Nepal has been facing a budget deficit for years. In 2017, it reached 6.40 percent of the gross domestic product, and is likely to increase as the country has adopted a federal system with a resultant increase in the number of local units. As far as the economic aspect of the budget deficit is concerned, it depends on when it occurs.

According to Keynesian economics, a rise in the budget deficit during a recession is a good thing. During a recession, deficit spending offsets a fall in private sector spending and stimulates economic activities. In this situation, austerity is self-defeating. However, a budget deficit during a boom period will be crowding out the private sector. Similarly, it is also important to analyse whether the deficit is based on recurrent or capital expenditure. All other things being equal, if the government deficit is capital expenditure based, it might improve the productive capacity of the economy.

Nepal’s budget deficit is due to an outrageous recurrent expenditure which makes up more than 60 percent of total government spending. In contrast, capital expenditure remains below 20 percent. This shows that the budget deficit is not growth-friendly and needs to be reduced. Finance Minister Yuvaraj Khatiwada has made it public that his ministry is all set to introduce austerity measures to balance government revenue and expenditure. However, considering the current economic condition in Nepal, the government has to be very cautious about using austerity measures to correct the budget deficit. Using austerity measures when the country is facing a downturn in economic activities and private sector investment may have a vicious effect on the economy.

Double whammy

Khatiwada has announced that austerity measures will be limited to unnecessary government spending, and he has also given an indication that federal taxes might be revised in the fiscal policy for 2018-19. In the short run, the budget deficit can be reduced by increasing tax revenue and decreasing government expenditure. However, in the long run, as any economics textbook will tell you that, other things being equal, cutting government spending will cause the economy’s overall output to fall, and that an increment in taxes will lead to a reduction in private sector investment. Failure to replace a fall in private sector spending may further stagnate the economy.

Similarly, it is also important to note that austerity measures are generally used when the government’s public debt is so large that the risk of default becomes a real possibility. However, according to the International Monetary Fund (IMF), Nepal’s risk of debt distress remains low. It has been decreasing over the years, from 44.3 percent of the GDP in 2008 to 26.8 percent of the GDP in 2017. Therefore, it is essential to analyse whether austerity measures are a current necessity for the Nepali economy.

All about timing

The argument is not whether austerity measures help to reduce the budget deficit. Of course, they do. However, the issue is whether this is the right time to cut spending. As far as the current announcement is concerned, using austerity measures to reduce unnecessary government expenditure seems rational. However, the problem is that slashing unnecessary spending is not enough to reduce the current deficit. This indicates that if austerity measures are the major tool that the government is considering to reduce the deficit, there is going to be a significant reduction in government spending and rise in taxes.

It is also important to note that Nepal is a country of small businesses rather than large corporations, so they benefit less from austerity measures like lower interest rates. These small firms do not even have the ability to reap the benefits of a weakened currency. Therefore, reducing government spending and increasing taxes may not be a good solution in Nepal’s current economic environment.

The fiscal policy for 2018-19 should not be contractionary in any way, and the government needs to find other ways to reduce the recurrent fiscal deficit instead of experimenting with austerity measures. The government should properly study tax elasticity in private sector investment. Accordingly, the government should increase tax revenue not by revising tax policies but by revising investment policies in order to reduce the budget deficit.

Therefore, the only way to bring down the Nepali government’s deficit in a sustainable manner, and put the country’s finances on a firmer footing, is to keep the economy growing by stimulating economic activities, private sector investment and capital expenditure. Nepal has long been struggling to increase aggregate demand, and if government spending is reduced, it will further erode the country’s productivity. Spending cuts and tax increases can also play a role, but they need to be introduced gradually.

- Bist and Joshi are MBA graduates from Pokhara University