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Pravakar Sahoo
Geethanjali Nataraj

CORRECTING fiscal imbalances is undoubtedly the most important of the unfinished agenda of economic reforms. The two-pronged fiscal consolidation strategy, of augmenting revenues and rationalising expenditure, has not been successful.

Though the fiscal deficit was brought down from 8.3 per cent in 1990-91 to 5.9 per cent in 1991-92, the Government has failed to keep it below 5 per cent. A major reason for this is the increasing revenue deficit, which has been over 3.5 per cent of GDP in the past four years.

The high and consistent increase in revenue deficit can be attributed to the rising revenue expenditure (12-14 per cent of GDP in the 1990s), comprising interest payments, pensions and subsidies.

Though there has been a marginal decline in total expenditure, this has been at the cost of capital expenditure.

The expenditure on capital formation (from 5.6 per cent of GDP in 1990-91 to 2.3 per cent in 2000-01) and social sectors, which is important for sustainable economic development, has fallen substantially.

Given the rigidity in the structure of government expenditure, revenue enhancement through tax reforms has been emphasised as the key to fiscal consolidation.

While the impact of tax reforms — the reduced slabs and rates of taxation for both income-tax and excise duty and the unification of corporation tax — has been positive, the tax structure still remains complicated, with innumerable exemptions and incentives.

Also, the tax-GDP ratio has been showing a declining trend. The Centre's gross tax revenue as a percentage of GDP has dropped steadily, from 10.1 per cent in 1990-91 to 8.6 per cent in 2001-02.

This could be attributed to a reduction in indirect tax revenue, which has slipped 2.9 percentage points over the last decade.

However, thanks to tax reforms, corporate and personal tax revenues as a per cent of GDP have been buoyant. The share of direct taxes in GDP, though still low, has been increasing steadily (see Table). On the whole, tax reform is one area of the strategy which appears to be working quite well. Efforts to broaden the tax base, coupled with stronger tax enforcement, need to be continued.

In the context of the numerous incentives and exemptions, much of the Kelker Committee recommendations should be implemented.

As regards indirect tax reforms too, most of the recommendations are welcome, particularly on the implementation of a nationwide value-added tax and a comprehensive service tax. Removal of exemptions and curbing leakages that arise out of exemptions extended to small-scale industries would certainly help the exchequer.

The tertiary sector has gained in importance and currently contributes to nearly 50 per cent of GDP. Therefore, tax on services, which now accounts for less than 0.5 per cent of GDP, assumes greater importance.

Another aspect of fiscal consolidation is reduction in government expenditure. Though the Government's total expenditure declined marginally in the mid-1990s, it increased again from 15.3 per cent of GDP in 2000-01 to 16.4 per cent in 2001-02. This was mainly because of higher outgo on defence, interest payments, subsidies, and budgetary support for the Plan.

Given the relations with the neighbouring countries, there is little scope for pruning defence expenditure. However, the Government must work towards curtailing both food and fertiliser subsidies, as recommended by the Expenditure Reforms Commissions (ERC).

Subsidies must be transparent and phased out gradually, by increasing user charges in power, transport, irrigation, agriculture and education.

Interest payment as a percentage of GDP has increased from 3.8 per cent in 1990-91 to 4.9 per cent in 2001-02. The Government must work towards reducing public debt by mobilising resources through disinvestment.

Another important expenditure component is wages and salaries which, as a percentage of GDP, has increased mainly because of the implementation of the Fifth Pay Commission.

In this context, the Government can consider the ERC proposal on government staff.

Inadequate public investment in the post-reform period has had an adverse impact on critical infrastructure sectors such as power generation, roads, railways and ports. Investments in gas, power, water supply, transport and storage and communication declined from 5.2 per cent of GDP in 1990-91 to 4.5 per cent in 2000-01.

For example, the addition to power generation capacity in the public sector in the Eighth Plan was only a little over half the target. These shortfalls would not have mattered if capacity in the private sector had expanded.

Since a high debt-servicing burden crowds out public investment in infrastructure, the task is to bring down the fiscal deficit through reductions in subsidies and consumption expenditures without cutting public sector investment.

High government borrowing could lead to the crowding out of private investment. Private savings as a percentage of GDP rose from around 20 per cent in 1991-92 to 25 per cent in 2000-01.

However, during the same period private investment stagnated.

This implies that a major part of the increase in private savings was used for financing the increase in fiscal deficit.

And with India's debt among the highest in the world and poised to grow faster than GDP, the country is on the brink of a debt trap

Since fiscal deficit still remains very high, the process of fiscal consolidation needs to be pursued much more vigorously.

There are several risks associated with high fiscal deficits — macroeconomic instability, savings and investment gap and unsustainability of high economic growth are but a few. Fiscal deficit also puts upward pressure on interest rate.

Real interest rates, though lower now, are still higher than international levels.

Further, high fiscal deficits crowd out private investment and pose a threat to price stability and the external balance.

The stability of the external balance has been facilitated by the closeness of the economy to international capital flows.

However, absence of serious efforts at reducing the fiscal deficit would imply a growing risk of an adverse change in market sentiments, which would lead to higher inflation and interest rates.

Far-reaching changes — such as phasing out of excise and customs duty exemptions and widening the service-tax base, which are expected to go a long way in reducing transaction costs, improving tax compliance and, thereby, increasing the tax-GDP ratio — have been proposed in the Kelkar Committee final report.

In the absence of substantial fiscal consolidation, it will be difficult to keep inflation low and achieve sustainable growth rates as proposed in the Tenth Plan. In this context, the forthcoming Budget is crucial.

It should aim at simplifying the tax structure, improving tax compliance, reducing unproductive expenditure and implementing VAT as envisaged (in April 2003), despite opposition from States.

These will be a step forward and a signal that the Government is serious about reducing the fiscal deficit. The crux of second-generation reforms should lie in curbing the fiscal deficit. However, this will require strong political will, especially with elections in major States round the corner.

(The authors are on the faculty of Institute of Economic Growth and Indian Institute of Foreign Trade respectively.)

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