Fiscal policy in the age of inflation targets

Fiscal policy in the age of inflation targets
The trajectory of nominal GDP growth in the medium term deserves to be watched—once the transient effects of the currency shock subside
One trend in the Indian economy that deserves far more attention right now is the sharp recovery in the nominal gross domestic product (GDP) over the past four quarters. This recovery is especially significant as the countdown to the new budget to be presented by finance minister Arun Jaitley begins. There is also a related policy quandary about the nature of fiscal policy when the Indian central bank has been tied down to a formal inflation target.

A bit of background: The deflation in wholesale prices had pulled down the growth of nominal output till recently. The low point was in the quarter ended September 2015. Nominal output in that quarter grew at its lowest pace in nearly a decade. There has been a gradual improvement since then as wholesale price deflation has receded. Nominal output in the September 2016 quarter grew at rates that were common before the strange episode of wholesale price deflation (see chart).

Click here for enlarge
Why should all this matter? Most analysts are focussed on how rapidly the economy is growing in real terms—after stripping away the effects of price changes. There are good reasons to do so. What matters for economic welfare is the increase in output rather than the value of output.

However, there is one important reason why economists sometimes need to look to nominal rather than real values. Nominal GDP matters when the government sits down for its annual budgeting exercise. The amount of tax that can be collected is based on the size of nominal rather than real output. That is because we pay tax on nominal incomes or profits rather than real incomes or profits. Indirect taxes are also imposed on the nominal prices of any commodity or service. The recent recovery in nominal GDP growth is good news for finance minister Jaitley as he does preparatory work for the budget due to be announced on 1 February.

There are two parts of nominal GDP growth—the increase in actual output plus some measure of price changes. How important these two parts are at any point in time is also important. High nominal GDP growth can be driven by a combination of low real growth plus high inflation. It can be the result of high real growth plus low inflation. Or it could be something in between. There are no prizes for guessing that a robust economy should be driven by high real growth plus low inflation.

The finance ministry usually works with an overall estimate of nominal GDP growth. It pays relatively less attention in its budget to whether nominal growth in the economy is dominated by high growth or high inflation. This could be a problem at a time when the Reserve Bank of India (RBI) has been formally asked to focus its monetary policy on meeting an inflation target. The question worth asking right now is whether Indian fiscal policy should explicitly take the monetary policy target into consideration when the budget is being finalized.

Most budgets as a thumb rule seem to assume that nominal GDP in the next year would grow at around 12%. The increase in tax collections is derived from this number after assuming some level of tax elasticity. It is quite likely that Jaitley will work with a similar assumption in his new budget. Now the question to ask is: What is the underlying inflation assumption?

Let us move back into the realm of monetary policy. The middle point of the inflation range given to the Indian central bank is 4%, though the range is 2 percentage points on either side of this level. There has been some ambiguity about how the RBI would interpret its policy target. Would the intermediate target of Indian monetary policy be a range or a point? Significantly, in the meeting of the monetary policy committee held in early December, where it was decided unanimously that policy rates should not be changed, governor Urjit Patel said: “Achieving the inflation target of 5 per cent for Q4 of 2016-17 and securing 4 per cent—the central point of the notified target range—remains the primary objective.”

Fiscal policy should ideally keep this inflation target in mind when the assumptions about nominal GDP growth are being made. There are two issues here. The first issue is of signalling. It is likely that the private sector will get confused if the inflation levels assumptions underlying monetary and fiscal policy are different from each other. The second issue is of policy coordination. An inflationary budget could then trigger off an asymmetric monetary policy response, a cue for friction between New Delhi and Mumbai on several occasions since 2004.

The trajectory of nominal GDP growth in the medium term deserves to be watched—once the transient effects of the currency shock subside. The importance given to the inflation target when designing the budget is also an issue that should attract more attention. There is too little discussion on these important macroeconomic issues as the finance minister prepares to unveil his fourth budget on the first day of February.