V Fiscal Adjustment and Reform
Author: Mr. Richard Hemming
Language:
English
Keywords:
OP; investment; India; liberalization; state government expenditure; import duty; expenditure priority; expenditure slippage; government indebtedness; Government debt management
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Abstract

The links between fiscal policy, investment, and growth are complex. Changes in the overall fiscal balance as well as in the structure of expenditure and taxation have important implications for investment and growth. This section examines the influences of each of these elements in turn over the recent reform period, before looking at the issue of center-state relations.

The links between fiscal policy, investment, and growth are complex. Changes in the overall fiscal balance as well as in the structure of expenditure and taxation have important implications for investment and growth. This section examines the influences of each of these elements in turn over the recent reform period, before looking at the issue of center-state relations.

The Magnitude of Fiscal Adjustment

In 1990/91, the consolidated public sector deficit was 10½ percent of GDP (Table 5.1). It had been high and rising throughout the second half of the 1980s. The upward trend was mainly the result of weakening central government finances, which in turn arose from an inelastic tax system and the rising burden of interest payments and other current expenditure. State government finances also deteriorated over this period, again because of stagnating revenues and rising current expenditure. Moreover, public enterprises were a drain on the budgets of both the central government and state governments.

Table 5.1.

Fiscal Deficits

(In percent of GDP)

Sources: Government of India, budget documents and Public Finance Statistics; and IMF staff estimates.

The public sector deficit is the sum of the deficits of the central government, state governments, and public enterprises less loans from the central government to state governments and public enterprises.

Central government public enterprises only.

In 1994/95, the public sector deficit still stood at 10½ percent of GDP, but this unchanged position masked an uneven pattern of fiscal adjustment in the intervening period. In first two years of reform, the deficit fell by 2 percentage points of GDP. But this gain was more than lost in 1993/94 and then barely recovered in 1994/95.

The behavior of the public sector deficit over this period very much mirrored that of the central government deficit. Thus, the latter was reduced by about 2½ percentage points of GDP between 1990/91 and 1992/93, mainly because of an increase in nontax revenue (including the proceeds from asset sales) and a reduction in capital expenditure (on infrastructure and loans to states and public enterprises). Central government public enterprises also contributed to fiscal adjustment, both through increased profits and lower capital spending. However, at the state level, despite an increase in tax collections over this period, higher spending led to a widening deficit.

To some extent, structural reforms led to the setback in 1993/94. Import duty reductions had a larger negative influence on revenue than was anticipated, while financial reforms raised interest costs.1 There were also expenditure slippages, including a reversal of earlier cuts in defense spending. While state government finances showed little change, public enterprise investment picked up and contributed to a further increase in the overall deficit. In 1994/95, the beneficial impact of the strong expansion on revenue, as well as receipts from asset sales, contributed to a reduction in the central government deficit, but the financial position of the states is likely to have deteriorated further.2

Notwithstanding the subsequent slippage, the stabilization of the economy owed much to the initial fiscal adjustment, which increased the credibility of macroeconomic policy and bolstered business confidence. Nevertheless, the cutback in public sector investment of about 1 percent of GDP in 1991/92–1992/93 had an adverse multiplier effect through the economy and on certain sectors in particular (for example, capital goods) that contributed to the growth slowdown in this period. The relaxation of fiscal policy in 1993/94 helped to preserve a faltering growth momentum. But the legacy was a high deficit and increasing government indebtedness. This situation has raised serious questions about the medium-term sustainability of fiscal policy, as well as an immediate risk that public sector claims on private savings would crowd out private investment as the economic expansion gathered strength (Table 5.2).

Table 5.2.

Domestic Savings

(In percent of GDP)

Sources: Government of India, National Accounts Statistics, budget documents, and Public Finance Statistics; and IMF staff estimates.

Taxation

Tax revenue of central and state governments amounted to just over 16 percent of GDP in 1990/91, two thirds of which was collected by the central government. After the statutory sharing of personal income tax and excise duty revenue, the revenue shares were approximately equal.3 The central government derived nearly 80 percent of its revenue from excise duties and customs duties, while the state governments collected 70 percent of their revenue from sales tax (Table 5.3). The emphasis on indirect taxation was, therefore, heavy. The tax ratio had increased by about 2 percentage points of GDP during the 1980s, with most of the increase from customs duties. This reflected the central government’s tendency to raise discretionary revenue in a manner that would minimize the need to share the proceeds with state governments.

