What would Shri Chidambram do as FM at the present juncture?

A rejoinder to his column in IE today

A rejoinder to @PChidambram_IN
column in the IE dated July 18th

I know he is the finest intellect there is, and a former Finance Minister to boot.  Furthermore, being a Congress leader, he is entitled to his occasional polemic salvo or two against the remarkably dense Govt. in power.  

But India is at critical juncture and I would have liked The former FM to propose a realistic solution to the problem facing the country instead of railing against inflation, and hinting deficit financing alone is the solution.

So here is my two bit on the “silent fiscal crisis” [as @EmergingRoy puts it], and how that ties into the inflation [actually inflation is the wrong word for it], or rise in prices that we face, & what can be done about it.

What Chidambaram says
on inflation:

“In my view, this inflation has not been caused by a spurt in demand. On the contrary, private consumption demand is low. This inflation has not been caused by excess liquidity or too much money in the hands of the people. This inflation has been caused by the wrong policies of the government, especially its tax
policies.”

The former FM is spot on. And exactly my argument for long.

The pandemic has caused job losses of about 30 million of which only 10 million have found replacement jobs.  That means many have lost income needed to support consumption in the economy.  Aggregate demand is much lower than normal.  As a result, economy is operating at well below capacity; some say at about 85%.  So the prices couldn’t have risen by excessive demand.  On the contrary, there is an urgent to need to replace lost incomes and shore up consumption and Aggregate demand.

So no quarrel there at all.

What is responsible for
the high rise in prices?

Chidambaram blames three factors for the inordinate increase in prices that we face.

1. Inordinately high taxes on petro-products.  Note crude itself has crept up from $50 average last year to $74 per barrel currently.  Modi has turned to taxing crude because demand for it is inelastic, and it is imported.  Both factors make it ideal as tax vehicle.  In fact UPA policy of “subsidies” over fuel was one of key reasons why the economy did badly in 2012-14 period.  [And something that Chidambaram deftly addressed through a series of small hikes in diesel pries.] So while I take his point, that high taxes contribute to price rise, this is not something inadvertent.  It is Modi’s deliberate policy choice, and one that I support.  As I shall explain later, the alternatives to not taxing crude, are far worse.
   

2. Chidambaram then blames import duties on consumer goods as the second cause of the price rise.  Except for food items like edible oil, and pulses, the taxed consumer goods are not “wage good”.  So I wouldn’t worry too much about them.  On the contrary, as commodity prices recover abroad, we will benefit from them via higher exports, that hopefully enriches farmers.  So I think this grouse cancels out.
   

3. He next blames faulty GST.  Well, GST has many flaws.  It is one of the most horrendous piece of “reform” inflicted by an unthinking Govt. It needs a complete overhaul.  But Chidambaram’s grouse doesn’t hold water.  A VAT is blind.  It taxes “value addition” and the whole philosophy of taxation is based on the Govt. taking a part of this value addition by way of a VAT tax.  There is no case for exempting food from a VAT.  In fact one of the most basic flaws in the structure of Govt. finances is that it doesn’t tax food.  You can always offset taxes on food for the poor through income disbursed through Aadhar based DBT.  On the other hand, we need to inquire why inflation is steepest in vegetables and why the supply-side response to emerging shortages are not adequate.
   

So if Chidambaram’s arguments are purely polemical, where does the problem lie?

The Silent fiscal
Crisis that nobody
will discuss:

Over the years all Govts. Have done their best to obfuscate the fiscal crisis, hide deficits, park Govt. borrowings off books, tinker around with definition and whatnot.  Modi has gone off the charts in such skulduggery.  So cut through all the fudge I will give you a very simple view of the crisis in the following table.

The numbers are from the budget 2021-22.

The budget is based on a projection that the nominal GDP for 2021-22 will be 223 trillion INR.

If the nominal GDP turns out to be 223 trillion, Govt. expects taxes - including the higher taxes on petro-products and all the other stuff that PC rails about - to be 17.88 trillion INR, which is about 8% of GDP.  Yes just 8% of GDP.  Many developed countries tax citizens as much 16 to 20% of GDP.  Our taxes are much more modest.  Surprised?

