Fiscal Consolidation in India

Himanshu Deshmukh, Kamalakar Chaudhari, Yogesh Powar, Anand Parhar and Arun Shejwal April 3, 2006

Contents
1 Introduction 1.1 Fiscal System . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Background To Fiscal Consolidation 2.1 Fiscal Balances . . . . . . . . . . . . 2.1.1 Defecit . . . . . . . . . . . . . 2.1.2 Domestic Debt . . . . . . . . 2.2 Receipts and Expenditure . . . . . . 2.2.1 Receipts . . . . . . . . . . . . 2.2.2 Expenditure . . . . . . . . . . 2.3 Overview of Reforms . . . . . . . . . 2.4 Outcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 3 5 5 5 6 6 6 7 7 8

3 Fiscal Consolidation - Reforms and Trends 3.1 Fiscal Sector Reforms . . . . . . . . . . . . . . . . . . . . . . 3.1.1 Tax Reforms . . . . . . . . . . . . . . . . . . . . . . . 3.1.2 Disinvestment/ Privatization/ Public Sector restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.3 Systemic reforms in Governments borrowing process 3.1.4 Expenditure Reforms Commission . . . . . . . . . . . 3.1.5 Fiscal Reforms Program for the States . . . . . . . . 3.1.6 Project Management Unit (PMU) for Externally Aided Projects . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.7 RBI initiatives on Reforms in State Finances . . . . . 3.1.8 Fiscal Responsibility Act . . . . . . . . . . . . . . . . 3.2 Recent Trends in Government Finances . . . . . . . . . . . . 3.2.1 Trends in Budgetary Balances . . . . . . . . . . . . . 3.2.2 Trends in Revenue Account Receipts . . . . . . . . . 3.2.3 Trends in Non Tax Revenue . . . . . . . . . . . . . . 3.2.4 Trends in Budget Expenditure . . . . . . . . . . . . . 1

9 . 9 . 11 . . . . . . . . . . . . 11 12 13 13 14 14 15 15 15 16 17 17

3.3 Fiscal Decit . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 3.3.1 Comparison between 80s and 90s . . . . . . . . . . . . 19 3.3.2 Observations . . . . . . . . . . . . . . . . . . . . . . . 20

Chapter 1 Introduction
Before going on to the main discussion on scal consolidation of Indian Economy, we will introduce the readers to the Fiscal system and scal policy to be followed by overview of reforms and scal consolidation in the next chapter.

1.1

Fiscal System

Fiscal system refers to the mechanism through which nancial resources for the government and its agencies are obtained, or raised, and the scale and pattern of allocation of such resources is determined. In the Indian scal system, the budgetary resources and expenditures are determined through the annual budget of the Central Government and the State Governments. The ve yeUntitled 1arly as well as annual resources and expenditure for development plans of the public sector as a whole are determined by the Planning Commission. Before discussing the scal sector reforms, consolidation and trends in the subsequent chapter, an introduction to important features of the Indian scal system in this chapter may be found of use. We will discuss various terms related to scal and budget thorugh and example. A lot of people use terms like decit and debt very loosely without really knowing exactly what they mean. Government Expenditure is divided into Plan and Non-Plan expenditure. And non-plan does not mean that the expenditure is unplanned. Plan in this context indicates what is covered in the Five-Year Plan. Non-Plan expenditure covers defence expenditure, interest payments and subsidies and grants to states. It can be divided into revenue account and capital account - that is, simply, expenditure that gets consumed and one that creates some productive assets. Defence personnel salaries, interest payments and subsidies would come under Non-Plan revenue 1

expenditure. Just to get an idea of the quantum of the numbers involved, year (2001-2002) Budget put the total Non-Plan expenditure at Rs 2,751 billion. The total central Plan outlay last year was Rs 951 billion. This includes Plan assistance to states and union territories. Plan expenditure can again be split into revenue and capital components. Needless to say, a majority of the money is spent on revenue expenditure, i.e. salaries, overheads and other stu, which does very little for the development of the economy. The central government funds its expenditure mainly through taxes - income tax, corporate tax, excise and custom duties.Its non-tax revenue come from interest received and surpluses of PSUs, nancial institutions and other departmental undertakings like the railways, Post, etc. Recoveries of loans from states (and others) and the government borrowings make up the capital receipts of the government. The total receipts and expenditure rarely match. The discrepancy between the two is the budget decit (surplus ?) . Moreover, every year the government exceeds its own estimates of decits, and has to borrow to meet the shortfall. In calculating the scal decit, government borrowings are not included on the revenue side of the budget. It is therefore the cash by which the government is short to cover the proposed expenditure. The target for scal decit is set as a percentage of GDP. Also, most of the revenue numbers depend on the GDP growth. This has made things very awkward for the government this year as GDP growth is likely to be less than 5%, while the projected rate was 6.5%. Hence, against the target decit of 4.7% of GDP, the actual decit might well exceed last years 5.1%. Primary decit also called non-interest decit and is the scal decit without taking into account the interest payments. Revenue decit, the dierence between the revenue receipts and revenue expenditure is the cause of much aggravation as it indicates the extent to which capital receipts are being used by the government to nance consumption expenditure - a situation that is clearly not viable or desirable in the long run. Drawing a a layman analogy, its like taking a loan for feeding the village at your daughters wedding. The loan has to be repaid, but no additional productive assets have been created with which to repay. So what does the government do to make good the budget decit? It builds up its liabilities - internal debt, external debt and other liabilities. Other liabilities are mainly debt held by common folk like you and me in the form of PPF, small saving schemes, etc. Rising liabilities of the government should get us all agitated because these need to be serviced in future - and 2

