GDP growth depends on four factors: Government expenditure, private consumption, private investment, and exports.
India and several other countries run a counter-cyclical fiscal policy, whereby the government cuts back on spending in boom years and steps up spending during economic downturns.
In a boom scenario, declining government expenditure would not cause decline in the growth rate as:
1. Private consumption will lead to demand-pull inflation, leading to increased supply of goods to meet the demand. This will spur private investment and GDP growth.
2. If the decline results from reduction in wasteful expenditure (such as doles or building statues), it will lend credibility to the priorities of the government, and increase investor confidence.
3. Foreign investments will bring in capital, leading to domestic growth.
4. Decline in government spending >> decline in borrowing >> banks would not have to mandatorily invest in government securities (like SLR in India), giving them more leeway to extend credit to businesses.
However, in the present scenario, it will cause a decline in the growth rates of a country as:
1. Global growth is subdued as many economies are in recession (EU, Japan), or just recovering (US). This has led to all-time low global trade volumes and consequently lower and lower exports.
The Baltic Dry Index (a measure of global trade) fell to an all-time low of 291 in Feb 2016 from a high of 2,330 in Dec. 2014.
2. Structural bottlenecks such as bureaucratic red tape, environmental compliances, a lack of Ease of Doing Business etc have led to decline in private sector investment and participation.
3. High inflation in emerging economies such as Brazil and oil-dependent economies such as Venezuela and Russia has led to a decrease in private consumption by decreasing their purchasing power. Measures like demonetization of high value currency in India have led to serious liquidity constraints and caused private consumption to crash. Lowered spending on schemes such as MNREGA or salaries of government employees would also lead to lesser purchasing power and thus lower private consumption, stalling GDP growth.
4. Low or no thrust on infrastructure will lead to lower demand in allied sectors such as cement, steel etc, which are huge employment generators. This will cause large-scale unemployment which will not only cripple growth, but may also lead to social unrest.
5. In the long run, lowered government spending will translate into lower spending on social welfare, healthcare and education. This will lead to a less productive workforce and less aware citizenry, which will translate to reduced productivity, low innovation, and lower GDP growth rate.
6. Lowered spending will have to be accompanied by lower taxes. If this benefit of lower taxation accrues to the relatively rich individuals by the way of lowered direct taxes (Income Tax or Corporate Tax), it will lead to an increase in inequality, which will be detrimental to the long-term growth.
In a market economy, government has to play the role of a facilitator. Economic redistribution is a legitimate aim of a government. Also, it is the government that has to revive the economic cycle by “priming the pump” during cyclical downturns or recession. Thus, government spending should be ramped up or scaled down as per the needs of the economy, in order to ensure a stable growth rate.
