M Govinda Rao: Fiscal adjustment: What prospects?

Persisting fiscal imbalance has been a major macroeconomic concern to policy makers in India. The remarkable downward inflexibility of fiscal deficits and the steady upward pressure on revenue and primary deficits have worried successive finance ministers. Despite their good intentions and efforts, success in achieving fiscal correction has been elusive.

Thus, the aggregate fiscal deficit-GDP ratio, after declining from 9.3 per cent in 1990-91 to 6.3 per cent in 1996-67, increased to over 9 per cent in 1998-99 and fluctuated around 9-10 per cent thereafter.

The revenue deficit increased from 3.6 per cent in 1996-97 to 6.7 per cent in 2002-03 and the primary deficit during the period increased from 1.1 per cent to 3.4 per cent. The share of the revenue deficit in the fiscal deficit increased from 50 per cent in 1995-96 to 67.5 per cent in 2002-03.

The Centre' recent attempts at fiscal reforms include the enactment of the Fiscal Responsibility and Budget Management Act (FRBMA). The Act sets the targets for the Centre's revenue deficit-GDP ratio to be reduced from 2.5 per cent in 2004-05 to zero and fiscal deficit to be brought down from 4.3 per cent to 3 per cent by 2007-08, which has been since shifted to 2008-09.

The strategy to achieve the targets was explored by the Task Force headed by Vijay Kelkar and more recently by the Twelfth Finance Commission (TFC).

Persisting fiscal imbalances have been attributed to several factors. The most important reason cited has been the inability of domestic indirect taxes to offset the revenue loss from the reduction in customs.

In fact, the former itself has declined over the years. Other reasons include rising pay and pension payments, increasing interest payments, poor productivity of public capital, and more importantly, pressures of competitive populism arising from coalition politics.

It is, however, curious that despite the persisting aggregate fiscal deficit of about 9-10 per cent of GDP for seven continuous years, the macroeconomic situation has been quite stable. This has raised the question as to whether the size of the fiscal deficit matters at all.

Despite a large drawing of household savings for government consumption and investment year after year, interest rates have remained benign. Therefore, it is argued that increased public spending on infrastructure financed through higher fiscal deficits would be a feasible option.

This contention is misplaced, for, fiscal imbalance has entailed significant growth costs. Pre-empting household savings for government consumption and crowding out infrastructure spending had an adverse effect on growth.

Moreover, the reason for continuing low interest rates despite heavy government borrowing has to be found in the decline in the ratio of corporate investment to GDP from 9.6 per cent in 1995-96 to 4.8 per cent in 2002-03. With its revival, the pressure will build on interest rates.

Interestingly, even in the benign interest rate regime, the small-scale sector could not access funds from the banking system at low cost due to high-risk premium attached to it. The managers of the financial system prefer to invest in government paper rather than lend to "risky" investments.

How is fiscal adjustment, mandated by the FRBMA, to be achieved? There are two sets of strategies, one worked out by the Kelkar task force (KTF) and the second, detailed by the TFC. The strategy for fiscal adjustment devised by the KTF mainly involves a "grand bargain" between the Centre and the states to calibrate a centralised goods and services tax.

Unfortunately, much as this is desirable from the viewpoint of economic efficiency, there are serious legal impediments. Besides, the states are unlikely to agree to this scheme.

The TFC has worked out sustainable levels of aggregate fiscal deficit for Centre and the states at 6 per cent of GDP and the targets for the Centre and the states is set at 3 per cent each. About two-thirds of the adjustment has to come from the revenue side; the tax-GDP ratio is stipulated to increase by two percentage points and the overall revenue-GDP ratio by three percentage points.

The expenditure-GDP ratio is set to decline by 1.7 percentage points primarily due to reduced interest payments. The capital expenditure ratio is set to increase by one percentage point.

For the central government, gross tax revenue is targeted to increase from 9.7 per cent in 2004-05 to 10.9 per cent in 2009-10, non-tax revenues are supposed to remain at the same level at 2.2 per cent of GDP, revenue expenditure is set to decline from 11.9 per cent to 10. 2 per cent and this should be achieved almost entirely by reducing interest payments.

Capital expenditure is set to increase by 0.5 percentage point. Overall, this adjustment is expected to reduce outstanding liabilities from 53 per cent of GDP to 43.7 per cent.

How are these adjustments to be achieved? The TFC advances several omnibus suggestions: tax administration should be improved, user charges should be determined by autonomous regulatory bodies, subsidies should be contained, salary expenditures as a percentage of GDP should be rolled back to the 1996-97 levels, the management of public expenditures should be guided by economy, efficiency and effectiveness to focus on outcomes, etc.

Indeed such "motherhood" statements can be found in all the Finance Commission Reports since the Ninth. At the state level, the main component of the strategy is to introduce the value-added tax (VAT). On this, it is doubtful whether the design of the tax and implementation strategy evolved by the Empowered Committee will ensure significant revenue gains.

Is the predicated scenario within the realm of feasibility? The question is pertinent because, one term of reference of the Finance Commissions right from the Ninth has focused on fiscal restructuring to eliminate revenue deficits and create surpluses for investment.

All the Commissions undertook the task in all seriousness, but neither the Centre nor the states bothered about the recommendations. In the event, outcomes varied widely from projections and instead of generating surpluses, the Commissions ended up merely distributing deficits!

This is not the Finance Commissions' fault because fiscal restructuring is not a function they are meant to undertake. The problem is political""an outcome of the declining time horizon of the politicians and competitive populism associated with coalition politics.

In fact, the Budget for 2005-06 allocates a Rs 25,000 crore outlay for the implementation of the National Common Minimum Programme and in coming years, additional amounts will be provided.

Not surprisingly, the finance minister has already pressed the "pause" button on the FRBMA. This he has done even after taking advantage of the additional cushion provided by the TFC, of stopping on-lending to states.

Surely, this gives a wrong signal and widens the credibility gap. Even before the ink on the FRBMA is dry, the Centre itself is caught in the web of non-compliance. Indeed, the TFC has recommended that the states too should enact a Fiscal Responsibility Act, but they are certain to take a cue from the Centre's "pause".

The important issue is, since the Ninth Commission, when the terms of reference on fiscal restructuring began, the Commissions' recommendations, despite their "acceptance", were not complied with. Unfortunately, there is little hope that this term will not be repeated for the next Finance Commission.

The author is Director, National Institute of Public Finance and Policy. The views here are personal.