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Is it time to exit from the fiscal stimulus provided by the Government to stall and reverse the downturn triggered by the global crisis? That is the question increasingly occupying policy debate, with support for those emphasising the need to ‘exit’ from stimulus mode gaining strength in recent weeks.

The case for exit is the same as that which underlies the kind of fiscal conservatism epitomised by the Fiscal Responsibility and Budget Management Act. The stimulus necessitated by the crisis, it is argued, has reversed the trend towards fiscal correction seen since 2001-02, which brought the gross fiscal deficit of the Centre down from 6.2 per cent of GDP in 2001-02 to 2.7 per cent in 2007-08.

In his Budget speech delivered on July 6, 2009, Finance Minister Pranab Mukherjee endorsed this view when he said that “fiscal accommodation” had resulted in a sharp increase in the fiscal deficit from 2.7 per cent in 2007-08 to 6.2 per cent of GDP in 2008-09 and estimated that the total fiscal stimulus (equal to 3.5 per cent of GDP at current market prices) in 2008-09 amounted to Rs 1,86,000 crore (Chart 1).

This of course is a gross exaggeration, inasmuch as it presumes that all of the increase in the fiscal deficit in excess of the growth in nominal GDP was entirely the result of the stimulus motivated by the downturn in growth.

It is indeed true that 2008-09 did see a significant increase in expenditures with non-Plan expenditures in particular rising by 23 per cent relative to the revised expenditures for 2007-08. However, two heads of expenditures that accounted for the bulk of this increase, namely subsidies and the implementation of the Sixth Pay Commission’s recommendations, had little to do with the stimulus motivated by the downturn.

Though the exact figure of the burden imposed by the Sixth Pay Commission’s recommendations is difficult to come by, the Commission itself had estimated that the payment of the new salaries and half of the arrears during 2008-09 would result in additional expenditure of about Rs 21,500 crore, which amounts to around 18 per cent of the actual increase in non-Plan expenditure in that year. And the huge increase in subsidies resulting from higher minimum support prices and larger procurement during that year added another Rs 59,500 crore to the non-Plan expenditures head, or a little more than half of the increase in those expenditures.

In sum, around 70 per cent of the increase in non-Plan expenditures had little to do with the stimulus per se, rendering the Finance Minister’s generous estimation of the size of the stimulus completely wrong. The real impact of the downturn was to be seen in the growth of revenue receipts which fell to just 7.7 per cent in 2008-09 as compared with 24.7 per cent in 2007-08. This obviously meant that the higher non-stimulus driven expenditures in 2008-09 resulted in a sharp increase in the fiscal deficit.

So it is not a higher fiscal deficit resulting from an unavoidable fiscal stimulus that is the problem facing the Indian economy today. The problem is that expenditures that are not easily reversible, if at all, are responsible for the increase in the deficit such as higher salaries and higher subsidies. On the other hand, pressure is mounting to reduce the deficit even though these expenditures are not reversible. In fact, imports necessitated by the drought during the kharif season and higher interest payments resulting from the borrowing undertaken to finance last year’s fiscal deficit are only likely to widen the deficit in 2009-10.

And lower growth would push up the deficit to GDP ratio even further. In these circumstances, even the Finance Minister’s fond hope that he can restrict the fiscal deficit to 6.8 per cent may remain unrealised.

If despite the fact that it is not the stimulus per se that is primarily responsible for the fiscal deficit at the Centre, the Government succumbs to the pressure to “roll back the stimulus”, then the impact would fall on Plan expenditures in general and capital expenditures in particular.

In fact, the trend over a long period has been for the ratio of capital expenditures in the Centre’s Budget to fall relative to GDP, and even in 2008-09 when revenue expenditures (as a proportion of GDP) rose sharply, capital expenditures fell (Chart 2). This hardly constitutes an appropriate strategy from the point of view of ensuring recovery and sustained growth.

One way that the demand of the fiscal conservatives can potentially be satisfied is by raising the ratio of revenues to GDP, primarily through an increase in the tax-GDP ratio. It must be noted that one of the creditable features of the rapid growth since 2002-03 in the Indian economy was that the long-term tendency for the tax-GDP ratio to stagnate or even decline was reversed.

A striking feature of the period since 1989-90 (which also marked the beginning of ‘economic reform’) till the early years of this decade was that despite evidence of higher growth rates and signs of growing inequality, there was no improvement in the Centre’s ability to garner a larger share of resources to finance expenditures it considered crucial. Even when corporate profits and managerial salaries were reported to be rising sharply, taxes were not buoyant. In fact, the Central tax- GDP ratios in India were declining for much of this period.