you, me or our children will ultimately have to pay the bill! If the government decit is nanced by the RBI holding more government securities (RBI prints more money) there is the ever looming fear of ination. The other option is market borrowing, which leads to more expensive debt for the government and also tends to crowd out private borrowing and investment, thus aecting the growth rate. The governments existing liabilities tell a sorry tale. The governments books at the end of the nancial year ending Mar 2002 will certainly did not make a pretty picture. The scal decit (as a proportion of GDP) is most certainly higher than expected. Tax collections have been poor and the divestment target of Rs 120 billion will not be met. The need for infrastructure investment is becoming more vital every year. The government cannot raise too much money from the market as this is hampering economic growth. However, since ination is low, the government might just decide to spend, and monetise the decit. The budget snapshot is given at appendix A to highlight the term explained above.

1.2

Fiscal Policy

Fiscal policy is the instrument by which a government adjusts its levels of spending in order to monitor and inuence a nations economy. It is the sister strategy to monetary policy, with which a RBI inuences a nations money supply. These two policies are used in various combinations in an eort to direct a countrys economic goals. Here we take a look at how scal policy works, how it must be monitored and how its implementation may aect dierent people in an economy. This theory basically states that governments can inuence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This inuence, in turn, curbs ination (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money. The idea, however, is to nd a balance in exercising these inuences. For example, stimulating a stagnant economy runs the risk of rising ination. This is because an increase in the supply of money followed by an increase in consumer demand can result in a decrease in the value of money - meaning that it will take more money to buy something that has not changed in 3

value. Lets say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making any money. A government thus decides to fuel the economys engine by decreasing taxation, giving consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. In the meantime, overall unemployment levels will fall. With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This in turn rekindles businesses and turns the cycle around from stagnant to active. If, however, there are no reins on this process, the increase in economic productivity can cross over a very ne line and lead to too much money in the market. This excess in supply decreases the value of money, while pushing up prices (because of the increase in demand for consumer products). Hence, ination occurs. For this reason, ne tuning the economy through scal policy alone can be a dicult, if not improbable, means to reach economic goals. If not closely monitored, the line between an economy that is productive and one that is infected by ination can be easily blurred. When ination is too strong, the economy may need a slow down. In such a situation, a government can use scal policy to increase taxes in order to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative eects of such a policy in the long run could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its scal policy to ne tune spending and taxation levels, with the goal of evening out the business cycles.

Chapter 2 Background To Fiscal Consolidation

Of late now, Indian economy has been in the spotlight. It has been among the fastest growing economies during the last two decades. Wide ranging economic reforms have taken place. It has undergone a signicant structural transformation. The economy is more resilient, less vulnerable to external shocks and has opened up for more potentials. But the attention on the economy is also because it has crossed one billion mark in population and almost a third of the population remains below a modestly dened poverty level. The debate on perspectives for the Indian economy is continuing. A second wave of reforms is already underway. This chapter highlights macro scal trends of the Indian economy with an overview of recent economic reforms.

2.1
2.1.1

Fiscal Balances
Defecit

Central governments scal decit for the year 1999-2000 was 5.64 per cent of GDP. State governments scal decit budgeted for 1999-2000 was at its historic high at 4.71 per cent of GDP. The combined scal decit of the government was 9.84 per cent of GDP in 1999-2000 which is only marginally lower than the level in 1990-91 (10.0 per cent) which was a crisis year. In the rst two years after 1990-91 scal corrections were visible through reduction in decits. Historically, there was a consistent trend of increase both in revenue decit and scal decit in the Central government budgets after 1970s. State governments were in revenue surplus even during the rst half

of eighties.

2.1.2

Domestic Debt

Sustainability of debt has been a major issue in analysing the trends in government nances. The nominal stock of domestic debt of the combined Government sector has been growing at a rate of about 16 per cent during the later part of the 1990s reaching to 60.7 per cent of GDP at end-March 2000 as against 55.5 per cent at end March 1999 and 56.12 per cent at end March 1991. Central governments debt as per cent of GDP was about 53 per cent at end 1999-2000 almost the same level as in 1990-91. State governments Debt GDP ratio for State governments at 21.50 per cent in 1999-2000 was about a percentage point higher than the level at end 1990-91. Historically, there was a sharp increase in the Central governments debt from about (on average) 31 per cent of GDP, in seventies to about 50 per cent during the second half of eighties. State governments debt had not increased signicantly during the similar period. Appendix B shows the scal trends in Decit and Debt in last two decades.

2.2
2.2.1

Receipts and Expenditure

Receipts

Central governments gross tax revenue/GDP ratio has fallen by almost 2 percentage points to 8.80 per cent in 1999-2000 from 10.75 per cent in 199091. States own tax revenue/GDP ratio however, has not fallen signicantly during the same period. Historically tax/GDP ratio both for the Central govt. and for the State Governments had shown about 2 percentage point increase from the rst half of seventies to the second half of eighties. Central governments revenue receipts (net of tax share to States) including tax+non tax revenue at 9.29 per cent of GDP in 1999-2000(RE) was lower by about one percentage point compared to 1990-91 (the crisis year).States revenue receipts including share in Central taxes and grants and nontax revenue as per cent of GDP in 1999-2000 was lower at 10.86 per cent by almost two percentage points from the average of rst half of nineties (1991- 92 to 199596) and even from the average of such ratio in the second half of eighties.

