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Subject ECONOMICS

Paper No and Title 6: Advanced Macroeconomics

Module No and Title 35: Fiscal policy in Action in India: Deficits and Debt over
Time
Module Tag ECO_P6_M35

ECONOMICS PAPER No. 6 : Advanced Macroeconomics

MODULE No. 35 Fiscal policy in Action in India: Deficits and Debt over
Time
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TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Instruments of Fiscal Policy in India
4. The Deficits and Debt in India
5. The Indicators of Deficit
6. The Indicators of Public Debt in India
7. Debt Sustainability at State Level in India
8. Summary

ECONOMICS PAPER No. 6 : Advanced Macroeconomics

MODULE No. 35 Fiscal policy in Action in India: Deficits and Debt over
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1. Learning Outcomes

After studying this module, you shall be able to

1. Know about the instruments of fiscal policy in India.

2. Examine the trends in deficits and debts in India.
3. Understand the various indicators of measuring deficit in India.
4. Understand the changes in the value of indicators of debt in India.
5. Examine the debt sustainability at the state levels in India.

2. Introduction

Fiscal policy deals with the taxation and expenditure decisions of the government. It
refers to changes in government expenditure and revenue to influence the level and
pattern of economic activity. The Indian Constitution provides the overarching
framework for the country’s fiscal policy. India has a federal form of government with
taxing powers and spending responsibilities being divided between the central and the
state governments as well as a third tier of government at the local level. But the taxing
abilities of the states do not necessarily commensurate with their spending
responsibilities. Some of the centre’s revenues need to be assigned to the state
governments on basis of the recommendations of the Finance Commission (FC) every
five years. The Constitution also provides that for every financial year, the government
shall place before the legislature a statement of its proposed taxing and spending
provisions for legislative debate and approval. This is referred to as the Budget. The
central and the state governments each have their own budgets. Besides the annual
budgetary process, since 1950, India has followed a system of five-year plans for
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ensuring long-term economic objectives. The main fiscal impact of the planning process
is the division of expenditures into plan and non-plan components. The plan components
relate to items dealing with long-term socio-economic goals and often relate to specific
schemes and projects. These are usually routed through central ministries to state
governments for achieving certain desired objectives. On the other hand, the non-plan
expenditures broadly relate to routine expenditures of the government for administration,
salaries, and the like. Taxes are the main source of government revenues. These can be
direct as well as indirect which can be collected at central, state as well as local levels.

3. Instruments of Fiscal Policy in India

Fiscal policy is an important constituent of the overall economic framework of a country

and is therefore intimately linked with its general economic policy strategy. The main
instruments of the fiscal policy include, tax policy, expenditure policy, investment or
disinvestment strategies and debt or surplus management. The taxes are the main source
of government revenues. These can be direct taxes and indirect taxes. The direct taxes in
India include taxes on personal and corporate incomes, personal wealth and professions
are direct taxes. In India the main direct taxes at the central level are the personal and
corporate income tax, levied through the Income Tax Act of 1961. Income taxes are
levied on incomes from business and professions, salaries, house property, capital gains
and other sources (like interest and dividends). Other direct taxes include the wealth tax
and the securities transactions tax, estate duty, gift tax, expenditure tax, fringe benefits
tax etc. Some of these taxes like the estate duty, fringe benefits etc. no longer exist
currently. The state governments are vested with the power to tax agricultural income,
land and buildings, sale of goods (other than inter-state), and excise on alcohol. Some
states charge a tax on professions. Most local governments also charge property owners a
tax on land and buildings.
The indirect taxes are charged and collected from persons other than those who finally
end up paying the tax. The current central level indirect taxes are the central excise duty,
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MODULE No. 35 Fiscal policy in Action in India: Deficits and Debt over
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the service tax, the customs duty and the central sales tax on inter-state sale of goods. The
main state level indirect tax is the post-manufacturing sales tax (the value added tax).
Similarly, on expenditure side, both the plan and non-plan expenditure is divided among
the central, state and local governments. The central government is responsible for issues
that usually concern the country as a whole like national defence, foreign policy,
railways, national highways, shipping, airways, post and telegraphs, foreign trade and
banking. The state governments are responsible for other items including, law and order,
agriculture, fisheries, water supply and irrigation, and public health. Some items for
which responsibility vests in both the Centre and the states include forests, economic and
social planning, education, trade unions and industrial disputes, price control and
electricity. There is now increasing devolution of some powers to local governments at
the city, town and village levels.

