The Hindu Business Line : Fiscal responsibility

The US' huge fiscal imbalance, highlighted in a recent study, is a standing example of the power of politics over economics. It is another matter that the US has not suffered because of its abandonment of fiscal standards and merrily carries on with its profligacy. But economic disaster faces those nations that spurn the essential principles of prudence, however tempting it may be.

FISCAL prudence is one of the strong messages sent by the gurus of Washington to the rest of the world. However, "do as we say, don't do as we do" seems to be the latest message from the capital of the richest country of the world.

Judging by what is happening to President Bush's proposals for a $350-billion tax-cut, I do not think anyone can hold the US as a model for fiscal austerity. Truth to tell, Mr Bush succeeded in pushing through his tax-cuts against grave doubts and attacks by critics from both parties. To cap it all comes the story that the US Administration concealed from Congressional scrutiny a devastating study of federal finances that showed that US's fiscal position was much worse than expected. The irony was that the study was commissioned by the former Secretary of the Treasury, Mr Paul O'Neill, himself.

The study, authored by Mr Jagdeesh Gokhale and Mr Kent Smetters, Assistant Professor, Wharton School, stated that the US' fiscal imbalance would amount to $44,200 billion — a far higher figure than estimated by various other sources. The pity is that the report was not presented to the Congress with the budget report for 2004, which incorporated the tax-cut proposal.

A report that portrayed the US' dire fiscal position was scarcely the right material to help promote the tax-cut proposals. So what was morally wrong turned out to be politically justified, and the report's authors were left with a hot potato on their hands.

The report had estimated that the order of gap disclosed by its analysis was roughly equivalent to ten times the publicly held national debt and four times the US' annual gross national product. The study estimated that closing the gap would require the equivalent of an immediate and permanent 66 per cent across-the-board tax rise — hardly a figure that could be used to persuade a reluctant Congress to agree to tax cuts! The Smetters-Gokhale report is a warning signal which President Bush has decided to push under the carpet.

All this is in line with the Bush Administration's practice of political doublespeak on both domestic and international affairs. The question is, who can blame a President caught on the horns of a dilemma? He believes he needs a tax-cut to "stimulate" the economy and deliver growth with jobs.

To add to his problems, the Fed has come to the end of its tether with interest rates as low as they can get — at 1.25 per cent. To reduce them further would be unthinkable, although not impossible. To stave off the threat of deflation, Mr Bush had to get his tax-cut — damn the report of wise gurus and threats of fiscal disaster.

The Gokhale-Smetters report makes valid points in its assessment of what it calls the financial imbalance of the US. In calculating fiscal imbalance, it makes a departure from conventional measures of the fiscal stress, such as debt and deficit.

It calculates a new magnitude, which is a measure of fiscal imbalance, arrived at by calculating the excess of total of expenditure over time over the available revenues, both taken at present value. In particular, the calculation takes care of the changing profile of welfare needs, such as medicare and social security, which reflect changing age structure and other demographic variations.

The calculations are much more sophisticated than the ones we are familiar with. Smetters and Gokhale have made a convincing case for adopting their measure in preference to the usually adopted ones.

It is, however, doubtful whether the fiscal experts will, in general, be converted by the exposition of its advantages. It is far better to be simple and direct when dealing with such magnitudes. The Smetters-Gokhale exercise involves discounting the future stream of receipts and payments back to the present, by assuming a rate of interest equal to the US Government's inflation adjusted long-term borrowing rate.

Other assumptions include the rate of growth of GDP and that of demographic expansion. In essence, the sophisticated exercise tries to work out the present value of future fiscal lapses.

The merits of the measure of fiscal imbalance advocated by the two authors are weighty. But chief among them is the fact that it takes into account the burden of social security and medicare. Indeed, the total measure of the fiscal imbalance, estimated at $44 billion, is mainly made up of fiscal imbalance on social security of $7 billion and medicare of $36.6 billion.