Table 5.3.

Tax Revenue

(In percent of GDP)

Sources: Government of India, budget documents and Public Finance Statistics; and IMF staff estimates.

Central government divestment proceeds only.

The pre-reform tax structure suffered from a number of structural deficiencies.

  • Excise duties (the main domestic indirect tax) were levied by the central government on a narrow base, equivalent to about 20 percent of traded output in 1990/91. Agriculture and small-scale industry and commerce were the principal omissions. The structure of tax rates was also differentiated elaborately, with many specific rates. A rebate scheme for tax paid on inputs (Modvat) had been introduced in 1986/87, but key sectors (including capital goods) were excluded. There was, therefore, significant cascading of tax rates, which together with the complex rate structure implied an arbitrary and distortionary tax structure.

  • Customs duties were high and differentiated, with many general and user-specific exemptions. Because of high excise and customs duties on capital goods, effective protection was sometimes much less than the high customs duties alone would suggest. The pattern of effective protection was also highly variable, with little apparent economic rationale.

  • Personal income tax had narrow coverage, with the tax base amounting to no more than 8 percent of GDP in 1990/91. Tax rates had been brought down and reduced in number during the 1980s, but the top rate of 50 percent, with a surcharge of 8 percent, was still high. For corporate tax, depreciation allowances and tax incentives were generous, offsetting high tax rates. The basic rates of 45 percent and 50 percent on domestic companies were also augmented by an 8 percent surcharge. The surcharges on the personal income tax and the corporate tax reached 12 percent and 15 percent, respectively.

  • State sales taxes varied widely in coverage, point of collection, and rates. They were not integrated with excise duties, which compounded the distortionary impact of the latter.

  • Tax administration was weak, resulting in high rates of noncompliance.

Since 1990/91, apart from an initial round of corporate tax and excise duty increases needed in support of stabilization, the central government has implemented a wide range of tax reforms aimed at producing a simpler and fairer tax system, consistent with fostering economic growth. These reforms have been guided by the report of the Chelliah Committee on tax reform (Tax Reforms Committee (1993)).

The principal feature of the tax reform has been the general lowering of tax rates (Table 5.4). Combined with a narrowing of the dispersion in tax rates, this has led to a reduction in distortions and disincentives. The structure of indirect taxes has also been improved. Most rates are now ad valorem, and many end-use exemptions have been eliminated. In addition, the Modvat has been extended, most notably by the inclusion of the capital goods and petroleum sectors. A limited number of services (telephones, insurance (other than life insurance), and stockbrokers) are also taxed outside of the Modvat. Import duties—particularly for capital goods, raw materials, and intermediate goods—have been lowered and restructured in tandem with trade liberalization. Rates are now converging to those recommended by the Chelliah Committee, with the average tariff rate now at 27 percent (incorporating the reductions in the 1995/96 budget), close to the Committee’s target rate of 25 percent.

Table 5.4.

Tax Rates

(In percent)

Sources: Indian authorities; World Bank; and IMF staff calculations.

Includes 8 percent surcharge.

Includes 15 percent surcharge.

On the direct tax side, the personal exemption has been raised, the top rate has been lowered to 40 percent, and the surcharge has been withdrawn. Lower tax rates, administrative improvements, and increased use of tax withholding have raised the number of taxpayers. The corporate tax is now levied at a uniform rate of 40 percent on domestic companies, but the 15 percent surcharge has been retained. To improve tax administration, there has been increasing use of minimum taxes and withholding, and computerization is being introduced. However, progress with reducing exemptions for both personal and corporate tax has been slow.

The recent reforms have produced a significant shift in the structure of tax revenue from trade taxes to income taxes, as shown in Table 5.5. This shift should allow redistributional objectives to be addressed more fully and systematically, which will be an important element in ensuring that growth is sustainable. In addition, lower import duties will make Indian industry more competitive, while reduced taxes on capital and intermediate goods will lessen distortions in production and encourage investment. Nevertheless, the tax-to-GDP ratio remains lower than in 1990/91, and greater effort is needed to increase the tax base. Widening the bases of the personal income tax and the corporate tax, by reducing exemptions and other tax concessions, is especially important and would provide the basis for further rate cuts and the elimination of the surcharges.

