«Fiscal Developments and Outlook in India Indira Rajaraman* Abstract The paper identifies those elements in the configuration of fiscal parameters ...»
Fiscal Developments and Outlook in India
The paper identifies those elements in the configuration of fiscal parameters
confronting the country that give cause for concern, and examines whether the fiscal
reform measures taken address these adequately. The primary fiscal indicators
consolidated across Central and state governments over the last fifty years, normalised
by GDP and taken in first differences, are examined for evidence of countercyclical fiscal
policy, and election-year profligacy. The underlying structural cause of fiscal stress since the start of reform in FY92 is then identified, as the uncompensated loss of trade tax revenues. This has led to a fall in the tax/GDP ratio, amounting by FY02 to two percent of GDP relative to the all-time peak of 16 percent achieved in FY90 (there is provisional evidence however of an upturn in FY03 by one percent). Finally, the two major fiscal reforms initiated in FY00 are examined. One is the accounting change whereby ‘small savings’, a supply-driven automatic borrowing channel, were re-routed into a newly created National Small Savings Fund, independently of the budget. Although just an accounting change, it had a profound effect in terms of signalling the need for financial viability in the small savings scheme, and thus eroding embedded political economy pressures in the system that served to keep up interest rates. The second major reform is the fiscal responsibility legislation that has been enacted by the Centre, and four state governments so far. Simulated outcomes show that without an improvement in revenue effort, the required fiscal compression of non-interest revenue expenditure is so extreme that it could well result in political turbulence. That could then feed back through the election-year compulsions revealed in the regression analysis to worsening fiscal discipline again. The paper concludes that improved revenue effort is key to fiscal reform in India.
JEL Numbers: D72, E62, H62 Key Words: revenue effort, election-year profligacy, political economy of federations, fiscal responsibility legislation *Reserve Bank of India Chair Professor, National Institute of Public Finance and Policy, New Delhi. This paper was presented at an NIPFP-IMF conference on Fiscal Policy in India, 16-17 January 2004. The author thanks T.N.Srinivasan for useful suggestions, and Deepti Jain for research assistance.
Fiscal Developments and Outlook in India Indira Rajaraman* Introduction The consolidated fiscal deficit in India aggregating across all tiers of government has in the last five years stayed in the range 9-10 percent of GDP.i The very large literature on the harmful growth impact of fiscal deficits of this magnitude is not reviewed in this paper.ii The focus instead is on identifying which particular features of the configuration of fiscal parameters confronting the country today are, or should be, cause for concern, and whether the fiscal reform measures taken address these adequately.
Worries about the sustainability of the public debt path in India have receded somewhat in the face of the favourable growth prospects in the current year, expected to extend into the medium-term,iii and the decline in nominal interest rates since FY00. The interest rate decline indeed, quite independently of its direct impact on debt sustainability, has been a critical factor in the current growth buoyancy of the economy, and is in turn an outcome of a major fiscal reform measure initiated in FY00.
Shepherding the decline through the political economy pressures keeping up interest rates required cautious and phased progress, and is undoubtedly one of the major successes of the fiscal reform effort.
Notwithstanding the rate decline, the interest bill on the consolidated debt stock in FY02 and FY03 was above 6 percent of GDP, as against tax collections of 14 percent in FY02, possibly 15 percent in FY03 (going by budget estimates).iv These figures, even with the tax upturn in FY03, are unsustainable in themselves.
Clearly any understanding of the fiscal situation in India requires identification of the drivers of fiscal imbalances in the system. Sections II and III of the paper address this.
Section II generates a fifty-year time series for the principal fiscal indicators aggregating across Central and subnational state governments, since it is this rather than the Central imbalance alone which matters macroeconomically. The data are then tested for evidence of countercyclical fiscal policy, and opportunistic election-year profligacy of the kind that has been empirically demonstrated elsewhere.v Received empirics focus on the Centre alone, perhaps because the fiscal deficit as internationally defined was not officially reported until FY89. Only the monetised deficit was reported, as the uncovered residual after subtraction from total expenditure of debt receipts along with non-debt receipts. The fiscal deficit for years prior to FY89 had to be generated here therefore.