2.2.2

Expenditure

Central governments revenue expenditure as per cent of GDP was 13.10 per cent in 1999-2000. This had shown an increase over the previous 3 years but was lower by about 0.6 percentage points when compared to the rst half of nineties and even during second half of eighties when, on average, it was about 13.70 per cent. This level was at its historic high since early seventies. State governments revenue expenditure (BE) was 13.82 per cent of GDP in 1999-2000. Though it was 1.5 percentage points higher over the previous three years, the level was higher only by about 0.5 percentage point when compared to early nineties or even during second half of eighties when it was 13.16 per cent. This level was at its historic high since early seventies. Appendix C shows the scal trends in Receipts and Expenditure in last two decades.

2.3

Overview of Reforms

It is by now almost a two since the process of wide ranging economic reforms was initiated in 1991. Faced with a balance of payments and scal crisis, it was well recognized that the relatively higher growth trend during 1980s was not sustainable with the over dominance of public sector, widespread protective system for dierent sectors of the economy and most complicated regulatory mechanisms. A process of stabilization and structural adjustment was, therefore, initiated since July 1991. Wide ranging policy changes and reform measures were taken up. This has been a continuing process. In the area of scal policy, the following changes in the system were proposed. (i) Streamlining and rationalizing the levels, structure, and procedures of the tax system. (ii) Changes in the nancing pattern of the scal decits through borrowings at market rates and reduced dependence on the system of monetising the decits. (iii) Changes in expenditure pattern through reduced transfer payments on services, subsidies, budget support to public sector entities, etc.

2.4

Outcome

Fiscal reforms were the integral and perhaps the most critical part of the overall economic reforms program. The scal consolidation measures taken immediately after the crisis situation yielded signicantly positive results in terms of reduction in scal decit, control in expenditure and marked changes in the scal system particularly in the nancing pattern of the decits through reduction in magnetization. However, the continued structural imbalances in terms of falling tax buoyancy, nature of scal correction in terms of reduction in investment expenditure, increased interest burden owing to borrowings at market related rates, impact of enhanced salary of government employees, compulsions of increased defense expenditure etc. were some of the major factors which reversed the situation such that at the end of the decade the combined scal decit of Centre and States was almost at the same level as was at the beginning of reform measures. The emerging situation has led economist to suggest that the second generation of reforms should constitute a program of action aimed at preventing another major economic crisis and should stimulate rapid economic growth in the country during the new century. In fact, in the strategy outlined by the Finance Minister in his budget speech in Feb, 2000, declaring the next 10 years as Indias decade of development one of the elements is to establish a credible framework of scal discipline. Many economist in their surveys have even warned that unless substantial scal consolidation is achieved continued scal decits pose Indias greatest risk to future destabilization. In the following chapter we will deliberate over the reforms and trends in the area of scal consolidation for a decade of nineties.

Chapter 3 Fiscal Consolidation - Reforms and Trends

3.1 Fiscal Sector Reforms

Fiscal sector reforms were perhaps the most critical part of the reforms initiatives taken by the government after the 1991 economic crisis. Not withstanding the initial scal adjustment measures for correcting the scal imbalances immediately after the crisis and the subsequent scal reforms, a high level of decits in the government budgets particularly during the second half of 1990s, continue to hound the growth impulses for the economy. The level of scal decit combined both for the Central government and State governments was more or less at the same level at the end of nineties as it was at the beginning. Government debt was approaching a critical mark beyond which it could be labeled as unsustainable. Almost all the state governments are facing hard budget constrain in providing even the basic minimum services through budget. Capital expenditure through budget has come down sharply. Public sector saving has hit the bottom, it being almost negligible. Any review or assessment of scal sector consolidation should be seen in the backdrop of certain operational features of the Indian scal system which have resulted in a slow and less satisfactory outcome. The scal issues are complex at the rst place and at the same time they are inter linked with all other macro variables and democratic/political issues as described below. Complexity and inter-linking. Tax rationalization process particularly for indirect taxes was not complex but also inter-linked to reform measures to be taken in other sectors like foreign trade policy, industrial policy,

opening of the economy for foreign investment, nancial sector reforms etc. The scal reform measures thus need be sequenced, aligned and restructured alongwith the reforms in all other sectors. Administrative structure. The deeply entrenched complex and rigid tax administrative structure has to change with modern practices and even with psychology and spirit of reforms. Even the tax payers lobbies could have interest in continuing with the same structure of discretionary concessions and ad hoc benets. Rigidities of expenditure pattern. The allocation of budgetary expenditure in terms of contractual and obligatory payments like interest payments, pensions, defence, transfers to states, etc. have been growing in such a proportion that there has been very little scope of any sharp change in the allocation pattern of expenditure in a short period. Democratic limitations. It is now well known that there remain certain basic issues which no elected government would prefer to even raise. Taxing agricultural income, sharp reduction of food subsidy, sharp downsizing of government sta etc. are some such issues which no government has been able to face head on, howsoever, critical these may be for correcting scal imbalances. Political uncertainties. Political uncertainties particularly during the second half of the nineties was an important factor for delays in implementation of reforms-so speedily required in a well structured sequence. Late start of State level reforms. It actually took long to realize, formulate and initiate scal consolidation reforms at state government levels despite the need for a well synchronized mechanism for reforms. Given the wide range of scal sector reforms, particularly at micro level, interms of changes in tax reforms and expenditure management, it is well beyond the scope of this project to list out all the measures taken during the last decade or so. An attempt, therefore, has been made in this part of the chapter to highlight the major areas of reforms strictly conned to scal consolidation at macro level.

