The case for balanced budgets

The other day I read a thread on Twitter in which two well-known economic historians were quoted as saying that during the Mughal period India was taxed at around 56 per cent. But doubts have been cast on the reliability of the data.

The thread also pointed out that during the British period this rate of extraction came down to around 40 per cent. This also seems on the low side.

I suspect that over the last 500 years, successive governments have been appropriating around half of the national income.

This sits well with the current figure which is somewhere between 50 and 55 per cent.

The difference between then and now is that  during the Mughal and the British periods, the money was spent on armies and wars. Now, thanks to democracy, it is spent on welfare schemes of one sort of the other. Another difference is that the armed armies of the past have now given way to an unarmed -- but equally lethal -- army of bureaucrats.

Macro consequences

The macroeconomic consequences of this high rate of extraction is, however, the same: the people are left with very little money in their pockets. As a result, they are poor in all but the highest income categories.

By poor I mean their income which can be spent on discretion is tiny. At present, if you take into account the inflation in services and finance, it is as little as five per cent.

This acts as a serious drag on economic activity and this is the big problem that the Modi government will have to fix over the next five years.

It simply has to lower the rate of extraction to around 35 per cent so that people can spend more on things that raise the level of economic activity in the country.

In short, the government has to reduce its expenditure massively by maybe as much as 3 lakh crores each year over the next five years. Alternatively, it has to raise this much without increasing taxes.

This sounds impossible and it probably is. But here are a few suggestions that will have to be adopted willy-nilly at some point when the curtain falls on the tax and spend philosophy that has characterised all post-1970 governments.

Five suggestions

First, regardless of whatever promises past governments might have made, it must stop paying pensions to nuclear families that have an alternative source of income that equals or exceeds the pension. There is no just cause for pensions in such cases at all, none at all.

Second, it must close down every single public sector enterprise that has never made a profit in the last five years. This must be done brutally, as indeed it will be when the bankruptcy axe falls a few years from now. It is hovering dangerously close to the neck even now.

Third, every single subsidy must be discontinued. This, too, will happen when the money runs out totally, which I suspect it already may have. (Otherwise what is the reason for considering sovereign bonds in foreign currency?).

Fourth, the government must reduce the salaries of its employees by at least a quarter, if not more. This may sound drastic but believe me this, too, will be forced upon us when the financial typhoon that’s coming finally hits – and then it may not be able to pay any salaries and pensions at all.

Fifth, it must fix a hard budget constraint, not via some mythical number such as a percentage of GDP -- like the fiscal deficit -- but via an absolute number that balances the budget. Globally, the case for unbalanced budgets was over in the mid-1980s but thanks to democracy and consequent populism, unbalanced budgets have gone on and on.

Their time is over now.

Before it’s too late

Recall that in all the countries that have gone broke, it was because their governments raised their consumption expenditures to wholly unsustainable levels. Eventually when they did go broke, what seemed impossible till then suddenly became the only possible way out of a complete collapse.

And I am not being alarmist here: if we take into account all the liabilities of the government – actual, revealed and contingent -- we are rapidly reaching the crisis point.

When it happened in 1991, it was confined to external payments. This time it will affect all payments.

And then our goose will be properly cooked.