How the Budget can help curb rising inflation

The 2008-09 global financial crisis led to severe economic contraction - actual decline in GDP - in several advanced economies.

In the UK, for example, the medium-term GDP trend shifted downwards for some years to come. This shift was accompanied by a decline in revenue/GDP and a rise in expenditure/GDP ratios reflecting unemployment benefits.

The revival of economic activity was anchored on quantitative easing which did not work fast enough since the injected finance froze as the money multiplier collapsed. Focus turned to fiscal support through tax reductions and further current expenditure enhancements. The already rising fiscal deficit/GDP was further exacerbated.

Public debt/GDP in some countries doubled. Stock market and rating agencies did not appreciate what the country indicators were showing and strategies had to be reformulated.

Strategies were refocused on fiscal consolidation and debates ensued on its pace and content. Elections were won and lost on this issue.

Indeed, at Brookings, Alesina, Perotti and Tavares in 1998 had found fiscal rectitude to be rewarded by voters. The UK proved a case in point: Labour departed and a Conservative-Liberal coalition entered in May 2010. The latter's more austere fiscal positioning won the voters' confidence.

Later at NBER Harvard, Alesina and Ardagna in 2009 also found that fiscal adjustments mostly on the spending side have a better chance of not creating large recessions on impact.

Mid-year, post-election UK opted for this route. The pre-election Labour Budget (March) and post-election Conservative-Liberal Budget (June) viewed corrective policies quite differently.

Figure 1 illustrates the additional tightening. The final calibration expressed in the coalition's Spending Review (October) that anchored a five-year austerity programme further recomposed expenditure in favour of investment over consumption. It cut back untargeted direct consumption subsidies and reduced the length and pattern of unemployment coverage.

Table 1 presents published figures on how the tightening - tax increase and expenditure reduction - was broken down in March, June and October. Only 2014-15, the last projection year, is selected for illustrative purposes, revealing a significantly tighter stance of the new government in nominal terms (Row 8). The coalition, in two (June and October) steps: (1) increased taxes more; (2) maintained investment spending; (3) scaled back current spending considerably; and (4) within current spending, cut back benefits (direct subsidies) much more than public services (mainly National Health Service (NHS), the universal health coverage for which the UK is well known).

Thus, tax increase shot up between March and June Budgets (Row 1) while expenditure reduction was more severe than tax increase (Row 2). Cut in investment spending was a bit deeper in June than March but the cut was pulled back and investment spending was restored in October (Row 3).

The severe cutback instead came from current spending. The cutback almost doubled between the two governments (Row 4). Interestingly, direct benefits (targeted and untargeted consumption subsidies and work incentives) had been protected in the March Budget; but they were reduced considerably in June by the incoming government - even more than their tax increase - and the benefits cutback was further increased in October (Row 6).

The reduction in expenditure on public services, the other major head of current spending - the significant component being the NHS - was also deeper between March and June. But in a reversal, the cutback was partially reduced between June and October.

In sum, the new government reallocated the cuts within current spending between June and October, making them deeper for direct subsidies and less so for the NHS. Thus the right combination of cutbacks emerged between: (1) tax and expenditure, (2) between investment and current spending, and (3) between pure consumption and service-oriented current spending.

The new mix relied more on spending cuts than tax increase (Rows 9 and 10). Also, the deeper fiscal correction implied that public debt/GDP improved faster by almost 5 percentage points (Row 11).

Most importantly, the much deeper nominal fiscal correction will be achieved with a lower economic growth - and, therefore, income path - that is more realistic than the pre-election projections.

Table 2 explains some basic macroeconomic projections between March, June and October. First is the considerable reduction in the trajectory of GDP growth between March and June Budgets, bringing the series closer to the average of independent projectors.

The October Review made small differences to those projections. Second, projections of public sector net borrowing/GDP also declined from March to June through October.

Third, a comparable change occurred in the cyclically adjusted current fiscal account surplus. The March figures had projected a deficit even for 2014. The subsequent tightening produced a small surplus in June figures for 2014, and a higher one in October.

Fourth, translated into net public debt, the increase in the series in terms of GDP became less pronounced between March and June Budgets, and further so in October.

Thus, the incoming UK government undertook difficult fiscal measures in 2010 on both the revenue and expenditure fronts. These corrections were higher in nominal terms compared to the pre-election measures.

And, since GDP projections were scaled down post-election, the measures represent tighter belt-tightening. This fiscal stance moved with academic empirical findings and won the regard of multilateral institutions.

A challenge appeared much later when the inheritors of an almost doubled public debt/GDP were also informed that they would face an almost threefold increase in their university tuition fees.

Clearly, the UK opted for a consolidated fiscal stance. India's forthcoming Budget should use fiscal policy to curb inflation. The components would be quite similar.

The views expressed are exclusively the author's