A blueprint to finance higher public spending
It becomes clearer by the day that the lockdown to contain the spread of the coronavirus disease (Covid-19) is creating enormous stress on every part of the economy, including public finances. The need for public expenditure to address the crisis has increased, but revenues are down. Given this, how should we finance the additional spending? Broadly, there are four options before the government: Cut other expenditure, increase revenues, increase borrowing, or print money to monetise debt. All these options are painful and are costly in their own way. But as the government confronts these difficult choices, it would do well to consider four key principles of public finance.
The first is that the costs of each of the options may increase non-linearly, and so the optimal approach may be a judicious combination of all four options. The second is to minimise frictions across tiers of national, state, and local governments and take a consolidated view on the best policy actions. The third is to ensure that short-term actions do not jeopardise longer-term fundamentals and also enable structural reforms that will put the country on a stronger economic trajectory. The fourth is to not let financing concerns impede essential investments to support public health and the economy.
Based on these principles, there are a few implementable ideas that the government can use to help fund its response. On expenditure, one simple idea is to change the structure of public employee pay so that all allowances other than basic pay are linked to government tax revenues. In good times, public employee pay will be higher, and in difficult times, the reduced payroll provides an automatic macro-fiscal stabiliser. It may also create an important symbolic link between public employee pay and state and national economic performance, which is missing right now. Over time, once the principle of variable pay for public employees is in place, it may be possible to link it to measures of department and individual performance which has been shown to meaningfully increase effort and productivity of public employees.
On revenues, there is substantial scope to increase property tax rates and collections by local bodies. The central government can incentivise these payments by making property taxes deductible from taxable income. This has several advantages. First, property taxes are less likely to dampen economic activity since they are based on immovable investments.
Second, urban areas contribute the most to GDP and tax revenue, but have been hit hardest by the pandemic and lockdown. This then becomes a form of central government support that disproportionately benefits urban areas. Third, it does not cost the central government much (since property tax collections are very low), but makes the extent of benefits to states and local governments conditional on implementing overdue property tax reforms.
Third, the government should issue debt with a commitment that these funds will be used primarily to invest in strengthening health systems. Increasing debt per se is not a problem if used to finance a public investment that has a positive net present social rate of return. The problem is that bond markets do not trust that governments will finance productive investments. Consequently, breaching deficit targets and borrowing more is often penalised with higher interest rates. Ring-fencing any additional Covid-19-related debt to focus primarily on health systems investment will reduce the likelihood of a bond market interest penalty. According to one estimate, each week of the full lockdown has cost nearly Rs 2 lakh crore. Thus, the public returns to health investments that enable even a partial release of the lockdown are likely to be very high.
Fourth, it is best to avoid discussion of monetising the debt. Even talk of debt monetisation will raise inflationary expectations, divert domestic savings to unproductive assets like gold, raise bond yields, and jeopardise India’s hard-won inflation credibility in recent years. At this point, we do not know if the crisis will be deflationary (through demand contraction) or inflationary (through supply chain disruptions). So it is best to wait. Importantly, this does not preclude the Reserve Bank of India from directly purchasing government debt. As long as there is a commitment from the government to paying it back (and markets believe that the debt can be paid back), this approach allows fiscal stimulus without jeopardising inflation credibility. If inflation stays very low, then a modest amount of monetisation of debt may make sense over time.
Finally, it is critical to recognise that states are at the frontline of the battle against the virus, both for securing public health and for protecting the vulnerable. But they simply do not have the policy instruments needed to respond fully. Consistent with first principles of public finance, the central government should lead on financing this war, and state governments should lead on-field implementation (including designing locally appropriate mitigation measures).
Further, it is essential for the central government to clearly communicate not just policies, but also the principles and broader thinking behind the pandemic response. Citizens, state governments, and market actors make decisions based on expectations. And in these uncertain times, greater clarity on policy will be critical to minimising the economic and health costs of this crisis.
Karthik Muralidharan is the Tata Chancellor’s Professor of Economics at UC San Diego
The views expressed are personal