth is likely to be significantly higher than just 5%, which is what the budget assumed. It also means that the budget’s revenue projections could be underestimates.

To be sure, this is not the first time that the budget’s nominal growth projection appears to be an underestimate. “I would put the chief economic advisor’s report, being an academic free thinker, as a bit more flamboyant whereas we in the ministry of finance, naturally and rightly, will have to be (more) reasonable in assessing what we can do,” finance minister Nirmala Sitharaman told HT when asked about the Economic Survey’s nominal growth projection exceeding that of the budget by one percentage point.

Nominal GDP growth exceeding the budget’s projection would be a first since the current government assumed office in 2014. It also means that there is a high probability of actual revenue collections exceeding budgetary projections.

But higher inflation also means that we could be overestimating the current fiscal stimulus

While a higher-than-expected inflation and, hence, nominal growth bodes well for revenue collections and fiscal numbers, it might not be the case for its multiplier value – government spending boosts GDP over-and-above its value – for the real economy. This is because a large part of the jump in government spending could just be a result of higher inflation rather than a greater demand for goods and services, as was explained in the steel example. A comparison of growth in central government spending in the first half of the financial year (April to September) with nominal growth buttresses this argument. Logically speaking, it can be said that a real fiscal boost requires government spending to grow at a value that is higher than nominal growth. It has always been the case since 2014-15 to 2019-20. In 2020-21, disruption from the 68-day lockdown due to the Covid-19 pandemic that was imposed on March 25, 2020, derailed a lot of government projects, and government spending actually fell. While government spending has increased significantly in the April-September period this year, it is lower than nominal growth for the first half of the fiscal year. This suggests we might be overestimating the fiscal impact on the ongoing recovery.

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