4. The Deficits and Debt in India

In any developing economy, the responsibilities of the government are always higher
than the resources they can use for this purpose. This results in to fiscal deficit. Like any
developing economy, India too has a long history of running huge fiscal deficits. A
higher fiscal deficit can be financed through domestic borrowing, external borrowing, or
by printing money. Excessive domestic borrowing can put upward pressure on interest
rates, while external borrowing may result in an external debt crisis. Printing money
would invariably lead to high inflation. The relationship among fiscal deficit, debt and
output growth and other macro targets is a much debated issue. The traditional view
states that high fiscal deficits created through higher public investment may displace
private investment, or more generally expenditure. According to this argument, public
investment-driven fiscal deficits ‘crowd out’ private investment through an increase in
the interest rate which in turn discourages private investment and overall economic
activity in a closed economy. However, the proponents of Keynes propagate the idea that
high fiscal deficits are not unusual for developing economies as governments use fiscal
deficits to keep aggregate domestic demand at high levels in order to generate growth and
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employment. High fiscal deficits accelerate capital accumulation and growth

(Krishnamurty 1984 and; 2002). They argue that that an increase in fiscal deficit due to
public sector investment, especially in infrastructure, stimulates growth in the private
sector. This is generally referred to as the positive ‘crowding in’ impact of fiscal deficit.
In Indian context, it is important here to quote the RBI study (RBI, 2001) which shows
that an attempt to raise public consumption to revive aggregate demand will crowd out
both private consumption and private investment with no long-run positive impact on
output growth. This study found that public investment in manufacturing appears to
adversely affect private investment. However, government expenditure on infrastructure
crowds in private investment. However, RBI analysts agree that excessive government
consumption expenditure has a negative impact on growth. Therefore, it must be
curtailed. Thus, in case of India, fiscal imbalances have remained a cause for concern in
recent years. Despite impressive increases in the revenue productivity from direct taxes,
there is a real fear that fiscal imbalances will worsen, causing interest rates to harden and
crowd out private investment. Thus the concerns have been voiced about controlling
public spending and fiscal deficit. On the one hand, the government has to raise public
spending to boost the economy, on the other, the fiscal deficit has to be controlled to
avoid its ill effects. In this context we can examine the change in deficits and debts in
India over a period of time.