The tax-GDP ratio in India was also low by international standards, including those of many developing countries. The ratio of Central Government tax receipts to GDP was only 7.9 per cent in 1989-90; by 2001-02 it had fallen to a miserable 5.9 per cent. Even if taxes levied by the State governments are included, the total tax-GDP ratio was still only 15.9 per cent in 1989-90 and fell to 13.8 per cent by 2001-02 (Chart 3).

This compared poorly with tax-GDP ratios in most developed and developing countries. India is by no means an overtaxed country, but has much fiscal space to expand its revenues.

It is true that in the case of India and many developing countries internationally quoted figures are not comparable with that for the developed countries because they exclude taxes collected by state or provincial governments. But the figures quoted above, which include State revenues, do not tell a very different story.

However, between 2001-02 and 2007-08 the tax-to-GDP ratio at the Centre rose from 5.9 per cent to 9.3 per cent. The aggregate tax-GDP ratio of the Centre and the States rose even more sharply from 13.8 to 19.1 per cent between 2001-02 and 2008-09.

It must be noted that the period after 2002-03 was one in which profits in the organised sector rose sharply, the ratio of profits to value added also rose significantly and saving and investment rates in the corporate sector recorded sharp increases. This was, therefore, a period when high growth was accompanied by significantly increased inequalities in the organised sector, leading to the rise in the tax-GDP ratio.

Not surprisingly, there has been a significant shift in the relative contribution of different components of taxes to the tax-to-GDP ratio at the Centre over the years. Liberalisation involving a reduction in Customs tariffs and a rationalisation of the indirect tax regime resulted in a decline in the tax-to-GDP ratio between 1989-90 and 2001-02.

Customs and excise duties contributed 86 and 55 per cent respectively to the decline in the central tax-to-GDP ratio during those years. On the other hand, corporate taxes, other income taxes and service taxes contributed 71, 25 and 30 per cent respectively to the increment in the central tax-to-GDP ratio between 2001-02 and 2008-09. Thus, higher tax collections from the industrial sector, better off individuals and a widening of the tax net accounted for the improvement in the Centre’s revenue base.

Interestingly, at the central level this rise in the tax-GDP ratio was beginning to reverse itself even by 2008-09. If that trend persists then the deficit in the Central Budget would only widen. There is reason to believe that this could occur.

Net direct tax collections during the first three months of fiscal 2009-10 (April-June) recorded an increase of 3.65 per cent, as compared with a budgeted increase of 9 per cent for the year as a whole and a much higher 38.6 per cent during the corresponding quarter of 2008-09.

The fear that this could encourage the government to increase tax rates, impose surcharges or reduce exemptions possibly explains in part at least the clamour for an exit from a near non-existent fiscal stimulus programme. This could worsen and aggravate the slowdown in growth, already threatened by a drought.

On the other hand, if the current tendency for the tax-GDP ratio to rise can be sustained through additional taxation measures, the fiscal situation is by no means dire. However, there is reason to believe there is a backlash against the tendency of the Government to enhance its revenues by increasing resources garnered through taxes on profits and higher income group incomes.

In what seems to be an effort to compromise with that tendency the Government has proposed in its new Direct Taxes Code a drastic scaling down of tax rates and a restructuring of tax slabs, arguing that this would simplify the direct tax regime and prove revenue enhancing because of reduced exemptions and better compliance. But there are many who believe that this is merely a step towards reversing the rather remarkable increase in the direct tax-to-GDP ratio seen in recent years.

We must recall that between 2001-02 and 2007-08, when the Central gross tax revenue-to-GDP ratio rose by 4.4 percentage points from 8.21 per cent to 12.56 per cent, the fiscal deficit-to-GDP ratio fell by 3.5 percentage points from 6.2 per cent to 2.7 per cent.

That is, much of the improvement in the fiscal position of the Central Government was because of a faster increase in its tax revenues relative to GDP. In 2008-09, not only was the rise in the tax-GDP ratio halted and marginally reversed (by 0.8 of a percentage point), but the ratio of expenditure to GDP rose by 1.8 percentage points on top of a one percentage point rise the previous year.

In the current year too, this rise in expenditure is likely to continue and what the Government should look to is to restore the rise in the tax-to-GDP ratio.

If it can achieve that, both growth and fiscal stability would be ensured. But the attention of the fiscal conservatives seems to be focused on expenditure reduction, which is not recommended at all in the current circumstances.

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