Monday, February 15, 2010

The case for automatic fiscal stabilizers for India

The turmoil in the global financial markets and the world economy over the last two years and its profound impact on the economically under-privileged (who were ironically those least responsible for causing it) is a timely reminder about the need to maintain a social safety net that can soften the impact of such adverse shocks on those people. In order for this safety net to provide the requisite insurance against recessions, it is also necessary for it to be dynamic and counter-cyclical.

According to the United Nations Department of Economic and Social Affairs's (UNDESA) recently released World Economic Situation and Prospects 2010, 47 million more people globally became poor or remained in poverty in 2009 than would have been the case at 2008 growth rates, and 84 million more would have been poor at 2004-7 growth rates.

The UNDESA has also some interesting statistics on the impact of the decline in India's GDP growth rate from 8.8% averaged from 2004-05 to 2006-07 to the 6.7% estimated for 2008-09. The 2.1% decline in India’s GDP growth rate has effectively translated into a 2.8% increase in the incidence of poverty. It estimates that the number of India’s poor was 33.6 million higher in 2009 than would have been the case if the growth rates of the years from 2004 to 2007 had been maintained. In 2009 alone, an estimated 13.6 million more people in India became poor or remained in poverty than would have been the case at 2008 growth rates.

The wave of globalization and liberalization of the last two decades unleashed forces that resulted in the closer economic integration among countries. While this has undoubtedly helped millions in the developing countries to take advantage and escape poverty, it has also had the effect of exposing the same people to the full force of the vagaries of the global economic cycle.

Accordingly, volatility in global food, fuel and commodity prices gets transmitted immediately to the domestic markets, hurting both producers and consumers. Similarly, the implications of financial market (which are increasingly getting closely inter-twined with the real economy) troubles are closely and immediately felt by people living in even the remotest areas of the developing world. Further, those at the lower end of the income spectrum are among the worst affected by these shocks. The need for automatic counter-cyclical fiscal support measures for softening the impact on the poorest have, for all the aforementioned reasons, never been more important.

Countries across the world have different levels of social security protection to assist the economically under-privileged. In India these include mainly the near universal Public Distribution System (PDS) and welfare pensions for the old-aged, widows, and physically handicapped. However, these are more in the form of one-time means-tested issuances, which reflect the economic status of the beneficiaries when they are issued, and do not respond dynamically to the changing economic environment.

Economic slowdowns are characterized by diminished purchasing power, greater intensity in the pinch of poverty for even the existing poor, and people falling into poverty in large numbers. It is therefore important that social safety mechanisms have a counter-cyclical dimension that can cushion people from these events. Such mechanisms provide a form of social insurance against the debilitating effects of economic slowdowns.

In developed countries this comes in the form of automatic fiscal stabilizers, which are "taxes and transfers such as unemployment compensation and food stamps that automatically change with changes in economic conditions in a way that dampens economic cycles". Such stabilizers not only mitigates the suffering of individuals concerned but also smooths over spending and thereby prevent deep declines in aggregate demand.

As Mark Thoma put it nicely, such stabilizers kick-in automatically without need for any elaborate political negotiations as soon as the economic conditions deteriorate. Apart from the standard stabilizers like food stamps and unemployment insurance, he also suggests having "payroll taxes that decline automatically when conditions deteriorate, investment tax credits that vary countercyclically, or a continuously updated list of infrastructure projects that can be started ahead of schedule or brought online anew if the economy goes into recession".

The Government of India recently took an adhoc decision to allocate an additional 10 kg of foodgrains (wheat and rice) per month for every family covered under the PDS for January and February. This decision could have been more effective if it was done early last year when the impact of the economic slowdown was more intense.

Other automatic fiscal stabilizers that can most effectively soften the impact of hard times on poor include food for work programs that should kick-in automatically without any legislative or elaborate bureaucratic requirements when the economy slows down below a certain level or unemployment rises above certain figure (though this is a difficult measure to accurately ascertain in Indian context).

Similarly, legislatively mandated automatic increases in the quantity of allocation of foodgrains from the PDS once food price inflation crosses certain level can go a long way towards protecting the economically under-privileged sections from price shocks. Besides, it will also act as an automatically acting open market operation that would contribute towards stabilizing food prices in the larger market.

Such automatic stabilizers assume greater significance for countries like India which experience considerable and frequent headline inflationary pressures that immediately get reflected in the higher prices for foodgrains and fuels.

Successful roll-out of the UID and TFI initiatives, currently under implementation, will dramatically enhance the ability of state and central governments to deliver such support to those affected. It will become possible to overcome the problems associated with beneficiary identification, targeting and pilferage in delivery that bedevil the administration of such welfare measures in India.

One of the problems with such stabilizers is the political difficulty in withdrawing them once the economic conditions improve. It is therefore important to very clearly define the conditions when it kicks-in, eligibility criteria for beneficiaries, and easily verifiable sunset provisions for such programs.

Update 1 (6/5/2010)
IMF working paper on the utility of automatic fiscal stabilizers. The authors write,

"Results generally provide strong support for the view that fiscal stabilization
operates mainly through automatic stabilizers. By contrast, fiscal policies systematically linked to cyclical conditions—be they pro- or counter-cyclical—do not appear to have a meaningful impact on output volatility."

Update 2 (27/8/2010)

Mathias Dolls, Clemens Fuest, and Andreas Peichl analyzs the effectiveness of the tax and transfer systems in the European Union and the US to act as an automatic stabilizer in the current economic crisis and find that "automatic stabilizers absorb 38 per cent of a proportional income shock in the EU, compared to 32 per cent in the US. In the case of an unemployment shock 47 percent of the shock are absorbed in the EU, compared to 34 per cent in the US. This cushioning of disposable income leads to a demand stabilization of up to 30 per cent in the EU and up to 20 per cent in the US."

Update 3 (17/9/2010)
Mathias Dolls, Clemens Fuest, and Andreas Peichl find that "social transfers, in particular the rather generous systems of unemployment insurance in Europe, play a key role in the stabilisation of disposable incomes".

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