10

3.1.1

Tax Reforms

Tax reforms during ninties have been mainly guided by the report of the Chelliah Committee on tax reform (1993). The main objectives have been simplication of the tax system, rationalization of tax rates, fairness in tax system, improvement in tax administration and above all providing a growth promoting tax structure. The wide range of reform measures taken during the last decade include - in the case of direct taxes: moderation of tax rates, widening of tax base, incentives for development of infrastructure and housing and strengthening of enforcement, and - in the case of indirect taxes: reduction in multiplicity of rates, rationalization of the rate structure, drastic reduction in the scope for discretionary changes and uniform oor rates for sales tax by the States, introduction of VAT. Further, rationalization and improvements in tax administration, of course, is a continuing process. An assessment of tax reform measures in India done by World Bankin Jan, 2000 has shown signicant improvements in tax structure in terms of revenue predictability (actual/budget ratio), administrative eectiveness etc. but deterioration in revenue adequacy (tax buoyancy) and revenue stability.

3.1.2

Disinvestment/ Privatization/ Public Sector restructuring

The strategy towards public sector enterprises reform encompasses a mix of strengthening strategic units, privatizing non strategic ones through gradual disinvestment or strategic sale and devising viable rehabilitation strategies for weak units. The policy announced in the budget speech 2000-2001 by the Finance Minister had the following as main elements: Restructure and revive potentially viable PSUs Close down PSUs which cannot be revived Bring down Government equity in all non-strategic PSUs to 26 percent or lower, if necessary Fully protect the interests of workers. Financial restructuring of many PSUs has been approved by the Government. As a result, many PSUs have been able to restructure their operations, improve productivity and achieve a turnaround in performance. Even so, a large number of procedural as well as policy issues continue to constrain the 11

progress on disinvestment process. Various scal reform measures relating to Central Public Enterprises (CPEs) undertaken by the Central government have shown some noticeable improvements in the nances of these enterprises during the decade (1990s). In particular, it needs to be noted that budget support (plan+non-plan) to CPEs as a per cent of GDP has come down to only 0.5 per cent in 1998-99 from 1.5 per cent in 1990-91 and CPEs decit GDP ratio has come down to 1.3 per cent in 1998-99 from 3.0 per cent in 1990-91. Moreover, protability trends have shown a distinct improvement. The prot after tax, as per cent of net worth, for CPEs, had increased to 10.4 per cent in 1997-98 from 3.9 per cent in 1990-91.

3.1.3

Systemic reforms in Governments borrowing process

The signicant changes in the process of central government borrowings to meet the budgetary decits and temporary mismatches have been part of the scal consolidation. Switchover to borrowings by government at market related interest rates, abolition of the system of automatic monetization of the budget decit, implementing a new system of ways and means advances, and developing as well as deepening government securities market have changed the whole system of nancing the budgetary decit and its relation with monetary policy stance. Notwithstanding the fact that greater reliance on market borrowings and bond nance (BF) and that too at market related rates rather than less borrowing along with monetization route, has led to an excessive debt burden for the government, empirical testing in a recent research study has shown that move to market borrowings has been benecial as : There is no evidence of a systematic shift to an unstable debt regime during the 1990s Reduction in monetization has helped curb the scal decit by inducing a fall in primary expenditures larger than the rise in interest payments. The decline in private sector interest rates due to the move to market borrowing indicates that overall costs of private borrowings are likely to have declined. There has been a surge in private investment relative to public investment.

12

Nevertheless, the study points out that Central and State government nances are in precarious condition due to large non-market debt, unfounded liabilities and contingent liabilities.

3.1.4

Expenditure Reforms Commission

To carry the process of reducing the growth in non-developmental expenditure, the government has set up an Expenditure Reforms Commission in 2000. The main terms of reference for the Commission are as follows To suggest a road map for reducing the functions, activities and administrative structure of the Central Government. To review the framework of all subsidies, both explicit and implicit for maximizing their impact on the target population and minimize cost. To review the framework for determination of user charges of Departmental and Commercial activities : suggest an eective strategy for cost recovery. To review the adequacy of stang under Central government Ministries, attached oces etc. To review the procedure for setting up of government funded autonomous institutions. To consider any other relevant issue concerning expenditure management in government and make suitable recommendation.

