Fiscal Correction

Introduction'Fiscal correction', defined as the reduction of the fiscal deficit with respect to GDP, has now become the sine qua
non of any stabilization program. In the context of macroeconomic stabilization in India too, the fiscal deficit has become an important variable and policy target. Reduction of the relative size of the FD is now a basic policy objective, and increases in this indicator are viewed with serious concern. Concept of Defict-In bringing about fiscal adjustment or, in other words, restoring fiscal balance, three types of deficit need to be considered. [Chelliah (1996)] The first is the fiscal deficit, which is the best available summary indicator of the macroeconomic impact of the budget. The FD, defined to mean the excess of government expenditure over current revenues, is synonymous with net borrowing by the government. It is necessary to monitor and regulate the FD because it impacts immediately upon domestic demand and the BoP. Excessive Government borrowing crowds out private investment and if government borrowing is used to finance current expenditures, there will be displacement of capital formation in the economy, resulting in Iower rates of growth. Even if private investment is crowded out by public investment (rather than consumption), there is a loss in terms of growth, if, as is often the case, private investment is more productive than public investment. Further, borrowing by the government adds to public debt, and an increasing debt GDP ratio is known to have harmful macroeconomic consequences. The second concept of deficit is the revenue deficit, which is the difference between revenue expenditure and revenue receipts. This deficit is measured to ascertain whether the recurrent expenditures of the government on account of public consumption and current transfers are fully met out of current revenues. Of course, some lumpy types of expenditure and the part of current expenditure that might lead to future benefits (such as that on health and education) could be met out of borrowings. However, current expenditures should largely be met out of current receipts. Ignoring this concept could lead to serious consequences, as is evidenced by the present condition of government finances in India. At the Central Government level, a dangerously large proportion (approximately 48%) of government's net borrowing is now used to finance the revenue deficit. The third type of deficit that is important from the policy point of view is the monetized deficit, viz. RBI credit to the Government. This concept indicates the quantum of additional money created as a consequence of credit extended to the Government. The proportion of the FD financed by net RBI credit rose from less than 16% in the early 1970s to nearly 33% during the latter half of the1980s. For many years it was believed that it was only this concept of deficit that had serious policy consequences since it represented an addition to money supply, seen as the prime cause of inflation. Yet, all three concepts of deficit are important in their own way. To avoid inflationary pressures the monetized deficit of the Center should be kept within control. With a reduction of the revenue deficit, the growth of net interest payments will be cut, making way for the growth of other developmental expenditures. The significance of regulating the fiscal deficit has been discussed earlier. To reiterate very briefly, government borrowing tends to crowd out private investment (by 1991, the government was absorbing around 81% of household savings), it adds to public debt, which in turn adds to future current expenditures and deficits, and, if The borrowing is used for non-productive purposes, capital formation suffers, leading to lower rates of growth, both present and future. Rising fiscal deficits in India have been the outcome of poor performance and indiscipline on both fronts, revenue and expenditure. To borrow a Malthusian analogy, taxes have grown in arithmetic progression, while expenditures have grown in geometric-progression, a surefire recipe for disaster! In terms of both rates and overall tax take, India is a relatively high-tax country given her per capita income level. So although the tax base should undoubtedly be increased, fiscal adjustment should come mainly from expenditure and non-tax revenue. Trends in Public Expenditure:There have been 4 distinct phases in real public expenditure (PE) since the 1970s. [Mundle & Rao (1997)]a) Phase 1 (mid 1970s-1981): During this first phase, real PE was growing at about 7% p.a. Both current and capital expenditure were growing at about the same rate and they were growing faster than revenues. Yet borrowing was modest, and the size of the FD was non?threatening, at about 5% of GDP.b) Phase 2 (1981 - 86): The annual rate of growth of PE rose to about 10%; current expenditure was increasing at about 11% while capital expenditure continued to grow at 7%. Current expenditure also rose faster than current revenues so that the government was now borrowing to finance both revenue and capital expenditures. The FD rose to an uncomfortable 9% of GDP. c) Phase 3 (1987 - 90): saw some attempt to rein in PE. Unfortunately, the brunt of this reduction was borne exclusively by