5. The Indicators of Deficit

At the beginning of the 80s, the combined gross fiscal deficit of the centre and the states
was about 6 per cent which however, increased to about 9 per cent in 1990-91 and was
almost the same in 2000-01. This can be observed from table 1. The table shows that
during the last five years, the combined fiscal deficit of the centre as well as the states has
remained close to 7 per cent. Actually, during the 80s along with high external
borrowings, a sustained increase in the combined revenue expenditure to stimulate
demand, particularly in the services sector, caused the fiscal deficit to rise. This led to
accumulation of debt at the unprecedented level accounting for a large portion of
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government revenue expenditure and creating a debt trap in the 1980s. During the first
half of the 1980s, these revenue expenditures averaged 18.5 per cent of GDP. In the
second half, they rose to an average of 22.4 per cent with the bulk of the expansion
coming under the heads of defence, interest payments, higher salaries (Fourth Pay
Commission) and subsidies (Kumar and Soumya, 2010). A sharp increase in government
salaries and pensions in the next year halted the process of fiscal improvement until
2003–2004 when the government introduced the Fiscal Responsibility and Budget
Management Act (FRBM) to control the fiscal deficit. According to this Act, the
Government of India is required to bring down its revenue deficit by 0.5 per cent of GDP
each year until it touched zero, and to reduce its fiscal deficit by 0.3 per cent each year to
a level of 3.0 per cent of GDP. However, there is a lot of disagreement among policy-
makers about targeting a zero revenue deficit in India, for the reason that it sounds
unrealistic to achieve these targets without affecting the growth process. For a developing
country, it is more desirable to target a small revenue surplus to finance capital formation
rather than target a zero revenue deficit. This means the government would be saving and
contributing to capital formation (Chelliah, 2000 in Kumar and Soumya, 2010).
Similarly, we can see that the revenue deficit declined from 4.1 per cent of GDP in 1990–
91 to 3.2 per cent in 2010-11, but rose steadily to 4.1 per cent in 2011-12. In 2014–15, it
declined to 2.6 per cent of GDP. However, the primary deficit is threatening debt
sustainability in the country.
Table 1: Finances of the Central and State Governments: Selected Indicators
(As % of GDP)
Year Central States Combined
GFD GPD RD GFD GPD RD GFD GPD RD
1980-81 5.55 3.81 1.36 2.48 1.66 -0.99 6.0* 3.9* -0.6*
1990-91 7.61 3.95 3.17 3.20 1.73 0.91 9.1 4.9 4.1
2000-01 5.46 0.90 3.91 4.04 1.70 2.54 9.2 3.4 6.4
2010-11 4.79 1.79 3.24 2.07 0.47 -0.04 6.9 2.4 3.2
2011-12 5.84 2.75 4.46 1.91 0.36 -0.27 7.8 3.2 4.1

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2012-13 4.91 1.77 3.65 1.96 0.45 -0.20 6.9 2.3 3.4
2013-14 4.43 1.13 3.15 2.50 0.98 -0.03 7.1 2.3 3.2
2014-15 4.09 0.81 2.89 2.35 0.81 -0.43 6.6 1.7 2.6
Source: RBI, Handbook of Statistics on the Indian Economy, various issues.
*figures for 1981-82
GFD: Gross Fiscal Deficit; GPD: Gross Primary Deficit; RD: Revenue Deficit

6. The Indicators of Public Debt in India

The trends in fiscal deficit are also matched with the rising public debt levels. This can be
observed from table 2. The table shows that the combined debt of the central and state
governments, which averaged 56 per cent of GDP in the 1980s, rose to about 63 per cent
in the 1990s and climbed further to 71 per cent in 2000–2001. A notable feature was the
drastic reduction in the share of the external liabilities to GDP from 6.7 per cent in 1980s
to 3.1 per cent in 2000–01 and 2.9 per cent in 2014-15. Actually, after the introduction of
the FRBM Act, public debt in India had shown trends of steady decline but in the post-
crisis period i.e. after 2008–2009, there was a reversal of this trend. In 2014-15, though
the total public debt is less than the average of the 90s but it is higher than that registered
in 2010-11. We can see from the table that the total public debt in India increased from
65.5 per cent of GDP in 2010-11 to 67 per cent in 2014-15. The fluctuations are much
wild actually between 2000-01 and 2010-11 (see RBI Handbook on Statistics on Indian
Economy). These trends also point to one of the main deficiencies in the FRBM Act,
namely the failure to set a cap on public debt. There is little doubt that the FRBM Act put
the country on a higher growth trajectory by reducing the fiscal and primary deficits, but
a sound fiscal system also needs to have in place measures to control the debt to GDP
ratio (Kumar and Soumya, 2010).

