Dealing with Indian fiscal cliff

Sunil K. Sinha and Anuj Agarwal

Averting the US fiscal cliff was all about a sharp decline in the US budget deficit, that could have occurred beginning 2013 due to increased taxes and reduced government spending — as required by previously enacted laws. However, with President Barack Obama signing the American Taxpayer Relief Act of 2012 on January 2, 2013, much of the tax side of the rescue act stands eliminated and the spending cuts delayed for two months.

EXPENDITURE SLACK

This may provide much-needed relief to the US economy, which, in the absence of the act, was expected to fall back into recession. But this still leaves the question on the US fiscal deficit (or ‘cliff’) wide open, as the borrowing limit of the US government is likely to be breached soon, triggering another round of debate among the policy makers.

The fiscal situation in India is equally precarious. The fiscal deficit-to-GDP ratio averaged 5.8 per cent between 2008-09 and 2011-12, compared with the target of 3 per cent set by the Fiscal Responsibility and Budgetary Management (FRBM) Act 2004.

In a few weeks from now, when the Budget for 2013-14 will be presented in Parliament, the question that will be at the top of everybody’s mind will be — will India avoid its own fiscal cliff? Reducing the fiscal deficit and restoring fiscal discipline is vital to steer the economy back to a sustainable high-growth, low-inflation path.

Post the 2008 global economic crisis, expansionary fiscal stance via cuts in taxes and increase in government spending on revenue items such as MGNREGS (Mahatma Gandhi National Rural Employment Guarantee Scheme) and implementation of the Sixth Pay Commission substantially boosted nominal income levels across the board.

This did help the economy to recover by boosting the consumption demand, but did precious little to enhance the productive capacity of the economy, leading to high levels of inflation and fiscal deficit. Revenue expenditure has been eating into a larger chunk of government expenditure in recent years. Revenue expenditure, including subsidies that benefit the poor as well as the rich, grew at an average of 18 per cent y-o-y over 2008-09 to 2011-12. India annually spends about 2.5 per cent of its GDP on subsidies, primarily food, fertilisers, petroleum products and electricity.

Subsidies, which comprise almost 13 per cent of the government’s total expenditure, rose by 66.8 per cent over 2008-09 to 2011-12. Revenue deficit, as a percentage of fiscal deficit, swelled to 96 per cent in 2011-12 from around 41 per cent in 2007-08.

The sharp rise in revenue expenditure left little room for expenditure on capital formation, which is imperative to ease the supply side constraints facing the economy. There is substantial scope to reprioritise public spending away from revenue expenditure and untargeted subsidies. Social and physical infrastructure is in dire need of more investment.

Since 1991, several reforms have been passed relating to direct and indirect taxes. Although these reforms have, over the years, led to simplified tax laws and administration, improved tax collections, reduced market distortions, and improved resource allocation, the prevailing tax regime is not yet in sync with the needs of a market-oriented economy. The tax incidence on Indian businesses is high despite rationalisation in taxes. According to the World Bank’s estimate in 2012, the tax rate in India was 61.8 per cent, which was far higher than the average tax rate of 34.5 per cent in the East Asian and Pacific region, and 42.7 per cent in the OECD (Organisation for Economic Co-operation and Development) countries.

TAX REFORM

According to some estimates, India loses about Rs 14 trillion ($314 billion) due to tax evasion annually. Thus, the country is deprived of funds that would enable it to shore up its social and physical infrastructure, which are critical for raising the productive capacity of the economy.

Further, the tax–to-GDP ratio in India at 10 per cent in 2011-12 is well below Russia’s 37 per cent, Brazil’s 36 per cent and China’s 21 per cent. Implementing the GST (Goods & Services Tax) and the DTC (Direct Taxes Code) at the earliest can enhance tax revenues, and create a tax regime that is robust, predictable and transparent.

By minimising ambiguities in the tax system and making the system less cumbersome, these measures can improve tax buoyancy and tax compliance, as well as the investment climate in the economy.

However, India’s fiscal challenge may not end with this. It is more crucial to steer government spending towards capital expenditure, as opposed to revenue expenditure to boost the economy’s productive capacity.

Increased public spending in agriculture, education, health and infrastructure, if well-designed and delivered, can help boost and sustain growth, besides achieving better income distribution in the economy.

Composition of government spending does matter for growth and poverty reduction (The Quality of Growth: Fiscal Policies for Better Results, IEG Working paper 2008/6, http://www.rrojasdatabank.info/quality_growth_wp.pdf.

Steering away from the cliff is difficult but not impossible. India has contained its fiscal deficit in the past. Fiscal consolidation was progressing well after the passage of the FRBM Act.

The country’s fiscal deficit was reduced to 2.54 per cent of GDP in 2007-08. However, this reduction in fiscal deficit was brought about mainly by augmenting tax revenues, rather than reducing expenditure.

During the high growth phase, higher tax buoyancy did help the government garner more revenues to finance expenditure.

However, now, when the economy is not in the “pink of health” and tax revenue growth unable to finance mounting government expenditure, there is an urgent need to rationalise government expenditure, along with finding new ways to augment government revenues.

(The authors are Principal Economist and Economic Analyst, respectively, at CRISIL Ltd.)