Context
Inflation refers to the general rise in price levels over time. For government budgets, what matters most is nominal GDP growth, which is a combination of real growth and inflation. Budget estimates, tax collection targets, and fiscal deficit ratios are all projected using nominal GDP, not real GDP.
The Link Between Nominal GDP and Budget Targets
Nominal GDP is the GDP at current market prices, inclusive of inflation. A certain level of inflation adds to the nominal GDP’s growth, which in turn helps governments achieve higher tax revenues since most taxes are collected as a percentage of this growing nominal base.
- For example, if real GDP grows by 7% but inflation is only 1%, nominal GDP grows by 8% (7%+1%), not the 10% (7%+3%) the government may have budgeted for.
- Budgeted tax revenues and deficit reduction plans are based on the higher anticipated nominal growth; if inflation falls unexpectedly, actual figures fall short.
Why Low Inflation Creates Fiscal Stress
- Shortfall in Tax Revenues: When inflation is lower than expected, nominal GDP and thus tax collections are subdued. Since taxes like GST, income tax, and corporate tax grow with the expansion of the monetary value of the economy, low inflation reduces anticipated revenue growth.
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- For instance, if the government expected 10% nominal GDP growth but achieves only 8.5% due to low inflation, actual tax inflows lag behind projections, causing a revenue shortfall.
- In India, recent periods of low WPI and CPI inflation have resulted in gross tax revenue rising just 1% year-on-year, even as net tax revenue fell 7.5% in some quarters.
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- Difficulty in Meeting Fiscal Deficit and Debt Targets: Fiscal deficit and debt-to-GDP ratios are calculated using nominal GDP. Lower-than-expected inflation shrinks this denominator, making deficits and debt ratios appear worse. This can undermine market confidence and restrict fiscal space for developmental spending.
- Expenditure Rigidity: Government expenditures, especially on salaries, subsidies, and welfare schemes, may be sticky or programmed to increase irrespective of inflation trends. Thus, when revenues stagnate due to low inflation, but expenditures keep rising or remain stagnant, it worsens the fiscal imbalance.
Broader Macroeconomic Concerns
- Fiscal rigidities: Governments may hesitate to curtail essential spending, further stretching fiscal gaps.
- Policy dilemma: While low inflation benefits consumers, it challenges fiscal sustainability, prompting governments to stimulate inflation or revise budget targets.
Conclusion
While moderate inflation supports healthy nominal growth and government revenues, persistently low inflation threatens fiscal consolidation by compressing tax inflows, undermining deficit reduction, and putting budgetary targets at risk. For effective macroeconomic management, governments must factor in the dual roles of real growth and inflation in all fiscal planning.
Source: The Indian Express
UPSC Mains Practice Question
(Q) Critically evaluate whether persistently low inflation is always desirable for a developing economy like India. Discuss its implications for government finances and the achievement of budgetary targets.
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