Table 5.5.

Central Government Revenue Shares

(In percent of gross tax revenue)

Source: Government of India, budget documents.

Corporate and personal tax.

The final steps to move to a more comprehensive value-added tax (VAT) at the central level will generate dynamic efficiency gains over time, even if the short-term revenue benefits will be small. There is immediate scope to impose indirect taxation on a wider range of services, either inside or outside the VAT. But perhaps the greatest remaining task is to replace the sales tax at the state level with a VAT, which would allow the elimination of important distortions (including the taxing of interstate trade), as well as more effective taxation of wholesale and retail margins.

Expenditure

Data shortcomings complicate the analysis of public expenditure trends in India and their impact on investment and growth. Indian public finance data distinguish between current and capital expenditure, development and nondevelopment expenditure, and plan and nonplan expenditure. None of these clearly separates public consumption from public investment or, more generally, productive from unproductive expenditure. A breakdown of expenditure into economically meaningful categories provides some guidance, but in India such a breakdown is only available for central government expenditure, which is half of the total, and available only with a considerable lag.4 Moreover, the states are responsible for most expenditure on infrastructure and social programs, on which only limited information is available.

Central government current expenditure at the beginning of the reform period was dominated by interest payments, defense spending, subsidies, and grants to states (Table 5.6). Much of the noninterest expenditure was unproductive. For example, the subsidy program for fertilizers not only had a high budgetary cost but also introduced a serious price distortion. Despite efforts to contain spending, with rising interest payments and subsidies current expenditure increased throughout the 1980s, and resources were drawn from capital programs, including loans to states and infrastructure, as well as operations and maintenance.

Table 5.6.

Central Government Expenditure

(In percent of GDP)

Sources: Government of India, budget documents and Public Finance Statistics.

Includes defense capital expenditure.

State current expenditure also rose, particularly the wage bill (Table 5.7). Consequently, infrastructure investment was squeezed, while other programs controlled by the states—most notably education, health, and poverty alleviation programs—did not receive sufficient funding. At the same time, rates of return on projects were low, partly because little use was made of proper investment appraisal techniques and poor management of programs. Many social programs were inefficient. Health and education programs paid insufficient attention to basic education and health care, while the increasing share of spending taken up by wages led to shortages of teaching materials and medical equipment. Anti-poverty programs did not always reach the intended beneficiaries. In particular, the large, high-profile programs that pre-empted most resources—the Integrated Rural Development Program, the Public Distribution System, and the main rural public works program—were subject to significant leakages and high administrative overheads.

Table 5.7.

State Government Expenditure

(In percent of GDP)

Source: Government of India, Public Finance Statistics.

The pattern of expenditure adjustment for the 1990/91–1994/95 reform period is shown in Table 5.8, which reports the elasticity of individual expenditure components with respect to total expenditure.

Table 5.8.

Central Government Expenditure Elasticities, 1990/91–1994/95

Sources: Indian authorities; and IMF staff calculations.

Current expenditure has risen twice as fast as total expenditure, although much of this reflects rising interest payments. The elasticity of noninterest current expenditures has been substantially less than 1, with the negative elasticities for both subsidies and wages showing that these—and especially the former—have borne a significant share of expenditure adjustment. In the case of subsidies, the negative elasticity in large part reflects the elimination of export subsidies. Capital expenditure as a whole has an elasticity of almost –3, with the elasticity for spending on economic services (which includes infrastructure) being especially negative.

Expenditure reform has clearly lagged behind tax reform. The composition of spending is still skewed toward unproductive expenditures. The reduction in the wage bill has reflected more a squeeze on real wage rates than reductions in excess labor. Inefficient food and fertilizer subsidy programs remain in place. Although allocations for social sectors and poverty programs have generally been protected, albeit at low levels, little action has been taken to improve program efficiency.5 A thorough reappraisal of the structure of expenditure is called for, supported by more effective expenditure control mechanisms. Greater emphasis needs to be placed on maintenance spending; reducing excess labor; reordering expenditure priorities; improved program design, management, and implementation, thus curbing leakages and administrative overheads; cost recovery (especially for higher education and curative health care); and an expanded role for the private sector.