3.1.5

Fiscal Reforms Program for the States

Several State governments have faced acute nancialproblems due to various structural rigidities as well as ad hoc compulsions including steep pay hikes to their employees. Specic time bound scal reform programs have, therefore, been discussed in the National Development Council (represented by the Chief Ministers of States) and with the Finance Minister. It was felt that joint eort on the part of the Centre as well as Sates is required to devise a medium term strategy for scal reform programs in the States. This strategy has taken the form of a package of advance nancial assistance to be provided by the Centre to the States for an appropriate time bound reform program by signing a Memorandum of Understanding (MOU). The main objective of the program is to wipe out the revenue decit in the State budget in the medium term. The program components are: 13

 Reduction in Non Plan Revenue Expenditure Pricing/subsidy reforms Institutional reforms Reduction in the role of Government in nonessential areas, through decentralization, disinvestment and privatization

3.1.6

Project Management Unit (PMU) for Externally Aided Projects

A mechanism of monitoring the externally assisted projects has been evolved in the form of a Project Management Unit (PMU) in Department of Economic Aairs. The PMU in close coordination with the Controller Aid Accounts and Audit, Planning Commission and State governments performs the following tasks: The Eective monitoring of implementation of EAPs. Regular review of disbursements to States. Strengthening of procurement procedures. Release of advance assistance. Coordination between Budget, Planning Commission, External Finance Division and CAA&A. Conducting regular training programs.

3.1.7

RBI initiatives on Reforms in State Finances

In response to the emerging new balances, it has been recognized that nances at the provincial level are critical to the realignment of the role of the state in the economy. Contextually, the Reserve Bank started a close and more intensive interaction with State Governments. Accordingly, several signicant initiatives have been taken over the years.

14

3.1.8

Fiscal Responsibility Act

On December 11, 2000 the Government has introduced a Bill in the Parliament titled as The Fiscal Responsibility and Budget Management Bill, 2000. The proposed legislation is to provide for the responsibility of the Central Government to ensure inter-generational equity in scal management and long-term macro-economic stability by achieving sucient revenue surplus, eliminating scal decit and removing scal impediments in the eective conduct of monetary policy and prudential debt management, consistent with scal sustainability, through limits on the Central Government borrowings, debts and decits, greater transparency in scal operations of the Central Government and conducting scal policy in a medium-term framework and for matters connected therewith or incidental thereto. The important features of the Bill was recommendation of laying before both Houses of parliament, along with the annual budget, the Mediumterm Fiscal Policy Statement, Fiscal Policy Strategy Statement and Macroeconomic Framework Statement by the Central Government and suggect measures to eliminate revenue decit and scal decit and build up adequate revenue surplus

3.2

Recent Trends in Government Finances

Trends in government nances in India continue to remain worrisome. The consolidation measures and economic reform initiatives taken since 1991 after the economic crisis had an encouraging impact in correcting the scal imbalances, particularly during the rst two years. The trend, however, could not be maintained. Budgetary imbalances widened again reaching almost the same level towards the end of the decade, as it was at the beginning. Analysis of these developments has revealed dominance of structural rigidities in the government nances, erosion of tax-GDP ratio over a longer period, virtual stagnation of non tax revenue and higher growth rates in expenditure compared to growth rates in revenue receipts. This part of the chapter presents a macro review of recent trends in government nances in India.

3.2.1

Trends in Budgetary Balances

Trends in dierent measures of budgetary balances both for the Central government and State governments as given at Appendix D

15

A closer look at the dierent measures of decit would reveal perhaps a more worrisome trend in that the scal decits are being driven more and more by decits in the revenue account of the budget. Thus revenue decit of the Central government which accounted for about 40 per cent of the scal decit in the budget in 1991-92 is now about 68 per cent. Much more so in the case of state budgets, where the increase in revenue decit to scal decit ratio is from about 28 per cent in 1991-92 to about 62 per cent in 1999-2000. These trends simply show that the government is increasingly borrowing to nance non-asset creating expenditure from where no returns are expected. Further, the trends in primary decit, show that increasing interest burden alone, is not the contributory factor in higher level of decit. Latest available estimates indicate that the combined primary decit in 1999-2000 (RE) at 4.2 per cent of GDP was highest during 1990s except for the crisis year (1990-91) when it was 5.0 per cent. Another important trend on decits is the increasing number of State governments with higher levels of decit. Thus in 1999-2000, 13 out of the 25 state governments had faced scal decit level of more than 7 per cent of their respective state domestic product, compared to 6 states in 1990-91, 4 states in 1995-96 and 8 states in 1998-99.

3.2.2

Trends in Revenue Account Receipts

Erosion in tax-GDP ratio over a long period of almost two decades and virtual stagnation in the level of non-tax revenue have been identied as signicant contributory factors in higher levels of decits in the government budgets, notwithstanding the relatively higher growth rates in expenditure. An analysis of trends in tax revenues by the Eleventh Finance Commission has shown that the buoyancy of tax revenue of both the Centre and the States which had been declining in the eighties, as compared to the earlier two decades went down further in the nineties. The same is illustrated at Appendix E. With regard to gross tax revenue of the Central government the trends show that between 1990-91 to 1998-99 the tax-GDP ratio declined by 2.6 percentage points from 10.8 in 1990-91 to 8.2 per cent in 1998-99. This is partly attributable to the change in the structure (sectoral composition) of the real economy where the share of industrial sector has fallen and services sector has increased signicantly without being brought in the tax-net in a signicant way.