contrary to popular belief. Currently interest payments appropriate a share of the GDP that is larger than that of the defence expenditure of the Government! Features of PE in recent timesIt is clear from the above discussion that current expenditures are spiraling out of control. Thus.68% in 1997-98.It has led to a drop in the rate of capital expenditure. and investment in human capital. There was also a sharp drop in Central.31% of GDP in 1991 .It appears that the current budgetary stance of the government is non-sustainable.6% of GDP even without direct retrenchment. the Government's path to bankruptcy will be hastened. Part of the deficit may be monetized. vvhich then lead to higher costs of deficit financing and then still higher deficits. while overall growth of PE was 8%.In respect of the second item. and cuts in such expenditure are thus likely to be resisted by those who are powerful enough to do so. irrigation and power projects. Although the compensation of employees has risen in absolute terms. A new aspect of the increase in revenue expenditure was the burgeoning interest payments. evidence suggests that this accusation may be too harsh for the 1990s. The burden of debt has assumed gigantic proportions.Another outcome has been a high interest rate regime where increased government borrowings have tended to push up interest rates (particularly long-term ones) and fuel inflationary expectations. a freeze on new employment. So just at the time when the need for such transfers is greatest. transfers to State governments especially on the capital side of the budget. the effects of capital spending are long drawn out and are felt more in the future than in the present. while the growth of revenue expenditure continued almost unabated. For a substantial part of the 1990s. by higher interest rates. following the freeing of interest rates.86% of GDP for 1994 . This would include rural and many urban roads. Firstly. Essentially future generations are easily bypassed. the higher interest rates fuel higher inflation rates. If a concerted effort is not made to bring current expenditures in line with current revenues. slow industrial growth and growing fiscal stress at both levels of government. This is more than the combined FDs of the Central and State governments! Combined subsidies are estimated to be almost 15% of GDP.95. and is an obvious way. and when the need for fiscal decentralization is felt most strongly. FD was cut to about 7% of GDP but was back to 9% by 1993-94.There is another important consequence of high deficits and borrowing.92 to 4. as mentioned above. growth of capital expenditures was actually negative. On the other hand. subsidies.capital expenditure. This is a very serious consequence.Two important reasons for the ballooning of revenue expenditures are . Revenue expenditure continued to grow at about 10%. as there are large parts of social infrastructure that can only be publicly financed. the amount of resources that can actually be transferred is dwindling.The rate of growth of Central government transfers to State government has also seen a decline. It is for this reason that fiscal 'correction' is often accompanied by a disproportionate reduction of capital as opposed to current expenditures on government account. . with wages and salaries constituting a large proportion of GDP. The rise accelerated in the 1990s. Arresting further growth of the Wage bill will require pay restraint and mainly. It then becomes a struggle to maintain the value of the real interest rate as well as the real exchange rate. a factor that has undoubtedly contributed to industrial stagnation. Almost half of fresh borrowing was used to finance current expenditure and the country was in a fiscal mess. Second. Yet. since they have no "voice". Some Important Consequences of the Growth in Revenue ExpendituresThe unchecked growth of the revenue element of PF has had some very deleterious effects on the Indian economy. Public employment and wages rose rapidly over the 1980s and undoubtedly there is tremendous overstaffing in public sector. Again the sacrificial lamb was Capital expenditure. but the increase has been more pronounced and relentless since the 1980s. the Ministry of Finance has estimated the total non-merit subsidies of Central and State government to be a mind-boggling 9. the climate for the conduct of monetary policy worsens. are well known. public sector employees as an interest group have not been powerful enough to protect their share in GDP after initiation of the stabilization process. Current expenditure affects immediately. This is despite awareness of the urgency of the need to control the deficit. viz. The growth of capital expenditure was now less than 1% in real terms and public investment in social infrastructure began to stagnate. A rough calculation by Joshi (1998) shows the potential saving in this regard to be around 0. Why is this? Some possible explanations are listed below. As government borrowings rise to very high levels. This then leads to erosion of the independence of monetary policy from fiscal policy.Interest on public debt as a ratio of GDP has grown continuously. d) Phase 4 (post 1991): At the behest of international lending steps were initiated to control the FD. the levels of living of some groups.The feedback effects of high deficits into high interest rates. Interest payments increased from 4.the growth in interest payments and the uncontrolled expansion of subsidies. the ratio of employee compensation to GDP has actually fallen through this decade. Past transgressions in terms of high revenue expenditure growth in the second phase began to impact severely upon the entire budgetary process. [Goyal (1999)]The huge workforce in the public sector is often blamed for deteriorating government finances.

