However, macro policy is flying blind if GDP is not properly measured. When a business cycle downturn is coming, we want the fiscal deficit to enlarge and vice versa, but this is infeasible in India as we have shabby measurement. For the monetary policy committee (MPC) to think about monetary policy, they need to know the state of the business cycle. For the Finance Commission to do its work, it requires SDP estimates. Weakness in measurement is hobbling our policymakers.
There is one place in the economy where numerical values of GDP play a mission critical role: The Budget process. In February 2018, Budget makers take a stand on their projected value for nominal GDP in 2018-19. That numerical value feeds into the entire Budget process. The first draft of the Budget for 2018-19 can be made by taking all ratios to GDP for last year and applying them to the new GDP value. As an example, if a certain tax yielded 3 per cent of GDP last year, and if next year's GDP estimate is Rs 150 trillion, we immediately get a first cut of the Budget estimate for the coming year for that tax: 3 per cent of Rs 150 trillion, or Rs 4.5 trillion.
The Budget process is shaped through and through by ratios to GDP. Whether we think about taxation, expenditure, deficits, borrowing or debt, in all these areas, the Budget process uses the projected value for nominal GDP and multiplies this with a sound value for the ratio to GDP. As an example, the discussion on the fiscal deficit is only conducted as a percentage of GDP. Once the Budget makers agree that they want a fiscal deficit of 2 per cent of GDP, this is multiplied by the GDP forecast to get the Budget estimate for the fiscal deficit in the coming year, in rupees.
What would happen in the Budget process if GDP were overestimated? Tax targets would then be set too high. There would be gnawing problems in achieving those tax targets. This would result in many small decisions to increase tax rates in order to get back to normative estimates for tax collections.
India has the remarkably bad concept of tax collection targets assigned to senior managers of the tax administration. When GDP is overestimated, the targets sent to the CBDT hierarchy are too high. Perhaps this gives a greater propensity to use harsh tactics in collecting taxes.
Similar problems show up with deficits and the borrowing programme. When GDP is overestimated, a borrowing plan that appears reasonable in terms of the borrowing/GDP ratio is one that involves asking for too much debt from the economy. This results in stress where the market is not able to absorb the borrowing.
The scenario of overestimating the level of GDP thus results in three predictions: Pressure to raise tax rates in tax policy, pressure to use harsh tactics in tax administration, and difficulties in executing the borrowing programme. These three problems are indeed present in varying degrees in the observed reality around us.
This is a reminder of the importance of sound economic measurement. GDP measurement was once the prestige project of India's best economists. Many of the top economists of India of the previous two generations devoted enormous effort to building the statistical system, and they were proud of the edifice they had constructed.
Unfortunately, the economists of my generation have lost interest in problems of measurement. We are now just users of data; we don't take an interest in how it is made. The editors and referees of foreign journals think that the data emanating from the government is always kosher, and academic economists are content with producing wrong research that is career-maximising. GDP data is, however, a mission-critical input into the fiscal process. We must diagnose what is wrong with GDP measurement, and build a capable statistical system.
The writer is a professor at National Institute of Public Finance and Policy, New Delhi