Inflation and the implications of taking supply-side path for growth

The fiscal policy of the Union government is highly paradoxical in nature while realising the growth targets. Deriving pieces of evidence from Budget-2022, which has overtly chosen the supply-side path and contradicted the fundamentals of ‘Keynesian economics’ (popularly known as demand-side economics) that showcases reluctance among the producers to produce in the absence of adequate demand.

The aggregate demand level is certainly affected given the high and unchanged tax slabs, excise duties on fuel, dwindling spending on social, rural sectors and other such measures which characterise the demand-side inertia of fiscal policy and incentivise people to spend significantly less. Given this policy prescription, the debate over what drives the economic growth of India is of high importance.

With no changes in the tax slabs and rates, the individual taxpayer will have to pay the same amount of tax against a reduced income due to the pandemic, inflation and unemployment. In recent days, due to the crude oil price hike, the Wholesale Price Index (WPI) jumped 13.11% in February which adds to the burden in terms of inflation.

Similarly, retail inflation has risen to a level of 6.07%, which is 0.07% higher than the RBI’s targeted band. The impact of WPI and CPI inflation on-demand on the economy has been severe. However, prioritising growth over fiscal consolidation is a step to be appreciated, but absolute focus on expanding capital and infrastructure spending doesn’t sound convincing.

In the absence of fiscal planning to avail consumers with income to spend and in the presence of high inflation, the effective demand is weak. Thus, here we discuss possible consequences of the preference for supply-side growth revival strategies in the absence of adequate demand in the economy.

Distressed rural demand

In the absence of a stimulus package to put money in the hands of people, policies strengthening the agriculture sector and the revival of the services sector stand largely ignored. Whereas agriculture is the sole sector with positive growth during the pandemic, the service sector, which is holding the backbone of the economy, happens to be the worst-affected.

Schemes like that of MNREGA — which create large rural employment witnessed a sharp cut of 25% while receiving an allocation of Rs 73,000 crore when compared to rural areas (of which 32% are poor) - frame the consumption backbone of the country with a higher propensity to consume. While increased medical expenses, hiked fuel prices and unseasonal rains have shattered the income side of the rural economy, the urban sector seems to have saved itself.

On savings (including the entire economy), apprehensions over the pandemic have led to increased precautionary savings, thus curtailing the consumption demand basket.

An appropriate example of distressed rural demand is two-wheeler sales of which rural demand constitutes 50-60% is at 14.5 million units (lowest in a decade). The farm and non-farm sector composition to rural demand are of critical importance as fiscal planning for the non-farm sector remains non-existent. With a huge dependency ratio of 48%, the non-farm rural sector is sidelined with the lowest per capita endowment from fiscal planning.

Disadvantaged social welfare

Social sector expenditure, including health, education and social welfare, is to witness a fall in total outlays. Though the expenditure on health and education has gained momentum but has been given into inducing the Capex component of these expenditures, which doesn’t directly serve the formation of demand by means of personal disposable income.

The budget, which exposed weaknesses of the healthcare system in India, has remained silent and the share of health has retreated to the pre-pandemic level with a total outlay of Rs 86,200 crore (0.2% hike on a y-o-y basis).

Though the budget is to go big on Capex, the outlay on social Capex (school, hospital etc) has seen a modest increase as compared to the core Capex (road, railways and power plants). This not only shows fiscal naivety but also resembles a focus on antecedents that may yield positive results in the long run.

Shattered expectations

Evidence is rich that expectations affect household and farm-level behaviours, thereby giving room for fiscal and monetary measures to control the functioning of the economy. Anchoring expectations has become difficult with the increased prices of raw materials, fuel prices, existing supply bottlenecks (worsened during the pandemic) and excessive savings (precautionary) in place.

At the same time, government policies focusing solely on the supply-side (even if expansionary) isn’t going to help in raising expectations and demand among the consumer class. Additional fiscal spending on the same front should encourage spending, which doesn’t seem to happen with very little money getting into the hands of the poor directly.

Irrational exuberance

Used emphatically at the outset of the depression of 2007-08 by the then Federal Reserve Chairman Alan Greenspan, it indicates baseless optimism in the market, which reserves the potential of becoming counter-productive.

The existing optimism of the government towards the manufacturing sector and its potential is highly questionable. At a time when personal and corporation tax contributes 15% of the Re 1 income that the government earns, it is crucial to encourage investments in sectors where profit margins can be moderate yet larger employment opportunities can be generated too.

Concentrating on manufacturing-inducing policies seems imitative (to policies adopted by countries like China) and leads to under-exploitation of our strength (potential of the services sector). In a nation with a low capital base with unequal spread, such schemes will be beneficial to a few, thereby furthering the issues of inequality in the country.

Inflation is costing the economy by reducing the aggregate demand. Further, the reluctance towards strengthening the demand-side is withholding the health of the economy as aggregate demand is the immunity that saves economies from downturns by ensuring scope for aggregate production, distribution and growth.

(Mishra is Junior UGC Research Fellow and Raj is Professor of Economics, Centre for Economic Studies and Policy, ISEC, Bengaluru)