the subsidy for canal irrigation is almost 100%. attempts at cross-subsidization that have proved unsuccessful in the long run. Total consumption of groundwater resources has risen from 4 million hectare-meter (MHM) in 1970 to 54 MHM in 1998. but also because capital expenditures financed by borrowings have not yielded adequate returns.The fiscal crisis and the attendant exponential growth of public debt has arisen. such as lowering of the groundwater table. and for the Center and State governments taken together. which have always been able to wring concessions and benefits out of governments. let us see what can be done to reverse the situation. It is expected to exceed the recharge level of 67 MHM by 2005. Interest payments: Interest payments have been growing rapidly. etc.Thirdly. Budgetary outcomes are thus seriously influenced by the reality of political economy. etc.A. the fiscal problem. provided they can be financed out of current revenues.First. This further reduced the capacity of the State to tax. both as a result of rising debt and also because of rising interest rates consequent upon financial liberalization. This may have been motivated by a desire to shield "poor voters" from higher prices. even though they have to pay for the latter.Causes of Fiscal deteriorationThe fiscal distress that the country is experiencing today is the outcome of several factors acting simultaneously. In a heterogeneous democracy like ours. budgetary actions are the result of pressures exerted by vested interests and the desire of the political class to nurture their constituencies and 'vote banks'. Theproliferation of private tube wells (that run on subsidized electricity) has had negative externalities as well. Rise in borrowing after the period of major cost shocks. At the same time the cost of providing water through public canals has risen steeply and quality of supply has fallen. Irrigation . rising current expenditures per se do not pose much of a problem.Fourth.g. Let us examine these contributory factors in greater detail. The uninterrupted and rapid growth of public debt in India since the late 1970s is a manifestation of this decline.These examples can be repeated ad nauseam. 3. railways. irrigation. the figure was a horrifying 67. But the government was the inability to raise taxes. telephone services. Policy SuggestionsWhat can be done to correct the situation? Since we have identified interest payments and subsidies as two of the major causes of the intolerable situation in respect of current expenditures. it seems that governments in the past have failed to adjust prices whenever they have faced a supply shock such a drought or an oil shock (both of which were features of the 1970s). the only way out is to retire existing debt as quick as possible. Gulf War of 1991.2% of GDP. Government budgetary considerations are susceptible to lobbying by special interest groups. 2. and budgetary losses combined with falling investment and quality.4%. in respect of which the government enjoys no discretion. The prices of a large variety of public goods and services were thus fixed over the years. the internal debt of the Government of India stood at 50. the cost shocks of the 1970s triggered off a cumulative decline in government finances. and The inability to raise taxes. To take only one example. leading to a lowering of quality and investment in the production of these goods. and partly as a result of political compulsions.). If the disinvestment proceeds are used to retire government . The rise in interest payments from this period also bears testimony to the fact of increased government borrowing in this decade. Political compulsions seem to have contributed significantly to the growing revenue deficits in the budgets of both Central and State governments. partly because of the state of the Indian economy. invest and provide services. education. Deterioration in the quality of services has been the result of. Farmers are willing to pay higher rates for irrigation that is more flexible adapted to their needs. Interest payments are a committed expenditure. they have shown this by switching to tube well irrigation. not merely because revenue expenditure has been running ahead of revenue receipts. Assuming there are limits on the latter due to the difficulty of reducing primary deficits. It is the manner in which the government chose to respond to these exogenous factors that are the proximate and immediate cause of the fiscal crises. What they demonstrate is the picture of prices held constant in the face of cost surges. oil price shocks of the 1970s. One of the criticisms of the disinvestment program has been that capital proceeds (from the sale of shares of PSUs) are being used to finance current expenditures. The truth of this claim can be seen in the case of electricity. and also contributed to. Fiscal deterioration can thus be attributed to The political economy of India's public finances. Secondly. By 1990?91. This can be achieved by the sale of land and Public Sector Undertakings. 1. While some of the ultimate causes are exogenous and beyond the control of the government (e. The widespread fall in the quality of services. Thus the only way by which these expenditures can be controlled is by retiring existing debt and curbing the growth of new debt.

