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Forget taxes, focus on expenses
April, 01st 2010

Fiscal challenges have resurfaced, not only in India but all over the world. This time, fiscal stress in most countries, particularly the developed ones, is far more severe than in India. Unlike many other countries, in targeting a lower fiscal deficit at 5.5 per cent of GDP for 2010-11, the government has already signalled the beginning of fiscal consolidation.

Fiscal concerns typically get suppressed during cyclical upturns, and amplified during phases of low growth. For example, during the high growth phases of 1992-93 to 1996-97 and 2003-04 to 2007-08, there was a proportionate reduction, in relation to the size of the economy, in both the deficit and debt. And during the low growth phase of 1997-98 to 2002-03 and, more recently, in the period beginning 2008-09, the deficits rose.

At a very basic level, the relationship between growth and fiscal variables is not difficult to understand. The fiscal health of the economy at any given point is a function of its revenue and expenditure. A large part of government expenditure is generally committed in nature and hence inflexible even during an economic downturn.

In contrast to government spending, government revenues mimic economic cycles, rising sharply during an upturn and slowing down during a downturn. Higher economic growth, especially if propelled by industrial growth, has yielded increased tax collections for the government in the past.

Whether this higher growth translates into adequately high tax revenue is measured by tax buoyancy. A tax-buoyancy greater than unity implies that growth in tax collections is higher than GDP growth. The chart traces the tax buoyancy in India during the recent upturns and downturns. It clearly shows that revenue buoyancy has a non-linear relationship with growth being higher in an upturn and lower in a downturn.

With inflexibility in expenditures, reduced revenue buoyancy accentuates fiscal stress during an economic downturn this is what happened in the last two years when matters got aggravated with the government having to spend more to fight the impact of global recession and some profligate steps like farm loan waiver etc.

Going ahead, a return to higher growth trajectory will reduce the fiscal stress as it did during 2003-04 to 2007-08. Another comfort factor for India vis--vis many developed nations is that it does not face the fiscal burden of an ageing population.

Its favourable population dynamics suggest that its fiscal health is unlikely to be burdened by an ageing population in the next few decades. Even though India has a high debt-to-GDP ratio of about 80 per cent of GDP, it is largely domestic debt. This does not expose India to the kind of external debt vulnerabilities that countries such as Greece, Portugal and Spain are currently facing.

Despite these apparent advantages, there is no room for complacency as far as Indias fiscal health is concerned. Some of the concerns are as follow. The first relates to slippage in growth. The fiscal targets are riding on the assumption of high growth and if the growth slips, the fiscal scenario is bound to deteriorate. The probability of the occurrence of this event is low at this juncture but it is a risk nevertheless.

The second factor of discomfort is the rather unimpressive medium-term tax targets set out in the recent Budget. The gross tax/GDP of the Central government is budgeted at 11.9 per cent of GDP by 2012-13, which is lower than the 12 per cent achieved in 2007-08.

This means the revenue booster to Indias fiscal health witnessed in the previous boom phase will be muted this time. The tax targets presumably do not consider the impact of the implementation of the goods and services tax (GST) and the direct tax code (DTC). It needs no emphasis that successful implementation of the DTC and GST will be critical for pushing the revenue beyond government expectations set out in the most recent Fiscal Responsibility and Budget Management (FRBM).

By 2012-13, over 85 per cent of Indias GDP will originate in the revenue-yielding non-agricultural sector, compared to 82 per cent in 2007-08. With a structural shift towards revenue-generating non-agricultural sectors, keeping the tax/GDP in 2012-13 lower than 2007-08 is akin to lowering the bar on the tax collection front.

In the last 20 years, India has witnessed spurts of high growth. It, however, has not been able to sustain it over an extended period of time. Indias stature as well as growth expectations today are undoubtedly higher than what they were when it began the reforms in the early 1990s.

Today, India benchmarks its economic performance against the near 9 per cent growth rate achieved during the five years preceding the global economic crisis. What India needs is not the spurts of high growth but sustained high growth for the next few decades to reduce poverty and catch up with its fast-growing east Asian neighbours. In addition to further economic reforms, on the government finances front, this will take both fiscal prudence and right fiscal choices.

This brings in the importance of pending expenditure reforms, which should cut expenditures in less productive areas and reallocate these to more productive ones. It is well understood that the government investment in infrastructure, education and health has a high multiplier effect on the economy than general consumption expenditure. And these are the areas where we have a lot of ground to cover. Infrastructure constraints and skill mismatches that amplified during the previous upturn will continue to plague us in future. The government has an important role in addressing these constraints.

In the absence of expenditure reforms, the fiscal space needed for spending in these critical areas may simply be absent if numerical fiscal targets are to be adhered to. The fiscal space will shrink further if the growth momentum is derailed for some reason. Together with expenditure reforms, the government needs to be more aggressive with its tax targets than it has been in the recent Budget.

Without these measures, the absence of fiscal leeway for investment in human development and infrastructure can emerge as a risk to sustained high growth. The fiscal challenge, therefore, is not merely to bring down the debt and deficit. We have achieved that in past cyclical upturns and will achieve if we get another spurt of high growth. What we have not achieved is fiscal flexibility to address vital constraints that the economy faces today. And that is the fundamental fiscal challenge for India.

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