16

Some of the other features of trends in tax revenue are as follows: Tax revenue, on an average, could nance about 60 per cent of the centres revenue expenditure during the eighties. The proportion during nineties, however, was about 55 per cent only. Continuing reforms and rationalization of the tax structure, have resulted in a structural shift in composition of tax revenue A fall in the share of indirect tax collections from about 80 per cent of total tax revenue in eighties to about 70 per cent in the nineties could not be fully compensated by the increase in direct tax revenue. On the states side, the dip in tax buoyancy occurred as revenue from sales tax, the principal component of their own tax revenue, showed a declining growth trend owing to tax competition among the States to attract trade and industry.

3.2.3

Trends in Non Tax Revenue

On the whole, non-tax revenue growth has practically stagnated at both levels of government, during the nineties. For the Central government budget, it was, on average, 2.5 per cent of GDP during eighties and the same level during nineties. Apart from the interest receipts the other two main items of non-tax receipts are (i) return on investments of the Government and (ii) recovery of cost of public services. By way of dividend and interest, return on Central government investment in public enterprises even though has shown some improvement was about 5.21 per cent in 1998-99. Trends in protability and nances of Central Public Enterprises have shown a distinct improvement during 1990s Rates of return of most of the State government enterprises, show that it does not cover even a fraction of their cost of funds. Results of a study (NIPFP) for the year 1995-96 and 1996-97 has shown that recovery rates were as low as 8.4 per cent of the costs for social services provided by the Centre and 16.6 per cent for economic services implying subsidization varying from 91 to 83 per cent of the costs. The level of cost recovery is still lower in the case of States. It is 2.15 per cent for social services and 10.75 per cent for economic services.

3.2.4

Trends in Budget Expenditure

We will restric ourselces to discussion on expenditure of central government. The highights are as follows. The Appendix F shows the trend in expenditure. 17

 Central Governments total budget expenditure (Revenue+capital) as a proportion to GDP is lower at 15.72 per cent in 1999-2000 (RE) compared to 17.85 But the worst thing to happen is a sharp fall in capital expenditure/GDP ratio from (average) 6.78 per cent during 1985-90 to just the half at 3.17 per cent (average) during 1995-2000. It was only 2.62 per cent in 1999-2000(RE). Even revenue expenditure ratio was lower at 12.16 per cent of GDP during the second half of nineties compared to 13.69 per cent in the second half of eighties. The reduction in revenue expenditure/GDP ratio is despite the fact that interest payments/GDP ratio has increased from 3.38 per cent in second half of eighties to 4.73 per cent in 1999-2000. The other major item of expenditure which has increased sharply is the expenditure on pensions. Expenditure on subsidies as percent of GDP has fallen in the second half of nineties compared to eighties, notwithstanding, a slight upward trend during 1995-96 to 1998-99. It has been reduced even in absolute terms during 2000-01 compared to the previous year. Even revenue expenditure on defence as percent of GDP has been less than 2 per cent during nineties compared to more than 2.5 per cent during eighties (on average). Budgetary support for the Central Plan as proportion to GDP has not increased during nineties. Grants to States as per cent to GDP have been lower during 1995-2000 compared to 1990-95 and 1985-90 (on average basis). An important recent development leading to bulge in non-plan revenue expenditure during 1997-98 and 1998-99 has been an abnormal increase in the expenditure on salaries of the government sta.

3.3

Fiscal Decit

Between 1990-91 and 1995-96 the consolidated scal decit declined by three percent of GDP thanks mainly the Centres eorts at scal prudence. This scal contraction made room for the investment boom of 1993-96, which 18

took aggregate domestic investment from 22.5 percent of GDP in 1991-92 (to which it had dropped during the crisis) to a peak of 26.8 per cent of GDP in 1995-96, without any undue stress on the external accounts. Of course scal rectitude was only one of the cause of investment boom. Other factors, such as the deregulation of industry and foreign trade, strong export performance and the overall reform momentum were also at work. But it does seem likely that the decit reduction in the rst half of the decade helped to nurture the rise in gross savings and investment, which, in turn, helped propel Indias growth to 7 per cent plus for three successive years in the mid-nineties. The converse seems to have happened in the second half of the decade, with a widening scal decit contributing to a slowdown in investment and growth. After 1995-96 (actually after 1996-97) the consolidated scal and revenue decits deteriorated steadily, with about half the worsening due to the phasing in of decisions on the Fifth Pay Commission. Between 199596 and 1999-2000 both the scal decit and the revenue decit increased by three per cent of GDP. This sharp widening in decits is fully reected in the decline of public savings from plus 2 per cent of GDP in 1995-96 to minus 1.2 per cent in 1999-2000. This, in turn, fully explains the drop in gross domestic savings from its peak of 25.1 per cent of GDP in 1995-96 to 22.3 per cent in 1999-2000. Gross domestic investment fell by a similar magnitude over these four years.

3.3.1

Comparison between 80s and 90s

One may compare high scal decit in the late eighties and the late nineties. In the eighties the high scal decits spilled into large current account BoP decits, which we nanced by unsustainable foreign borrowing that ushered in the crisis of 1991. In the late nineties, the rising scal decits have taken their toll of savings and investment, and thereby, growth. What both episodes have in common is damage to sustainable economic development. It has also been shown that in India, during the eleven year period since 1986-87, an increase in the Central Governments scal decit (inclusive of oil pool account) by one percent of GDP was associated with a reduction in private corporate investment by one percent of GDP. It needs to be recognised that the conditions that have restricted the adverse macroeconomic impact of high scal decit are transitory in nature. With a revival of economic activity, spurred by a pick-up in the private investment demand, rise in scal decit could raise the saving-investment 19

gap and eventually raise interest rate and widen current account decit. The problem could be compounded if inationary pressures re-emerge due to buoyant economic activity. In view of this, sustainability of decit and debt and scal consolidation continues to be a matter of serious concern.

