After six buoyant years, the Union governments tax revenues contracted at an accelerating pace for the third straight month in December.

Tax collections contracted by 13% in October, 15% in November and 25% in December over the previous 12 months. According to data on the website of the Controller General of Accounts (CGA), net tax revenue in the third quarter ended December contracted by a little over one-fifth to Rs1.07 trillion, compared with the same period in 2007-08.

Also See Taxing Deficits (Graphic)

The drop in tax collection is not unusual in a slowing economyand points to a further deterioration in public finances that have already been hit by extra government spending to prop up domestic demand. The government is now likely to substantially overshoot its budgeted fiscal deficit target for this fiscal year.

Expectation was (that) expenditure would be overshot. Revenue impact to the extent (last quarter of 2008) was unknown, D.K. Srivastava, director of the Madras School of Economics, said.

Total tax revenue, the primary source of government income, was Rs3.09 trillion for the first nine months of 2008-09, around 61% of the budget target of Rs5.07 trillion.

The fiscal deficit, the excess of total government expenditure over revenue that is made up through borrowings, as of 31 December, was Rs2.18 trillion, almost twice the 2008-09 budget estimate. The revenue deficit was Rs1.73 trillion, at least three times the budget target. Revenue deficit, a part of the fiscal deficit, is the excess of the current years expenses over revenue.

The combination of an economic slowdown and a mid-course cut in indirect tax rates to stimulate demand had made economists mark down revenue collections.

In January, the Prime Ministers economic advisory council (EAC), in its review of the economy for 2008-09, had marked down tax collections by Rs52,800 crore (1% of gross domestic product or GDP). Fiscal deficit calculations under the current situation are uncertain. It (deficit) depends on the responses of bankers, investors and consumers, Suresh D. Tendulkar, chairman of ECA, said.

CGA data on tax collections indicated the revenue shortfall could be higher. In December, the government cut excise duty, the so-called Central value-added tax rate, by four percentage points to 10%. The impact of the move will be felt in the last quarter of 2008-09.

The first impact of a sudden change in the economic outlook was reflected in this quarter. Since then, gross direct tax collections in January grew by 34.29%, the finance ministry said in a statement. However, the crucial month for direct tax collections will be March, when companies pay the final instalment of advance tax based on 2008-09 profit estimates.

Some economists said this quarter may see a revival in tax collections, thereby easing the pressure on government finances. The quarter that went by was one of the worst quarters we have seen in a decade. There will be some recovery going forward from this quarter, Manoj

Vohra, director (research) at the Economist Intelligence Unit, said.
Vohra based his optimism on three factors: Monetary policy measures should show results by the end of the current fiscal year, some of the government spending would show up in consumption and some amount of stabilization in the economy has started after last quarters shock.

Even if tax revenues recover somewhat in the final quarter, their sudden contraction in the fiscal third quarter had Srivastava worried. According to him, last quarters net tax collections showed revenue buoyancy was below 1, which is quite a shock.

Revenue buoyancy (a measure of how much growth in revenue collection exceeds growth in nominal GDP) has been at least 2 in the past few years. That is, for every percentage point growth in economic activity, tax revenue has grown twice as fast.

According to Srivastava, in the current fiscal year, nominal GDP is expected to grow by about 11%, which made a mere 5% growth in tax revenue between April and December worrisome.

More government borrowings to plug a growing fiscal deficit has pushed up interest rates on government bonds. The money market has been worried that the government may announce a large increase in bond auctions before the fiscal year ends on 31 March. The yield on the 2018 bond hit an eight-week high of 6.53% on Thursday, 167 basis points above a life-time low of 4.86% in early January.

On Friday, after Reserve Bank of India governor D. Subbarao said the governments borrowing programme would be managed in a way that would minimize market impact, the yield on the 8.24% 2018 bond closed at 6.19%, after falling as low as 6.14%. It had ended at 6.49% on Thursday. A basis point is one-hundredth of a percentage point.

A higher fiscal deficit could also crowd out private sector borrowers, affecting investments in new capacity. The costs of sticking to FRBM (fiscal responsibility and budget management legislation) are going to be far higher than crowding out in the current situation. The potential benefits (of increasing deficit) are quite significant in terms of revival, ECAs Tendulkar said.

According to Montek Singh Ahluwalia, deputy chairman of the Planning Commission, one of the aims now of monetary policy is to neutralize the possibility that increasing fiscal deficit would crowd out private demand for funds.

An accommodative monetary policy, such as the one prevailing over the past few months, was meant to complement the increase in government spending, Ahluwalia had told The Hindu in an interview in January.