Second, expenditure on all things, including interest payments, a modest amount of money on infrastructure, defense, subsidies and Govt. salaries - everything - is 34.83 trillion INR or 15.82% of GDP.  Let us round the expenditure off at 16% of nominal GDP.

So dear P Chidambaram sir, this is your basic equation that every Finance Minister since V P Singh has been hiding under the carpet.

Govt.’s actual revenue is only 8% of GDP, while it spends 16% of GDP, twice the revenue it raises.  Surprised?  

See how propaganda & polemics serves to hide the truth.  How long can a Govt. go one spending 16% of the GDP, while citizens pay it only 8% of GDP annually as taxes?  Something somewhere has to break the camel’s back, right?  

The Covid-19 crisis may have revealed what we have been trying to run away from over past few decades.  Simply put, the Govt. is living beyond its means. 

The problem is not in
high taxes but high
Govt. expenditure
relative to taxes:

This is the elephant in the room that both Modi and Chidambaram ignore.  Govt. can’t continue spending 16% of GDP when taxes tote up to only 8% of GDP.

So how does Govt. fund the shortfall of 8% of GDP.  By borrowing from the very people it won’t tax!!  No I am not joking.  I am dead serious.  We do live in freaking Rabbit Hole created by politicians.

Govt. claims we are a poor country that cannot afford high taxes.  So we set taxes at 8% of GDP.  But Govt. needs 16% of GDP to run the country’s affairs.  So we borrow 8% of the GDP from the very same people who don’t have the money to pay taxes!

How is this possible?  Here is a guy who cal loan/lend you 8% of GDP very happily out of his savings of 16% of his annual income [household savings as percentage of GDP] but will not pay taxes.  He does’t lack the money to pay them for sure.

See the point.  Somewhere in the system, there is money to pay Govt. the 16% of GDP that it needs, but the will to raise taxes simply doesn’t exist.  THAT is the problem.

How do get along for
decades with such a
lopsided Govt. financial
architecture?

Firstly, of course Govt. borrows and we for the most part are happy to lend it the money.  But do note this pure fiction.  There is no way the Govt. can really repay your loans of 8% of GDP when it perpetually needs to borrow an incremental 8% of GDP over and above taxes.  So one day or the other, you will be forced to write off the bonds and whatnot that you thought were your savings.  Or Govt. will inflate them away.  Or devalue the currency.  But what you think is savings is just the taxes you you won’t pay now & so will be forced to pay when you can least afford them.  That’s the truth about Govt. borrowings.  You can dress it up anyway you wish.

Second, every 10 years or so we devalue the INR.  One is over due.  Devaluation is just another way to write off your savings quietly without your finding out how it was done because the nominal vale of paper assets in INR is preserved in the process.  One such devaluation is long overdue.

For more details on the devaluation as device to write off your savings because you won’t pay taxes is in my essay at @NH_India. As I have often argued, we have little option but to do so.  The sooner the better.

What is the solution?

I have been putting up series of essays to show that export led growth is the only viable solution to our problems. You can read the series at @NH_India.

A devaluation of the INR, with more one-time rise in inflation is inevitable.  The sooner it is done, the better for the polity, because then it opens up the way far more Govt. spending on programs like MNREGA, that actually put hands in the poor that can help revive aggregate demand in the economy by creating jobs & boosting incomes.

The “trickle-up effect” of such spending is like a rising tide that raises every boat.  Both N Sitraman and Modi need to study the trickle-up effect of spending money at the bottom of the income pyramid.  Every INR spent at the bottom actually surfaces as INR 2 at the top of the pyramid but that is another topic for another substack.

The next devaluation should not be done in isolation to simply make the national debt look respectable.  It is currently 90% of GDP and a 20% devaluation will over time diminish the debt to about 70% of GDP.  Instead it should coincide with National strategy to double exports from $450 billion currently to $900 billion over 5 years.  

It can be done.