By Vaibhav Yadav
India needs to raise its tax base urgently to meet the fiscal deficit target without curbing essential expenditure, says an SBI report. The country’s gross fiscal deficit as a percentage of GDP started shooting up after the 2008 financial crisis, said the report India’s Public Finance Trends.
Staring at a breach
However, with economic recovery gaining pace, the government embarked on the path of fiscal consolidation and has brought down its fiscal deficit to 3.5 percent of GDP in 2016-17. The Government has been able to meet the fiscal deficit target in the last four financial years.
India’s fiscal deficit at the end of December was 112 percent of the Financial Year (FY) ’18 budgeted estimate. This was on account of lower income and front-loading of expenditure due to the early presentation of the Budget. This lower income has been driven by lower GST collections, RBI dividend to the government at Rs.30,659 crore being half of what it was last year, and lower than budgeted spectrum sale proceeds from the beleaguered telecom sector.
For 2017-18, the government aims to bring down the fiscal deficit to 3.2 percent of the GDP. It is likely to reach this target by about 30 basis points after it unveiled an additional market borrowing of Rs 50,000 crore for the current financial year.
India’s revenue and expenditure
The breakup of India’s income contains – borrowing and other liabilities-19 %, corporate tax-19%, income tax-16%, union excise duties-14%, service tax-10%, non-tax revenue (divestments and dividends)-10%, custom duties-9%, Non debt capital receipts-3%
The Government Expenditure comprises of share of states in taxes and fees-24%, interest payment-18%, other expenses-13%, expenditure of centralised schemes-11%, subsidies-10%, centrally sponsored schemes-10%, defence expenditure-9%, finance commission and other transfers-5%
Keeping fiscal deficit in check
A deficit is usually financed through borrowing from either the central bank of the country or raising money from capital markets by issuing different instruments like treasury bills and bonds. The Government recently decided to raise fifty thousand crores using this bond route.
A higher fiscal deficit for an economy means increased government borrowing which, in turn, implies higher interest burden. India has a debt-to-GDP ratio of 68 percent, which is the highest among its emerging market peers. Most of India’s government debt is internal, implying less external vulnerability. Nevertheless, high government debt implies high-interest burden. Many of the developed economies like the US and Japan have a much higher debt-to-GDP ratio (108 percent and 240 percent, respectively). However, their interest burden is much less as their governments are borrowing at much lower interest rates. US and Japan policy interest rates hover around 1.5 percent and 1.25 percent, respectively against India’s six percent. In India, the government’s interest payment to total expenditure is around 19 percent, while for Japan and the US it is much lower at 9.5 percent and 11 percent, respectively.
Higher interest payment burden translates to lower developmental expenditure by the government. Capital expenditure accounts for only 12-14 percent of India’s total expenditure.
The other disadvantage of a high debt-to-GDP ratio is that it has an impact on the country’s credit ratings and investor sentiments. The present government’s resolve to stick to the fiscal deficit target and the prevailing strong macros prompted Moody’s to upgrade India’s investment rating.
The crowding out effect
There has been a school of thought that believes that even though India’s borrowing is majorly internal it leads to crowding out of the private investment. According to this effect, the sheer scale of government borrowing leads to a substantial rise in real interest rates dissuading the private sector from borrowing. In addition, there is a lack of availability of funds left with the banks to lend to the private sector for capital expansion. The Indian banks that need to become Basel III norms compliant are further hard-pressed by this government borrowing.
However, the ground reality is slightly different. The Indian banks have been investing more than the mandatory requirement in government securities, reflecting the lack of better avenue for banks. The recent recapitalisation package of 2.1 trillion for public sector banks will also free up more money that can be lent to the private sector. Hence, a higher government borrowing will most certainly not crowd out private investment in India’s current scenario.
Counter-cyclical fiscal deficit target
It is being increasingly proposed that our fiscal management should be counter-cyclical. This means that when the economic growth is languishing, fiscal deficit targets can be allowed to be breached to a certain limit.
For instance, the Fiscal Responsibility and Budget Management (FRBM) Act enacted in 2003 led to an improvement in the fiscal deficit of Centre from 5.7 percent of GDP in Financial Year (FY) ’03 to 2.5 percent of GDP in Financial Year ’08. However, there was a pause button on the FRBM Act post the global financial crisis. Fiscal deficit shot up to six percent in FY ’09 and it was only in FY ’12 that the path to fiscal consolidation was recalibrated.
The N.K. Singh Committee on FRBM has recommended reducing the fiscal deficit-to-GDP ratio to 2.5 percent of GDP by 2022-23. It has also recommended reducing India’s debt-to-GDP to 60 percent by 2022-23 from the current level of 68 percent. The interesting point to note is that it has allowed a deviation of 0.5 percent in the fiscal deficit to GDP target in a year under three conditions, one of them being the structural reforms.
Being fiscally prudent
The next pre-election budget is expected to be a populist one which might further widen the fiscal deficit. Additionally, the Government is planning to reduce the corporate tax from 30 percent to 25 percent by the end of FY ’20. This will make it increasingly difficult to stick to the fiscal target as a corporate tax is the joint highest source of national income standing at 19 percent of the overall pie.
There is a growing clamour for the government to be liberal on spending and generous with tax cuts and yet be fiscally prudent. This could have been aided by imposing a long-term capital gain tax on equity, but that seems unlikely as the government would want the markets to be buoyant to meet their divestment targets.
Some measures that can help the Government in walking this tightrope: Introduction of Estate/Inheritance taxes. The estate tax is levied on an heir’s inherited portion of an estate if the value of the estate exceeds an exclusion limit set by law. It was abolished during the Rajiv Gandhi rule in 1985. Several countries across the globe levy this tax which helps in the redistribution of wealth; The government has levied various cesses over the years namely Education Cess, Swacch Bharat cess and more. These cesses amount to about 1.44 lakh crore as per the 2015 CAG report. The Government can introduce clauses in the upcoming budget that allows the usage of this corpus for capital expenditure; The Government of India is sitting on enormous swathes of land banks which can be monetised to invest in infrastructure projects; A blanket tax exemption on agricultural income needs to be done away with. There are several HNI’s who earn handsomely from agriculture and do not pay a penny to the Government owing to this loophole.
Lower tax rates, easier compliance and stricter penalties on evaders should further help increase the tax component of revenue. The Government should follow a counter-cyclical fiscal policy. If the economy of the country needs a fiscal stimulus, the Government should use the 0.5 percent limit set by the N.K. Singh Committee to invest in the infrastructural development of the world’s next superpower.
Featured Image Source: Visual Hunt
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