On February 1, India’s Union Government presented its budget for 2022-23. Four years of slowdown, followed by two years of pandemic-induced crisis and recovery, and a high level of debt mean that rapid economic growth is the main objective for the government to pursue. The government seems to realize this and made growth the center of the finance minister’s speech announcing the budget. Whether the government’s fiscal strategy for growth will work is perhaps the most important question for India’s economic prospects in the medium term.

When the coronavirus pandemic hit, India’s economy was already slowing down. Economic growth had decelerated from 8.3 percent in 2016-17 to 3.7 percent in 2019-20—a period that wasn’t a crisis for the global economy. Only a few other emerging market economies (EMEs) slowed down in this way. Then, on account of the government’s highly stringent lockdowns, the Indian economy contracted by 6.6 percent in 2020-21 before bouncing back to its pre-pandemic level in the current year. But the pandemic has cost India two years of economic growth and substantially increased income poverty. However, India’s fiscal response to the pandemic has been reasonably extensive, with additional expenditures close to the median among emerging market economies and liquidity support backed by government guarantees double the median among EMEs.

Suyash Rai
Suyash Rai is a deputy director and fellow at Carnegie India. His research focuses on the political economy of economic reforms, and the performance of public institutions in India.
More >

Fiscal policy has evolved since the pandemic began. In 2020-21, the fiscal deficit was 9.2 percent of GDP, double the previous year’s deficit. That year, the government deployed an all-of-the-above strategy: it increased current expenditures such as rural employment and food subsidy programs; guarantees for finance for small enterprises, farmers, non-banking financial firms, and more; and capital expenditures on infrastructure. In 2021-22, the deficit is expected to be 6.9 percent of the GDP, with reduced current expenditure and increased capital expenditure. The new budget pegs the deficit in 2022-23 at 6.4 percent of GDP, again with a reduction in current expenditure but a large increase in capital expenditure.

These deficits have pushed public debt to high levels. India’s public debt to GDP ratio is the largest among similarly placed EMEs and is budgeted to rise in the next fiscal year. Interest payments were 42 percent of revenue receipts in 2020-21 and 39 percent in 2021-22; they are budgeted to jump to 43 percent in 2022-23. In pre-pandemic years, they hovered at about 36 percent. Further, some of the government guarantees given to ensure liquidity support during the pandemic will also add to the liabilities in the coming years. Although the government has not presented its medium-term outlook for debt and deficits in the last two budgets, it is clear that high growth is necessary to ensure that debt servicing does not become a problem.

The budget for 2022-23 and the government’s decisions in the last two years reveal a fiscal strategy for growth that seems to comprise three Ps: protectionism through increasing tariffs, incentives to increase production, and projects to create infrastructure by the government to raise demand and crowd in private investments.

After many years of opening up, India’s pivot toward protectionism began in 2017, and this budget moves the country further in that direction. The government announced phasing out of the concessional rates in most capital goods and projects imports (goods required for initial setting up of a unit or substantial expansion of an existing unit). More than 350 exemption entries will also be phased out, including certain agricultural produce, chemicals, fabrics, medical devices, and medicines for which the government says that sufficient domestic capacity exists.

Since 2020, the government has announced a number of production-linked financial incentive schemes to create national manufacturing champions and generate job opportunities. These programs began with pharmaceutical ingredients, electronics manufacturing, and medical devices and have expanded to include telecom and networking products, food products, certain household appliances, textile products, drones, and more. In this year’s budget, a scheme for manufacturing of 5G equipment also has been announced.

Perhaps the central pillar of the fiscal strategy for growth is the push for capital expenditure projects. The government intends to shovel its way out of the crisis by undertaking infrastructure construction in roads and highways, railways, urban metro rail, telecommunications, and more. As a percentage of GDP, capital expenditure increased from 1.67 percent in 2019-20, to 2.15 in 2020-21, to 2.3 percent in 2021-22 (excluding one-time discharge of debt for the government-owned airline), and is again budgeted to rise to 2.9 percent in 2022-23. Further, the budget proposes financing some of this infrastructure construction through transfers from the Union Government’s budget to the budgets of state governments, because many infrastructure projects are in their jurisdictions.