In India, as in all developing countries, a distinction is made between the overall fiscal deficit, and the excess of current expenditures over revenue receipts (termed the ‘revenue deficit’). A high fiscal deficit in conjunction with a low revenue deficit (or surplus), is not necessarily a bad thing prima facie. When net new borrowing goes towards funding capital expenditure there is, potentially at any rate, a basis for both higher growth and higher revenues in future years. A high revenue deficit on the other hand carries fewer possibilities of recovery (although a contrary empirical finding in Devarajan, et. al., 1999 shows that growth in the developing world has a positive functional dependence on noninterest current expenditure rather than capital expenditure).
Within fiscal and revenue deficits, in turn, the imbalance of relevance for an understanding of year-to-year variations in fiscal policy is the corresponding primary deficit, the discretionary residual imbalance after subtraction of interest payments from total expenditure. Primary deficits, revenue and fiscal, are the variables subjected to the regression analysis of Section II.
There has been a clearly visible worsening in these primary indicators starting with FY98. This is popularly attributed to the real wage hike granted to civil servants on the recommendation of the Fifth Pay Commission. The wage hike is only the immediate precipitating factor however, and cannot be treated as an exogenous event. Section II examines whether that, in turn, was an endogenous outcome of the underlying political economy drivers of the system.
Section III looks at the steady worsening in the tax/GDP ratio over the nineties. The all-time tax revenue peak of 16 percent of GDP achieved in FY90 has been steadily eroded over the nineties, a result of the uncompensated loss of trade tax revenues. Trade tax cuts have undeniably given a long-overdue competitive edge and buoyancy to the economy. However, in a country where trade taxes accounted pre-reform for 3.7 percent of GDP, and 35 percent of total tax revenues at the Centre, the issue of fiscal compensation for lost revenues was grossly neglected. There was a vacuum in the theoretical literature on the optimal source of replacement revenue for reduced trade taxes, with no robust results on non-infinitesimal changes until a recent contribution by Keen and Ligthart, 2001. The price-neutral VAT suggested there as a welfare-enhancing source of compensation, however carries a political feasibility problem. An IMF empirical cross-country study does not encourage confidence in its revenue-enhancing properties in the developing world.
Thus, the fiscal stress in India today, as in all developing countries undergoing a process of trade tax reform, is a result of both theoretical and practical neglect of the revenue loss from falling trade taxes. Lost trade tariff revenues in India have resulted in an uncompensated loss in aggregate tax revenue, which had amounted to two percentage points of GDP by FY02.vi This is a disastrous decline in a developing country critically in need of growth-promoting public goods.
Sections IV and V examine two major official moves towards reform of the fiscal situation, against the background of the analysis of the earlier sections. Section IV examines the fiscal responsibility legislation initiated in FY00 and recently enacted by the Central government, and four state governments. The simulations of the fiscal correction projected in the legislation in Section IV show compression of non-interest current expenditure to a fairly extreme degree, which can be relieved only if there is a substantial improvement in revenue performance, over historically achieved rates of increase.
Section V examines the engineered reduction in nominal interest rates already referred to, starting with the accounting change in FY00 whereby ‘small savings’ were nested in a newly created National Small Savings Fund, independently of the budget. Although just an accounting change, it had a profound effect in terms of eroding embedded political economy pressures keeping up interest rates.
II. Diagnostics: Fiscal Indicators 1951-2001 The principal fiscal indicators for the fifty years 1951-2001, consolidated across national (Central) and subnational (state) governments, are examined in this section for evidence of countercyclical properties, and opportunistic behaviour by governments confronting elections.