Center-State Relations

The fiscal adjustment process since 1990/91 has relied heavily on measures taken by the central government, which indicates the constraints that the federal system of government places on the center’s ability to influence state finances. The constitution assigns to the states primary responsibility in a number of key expenditure areas and the right to levy certain taxes. States then receive formula-based shares of central tax revenue, as well as grants and loans. While in principle grants and loans have a discretionary element, in practice this has been limited. The central government has therefore restricted states’ ability to borrow and has raised the cost of borrowing to market levels to impose financial discipline upon them. But this has not provided sufficient leverage to force states to address their four major problems: a weak revenue effort; a growing wage bill; uneconomic enterprises (especially in the areas of electricity distribution and transportation); and low cost recovery.

State finances need to be strengthened, for both macroeconomic and structural reasons. As regards the former, the risk is that expansionary policies on the part of states will compromise fiscal adjustment at the center. From the latter standpoint, the inefficiency of state spending programs curtails the scope for efficiency gains from adjustment by the center. In particular, inadequate infrastructure and human capital—both of which are substantially state responsibilities—have large spillover costs. Similarly, inefficient state taxes can limit the benefits from the reform of central taxes.

Shifting the burden of adjustment to the states requires a change in the way expenditure decisions are made by states. In particular, their discretionary spending should be limited by their ability to raise the revenue to pay for it. This in turn requires that states be provided with a flexible, nondistortionary source of own revenue. In this connection, introduction of a state-level VAT, as a supplement to an expanded central Modvat, would be an important measure. This has to be accompanied by revenue-sharing and transfer arrangements that impose expenditure discipline by not validating discretionary spending. In particular, the total resources flowing from the center to the states—revenue shares, grants, and loans—should be guided by the expenditure responsibilities assigned to them rather than the spending they choose to undertake.6 In combination with tight control of borrowing, this would impose a hard budget constraint on states, which would in turn force them to control wages, to improve enterprise efficiency, and to increase cost recovery.

Table 5.9.

Fiscal Operations

(In percent of GDP)

Sources: Data provided by the Indian authorities; and IMF staff estimates.

The consolidated public sector comprises the operations of the central government, the state governments, and the central public enterprises.

The figures for the states’ deficit in 1994/95 are IMF staff estimates.

The Need for Fiscal Consolidation

A central policy challenge facing India is to reduce its extremely high public sector deficit. Continuing high deficits have a number of adverse consequences:

  • The task of preserving macroeconomic stability is complicated as a heavy burden is put on monetary policy.

  • There is a risk of a rising public debt and debt-service burden that would eventually become unsustainable.

  • National savings are lowered, thus reducing the scope for domestic investment without heavy reliance on foreign savings.

  • The pace of structural reform could be slowed, particularly trade liberalization and financial sector reform.

As noted earlier in this section, the stabilization of the economy owed much to the initial reduction in the central government fiscal deficit. However, in view of the subsequent fiscal slippage at the central level and a deterioration of the states’ fiscal position, the consolidated public sector deficit in 1994/95 remained around its level in 1990/91 (Table 5.9).

Thus, the stock of public sector debt is estimated to have reached about 90 percent of GDP, which is very high by international comparison.7 Also of concern is the high primary deficit of the consolidated public sector, estimated to be nearly 4 percent of GDP in 1994/95.

Until recently, India financed its deficits to a large extent by borrowing domestically (including from the central bank) at below-market interest rates. The maintenance of high cash reserve and statutory liquidity ratios on bank deposits created a captive market for low-interest government debt. Four years ago, over two thirds of bank deposits were preempted by the government because of these high ratios, thereby eroding bank profitability. However, a number of steps have been taken since 1991 to strengthen the financial system and to shift government borrowing to market terms. This has contributed to a rise of about 2 percentage points in the implicit interest rate on outstanding government debt to about 10 percent.8 The shift to market borrowing in the context of high primary deficits has meant a sharp increase in the government’s interest bill, which has risen from 5¼ percent of GDP in 1990/91 to almost 7 percent of GDP in 1994/95 (see Table 5.9). Interest payments absorb nearly one third of public sector revenue, and over one fourth of current spending.