the element of externality is extremely limited. viz.There are many Frequently Asked Questions in respect of subsidies. it is to serve a distributional objective that food subsidies are advocated for BPL families. The combined Central and State Government subsidies on economic services alone amount to about 7% of GDP. with merit subsidies at 3.  Net Non-merit subsidies on the other hand. It is also well known that a substantial part of the subsidy goes to covering the cost of the grossly subsidy bill to say 0. while for the States the corresponding figure was 9. etc. benefit from these hidden subsidies. At the State level. the corresponding recovery rates are 12.3%. an estimate of the aggregate budget-based subsidies in India for 1994-95 revealed thatTotal subsidies stood at 14. Are subsidies in India provided for the right reasons? Subsidies can be justified when there are significant positive externalities in the public provision of non-public goods (for e. in all these cases.the Centre accounting for 19% and the State 81%. subsidies have historically been extended to all households or farmers. the Ministry of Finance placed a discussion paper on subsidies before Parliament based on a detailed study conducted by the NIPFP.g.g. most of them go to the not-sopoor.93.69% and non-merit subsidies at 10. For e. As mentioned above. Public goods like defence. food. while at the State level economic services. and for social services it is 18. .1%.5% of GDP. the good or service is provided to the public and some part of the cost is recovered by way of fees. subsidizing irrigation and fertilizers helps poor farmers. (e. 35. Explicit subsidies are those where there is a direct expenditure or transfer by the government. subsidized loans and housing for government and bank employees. irrigation and power) claim 61% of the total subsidies.40% of GDP. Similarly subsidizing kerosene or LPG helps poor households.the share of the Centre being 33. Fertilizer subsidies also reach the very poor to a negligible extent. Some of these are discussed below. law and order.7% of the cost. sewage and sanitation.993 crore . the recovery rate for economic services is a mere 11.liabilities then this criticism ceases to be valid. For e. In such case. Subsidies: In 1997. At the aggregate level.5% and that of the States 66.At the Government of India level. In case of the first two. The most important explicit subsidies that remain are food and fertilizer subsidies amounting to 0.… There is no valid justification for such subsidies. and so on. public health. charges.6% of GDP respectively in 1995-96. however. The economic case for subsidizing merit goods is very strong. another classification of subsidies is into explicit and implicit or hidden subsidies. etc) account for almost 93% of total subsidies. Aligning charges with costs would obviously yield substantial fiscal savings and would also lead to more rational use of inputs such as water and electricity and help to correct the massive under-investment in these sectors. In the case of implicit subsidies. The paper detailed three categories of goods and services where the government was providing either explicit or implicit subsidies.3% of GDP.9% and 4%. and agricultural and scientific research. half the industry would probably collapse. If the subsidy were abolished overnight. fertilizer and non?elementary education. roads and bridges.g. Implicit or Hidden Subsidies: Explicit subsidies are only the tip of the iceberg. B.5%. transport. flood control and drainage.3%. soil conservation. Nor would it hurt the poor. since they do not. Merit goodsinclude primary education. are not amenable to the pricing mechanism and the expenditure incurred on them must necessarily be met out of tax revenues. Explicit subsidies: Export subsidies were abolished when the rupee was devalued in 1991. rich and poor alike and the distributional objective has rarely been served. by and large. aggregated Rs. But that is no excuse for not reducing the subsidy by restructuring the industry and closing down high-cost units in a phased manner. or if there is a significant distributive objective to be achieved. without hurting the poor.At the Central level. many social welfare schemes. There is also a lot of self-serving subsidization: subsidized travel for railway and road transport employees. All other goods and services that are subsidized by the Government have been termed as non-merit goods and services.Merit subsidies of both Centre and States amount to Rs. social and equity objectives. given the large social benefits arising out of their provision. They are partly subsidies to the inefficient parts of the industry and partly to farmers. economic services (industry.In the white paper.5% and 0.1% for non-merit goods and services. etc.193 crore . Joshi (1999) has estimated that a well-structured privatization programme could contribute fiscal savings of about 1.g. the-recovery rate was 10. but these subsidies are notoriously badly targeted. In India.The recovery rate in case of the center was 12.71% of GDP. The theoretical justification for food subsidy is poverty relief. subsidies may have to be on grounds other than strong externality. elementary education).

