A pentagon model to make the budget simpler
If we compare an economy to an aeroplane, fiscal policy and monetary policy would be its two wings. It is hard to argue which one is more important, but a developing economy needs both to get the economy flying. Hence, the two policies are complementary to, and not substitutes of each other. Sitting in the cockpit, the government is the pilot that runs the economy and controls the rudder to achieve the prime targets.
The major tasks or components of fiscal policy can be viewed through a pentagon model. In developing economies, where data on employment are unauthentic, targeting growth becomes optimal since growth promotes employment and thus reduces unemployment. US President John F Kennedy's economic adviser, Arthur Okun, discovered this relationship, and hence we call it Okun's law. In the pentagon model, the position of growth is at the pinnacle.
There are three layers to the pentagon: 1) the bottom layer for primary targets; 2) the middle layer for intermediate targets; and 3) the top layer for the final target. A family earns first then it decides on a slightly lower spending; a national budget, on the other hand, first sorts out its spending. Then the fiscal authority steps up to go to the second layer to hunt for sources of income. Sources such as tax and nontax revenue are already known to the government. All they do is explore new avenues for generating revenue, since current spending and development expenses always keep rising every year, partly due to inflation and partly for the growing needs of the economy.
Once the revenue figure is derived, the government gets an idea of the fiscal or primary deficit. However, the fiscal deficit is not instantly finalised this way. Usually, there is a norm that a developing country like Bangladesh will keep its fiscal deficit within a limit both as a share of GDP and also as a share of the total budget. These two normative numbers nevertheless follow previous records along with best practices of other comparable countries. If deficits happen to throw a figure exceeding these norms and practices, the authority goes back to the figures of the three areas: revenue, expenses, and development items, until the juggling exercises deliver desirable numbers for all four components of the bottom and intermediate levels in the pentagon model.
To clarify the model further, we can take the budget of FY2017 as an example where the growth target is 7.2 percent. Say, a current spending of Taka 66 and a development spending of Taka 34 make it a budget of Taka 100 (this can be thought of as the Taka 340,605 crore in the actual budget document, and thus all figures are roughly proportional). Now the government figures out that it can earn revenue and grants of Taka 73 (proportionately Taka 248,268 crore in the actual budget). The fiscal deficit turns out to be Taka 27 [=100 – 73]. Taka 18 will be financed from domestic sources and the rest Taka 9 will be borrowed from foreign lenders.
If the government did not spend on development programmes, it would scoop up a fiscal surplus of Taka 7 [= 73- 66]. But that is not desirable. A developing country without a development budget would be inviting disaster on itself. Put differently, the matter of development is so crucial that the government would not hesitate to run a fiscal deficit of Taka 27 to meet the development budget of Taka 34 – which is one third of the total budget.
Since the government's objective is to maximise welfare, subject to resource constraints, the determination of the fiscal deficit becomes an important task for the finance ministry. As a share of GDP, it is usually 5 percent or below for a developing country like Bangladesh. Thus, deficit and debt management turns out to be a serious task for the fiscal authority, and hence deficits and debts (accumulated annual deficits) represent one of the most important corners in the middle level of the pentagon.
The government must devote current expenditures to pay the public employees to service the economy so it can proceed swimmingly. Unlike a developed economy, a developing economy will always crave for growth so it can take off at one stage. As a result, the development budget plays a crucial role to help the economy graduate to the next stage of prosperity. And hence it is central for fiscal policy to pay for development of the nation. Spending on power and infrastructure transforms a nation rapidly – a case Bangladesh has already begun to evidence.
Fiscal policy is committed to hitting the growth target of 7.2 percent for FY2017 – a target equivalent of Taka 42 when the total budget is of Taka 100. Apparently it looks like a gigantically powerful budget that generates 42 percent growth. Of course, a few growth generating nations are capable of maintaining this high ratio, but that is not how growth should be attributed to the sole credit of fiscal policy. Herein comes the role of monetary policy and other sectors of the economy that jointly contribute to achieving this growth. The domestic credit that monetary policy manages is almost the half of the GDP whereas the budget is roughly the one sixth.
A rise in current spending is likely to raise growth via consumption and output, but huge unproductive current spending may reduce growth via higher inflation and lower consumption. The impact of deficits on growth is ambiguous and so is that of debts on growth. A high level of deficits, however, will risk the economy and weaken its future growth apparatus. High revenue through high taxes may reduce private consumption and thus hurt growth. But if the development spending is high enough to compensate that loss, growth may eventually go up. This series of complicated relationships among different corners of the pentagon makes the engineering of fiscal policy a difficult task for the government.
The writer is visiting fellow at Bangladesh Institute of Development Studies (BIDS) and guest faculty at the Institute of Business Administration (IBA), University of Dhaka.
Email: birupakshapaul@gmail.com