The rise in public debt can be attributed to the sharp rise in the primary deficit
(i.e. fiscal deficit minus interest payments). Principally, the ratio of debt to GDP will
keep rising if there is a primary deficit or if the interest rate on debt exceeds the growth
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rate of GDP. As after financial crisis, the growth of GDP has slowed down, there are
greater concerns regarding the sustainability of such high levels of public debt. Following
the austerity measures to get an an early exit from the high fiscal deficit regime and
following the principles of fiscal responsibility are highly propagated. However, there is
little consensus on the ideal debt to GDP ratio for the economy. Internationally, the
Maastricht Treaty has set the tolerable debt level at around 60 per cent of GDP for the
European Union countries. The Twelfth Finance Commission had recommended an even
lower target of 56 per cent over a period for India.

Table 2: Debt Components of the Central and State Governments (As % of GDP)
Period/Year Internal Internal External Outstanding Outstanding Combined
Debt Liabilities Debt and Liabilities Liabilities Outstanding
(Central) (Central) Liabilities (Central) (State) Liabilities
(Central) (Central and State
Public Debt)
1980–1989 24.7 41.2 6.7 47.9 20.7 56.0
1990–1999 27.4 48.0 4.5 52.5 22.4 63.2
2000–01 38.2 52.4 3.1 55.6 28.3 70.6
2010-11 34.3 48.6 3.6 52.16 23.5 65.5
2011-12 36.6 49.2 3.7 52.9 22.6 66.6
2012-13 37.7 49.0 3.3 52.3 22.1 66.3
2013-14 37.4 48.4 3.2 51.7 21.6 65.5
2014-15 38.1 48.5 2.9 51.7 21.9 67.0
Source: RBI, Handbook of Statistics on the Indian Economy, various issues.

The budget 2015-16 was presented as the first year of fourteenth finance
commission. This finance commission has recommended an increase in state’s share in
gross tax revenue from 32 per cent to 42 per cent which means greater resources with the
states. Apart from containing growth in expenditure, the reduction in fiscal deficit is
planned to be achieved in conjunction with targeted revenue augmentation both through
tax and non-tax revenues. Despite the growth rate improving in the current financial year,
easing of inflation implied lower growth in nominal terms. Thus, tax revenues continued
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to be lower than the budgeted level. Given the resource constraint under low tax to GDP
ratio, only option to raise additional resources remains through borrowing. In India, debt
policy is driven by the principle of gradual reduction of public debt to GDP ratio so as to
further reduce debt servicing risk and create fiscal space for developmental expenditure.
Indian debt profile is characterized by reliance on domestic market borrowings, with
market determined rates rather than administered rates. Pursuing with Government’s
commitment to carry on with the fiscal consolidation measures, the fiscal deficit for
2015-16 is budgeted to decline to 3.9 per cent of GDP. Total borrowings requirement for
2015-16 has been budgeted at Rs. 5,55,649 crores. Net market borrowings (adjusted for
repurchases/switches in2015-16) of Rs. 4,56,405 crore has been budgeted to finance 82.1
per cent of gross fiscal deficit. The net market borrowing projection shows an increase of
2.1 per cent over the previous year. In terms of GDP, however, net market borrowings are
budgeted to decline to 3.2 per cent as compared with 3.5 per cent in the previous year.

7. Debt Sustainability at State Level in India

The attempts of fiscal consolidation at the centre also affect the fiscal situations at the
state level. However, the growing economies need increasing public expenditures at the
state as well as the central level. If the expenditure requirements of the states fall short of
their own revenue receipts and inter-governmental transfers from the central government,
the states too have to rely upon the borrowings to meet their socio-economic targets. In
India, the state governments often resort to borrowings to meet various development
needs. The debt position of the state governments in India, which deteriorated sharply
between 1997-98 and 2003-04, has witnessed significant improvement since 2004-05,
reflecting the impact of both favourable macroeconomic conditions and policy efforts by
the Central and state governments (Kaur et al., 2014). Despite the improvements in the
debt position of the state governments in India in the last decade, the recent growth
slowdown and volatility in the financial markets have raised fresh concerns about their
financial health. Actually, the state government finances in India have exhibited signs of
fiscal stress after the mid eighties. This can be observed from table 3. The table shows
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that the average debt to GDP ratio of all the states has increased from 18.3 per cent for
the period 1980-81 to 1991-92 to 20.8 per cent during the period 1992-93 to 1996-97.
The period from 1997-98 to 2003-04 witnessed a sharp increase in this ratio and reached
at 26.9 per cent. But it declined to 26.4 per cent during the period 2004-05 to 2012-13.
We can also observe that the special category states have much higher debt to GDP ratio
and it has been increasing ever since the period 1992-93 to 1996-97. At the disaggregated
level, the states of Punjab, Bihar, West Bengal and Uttar Pradesh are the states having
very high debt to GSDP ratio. For Punjab, it was 37.6 per cent in 2013-14 while for rest
of these states, it was more than 40 per cent.