Although some of the increase in the government’s capital expenditure is substituting for lower borrowing for these items by public sector agencies, there is still a large increase over the three years between 2019-20 and 2022-23. Some commentators have combined the government’s total capital expenditure with that of public agencies to argue that capital expenditure has not increased. This is wrong, because such “capital expenditure” by public agencies as given in the budget documents includes many current expenditures such as food subsidies.

Prior to the pandemic, the budget focus was on current expenditure to reach a large number of people through subsidies, cash transfers and basic goods and services, such as electricity, cooking gas, or piped water supply. The shift in emphasis to capital expenditure suggests that the previous strategy seems close to running its course. Perhaps the government is worried that unless growth picks up, it may not be able to sustain its current expenditure, or that such expenditure will not be able to substitute for the lack of increase in incomes.

These three Ps have the common feature of being able to produce gains in the short to medium term. Protectionism and production-linked incentives will lead to more domestic production, albeit at a cost. For instance, India’s automobile sector, which is protected by high tariffs, does much of its production domestically, but consumers pay a higher price for the vehicles, so the policy is a transfer from consumers to producers. Further, capital expenditure will surely give a boost to the GDP while it is implemented.

Another common feature of these policies is that they can, by use of discretionary powers, make the fortunes of certain sectors or firms, but the success of these policies depends on improving the productivity and competitiveness of India’s economy, not just helping some domestic producers do better in the Indian market. For each of these policies, therefore, the key question is whether the net social benefits in the long term are positive. What does evidence say about the potential success of this strategy?

While tariff increases and production-linked incentives can arguably be justified for specific product categories, India’s comprehensive turn toward these measures is not consistent with the demonstrated capabilities of its economy. An activist approach is usually prescribed for countries lacking the technological knowhow required to grow—either producing the same products more efficiently or producing new products related to those they produce already. There are a number of product categories in which India’s economy can compete either by improving efficiency of production or by producing products similar to those that India already exports: information technology, pharmaceuticals, industrial machinery, electrical machinery, automobiles, textiles, and more. India should be able to compete with the world in an increasing number of products without an activist industrial policy or protectionist tariffs.

Instead of identifying and addressing the specific causes for the economy’s inability to capitalize on its capabilities, the government seems to have chosen to offer palliatives. (This is not a critique of protectionism or an activist industrial policy, but a critique of India’s turn toward such policies, given the facts about its economy.) One risk of this pivot is that India’s political economy may become more invested in seeking greater protectionism and higher fiscal incentives than advocating reforms and trade agreements to compete with the world on the basis of innovation and productivity. When there are large gains to be made—access to a captive domestic market or transfers from government—it is rational for many firms to focus on playing this game.

Further, the protectionist turn also makes India a riskier destination for global firms looking at it as part of global value chains. Tariff barriers create frictions for firms looking to locate parts of their business in different countries. Specifically, for firms moving out of China, this raises an additional concern, as some of them may want to rely on imported capital goods and project imports. The uncertainty around future tariff increases can also act as a deterrent.

The story with capital expenditure is a bit more complicated. There is evidence to suggest that, in the past, capital expenditure has had a much higher impact in boosting the economy than tax cuts and current expenditure. On its face, this supports the government’s strategy. However, the effect of public capital expenditure on private investment depends on the overall policy environment. In India, before 1980, such investment crowded out private investment, while after 1980, it started crowding in private investments, perhaps because of policy reforms and/or better implementation of policies.

