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One of the vital themes of the Economic Survey 2020-21 presented on January 29 was a big push in public spending in the budget. The government should not worry about debt or be fiscally conservative at a time of global slowdown, the survey advocated. It did so by making a case for a so-called counter-cyclical fiscal policy.
Below is a quick primer on what counter-cyclical fiscal policy means.
First, let’s talk about cyclicality of the fiscal policy
Cyclicality of the fiscal policy simply refers to a change in direction of government expenditure and taxes based on economic conditions. These pertain to decisions by policymakers based on the fluctuations in economic growth. There are two types of cyclical fiscal policies – counter-cyclical and pro-cyclical.
What is counter-cyclical fiscal policy?
Counter-cyclical fiscal policy refers to the steps taken by the government that go against the direction of the economic or business cycle.
Thus, in a recession or slowdown, the government increases expenditure and reduces taxes to create a demand that can drive an economic boom. The survey gives the colourful example of ancient Indian kings building palaces during droughts to drive home this point. On the other hand, during a boom in the economy, counter-cyclical fiscal policy aims at raising taxes and cutting public expenditure to control inflation and debt.
What is pro-cyclical fiscal policy?
In a pro-cyclical fiscal policy, the government reinforces the business cycle by being expansionary during good times and contractionary during recessions. Pursuing a pro-cyclical fiscal policy is generally regarded as dangerous. It could raise macroeconomic volatility, depress investment in real and human capital, hamper growth and harm the poor, say economists.
How does counter-cyclical fiscal policy work?
Such a policy works through multiple channels.
One, an expansion in government expenditure cushions the contraction in output by offsetting the decline in consumption and investment.
Two, higher government spending builds confidence in tough times. Through this policy, governments are able to show their commitment to sound fiscal management, said the survey.
This in turn gives confidence to the private sector that the economy will not fluctuate too much. It helps businessmen overcome risk aversion and brings animal spirits in the economy.
Why is this relevant to India now?
Currently in India when private consumption, which contributes to 54 per cent of GDP is contracting, and investment, which contributes to around 29 percent is uncertain, the relevance of counter-cyclical fiscal policy is paramount. Note that even after a sharp 11 percent growth projected by the survey in FY22, the size of the economy won’t be much larger than what it was in March 2020.
The survey said the call for a more active counter-cyclical fiscal policy is not one for fiscal irresponsibility.