India’s high fiscal deficit has created tensions in macroeconomic management and hindered progress in structural reform. The trade-offs between the authorities’ multiple objectives of containing the debt-service burden, reforming the financial system, controlling inflation, and achieving rapid growth have become increasingly evident. The tightening of liquidity since October 1994 has contributed to rising real interest rates, a reduction in banks’ holdings of excess government securities, and increased difficulties in managing the borrowing program. Given the rising cost of borrowing in the market, there are increasing pressures on the Reserve Bank to accommodate the fiscal deficit. The high deficit also hinders the progress in financial sector reform; limited flexibility in fiscal policy has encouraged the use of directed credit programs to achieve development objectives, while the cash reserve requirement and the statutory liquidity ratio remain high. Furthermore, continued import tariff reductions may be affected by concerns about the potential loss of revenue from a reduction in rates.

Sustainable fiscal consolidation will require vigorous efforts by all levels of the public sector—the center, states, and public enterprises. In this connection, although a restructuring and streamlining of expenditures is required, it is unlikely that the overall ratio of government spending relative to GDP can be brought down appreciably. Interest payments will continue to rise, while the heavy demands for productive spending in areas such as infrastructure, education, and health care would need to be met. Inevitably, therefore, much of the deficit reduction would need to be achieved by raising the ratio of revenues to GDP. This will require continuing efforts to broaden the tax base so that revenue yield can be increased without adversely affecting economic efficiency.

As discussed above, the states will need to make a greater contribution to the adjustment process. Accelerated public enterprise reform could also contribute to fiscal adjustment. Improved profitability of public enterprises would boost dividend payments and reduce the need for direct budget support, without jeopardizing essential public investments. An ambitious divestment program could generate resources to retire domestic debt, thus lowering interest costs.

In conclusion, without substantial fiscal adjustment, it will be difficult to achieve both low inflation and the rapid growth that is needed to make effective inroads against poverty. Although the task will not be easy, with determined efforts it should be feasible to eliminate the primary deficit of the consolidated public sector by the end of this decade.

1

With stagnant imports and a reduction in the average (import-weighted) tariff from 64 percent to 47 percent, revenues from customs duties fell from 3.4 percent of GDP in 1992/93 to 2.8 percent of GDP in 1993/94. However, as discussed in Section VII. with the gradual elimination of tariff exemptions the collection rate fell only slightly from 32 percent in 1992/93 to 28 percent in 1993/94. Central government interest payments rose from 4.4 percent of GDP in 1992/93 to 4.7 percent of GDP in 1993/94; about half of this increase can be attributed to a rise in interest rates on government debt.

2

Although revised estimates for the states’ finances are not yet available for 1994/95, their deficit is estimated to have increased in part as a result of an unanticipated increase in resources received from small savings deposits. It is assumed that the states spent these additional resources.

3

States received 8.5 percent of personal income lax revenue and 45 percent of excise duty revenue collected by the central government. These percentages were changed with effect from 1995/96 to 77.5 percent and 47.5 percent, respectively.

4

The data are adjusted for transfers from the central government to states.

5

For example, a large part of the expenditure under the “public distribution system” is due to the high costs of the Food Corporation of India, including its excessive staffing and inefficiencies in its purchase, storage, and transport operations.

6

The Tenth Finance Commission (Ministry of Finance (1994)) has recommended that grants-in-aid, which at present are set to fill anticipated resource shortfalls at the stale level, be phased out. In addition, the Commission has recommended that a uniform rate be applied across all taxes collected by the center in determining the states’ share of these taxes.

7

This figure represents the gross liabilities of the consolidated public sector, which comprises the operations of the central government, the state governments, and the central public enterprises, but not the state public enterprises.

8

The marginal cost of government borrowing, for example through a ten-year bond, is about 14 percent at present.

Within Same Series

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Cover India
India
Economic Reform and Growth
Author: Mr. Richard Hemming, Woosik Chu, Mr. Charles Collyns, Ms. Karen Elizabeth Parker, Mr. Ajai Chopra, and Mr. Oliver Fratzscher
ISBN:
9781557755391
ISSN:
0251-6365
Publication Date:
01 Jun 1995
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557755391.084
Pages:
88

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