Table 3: States' Debt-GSDP/GDP ratio (in per cent)

States 1981-82 to 1992-93 to 1997-98 to 2004-05 to
1991-92 1996-97 2003-04 2012-13
Non-special 20.7 23.0 31.2 30.6
Category States
Special 34.1 30.2 36.7 40.9
Category States
All States 18.3 20.8 26.9 26.4
Note: Ratios pertaining to ‘All States’ are as percentage to GDP.
Non-special category states, include Andhra Pradesh, Bihar, Chhattisgarh, Goa, Gujarat, Haryana, Jharkhand,
Karnataka, Kerala, M adhya Pradesh, M aharashtra, Odisha, Punjab, Rajasthan, Tamil Nadu, Uttar Pradesh and West
Bengal
Special category states, include Arunachal Pradesh, Assam, Himachal Pradesh, Jammu & Kashmir, M anipur,
M eghalaya, M izoram, Nagaland, Sikkim, Tripura and Uttarakhand.
Source: Kaur et al. (2014).

Traditionally, the assessment of the debt-sustainability is generally done in terms of

credit worthiness and the liquidity status of the economy. For this purpose, the debt and
debt service indicators are monitored to assess the existing debt as the ratio of various
fiscal balances. In addition, debt sustainability is also associated with a non-financial
dimension about the capacity to plan, organise and implement policies, which may be
both budget and debt-related. Improvement in fiscal conditions creates fiscal space, and
enhances debt repayment capacity, while worsening of fiscal conditions entails higher
borrowings, adding to the debt burden. Some of these indicators are explained here in
table 4. The table gives an overview of the fiscal situation of the states of India for the
period 1980-81 to 2012-13.

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MODULE No. 35 Fiscal policy in Action in India: Deficits and Debt over
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Table 4: Statistical Summary for Fiscal Variables for the Period 1980-81 to 2012-13
(per cent of GSDP/GDP)
States Revenue Total Total Revenue Primary Gross Primary
Receipts Receipts Expenditure Deficit Revenue Fiscal Deficit
(non- Deficit Deficit
debt)
Non- 12.69 13.03 16.34 0.84 -1.13 3.31 1.34
special
Category
States
Special 22.60 22.74 26.89 -1.13 -3.81 4.14 1.39
Category
States
All States 11.32 11.60 14.47 0.62 -1.10 2.87 1.15
'-' sign indicates surplus.
Source: Kaur et al. (2014).

We can see from this table that the total expenditure of the states during the period 1980-
81 to 2012-13 had been higher than the total non-debt receipts. It has been 14.47 per cent
of the GDP as compared to 11.60 per cent for the total receipts leading to a gross fiscal
deficit of 2.87 per cent of GDP. However, the primary deficit was 1.15 per cent of GDP
during this period. Actually, the sustainability of debt can be gauged on basis of six main
indicators. These are:

1. Rate of growth of debt should be lower than rate of growth of nominal GDP.

2. Rate of growth of debt should be lower than effective interest rate.

3. Real rate of interest should be lower than real output growth.

4. Primary balance as well as primary revenue balance should be in surplus.

5. Revenue receipts as percentage of GDP should increase over time but the revenue
variability, debt to revenue receipts ratio, debt to tax revenue ratio and the debt to own
tax revenue ratio should decline over time.

