A call for greater focus on revenue side

Government must strategically expand the fiscal space to face any exogenous shocks

The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in August 2003, mandating the central government to reduce the gross fiscal deficit (GFD) to 3 per cent of gross domestic product (GDP) by 2008, with some escape clauses. In April 2018, the primary target of GFD of 3 per cent was replaced by the debt-GDP ratio of 40 per cent, with the GFD of 3 per cent being made the operational target. 

After the FRBM Act was enacted, there have been two periods of fiscal consolidation efforts. In the first period, the GFD was reduced from 5.8 per cent in 2002-03 to 2.6 per cent in 2007-08. However, with the collapse of Lehman Brothers in September 2008, the global financial crisis (GFC) hit many countries, including India, because of which the GFD surged to 6.6 per cent by 2009-10. After a brief hiatus, fiscal consolidation resumed from 2010-11, and the GFD was reduced to 3.4 per cent of GDP by 2018-19.

However, India, along with many other countries, was impacted by the pandemic in 2020, which sent the GFD of the central government soaring to 9.2 per cent of GDP in 2020-21, and the debt-GDP ratio to 61.0 per cent, much above the mandated target of 40 per cent. Thus, on both these occasions, the hard-won gains of fiscal consolidation of several years were wiped out by the two separate exogenous shocks. 

There were some marked differences in the two periods of fiscal consolidation. First, the pace of fiscal consolidation (0.6 per cent of GDP each year on an average) in the first period (2003-08) was fast. In this period, fiscal consolidation was achieved partly by compressing expenditure and partly by raising revenue. Of the total fiscal consolidation of 3.2 percentage points  during this period, fiscal consolidation of 2.1 percentage points was achieved by compressing expenditure and 1.1 percentage points by augmenting revenue. The gross tax-GDP ratio during this period improved significantly from 9.1 per cent of GDP in 2003-04 to 12.1 per cent by 2007-08. This was driven both by an increase in personal income tax revenue rising from 1.1 per cent of GDP in 2003-04 to 1.8 per cent by 2007-08 and also corporate tax collection from 1.6 per cent of GDP to 3 per cent.

In the second period (2010-2019), fiscal consolidation was only of 1.7 percentage points (0.2 per cent of GDP on an annual average basis) comprising expenditure compression of 1.5 per cent of GDP and 0.2 per cent of revenue augmentation. The tax-GDP ratio was broadly unchanged at 10.5 per cent of GDP during this phase. Corporate tax revenue declined from 2.7 per cent of GDP in 2010-11 to 2.2 per cent of GDP in 2018-19, primarily due to the tax cuts announced in September 2019, which were intended to spur private corporate capital expenditure (capex). However, corporate taxes remained sluggish at 2 per cent of GDP even in 2023-24 as the private capex cycle has failed to pick up so far.

Two inferences can be drawn from the above analysis. First, any major exogenous shock can throw government finances completely out of gear. Therefore, to better withstand any exogenous shock in future, it is important to create enough fiscal space when macroeconomic conditions are normal. Second, fiscal consolidation (required to create fiscal space) needs an improvement in the tax- GDP ratio. There are limits to fiscal consolidation by compressing expenditure, especially because about two-thirds of revenue is pre-empted by committed items such as interest payments, defence and pension. Therefore, fiscal consolidation beyond a point can be achieved only by improving the tax-GDP ratio.

The central government has done well to follow a glide path of fiscal consolidation, whereby the GFD was reduced to 5.8 per cent of GDP in 2023-24 and it is budgeted (Interim Budget) to decline to 5.1 per cent of GDP in 2024-25. Despite this fiscal consolidation, the debt-GDP ratio remained elevated at 55.3 per cent of GDP in 2023-24. 

Our analysis suggests that given the current macroeconomic conditions, the interest rate on 10-year benchmark Government of India securities and the primary deficit reduction by 0.6 per cent of GDP (average of last three years) every year from 2025-26 onwards up to 2030, the debt-GDP ratio will moderate, but it would still remain elevated at 54.4 per cent in 2030. 

In the 20 years since the FRBM Act was enacted, 2007-08 was the first and the only instance when the mandated target was achieved. There is no denying that two unprecedented exogenous shocks hit the economy, requiring huge fiscal stimulus on each occasion, but it is also true that we have not made sufficient efforts to improve the tax-GDP ratio — the key to sustained fiscal consolidation and reduction in the debt-GDP ratio. Concerted efforts, therefore, need to be made to raise the direct taxes-to-GDP ratio by broadening and deepening the tax base and improving the tax administration. In addition, efforts also need to be made to rationalise expenditure, wherever possible. Fiscal policy needs to create enough space in a calibrated manner to face any exogenous shock in future and play the counter-cyclical role effectively. 

The writers are, respectively, senior fellow, and research associate, Centre for Social and Economic Progress.