Can India’s fiscal stimulus aid growth in FY22 and help overcome economic challenges?

Along with COVID-19’s second wave adversely impacting India’s economic growth in 1QFY22, rising inflation and challenges emanating from center-state financial relations are causing concerns.

Impact of COVID-19’s second wave on India’s GDP growth in 1QFY22

COVID’s second wave appears to be subsiding after having deleterious effects on the economy in 1QFY22, particularly in May and June 2021. PMI manufacturing in June 2021 dipped to an eleven-month low of 48.1 from 50.8 in May 2021 and PMI services contracted for the second successive month to its lowest level since July 2020 at 41.2 in June from 46.4 in May 2021. Passenger vehicle sales continued to languish in the months of May and June 2021 at levels that were nearly half of those in March 2021. Growth in power consumption dipped to 8.3% in May and further to 7.9% in June 2021 as compared to 39.1% in April 2021. GST collections also dipped to INR92,849 crore in June 2021 as compared to a spike of INR1,41,384 crore in April 2021. These trends indicate a short-term effect of COVID’s second wave, which was relatively severe in terms of impact on health. However, due to decentralized lockdowns, its economic impact is so far limited to 1QFY22.

Inflation under pressure

CPI inflation at 5.6% in 1QFY22 has exceeded the RBI’s expectation of 5.2%^[1] as per the June 2021 monetary policy statement. In particular, the CPI inflation has remained at 6.3% in both May and June 2021. Pressure on inflation is emanating from higher liquidity injected by the RBI as well as cost push pressures due to relatively high global crude and commodity prices and high taxation levels of petroleum products of the central and state governments.

Global crude prices have been under pressure since May 2021 because of supply side curbs and rigidities and recovering global demand. Both central and state governments have relied heavily on taxation of petroleum products (PoL) through central excise duties and state VAT respectively. Given the relatively lower revenue performance of corporate income tax and the GST, both tiers of government find it difficult to reduce their component of petroleum taxes. In fact, there is evidence to show that the central government has pre-emptively used the available revenue space in a manner such that its share in the retail prices has increased considerably over time. States have not been able to adequately hike their relevant VAT rates given the limited revenue space. It is also clear that with such a heavy dependence of the central and state governments on revenues from petroleum taxes, it would be difficult to persuade them to make the PoL products that have remained outside GST as part of the GST regime. Since retail prices of PoL products have a potential inflationary impact through transport and energy costs which also affect the food prices, this matter needs to be carefully monitored as the fiscal year progresses.

Table 2 shows the deviation of share of states in access to vaccines viz.-a-vis. (a) share of states in 18+ population and (b) share in COVID cases. With respect to (a), the states which received relatively lower vaccine shares are notably Uttar Pradesh, Bihar and Tamil Nadu. With respect to (b), states which received notably deficient share of vaccines include Maharashtra, Kerala and Tamil Nadu. Tamil Nadu appears to be receiving less than their due share in vaccines with respect to both criteria. The formula for inter-state distribution may be modified so as to make it more effective in combating the spread of COVID.

Since the pace of economic recovery would depend on the continuing incidence of COVID and the related lockdowns as neutralized by the pace and coverage of vaccination, we notice that COVID’s second wave appears to be stabilizing after entering into the subsiding stage at about 40,000 new cases per day as compared to the corresponding figure of 10,000 cases per day when the first wave had subsided (Chart 1).  Clearly, there is a strong reason to continue to take all necessary measures to contain the spread of COVID and accelerate the pace of vaccination with a strategic inter-state vaccine allocation methodology.

Fiscal policy stimulus during FY22

The Union Finance Minister announced the first fiscal stimulus package for FY22 on 28 June 2021^[6]. The thrust of this package was to stimulate the sagging growth in credit offtake mainly by providing interest rate concessionalities with a focus on priority sectors such as health, power and other infrastructure sectors. This will benefit a number of MSMEs, small borrowers and entrepreneurs in contact intensive sectors including travel and tourism stakeholders. The direct stimulus, however, is limited to three main initiatives.  These include extension of the distribution of free food grains under Pradhan Mantri Garib Kalyan Yojana (PMGKY) with an estimated cost of INR93,869 crore. Further, additional health sector expenditure amounting to INR23,220 crore is being provided of which the Center’s share would be INR15,000 crore.

In addition, for improving rural connectivity through expanding BharatNet, an additional expenditure of INR19,041 crore spread over two years starting FY22 has been envisaged. Considering half of this amount as pertaining to the current fiscal year, the total additional burden on the FY22 budget from these three initiatives would be INR1,18,390 crore. This amounts to about 0.5% of estimated GDP for FY22. Although this is a limited magnitude of direct stimulus, it would be desirable to follow it up with another dose of stimulus later in the year. In addition, the government would do well to ensure that the budgeted capital expenditure for FY22 is spent in the earlier part of the financial year so as to generate benefits of frontloading of expenditures.

Concluding observations

The Fifteenth Finance Commission (FC 15) had submitted two reports covering a six-year period from FY21 to FY26. Their forecasts and recommendations have been characterized by significant uncertainties arising from COVID’s shock to the economy and economic and fiscal trends preceding it. Available evidence indicates that their projections have gone out of alignment particularly in FY21 which was used as their base year. However, there is reason to believe that while the base year may have been under-assessed, the relevant growth rates and buoyancies for future years may have been over-assessed. These opposite effects may eventually cancel out some of the errors, thereby, minimizing their impact. The Commission had also suggested a medium-term fiscal consolidation path indicating borrowing by the central and state governments. This path has also been exceeded particularly by the central government in FY21 and in FY22 (BE).

There are continuing concerns in center-state financial relations in India.  First, so far, no decision regarding state/sector specific grants as recommended by FC 15, which were put on hold as per the Action Taken Report, has been taken by the central government. Second, there is an apprehension that Commission’s projections regarding the Center’s revenue buoyancies may turn out to be optimistic. Third, there are four major issues with respect to GST: (a) likely revenue shock after June 2022 particularly for net producing states, (b) cash flow problems with respect to the timing of transfer of SGST, IGST and the compensation cess to states, (c) frequent rate revisions and lower than expected buoyancy and (d)  exclusion of a number of important goods from the GST base. Fourth, in regard to the taxation of petroleum products, the Center’s share in the incidence of tax has been higher than that of states. Fifth, there are concerns with respect to the Center’s strategy for procurement of COVID-19 vaccines and their interstate allocation. Sixth, the fiscal consolidation path up to FY26 as recommended by FC 15 departs from the existing FRBM norms particularly for the central government. Since FC 15 has recommended revision of the FRBM by a High-powered inter-governmental group, states would require representation when the Center’s FRBM is recast.