Official reporting in India of the fiscal deficit as internationally defined started only in FY89. Perhaps for this reason, there are only two formal econometric studies of fiscal deficits in India going back beyond the nineties, both confined to the Centre (Sen and Vaidya, 1996 and Cashin, et. al., 2001).vii The data series for years prior to FY89 has been generated here therefore, and was terminated by data availability at FY01.viii The accounting discontinuity starting FY00 with the re-routing of small savings makes the Central fiscal deficit non-comparable across that year,ix but does not affect the consolidated fiscal deficit.
Chart 1 shows the fifty-year series for the primary revenue deficit and primary overall fiscal deficit, both as percentages of GDP, which define the discretionary component of the deficit after deducting interest on the public debt accumulated from past fiscal deficits. The difference between the two, in the absence of disinvestment receipts on the capital account (which by official figures only began in FY92)x yields the percentage of publicly-funded capital expenditure to GDP.
The figures exclude the third tier, local government. Local government is not empowered to run budgetary deficits, but urban xi corporations can borrow on a project-specific basis. Starting 1998, there are municipal bond flotations by urban corporations, aggregating to the comparatively trivial sum of 600 crore (Mathur, 2003). These are not added on here, because they are akin to borrowing by other parastatals.
Parastatal debt does not add to the explicit budgetary deficit but often carries a Central or state government guarantee. The issue of guarantees will be addressed in section IV of the paper Chart 1: Primary Fiscal and Revenue Deficits
Notes: 1. Primary deficits are obtained after subtracting interest payments from the reported consolidated figure across Centre and states, which nets out inter-governmental flows. All reported capital expenditure figures are net of loan recoveries, and net out loan repayments.
2. Negative values indicate primary surpluses.
Source: The fiscal deficit (FD) starting FY89 is the reported figure in Government of India, 2003b, assorted issues. For earlier years, obtained from the difference between expenditure and non-debt current receipts from the same source, or where unavailable, as for the fifties, from Rangamannar, 2002. The change starting FY00 in the role of the Central government as on-lender of small savings to states (see section V) does not affect the consolidated figure.
The following stylisations of the Indian fiscal stance over the fiftyyear period emerge quite clearly from chart I:
• The primary revenue balance was in surplus until FY98. It is only starting FY99 that there has actually been a primary revenue deficit, never exceeding 1 percent of GDP.
• The primary fiscal balance has been consistently in deficit all through, but in conjunction with the primary revenue surplus, has clearly gone towards funding of capital expenditure, and thus towards the accumulation of public assets. The efficiency or revenue-yielding properties of that capital expenditure are another matter altogether.
• The primary fiscal deficit (PFD) reached an all-time peak of 7 percent of GDP in FY87. The downward adjustment of the PFD by 6 percentage points of GDP over the ten years 1987-97 against a roughly constant primary revenue surplus (negative PRD) of around 1 percent of GDP implies a corresponding reduction in public capital expenditure. Independently of the quality of the capital expenditure in previous years, fiscal correction through reduction of capital expenditure robs it of growth-promoting properties. After 1997, the PFD has risen again to its present level of around 3.5 percent of GDP.
• Starting FY98, both fiscal and revenue balances have worsened in tandem.
Chart 2: Fiscal and Revenue Deficits and Interest Rates on Public Debt
Notes and Source: See notes and source to chart 1. The interest rate for year t is the average nominal rate, calculated from interest payments in year t on the closing debt stock in year (t-1).
Chart 2 shows the fiscal and revenue deficits, along with the nominal interest rate (the average paid on the closing stock of the previous financial year of public debt, external plus internal, including monetised liabilities held by the RBI). This average rate, which is a lagged indicator of the marginal rate on fresh liabilities, shows a steady rise from the eighties after a long period of stagnation at 4 percent, finally peaking in FY00. Clearly, it is the interest bill that drove the emergence of a consolidated revenue deficit in 1983, and its steady rise thereafter, at a time when the primary revenue balance was still in surplus.
There are thus two basic components to the fiscal deficit story.