An MMT perspective of the GST shortfall quandary

The Indian economy is reeling under an economic crisis unleashed by COVID-19. A direct outcome of the crisis has been the massive shortfall in GST tax collections to the tune of some Rs 2,35,000 crore. This translates into lower revenues for state governments who are already shaken by increased health-related expenditures — which is a state subject — alongside shortfalls in their own revenues from sources such as motor vehicle and land registrations.

Finance Minister Nirmala Sitharaman asserted that the contraction in the economy was an “Act of God”, which was not anticipated by the Compensation Act. The question now facing the Centre and state governments is how this shortfall can be made up. The answer seems to be that state governments borrow the amount they need from the market. This has led to a debate as to whether it is better for the Centre to borrow the money and share the proceeds with states, or whether the states go directly to the market.

It seems obvious that the Centre, with zero default risk, would be in a position to ‘borrow’ this amount at lower costs than state governments who would have to bear the burden of higher interest payments given the higher default risk they face.

While the debate rages on, it is useful to look at the issue from the perspective of Modern Money Theory (MMT). The shortfall in tax revenue is in fact a critical fiscal policy response to the contraction in GDP. The fiscal deficit or (government expenditure minus tax collections) is an automatic stabiliser. This is why the fiscal deficit outcome is always non-discretionary even though economists and commentators are obsessed with target numbers like 3.2 percent or 3.4 percent.

The budget only fixes the level of government expenditure and tax rates while the actual tax collections are almost entirely dependent on the level of economic activity. When the latter declines, so does tax collections and consequently the deficit widens. At the same time, the economic contraction also forces the government to spend more on programmes such as MNREGA and in the present pandemic, on public health, thereby widening the deficit more. This should, however, be seen as a positive, rather than a negative, characteristic of fiscal policy.

Attention then turns to the same old problem. Where does the government get the money to cover the deficit? It must obviously ‘borrow’ this amount in the market (keeping aside profits of the RBI and disinvestment, etc.). However, this time we have to deal with an additional problem, at least in so far as the magnitude is concerned. Who ‘borrows’ the money, Centre or the states? The MMT position is categoric; the Centre should. This is not because of yields — it is because the Government of India does not ‘borrow’ its own currency. It is the issuer of currency, and it is does not make sense that it actually ‘borrows’ the same financial liability it issues.

How can the private sector buy bonds in rupees unless the government has first spent rupees into existence? In an earlier article, I’ve explained the elaborate process through which governments work through a self-imposed constraint of first raising money through a network of Primary Dealers (PDs) before actually spending. The net effect of this process is actually identical to ‘monetization of debt’.

The argument that raising funds through bonds in the market will drive up yields on government bonds is based on the problematic loanable funds model. Instead, it is now accepted that central banks set the interest rate at the level they choose to. If deficits and debt were to drive up yields it is strange that interest rates are presently close to zero across the world. Japan is, in fact, experimenting with negative rates even as public debt (in yen) is 250 percent of the GDP. In India, at the peak of the crisis (June), the Reserve Bank of India (RBI) reduced the interest on government bonds from a fixed 7.75 percent to a flexible and lower 7.15 percent due to surge in demand. Shouldn’t the anticipated rise in fiscal deficit have prompted the RBI to raise interest rates? It must also be emphasised that public debt is nothing but net financial asset accumulation by the private sector. In times like this the desire of the private sector for safe financial assets is increasing.

The MMT unequivocally asserts that an economically sovereign government which issues its own fiat currency, does not face a solvency issue in its own currency. The same cannot be said for state governments or municipalities, which are more like the private sector in so far as they are users of currency. It is, however, implicitly assumed that state governments too will not default on their debt repayments simply because the Centre will bail them out.

Austerity measures — whether on the part of the Centre or the states — will only worsen the present crisis that we are in. In a situation of falling private sector consumption and investment as well as declining exports, a lower level of government spending will reflect directly in decreased output. This will further dampen tax collections and result in a vicious circle of falling GDP and widening of fiscal deficit.

The MMT argument is that the Government of India must support the states with adequate financial resources rather than worry about the deficit and debt. In any case, we are in a Catch-22 predicament with rating agencies; damned if you don’t do anything about the recession and damned if you do (in terms of rising fiscal deficits and public debt).

The latter option will at least stabilise the economy and reduce the suffering of the people.

Sashi Sivramkrishna is an MMT researcher, economic historian and documentary filmmaker. Views are personal.