ECONOMICS PAPER No. 6 : Advanced Macroeconomics

MODULE No. 35 Fiscal policy in Action in India: Deficits and Debt over
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6. Interest payments as per cent of GDP, revenue expenditure as well as revenue

expenditure should decline over time.

In this respect, the RBI study by Kaur et al. (2014) has analysed the debt sustainability of
the states over four phases viz. Phase I from 1981-82 to 1991-92; Phase II from 1992-93
to 1996-97; Phase III 1997-98 to 2003-04 and Phase IV 2004-05 to 2012-13. This study
revealed that the rate of growth of debt of states at the aggregate level exceeded the
nominal GDP growth rate during Phase I and Phase III. However, the real rate of interest
on debt (i.e., effective interest rate adjusted for inflation) remained lower than the real
output growth in all the phases except in Phase III when it was almost equal to the real
output growth. The strain on state finances in Phase III was reflected in deterioration in
all the indicators of sustainability, with a sharp rise noticed in debt service burden. It was
also indicated that the primary balance ratio was negative in all the phases while primary
revenue balance ratio deteriorated sharply in Phase III, but improved slightly in Phase IV.
The improvement in various debt sustainability indicators in Phase IV was driven by
fiscal correction measures undertaken by the state governments, debt restructuring
initiatives of the Central government based on the recommendations of the 12th Finance
Commission along with the favourable interest rate environment. Interest payments,
which had crossed one-fifth of revenue receipts during Phase III declined to around 16
per cent in Phase IV. However, the debt repayment capacity and interest burden
indicators in Phase IV lagged behind their respective performance levels achieved in
Phase I. The positive gap between the rate of growth of GDP and effective interest rate in
all the phases, except Phase III, turned out to be a predominant factor that influenced the
movement of debt-GDP ratio during the period under review. It may be seen that most of
the states have met two of the debt sustainability conditions during the latest phase i.e.
Phase IV. Similarly, the rate of growth of GSDP is higher than the effective interest rate
in all the states. However, the third condition, i.e., the rate of growth of public debt
should be lower than effective interest rate is met by only two states, viz., Bihar and
Odisha. On basis of these results, this RBI study argues that while most of the debt
sustainability indicators showed significant improvement during 2004-05 to 2012-13
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compared to the earlier phase (1997-98 to 2003-04), debt repayment capacity and interest
burden indicators lagged behind their respective performance levels achieved during
1981-82 to 1991-92.

8. Summary

India has a federal form of government and therefore, the responsibilities and rights are
also shared between the centre, states and other levels of the polity and administration.
This is also true for fiscal management of the country. The central government is
responsible for issues that usually concern the country as a whole like national defence,
foreign policy, railways, national highways, shipping, airways, post and telegraphs,
foreign trade and banking. The state governments are responsible for other items
including, law and order, agriculture, fisheries, water supply and irrigation, and public
health. Like any developing economy, India too has a long history of running huge fiscal
deficits. The relationship among fiscal deficit, debt and output growth and other macro
targets is a much debated issue. However, the proponents of Keynes propagate the idea
that high fiscal deficits are not unusual for developing economies as governments use
fiscal deficits to keep aggregate domestic demand at high levels in order to generate
growth and employment. But lately, the government of India is trying to control the fiscal
deficit and the debt under the Fiscal Responsibility and Budget Management Act. This
has led to improvements in deficit indicators in the recent time periods. Same can be
observed at the state level. At the state level, it has been found that while most of the debt
sustainability indicators have shown significant improvements in the latest phase as
compared to the 80s and 90s, the debt repayment capacity and interest burden indicators
still lag behind as compared to their positions in earlier time periods. Still, the fiscal
position of India can be stated to be moving on the path of improvement.

ECONOMICS PAPER No. 6 : Advanced Macroeconomics

MODULE No. 35 Fiscal policy in Action in India: Deficits and Debt over
Time