Evidence from recent years complicates the assumption that public expenditure will crowd in private investment. Between 2010 and 2020, the total private sector–led infrastructure projects under implementation fell sharply, from more than 26 percent of GDP to less than 7 percent of GDP. New project announcements by private sector also dropped, to a fifth of what they were at the beginning of the decade. During the same period, the total government-led infrastructure projects under implementation remained stable—about 30 percent of GDP at the beginning of the decade, rising to 34 percent in the middle, and falling to 27 percent at the end. As a percentage of GDP, more government investment into infrastructure was done in this decade than in the preceding decade, which was the decade of the biggest private investment boom in India. To be clear, this is not to suggest that the proposed scale-up of capital expenditure will not crowd in private investments, but only to imply that other conditions may need to be met for such an effect to materialize.

The budget has sent mixed signals on another P that could boost growth: privatization. In recent years, two newly announced policies sought to redefine the government’s role in the economy: privatizing public-sector firms to leave only a few in government ownership, and placing operational infrastructure assets in private hands so that the government could focus on new infrastructure development. India’s previous experience with privatization has been good, leading to profitability and efficiency gains in the privatized firms. Privatization also frees up financial and administrative resources to focus on areas where the government’s investment in productive assets is most required.

In the previous year’s budget speech, the finance minister laid out the government’s plan to privatize all public-sector enterprises in “non-strategic sectors,” and all but a few enterprises in strategic sectors. When the government concluded the sale of its airline, Air India, it was expected that the privatization process would pick up pace, because earlier announcements on privatization (one was made in 2016 as well) had not led to action. However, this budget has drastically reduced the expected receipts from disinvestment, indicating a departure from last year’s ambitious plan.

Last year’s budget speech also included major announcements on monetizing operational public infrastructure assets in a variety of sectors—including roads and highways, power transmission, oil and gas pipelines, and warehouses—for financing new infrastructure construction. However, going by the revenues reported in this year’s budget, it seems that significant monetization is only happening in the roads and highways sector. Further, the non-tax revenues budgeted for next year do not suggest that the asset monetization is likely to be taken up at a large scale.

There are many ways for a government to leverage its fiscal powers. Some work by harnessing market forces, while others rely more on the government gathering information and making the right decisions. Overall, the budget reveals a fiscal strategy for growth that counts a great deal on the capacities of the Indian government to use its fiscal powers well. Specifically, four aspects of capacity may define success of this strategy.

First, the government would have to maintain a high level of autonomy while exercising these powers, especially for protectionism and production incentives. Because of the high stakes, such powers tend to create conditions for corruption. It is not easy to ensure that these powers are used only for developmental purposes.

Second, the government would have to build mechanisms for verifying facts on the basis of which financial incentives are released and protectionist barriers are raised. This is necessary to ensure that the firms are not gaming the system. The Indian state performs quite poorly at establishing facts, especially when there are incentives to distort them. Many studies have found that in India, the government often fails to apply rules based on reliable and valid measurements of facts.

Third, the government must improve its capacity for open and collaborative decision-making. The knowledge required to make the right decisions when intervening through protectionism or fiscal incentives is not easy to come by. Firms in most sectors love such policies, but what is good for them may not be good for the economy as a whole. So far, the process for making these policies has been opaque, albeit presumably involving consultations with industry bodies. Given the risks of capture, it is important for the government to share its rationale and seek critiques from diverse stakeholders on an ongoing basis.

Fourth, to make the most of the huge increase in capital expenditure, the government will have to enhance its capacity to choose and implement high-impact projects. When a rapid scale-up in expenditure happens, it is easy to become lax in choosing projects. This is more likely because much of India’s infrastructure has been built only in the past generation. When faced with the pressure to spend quickly, it is easier to put money into building more of the same type of infrastructure that has been recently built than it is to learn to build new types of infrastructure, even if the impact of the former is smaller. For instance, once large urban centers have metro railways, building them in other cities will be easy but may have less of an impact.

While there are many pre-conditions for this strategy to succeed, the government needs to focus on getting done what must be done. If the strategy fails to yield the desired outcome—high and sustained growth—India will find itself in a very difficult situation in the next few years.