Covid-19: Getting fiscal policy right

  • Blog Post Date 07 May, 2020
  • Perspectives
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The textbook answer to financing of additional government expenditure in a recession is that the government should borrow the funds rather than impose a tax. Gurbachan Singh argues that the conventional wisdom applies to a normal economy in recession, but not to an economy that is in recession due to lockdown. He explains that the Government of India need not incur additional fiscal deficit to provide an additional relief package; it can instead impose direct taxes without making a significant dent into the aggregate demand.


On 27 March 2020, the Government of India (GOI) announced a relief package of Rs. 1.7 trillion to deal with the Covid-19 crisis. Many commentators have observed that this package is woefully inadequate. Why was this small? This is possibly because of a worry about incurring large fiscal deficits, which may be problematic at some stage later on, if not now. In this post, I will show how we can deal with this issue of financing.1

The analytical framework

This section draws its inspiration from the two-sector models in Rakshit (1982). We have a lockdown in India at present. There are differences across states in India, but it will help for analytical purposes to simplify. Under the lockdown, the functional part of the economy produces, what have been viewed as, the essential goods and services (hereafter, essentials). At present, the closed or non-functional part of the economy produces, what may be called non-essentials (this includes not just 'luxuries' but also much of what is involved in economic activities such as capital formation).

Currently, production and supplies of non-essentials are anyway restricted, if not completely banned. So, it hardly matters whether there is adequate demand for those goods and services! It follows then that the GOI need only worry about maintaining demand for goods and services from the remaining part of the economy, which is not closed.

It is interesting that the demand for essentials will remain intact insofar as the demand by the rich and the "upper-middle class" is concerned. The reason is simple. These people have funds, or access to funds, to be able to buy – more so when we are considering demand for essentials only. So, from the viewpoint of maximising output and employment under the circumstances of a lockdown, our focus needs to be on maintaining demand by only the poor and the lower-middle class.

Within the category of the poor and the lower-middle class, let us consider two groups. One group works in the sector that produces essentials. Another group (used to) work in the sector, which produces non-essentials but is in lockdown currently.

Note that the poor and the lower-middle class who are engaged in the sector that produces essentials are by and large still earning their livelihood, and so their demand for goods and services is more or less intact (more on this later). We are now left with the poor and the middle class who (used to) work in the sector that is under lockdown. Their incomes have fallen. Accordingly, their demand for goods and services has got adversely affected.

It follows now that under the circumstances of a lockdown, the GOI needs to, in principle, maintain: (a) the demand for essentials only, and (b) the demand by the poor and the lower-middle class that (used to) work in the sector producing non-essentials.

Size of the fiscal boost, given the lockdown

It is clear now that the scale of the Keynesian fiscal policy required in a downturn due to the lockdown, is smaller than in the case of a normal economy that is not facing a lockdown. In such an economy, policymakers have to worry about maintaining demand for almost the entire spectrum of goods and maintaining demand by all the poor and the middle-class people.

If a relatively small size of the fiscal stimulus sounds counterintuitive in the context of a serious recession in the economy, one need only remember that the economic downturn at present is basically not a demand-side issue anyway. It is primarily a supply-side issue, given the lockdown. I should not be misunderstood. I am not saying that the economy is facing a supply-side problem in the (usual) sense that we need long-term structural reforms to increase productivity and raise growth rate of GDP (gross domestic product). Instead, we are facing a supply-side problem in the (unusual) sense that we have a lockdown in the economy.

Even though the size of the fiscal stimulus required is smaller than in the case of a normal economy in recession, there are reasons to believe that the announced package of Rs. 1.7 trillion is inadequate even relative to this requirement (see, for example, Khera 2020). So, there does remain a need for an additional relief package; the GOI needs to give money to the vulnerable sections of the society.

If the GOI provides adequate relief to the poor and the middle class in the sector that produces non-essentials, it will help maintain their demand for essentials. Given that the demand for essentials is maintained, and at least this sector operates at close to maximum employment – if not full employment – it may be reasonable to say that the essentials sector can be independent in the sense that the GOI, under the circumstances, need not worry much about a relief package for people in that sector, from the viewpoint of maintaining livelihoods (medical care is another matter).

The next and the more important question is how additional government expenditure should be financed. This is where we have a more interesting story. And the analytical framework above will help understand the issues better.

