Lesser evil

Finance Minister Pranab Mukherjee has increased the price of oil in his effort to control the runaway fiscal deficit of the current year. Large fiscal deficit is fundamentally harmful for the economy. The RBI prints notes and makes them available to the government for making expenditures in excess of its income. This is convenient but impacts the economy adversely in the next cycle. It adds to price rise.

An increase in the money in circulation in the economy takes place. This leads to high pressure in the economy much like in the pressure cooker on the stove. Larger amounts of money begin chasing the same amount of goods in the economy and that leads to an increase in prices - as is happening at present.

Devaluation of currency
Yet later, a devaluation of the currency takes place. It is beneficial, therefore, to resort to fiscal deficit only for overcoming short run problems just as a company may resort to overdraft from the bank for meeting short term contingencies.

The fiscal deficit that has already been incurred can be controlled in two ways - by raising tax revenues or by reducing expenditures. The latter is difficult at the present. Defence expenditures cannot be reduced given the unstable situation in Pakistan. Social sector expenditures cannot be reduced in view of the pervasive Naxalite activities in nearly one-half of the country. The common man is restive because fruits of economic growth are not reaching him. This is also reflected in the resurgence of son-of-soil demands such as that is taking place in Maharashtra.

These expenditures on social sector do not appear to be successful in alleviating the plight of the poor because most money is pocketed by corrupt politicians and government employees. Yet these cannot be reduced until alternative programmes for reaching relief to the poor are set in place.

The finance minister has boldly moved in this direction. He has reversed the relief given in excise duty that was given earlier in the wake of the global financial crisis. He has also increased the price of oil. Many analysts and politicians from the opposition have criticised this move. They have alleged this will lead to price rise.
Prices increase both from a high fiscal deficit as well as from high price of oil. But there is an important difference in the nature of price rise caused by these two routes. The price rise caused by fiscal deficit continues to increase as in a spiral while that caused by increase in price of oil settles down as in a plateau.

Let’s assume the government followed the policy of living with high fiscal deficit. Reserve Bank printed notes of Rs 100 crore which led to an increase in prices of 10 per cent. In the next year and the year after that, the government would face the same problem again. In this way fiscal deficit spirals into a continuous increase in prices. The situation of the government becomes like that of a loss-making company.

The impact of increases in taxes is benign in comparison. It seems to me, it is better to resort to higher taxation to control fiscal deficit rather than allow it to run amok. Politicians of the opposition should remember that the fiscal deficit will persist and lead to spiralling increase in prices if taxes are not raised.

An increase in price of oil is justified on other considerations as well. The domestic price of oil is slightly lower than international prices at present. Public sector oil companies are importing oil at high price and selling it cheap in the domestic market. The government is issuing oil bonds to make up the losses of the companies.

Imposing taxes
These bonds will be redeemed by imposing taxes on the people in the future. Thus, cheap oil does not come free. We are only consuming cheap oil today by taking a loan on our future tax revenues. More importantly, cheap oil sets into motion a vicious cycle of increased consumption and yet more losses. Consumption of oil increases due to low price, the oil companies have to import more oil, the government has to issue more bonds to make up the losses and taxpayers will have to pay higher taxes in future.
This writer had an occasion to study the gobar gas plants near Haridwar some years ago. Many gas plants were found to be dilapidated and non-operational. Previously they were working because LPG gas was not available. Farmers used gobar gas to burn the stove and the lights. Then cheap LPG gas became available. Almost immediately, the farmers stopped making gobar gas. They sold off their cows and bullocks and started cultivating with tractors because diesel oil was also available cheap.

They will now be in deep trouble if supply of LPG and diesel is cut for some reason. It will not be possible to resume production of gobar gas as the cattle have been sold. It is better to face high prices of oil immediately and reduce consumption instead of risking spiralling fiscal deficit and loss of economic sovereignty.