India's post-pandemic fiscal future

Tax collection in the current fiscal year is likely to exceed the Budget estimate by a significant margin. This would not only enable the government to increase growth-enhancing capital expenditure but also help reduce the fiscal deficit to some extent. The Union government is targeting to contain the fiscal deficit at 6.8 per cent of gross domestic product (GDP) in the current fiscal year, compared to 9.5 per cent last year. However, better-than-expected revenue collection in the current year should not lead to an underrating of medium-term fiscal challenges. The general government debt has increased to about 90 per cent of GDP and, according to International Monetary Fund (IMF) projections, it will remain above 85 per cent of GDP by 2026-2027, which would be over 10 percentage points higher than the pre-Covid level. 

To be fair, India is not the only country where government debt has gone up substantially. The global public debt is estimated to have increased to about 100 per cent of GDP, with advanced economies contributing the most in 2020. Developed countries provided large fiscal support, which has led to a sharp recovery from the pandemic-induced economic disruption. Although the global debt stock is expected to remain elevated in the medium term, India will need to work on multiple levels to bring government finances under control and redirect spending to support growth. It cannot sharply reduce spending to contain debt and deficit in the near term as this would impair economic recovery. Thus, the government would need to strike a balance. As the IMF suggested in its recent report on India, fiscal space can be created through a credible medium-term consolidation strategy. The Union government has said that the fiscal deficit will be brought down to 4.5 per cent of GDP by 2025-26.

In this context, the government would do well to present a clear road map along with revised fiscal responsibility and budget management (FRBM) rules. According to IMF projections, India’s general government Budget deficit will come down to 7.8 per cent of GDP by 2026-27, compared to 12.8 per cent in the last fiscal year, but this will again be higher than the pre-pandemic level. Higher deficit and debt will affect government spending in the coming years with implications for growth. The government will, therefore, need to work on both revenue and expenditure fronts to attain faster consolidation without hurting growth prospects. It is also important to create some policy space as soon as possible. One of the biggest reasons why India’s fiscal response during the pandemic remained relatively muted compared to other large economies was the lack of policy space.
 

On the revenue side, the government will need to systematically address the low and stagnant tax-to-GDP ratio. India’s tax gap is said to be worth about 5 per cent of GDP. The goods and services tax (GST), for instance, has not performed as desired. Issues in the GST system, including simplification of processes and adjustment of rates to the revenue-neutral level, need to be addressed immediately. This is also urgent because the flow of compensation to states against the shortfall in GST collection will end next year. This could affect the fiscal position of a large number of states and create policy risks. A more robust indirect tax system is also necessary to reduce the dependence on high fuel taxes to fund government expenditure, which may not be sustainable in the medium term. The direct tax system needs to be reviewed as well to increase the tax base. Besides, the government will need to aggressively push the disinvestment programme to raise resources.    

The post-pandemic fiscal future would also depend on the way government expenditure is directed. The quality of expenditure is an issue as the government has been borrowing to fund current expenditure. As a recent article by Reserve Bank of India economists highlighted, the share of revenue deficit in gross fiscal deficit has been around 70 per cent for the Central government, which is more than twice the level envisioned by the FRBM review committee. As a result, capital outlay of the government has suffered. As a percentage of GDP for the central government, for instance, it has remained stagnant for decades. It improved for states in recent decades, but worsened over the last few years. A review and redirection of expenditure would be necessary for healthy consolidation.

The biggest risk to consolidation and debt sustainability, to be sure, would be slower economic growth. The IMF expects India’s medium-term potential growth to be about 6 per cent. The policy establishment will need to aggressively push reforms to attain higher sustainable growth. Higher public sector resource requirements for an extended period would affect longer-term growth potential. At a broader level, since both private and public sector expenditure is likely to remain constrained for some time, India must focus on exports for higher growth. It’s also necessary to sustain higher growth for a considerable period. However, exports as a percentage of GDP slipped from about 24 per cent in 2008 to about 18 per cent in 2020. The government should focus on convincingly reversing this trend. A lower than desired policy intervention at various levels could make government finances a constraint for growth in the medium term and increase financial stability risks.