Financing the fiscal boost

The textbook answer to financing of (additional) government expenditure in a recession is that the government should borrow the funds rather than impose a tax (Blanchard and Johnson 2013). The reason is simple. If it taxes and spends, then a part of the positive effect of additional expenditure on the economy is negated (taxes reduce purchasing power in the private sector). In contrast, if the government expenditure is financed by borrowing and not by taxes, then such negation is much less, if not zero. So, it is better for the government to borrow more rather than tax more under the circumstances. This conventional wisdom is indeed correct, but it applies to a normal economy in recession. It does not apply to an economy that is in recession due to lockdown. Why?

Note that the rich and the upper-middle class cannot spend on non-essentials anyway, given the lockdown. So, if they are required to pay additional tax, this tax will not lead to a leakage in spending, that is, it will not affect the aggregate demand in the economy under the circumstances. This is unlike what can happen in a normal economy, which is in recession but not under a lockdown. In that, the whole rationale for financing the expenditure by borrowing rather than through taxes, is to avoid or reduce the leakage in demand due to the taxation. But that does not apply in the prevailing situation. So, the GOI need not incur a fiscal deficit in order to provide a fiscal boost. It can instead do so by (direct) taxes on the rich and the upper-middle class.2 This obviates the need to incur additional fiscal deficit. It follows now that the issue of possible adverse effects of large fiscal deficits is not quite relevant in the present situation.

The conclusion here that the additional government borrowing can be financed by additional (direct) taxes is consistent with some of the recommendations made in FORCE (2020). However, there is an important difference. That report considers additional taxation as a way of mobilising revenues for the GOI, and as a way of reducing economic inequalities. This post goes further by showing that the additional tax will not make any significant dent into aggregate demand in the economy, given the lockdown situation.

Many commentators have suggested that if the GOI incurs additional fiscal deficit in the current crisis situation, then that can be monetised. Whether or not a fiscal deficit should be monetised remains a debatable issue (see, for example, this interview of C. Rangarajan, Subbarao 2020). However, note that this column has shown that in any case there is no need for an additional fiscal deficit in order to provide an additional relief package. So, the question of monetising the fiscal deficit does not arise.


  1. In my previous I4I post, I had shown how a fraction of 'excess' foreign exchange reserves can be used in the fight against Covid-19.
  2. It is true that some of the rich and the upper-middle class people may be facing liquidity issues, given the lockdown. However, they are in a position to borrow – more so when the banks are sitting on a huge amount of cash reserves (beyond what is required under the cash reserve ratio (CRR) regulation) to the extent of more than Rs. 7 trillion (though this may require a change in the regulations regarding personal loans).

Further Reading


By: Gurbachan Singh

Thank you for your comments, Arijit. Yes, you are right in what you stated though I would use different wording, approach and emphasis but that's more a matter of detail. What you said in essence is absolutely fine. I did read your article in Economic Times, and I really liked it. Stay safe, Gurbachan

By: Arijit Sen

Hi Gurbachan, This is Arijit from IIM Calcutta. I read your article with interest, and want to check with you whether I have gotten the basic argument right. Common sense suggests that the pandemic-generated recession will lead to the following changes in people’s demands: [1] For the affluent, demand for necessities will be sustained, while demand for non-necessities will be curtailed/postponed; while for the poor, there will be demand reduction across the board. [2] Some wealth transfer from the affluent to the poor is unlikely to change the demand levels of the affluent, while it will likely raise only the demand for necessities by the poor. (I have discussed these demand composition issues in a May 2 Economic Times article.) Then from the supply side, given that it is prudent to reopen the economy in stages, it makes sense to open the supply chains of the necessities in the near-term, and worry about re-starting the supply chains of all other goods in the medium- to long term. [It makes little sense for the Daryagunj book-sellers to open when there is little demand for books (see the 7 May Print report on this); it might only raise the probability of disease spread among these book-sellers.] Given these demand-supply considerations, the following argument seems logical: Imposing one-time taxation on the affluent – e.g., a cess – will not reduce their necessity demand, while transferring the tax receipts to the poor will increase their necessity demand. In the short term, this redistributive taxation will indeed increase the demand for precisely those kinds of goods whose demands are influenceable in the near-term. So, it makes economic sense (if not political sense!) to use this kind of fiscal policy intervention in the near-term, and postpone the strategy of “borrowing from the future” to a later date, when the planner's objective will change to increasing overall demand. Have I gotten the argument more-or-less right? Thanks, Arijit

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