The US Administration's own fiscal imbalance, ignoring these two items is a modest $0.5 trillion. But the disturbing factor is that social security and medicare entitlements are part of the direct commitments of the Government. They have to be met so long as the current legal provisions guarantee the benefits.

At present, the US Administration meets the gap between income and expenditure on these accounts from out of its general revenues. So, the authors of the report are absolutely right to warn the US Administration about the looming gaps.

The fiscal irresponsibility which the US Administration has shown is a reflection of the power of politics over economics. Or rather, it is the effect of the power of short-term economic gains over long-term fiscal health. But the recent developments a la Bush's benign neglect of fiscal advice have important lessons for other countries, including India.

When fiscal responsibility is in conflict with the demands of political management, fiscal probity goes out the door. The US offers by its latest actions a standing example of doctrinal purity abandoned at the slightest suggestion or hope of economic advantage.

True, the US has not suffered because of its abandonment of fiscal standards. It has been running a budget deficit of nearly $500 billion on conventional definition. This amounts to as much as 5 per cent of GDP — a figure which would have led IMF's watchmen to read the Riot Act to lesser nations.

So, too, would the veterans of the Maastricht Treaty have asked the Governments to constrict their expenditures and raise taxes if the fiscal deficit exceeded even 3 per cent. But the US carries on in glorious nonchalance. And its inflation numbers are none the worse for the entire fiscal splurge, although the high fiscal imbalance should have let loose the inflation demon. This has not happened.

True, we in India cannot follow the US example in this as in other domains. The US was able to launch a preemptive attack on Iraq on the mere suspicion of the latter's owning weapons of mass destruction. Woe betide any other nation that dares to take a leaf from the US' book.

As in matters diplomatic, so too in economic affairs; the US case is unique and it would be a daredevil of a nation that would follow the US's reckless ways. The US's latest encounter with fiscal irresponsibility should serve more as a warning to lesser mortals to avoid temptation.

When fiscal imbalance threatens, the sooner we take note of the need for correction the better and the lesser the need for correction later. The more we delay our responses, the harder are the corrections we have to make, both in respect of expenditure and revenue.

This is the one lesson we take away from the Gokhale-Smetters' study and its impact, however much we differ from its technical niceties.

I hear demurring, stating that India's fiscal position is not subject to such "hidden" dangers such as medicare and social security. I am not so sure. There have, of late, been many open-ended commitments, such as those in the recent Budgets, including those relating to insurance, which can blow in the face of future Governments.

So too, the present structure of pensions is prone to danger, its "pay as you go" basis making its future costs uncertain. It is time we took a clear decision not to take on such open-ended commitments in future.

Fiscal responsibility is not to be spurned merely because the most powerful nation on earth has decided to give it shove-over. Poorer nations have to live by the laws of economics. There is no way we can defy them. Economic disaster faces those nations which spurn the essential principles of prudence, however tempting they may be because of the US' triumphant display of arrogant fiscal behaviour.

While discussing the US' current behaviour, I am reminded of an exchange of views in the days when the late Rajiv Gandhi was Prime Minister. I was, in keeping with the responsibilities of my position as Finance Secretary, arguing against expansion of subsidies and concessions, in view of the high budget deficit.

One of the leading Ministers, an economically literate gentleman with political clout, interrupted my exposition, saying: "The US is running a large budget deficit and doing well. Why not we?" My answer was that US is printing the world's currency. It can borrow all its needs from the rest of the world. That is not true of India. So long as this situation lasts, India cannot afford to follow the US's profligate example!

Article E-Mail :: Comment :: Syndication

Stories in this Section
Calls wrong and right

Globalisation: The great leveller

Fiscal responsibility — Lessons from US' profligacy

Reform in reverse gear?

A changing paradigm in semiconductors

Upasi clarifies: Fair price for natural rubber

Hope for elderly

Between equities and bonds

EPF rate

Farmers' distress