3.3.2

Observations

The above analysis and assessment clearly revealed that the signicant scal consolidation in the immediate aftermath of the scal reforms was essentially brought about through cut in investment expenditure, as rise in committed revenue expenditure could not be curtailed. Within a short span, it became increasingly obvious that the Indian approach to scal correction was not sustainable. While reduction in investment spending aected future growth prospects with consequent slowdown in revenue receipts, the interest payments at public debt continued to grow, resulting in reversal of scal consolidation process in the latter half of the 1990s. Downward rigidity in the revenue decit, which amounts to dissaving by the Government sector, has signicant implications for the growth target of 8 percent; set in the Tenth Five Year Plan. This would require an investment rate of about 32 per cent, whereas, over the years, the investment rate has stagnated at around 24 to 25 per cent of GDP. Acceleration of saving and investment rate would critically depend upon the eorts to restore balance on the revenue account. The key factors underlying the growing resource gap across the States are uneconomical level of user charges particularly in the power sector, sluggishness in the Central transfers due to low buoyancy of Central taxes and the rising interest payments. Restoration of revenu balance both at the Central and the State level would require that user charges are adequately raised, the tax collection machinery is overhauled to achieve better tax compliance, returns on Governmer investment in PSUs are raised through appropriate pricing policies eliminating implicit subsidies and the burden on the scal is lowered through phasing out of unviable public sector units. The introduction of VAT should eliminate the practice of competitive tax concessions. The elimination of automatic monetisation and reduction in preemption of institutional resources by the Government has provided a conducive environment to generate market liquidity and softening of interest rates in the economy. However, with a widening of the scal gap, it would be increasingly dicult to maintain a softer interest rate regime. In such an eventuality, it would not only crowd out the private investment initiative, but would also make public debt highly unstable given the level of returns on Government 20

investments. The institutional support in the form of scal rules should be the prime mover of future agenda of scal consolidation programme. Such scal rules could prescribe quantitative limits for elimination of the revenue decit, reduction in the scal decit and the public debt over a specic period in a phased manner. In a recessionary environment along with low ination, growing forex reserves and comfortable level of food stocks, there is a denite role for the expansionary scal policy. The apprehension is that the stringent scal rules may hinder appropriate steps by the Government. However, it may be noted that such rules generally make a clear distinction between public consumption and public investment expenditure while envisaging a complete elimination of revenue decit. Rule based scal policy would facilitate the path for durable scal consolidation through mandatory scal discipline, enhanced accountability and improved transparency in scal operations. In 2006-07 Annual budget, three principal themes underpin the Budget proposals - a focus on the rural sector, augmentation of infrastructure and scal consolidation. On scal consolidation, the Finance Minister avers his determination to adhere to the targets set under the Fiscal Responsibility and Budget Management Act by lowering scal decit from 4.1 per cent in nancial year 2005-06 to 3.8 per cent in nancial year 2006-07 and revenue decit from 2.6 per cent to 2.1 per cent over the same period. This is expected to be achieved through more eectively targeted spending, tax revenue buoyancy as the economy maintains a scorching GDP growth rate and through more ecient and eective tax administration. With an unprecedented 8 per cent growth in two out of three consecutive years, the economy clearly has the wind behind it. We have an opportunity where we can maintain and build on this momentum and transform the economy - the agenda is clear, the ingredients and drivers all exist. To borrow from a quotation that the Finance Minister referred to, we now need to make our own destiny.

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Appendix A : Snapshot of Annual Budget

In Rs Billion Revenue Receipts Tax Receipts Non-Tax Revenue Capital Receipts Total Receipts Non-Plan Expenditure Plan Expenditure Total Expenditure Revenue Decit Fiscal Decit Primary Decit 2004-05 2005-06 2005-06 2006-07 Actuals BE RE BE 3,060 3,512 3,485 4,035 2,248 2,735 2,741 3,272 812 777 743 762 1,917 1,631 1,602 1,605 4,977 5,143 5,087 5,640 3,654 3,708 3,649 3,913 1,323 1,435 1,438 1,727 4,977 5,143 5,087 5,640 783 953 918 847 (2.5) (2.7) (2.6) (2.1) 1252 1511 1462 1,487 (4.0) (4.3) (4.1) (3.8) -17 172 161 88 -(0.1) (0.5) (0.5) (0.2)

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Appendix B : Fiscal Trends: Decit and Debt