In July 1991 India launched a major reform programme under similar crisis conditions. He was a politician as well. A major component of the programme is comprehensive fiscal reform. In a letter to a friend he later said that Lerner was right in his logic. [Colander (1994)] . he spent little time advocating fiscal policy. one sure way of reducing fiscal stress In India is to target reduction of non-merit subsidies. infrastructure and human resource development and in redundancy and poverty-related programmes. for transport. For example over-subsidization of irrigation has led to careless use of water resulting in long-term destruction of soil fertility. "Keynes should read The General Theory". Conclusion India has now reached a turning point in her economic history. Given that subsidies stand at nearly 15% of GDP and that few of them can be justified on economic or even equity grounds. Abba Lerner. All these are a matter of purely private benefits where public payment is unjustified. With spreading disillusionment. Untargeted subsidies are known to be costly. The disinvestment proceeds of the government can be fruitfully used for this purpose. before Keynes wrote The General Theory.user charge. but he hoped the opposition did not realize what Lerner was saying. without which the reform are doomed. Keynes was more than an economist. subsidies for fertilizers. A suitable tax . never mentions fiscal policy in his magnum opus . which will then help serve the objective of distributive justice. Towards the middle of the twentieth century. can be reduced and better targeted. Excessive subsidization of chemical fertilizers has led to their overuse and long-term destruction of soil fertility. the other major component of current expenditures. politically dangerous policies. another Keynesian. can be curtailed by retiring public debt as early as possible. which have reached alarming proportions. he was arguing strongly for public works programs and deficits as a way to get the British economy out of the Depression.g. pulses. The State was supposed to compensate for various form of market failure under this institutional arrangement. markets were often suppressed or supplanted even in those spheres where they could have performed reasonably well.When one of his followers. expenditure control. chemicals. etc. which will leave room for muchneeded increases in public investment in agriculture. propagated fiscal policy at a seminar that Keynes attended. I would like to end with a small anecdote. for specific crops such as oilseeds and. By the early 1970s it had become clear that the 'mixed economy' entailed a huge cost in terms of efficiency without much gain in terms of equity. including deficit reduction. While all reforms aim at the reduction of the Gross Fiscal Deficit. Subsidy programmes should be target-oriented. In addition to the overall level of subsidies being reduced. Why did Keynes oppose the policy implications of his work?Because he was also a student of politics and he recognized that economic theory can sometimes lead to politically unacceptable or more seriously.Are many wrong goods / services being subsidized? There is a long list of goods and services where continued subsidization is not warranted.The General Theory. many newly independent developing economies across the world opted for the State-dominated 'mixed economy' model pioneered by India. After arriving at his new theory. Excessive subsidization of chemical fertilizers has led to their overuse and long-term destruction of soil fertility. cannot be justified. often triggered by external aid conditionally in rescue packages.expenditure policy mix can generate potential extra public savings. It neither promoted growth nor eliminated poverty. location and person-specific and should in no case be global in character. subsidies must be periodically reviewed and it should be made clear that subsidies are not meant to be permanent. and in fact. the entire subsidy structure needs to be made more transparent. to whisper to a friend. tax reform and inter-governmental fiscal relations. In the 1930s. however. This calls for a concerted attempt to raise direct tax collections while at the same time curbing current expenditures. The programme has now been under way for a decade. Keynes objected vociferously. reduction of the Revenue deficit is equally relevant. several developing countries undertook market-oriented reforms. Interest payments. The issue of deficit reduction begs the question of which deficit is to be reduced. For e. Can subsidies be harmful?Some subsidies have the potential to damage the environment. its pace dampened by the pulls and pressures of electoral politics. Wasteful and inefficient. leading Evsey Domar. The situation demands a judicious mix of expenditurereduction and expenditure-switching policies. Subsidies. In reality.