Mr. Mukherjee's Grand Bargain

Op-ed in the Business Standard, New Delhi

February 22, 2012

Dear Finance Minister,

The economic reputation of the Indian government is in tatters because of the damage to the investment climate and the real sector from the spate of corruption scandals, the deterioration of governance, and the sense of drift over these last few years. But by bequeathing a sound fiscal legacy, that reputation can still be salvaged. And you are the one person who can salvage it. The fact that you were a seasoned practitioner of populism (having learnt it at the feet of the mother of all populists, Indira Gandhi) gives you the credibility to push the present government towards renouncing such politics. The concern that you expressed recently about the rising subsidy bill does not ring hollow in your case. It is time to translate that concern into action.

You should propose a grand bargain that would help implement three big policy measures for which this government could be remembered: chipping away at, if not eliminating, subsidies; instituting an efficient and targeted anti-poverty scheme; and implementing the goods and services tax (GST). Consider why and how.

Some will argue that the fiscal situation has improved considerably: After all, the 13th Finance Commission’s target on the ratio of overall public debt to GDP for 2014–15, of 68 percent, has already been met. But this has happened through the dubious means of high inflation, which as a fiscal remedy has prohibitively high costs elsewhere in the economy. In fact, given high inflation and rapid growth relative to the government’s borrowing costs, outstanding debt should have been substantially lower.

Perhaps more importantly, on a flow basis, the general government fiscal deficit, of about eight percent, remains perilously high. This, together with large current account deficits, makes India one of the emerging economies that are most vulnerable to external shocks. Moreover, it is by reducing these fiscal deficits that you can hope to bring India’s stubborn inflation under control, thereby keeping the economy competitive internationally.

So, the case for fiscal consolidation is strong. The ingredients of reform are also well known: eliminating the fuel, food, and fertilizer subsidies on the expenditure side and implementing the GST on the revenue side. The problem, as everyone knows, is the considerable opposition to both sets of measures.

In the case of eliminating subsidies, opposition will come from its numerous beneficiaries, while opposition to the GST is from state governments (rather than individuals) that fear a loss in revenues. The former will, of course, be more difficult because it will involve taking away benefits. In both cases, though, there will have to be some quid for the quo. It is simply unrealistic to think that subsidies can be eliminated and GST implemented without compensating the “losers.”

The good news is that you have the financial means to provide such compensation and—courtesy of the Aadhaar project—you will soon also have the organizational and technological means to implement the grand bargain. This will comprise a two-pronged strategy. First, eliminating the subsidies must be linked to the simultaneous provision of a cash transfer scheme for the most affected households (or, alternatively, all households below the poverty line). The link must be made explicit to minimize political opposition.

Consider the arithmetic. This year, subsidies together will amount to about Rs 2.3 lakh crore [2.3 trillion rupees]. Extrapolating from analyses of the kerosene subsidy that suggest that at most 25 percent of the total benefits reach the poor, a targeted cash transfer scheme (with a leakage rate of, say, 30 percent) will entail costs of about Rs 1 lakh crore. Assuming that there are about 85 million households below the poverty line, a poverty line of Rs 1,000 per person per month (higher than the Planning Commission’s estimates), an average household size of 4.8 persons, the cash transfer will amount to about 1.5 times the poverty line for each poor household.

The Aadhaar program will be critical to translating financial resources into a reasonably efficient program with fewer leakages than the current subsidy schemes. Ultimately, this part of the grand bargain can be sustained only if it can be shown that the Aadhaar-based replacements to subsidies work. Now that disputes over the reach and scope of Aadhaar have been resolved, it is time to put the scheme to the test—of course, over time, and taking into account the lessons from the pilot projects.

The second part of the grand bargain will involve using the additional resources released by the subsidies elimination to incentivize states to adopt the GST expeditiously. The 13th Finance Commission had suggested the allocation of about Rs 50,000 crore to make up for any possible loss of revenues, especially to the larger states, as a result of implementing the GST (and eliminating the central sales tax). Vijay Kelkar, chairman of the 13th Finance Commission, has said that if necessary the cushion provided to the states could be increased to Rs 1 lakh crore at least for the first few years after GST implementation. The gains from GST implementation—not just from the likely revenue buoyancy but also the provision of resources to urban bodies, including cash-starved Mumbai—would more than repay the initial investment.

The broader point, Mr. Minister, is that eliminating the current subsidies (Rs 2.3 lakh crore) would provide adequate resources to implement the grand bargain: to compensate individual beneficiaries of the subsidies (Rs 1 lakh crore) and to cushion the states for any losses from GST implementation (up to Rs 1 lakh crore).

For sure, your task will not be easy. On the GST, certain state governments will hold out for political reasons. And on subsidies, the elimination of waste and inefficiency that allows the arithmetic to work will entail losses to a host of middlemen, contractors, bureaucrats, and politicians. Their resistance will be considerable.
But with a modicum of political courage, some Chankya-esque statecraft for which you are deservedly famous, a bit of luck in the Uttar Pradesh elections, and plenty of resources at your disposal, you can still make it work. Next month’s budget offers you the opportunity to implement three game-changing policy measures that could consolidate the economy’s long-term fiscal situation and allow growth to be re-ignited. By seizing this opportunity, you, populism turned to prudence, might persuade posterity to pronounce positively on the present United Progressive Alliance government.