Post-Reform Pre-Reform Historical 1999-2000 1998-99 1997-98 1996-97 1991-92 1990-91 1985-86 1980-85 1975-76 1970-71 (RE) to to to to to 1995-96 1989-90 1984-85 1979-80 1974-75 (5 yrs) (5 yrs) (5 yrs) (5 yrs) (5 yrs) Fiscal Decit Centre States Revenue Decit Centre States Debt** Centre States Combined (Net) 5.64 4.71 3.81 2.96 52.90 21.50 60.70 6.43 4.23 3.85 2.57 50.60 19.40 55.50 5.87 2.93 3.06 1.22 46.20 18.00 53.50 4.90 2.79 2.40 1.34 44.10 17.30 51.00 6.08 3.01 3.04 0.70 48.82 18.82 55.72 8.33 3.51 3.47 0.99 52.85 20.59 56.20 8.21 3.15 2.58 0.26 50.24 20.66 56.33 6.26 2.94 1.11 -0.43 38.20 17.85 43.12 4.64 2.07 (-)0.32 -0.21 31.69 17.83 36.79 3.44 2.21 (-)0.31 -0.04 30.62 19.49 35.86

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Appendix C : Fiscal Trends: Decit and Expenditure

Post-Reform Pre-Reform Historical 1999-2000 1998-99 1997-98 1996-97 1991-92 1990-91 1985-86 1980-85 1975-76 1970-71 (RE) to to to to to 1995-96 1989-90 1984-85 1979-80 1974-75 (5 yrs) (5 yrs) (5 yrs) (5 yrs) (5 yrs) Centre Gross Tax revenue Net Revenue Receipts Revenue Expenditure Capital Expenditure State Tax receipts (own) Revenue Receipts Revenue Expenditure Capital Expenditure 8.80 9.29 13.10 2.62 5.38 10.86 13.82 1.95 8.16 8.48 12.34 3.51 4.87 9.80 12.38 1.87 9.19 8.83 11.90 3.41 5.17 11.09 12.31 2.08 9.45 9.27 11.67 3.09 5.04 10.99 12.33 1.89 9.77 9.96 13.70 6.78 5.54 12.89 13.48 3.26 10.75 10.26 13.73 5.93 5.63 12.41 13.40 3.61 11.20 11.11 13.69 6.78 5.67 12.85 13.16 3.21 9.93 9.43 10.69 6.13 5.18 11.90 11.47 3.79 9.84 10.05 9.73 6.78 4.73 10.83 9.62 4.68 8.29 8.37 9.83 6.00 3.75 8.78 8.75 4.18

Table 3.1: Fiscal Trends : Receipt and Expenditure

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Appendix D : Aggregate Budgetary Balance : Centre and States

Year Centre 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 8.33 5.89 5.69 7.43 5.99 5.38 5.23 6.21 6.80 5.96 7.01 5.71 5.10 4.90 5.87 6.43 5.64 Fiscal Decit States Combined 3.28 2.93 2.92 2.49 2.86 2.75 2.97 3.10 4.47 4.98 2.35 2.73 2.60 2.79 2.93 4.23 4.71 9.64 7.17 7.38 8.68 7.36 6.81 6.82 7.74 9.50 10.40 8.19 7.02 6.44 6.40 7.32 8.99 9.84 Revenue Decit Center State Combined 3.47 2.64 2.63 4.04 3.22 2.66 2.56 3.24 4.08 4.03 3.81 3.07 2.52 2.40 3.06 3.85 3.81 0.84 0.81 0.72 0.47 0.73 0.77 1.43 1.29 2.72 3.13 0.45 0.70 0.73 1.34 1.22 2.57 2.96 4.31 3.45 3.36 4.51 3.95 3.43 3.98 4.53 6.80 7.16 4.25 3.77 3.25 3.73 4.28 6.43 6.77 Primary Decit Centre States Combined %of GDP Old Series 4.32 1.69 5.00 1.58 1.19 2.19 1.29 1.06 2.23 2.90 0.56 3.39 1.42 0.84 1.93 0.91 0.86 1.61 0.57 0.97 1.35 1.63 1.00 1.40 2.13 2.34 3.23 0.96 2.55 2.13 %of GDP New Series 2.74 0.52 3.20 1.35 0.80 1.84 0.86 0.81 1.52 0.53 0.91 1.26 1.54 0.94 1.33 2.01 2.22 3.06 0.90 2.41 2.02

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Appendix E : Tax buoyancy : Centre and States

Total Tax Revenue (Combined) 1.38 1.16 1.30 1.14 0.96 Centres Gross Tax Revenue 1.38 1.15 1.27 1.15 0.91 States Own Tax Revenue 1.39 1.17 1.35 1.12 1.04

1950-51 1960-61 1970-71 1980-81 1990-91

to to to to to

1959-60 1969-70 1979-80 1989-90 1998-99

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Appendix F : Trends in Expenditure : Central Government

ITEMS 1980-81 to 1984-85 (Average) 16.82 10.69 6.13 2.20 8.49 0.27 8.22 1.96 1985-86 to 1989-90 (Average) 20.47 13.69 6.78 3.38 10.31 0.42 9.89 2.45 1990-91 to 1994-95 (Average) 17.85 13.24 4.61 4.37 8.87 0.40 6.47 2.44 1995-96 1999-2000 to (RE) 1999-2000 (Average) 15.33 15.72 12.16 3.17 4.61 7.55 0.49 7.06 1.58 13.10 2.62 4.73 8.37 0.74 7.63 1.52

Total Expenditure Revenue+Capital Revenue Exp. Capital Exp. Interest Payments Revenue Expenditure minus Interest Payment Pension Revenue Expenditure minus Interest Pension Grants to States

27