Fiscal Consolidation
Fiscal Consolidation
April 3, 2006
Contents
1 Introduction 1
1.1 Fiscal System . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1
3.3 Fiscal Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.3.1 Comparison between ’80s and ’90s . . . . . . . . . . . . 19
3.3.2 Observations . . . . . . . . . . . . . . . . . . . . . . . 20
2
Chapter 1
Introduction
A lot of people use terms like ’deficit’ and ’debt’ very loosely without
really knowing exactly what they mean. Government Expenditure is divided
into Plan and Non-Plan expenditure. And non-plan does not mean that the
expenditure is unplanned. ’Plan’ in this context indicates what is covered
in the Five-Year Plan. Non-Plan expenditure covers defence expenditure,
interest payments and subsidies and grants to states. It can be divided into
revenue account and capital account - that is, simply, expenditure that gets
consumed and one that creates some productive assets. Defence personnel
salaries, interest payments and subsidies would come under Non-Plan revenue
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expenditure. Just to get an idea of the quantum of the numbers involved,
year (2001-2002) Budget put the total Non-Plan expenditure at Rs 2,751 bil-
lion. The total central Plan outlay last year was Rs 951 billion. This includes
Plan assistance to states and union territories. Plan expenditure can again
be split into revenue and capital components. Needless to say, a majority of
the money is spent on revenue expenditure, i.e. salaries, overheads and other
stuff, which does very little for the development of the economy.
The central government funds its expenditure mainly through taxes - in-
come tax, corporate tax, excise and custom duties.Its non-tax revenue come
from interest received and surpluses of PSUs, financial institutions and other
departmental undertakings like the railways, Post, etc. Recoveries of loans
from states (and others) and the government borrowings make up the cap-
ital receipts of the government. The total receipts and expenditure rarely
match. The discrepancy between the two is the budget deficit (surplus ?) .
Moreover, every year the government exceeds its own estimates of deficits,
and has to borrow to meet the shortfall.
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you, me or our children will ultimately have to pay the bill! If the government
deficit is financed by the RBI holding more government securities (RBI prints
more money) there is the ever looming fear of inflation. The other option is
market borrowing, which leads to more expensive debt for the government
and also tends to crowd out private borrowing and investment, thus affecting
the growth rate.
The need for infrastructure investment is becoming more vital every year.
The government cannot raise too much money from the market as this is
hampering economic growth. However, since inflation is low, the government
might just decide to spend, and monetise the deficit.
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value. Let’s say that an economy has slowed down. Unemployment levels are
up, consumer spending is down and businesses are not making any money.
A government thus decides to fuel the economy’s engine by decreasing tax-
ation, giving consumers more spending money while increasing government
spending in the form of buying services from the market (such as building
roads or schools). By paying for such services, the government creates jobs
and wages that are in turn pumped into the economy. In the meantime,
overall unemployment levels will fall. With more money in the economy and
less taxes to pay, consumer demand for goods and services increases. This in
turn rekindles businesses and turns the cycle around from stagnant to active.
If, however, there are no reins on this process, the increase in economic pro-
ductivity can cross over a very fine line and lead to too much money in the
market. This excess in supply decreases the value of money, while pushing
up prices (because of the increase in demand for consumer products). Hence,
inflation occurs.
For this reason, fine tuning the economy through fiscal policy alone can
be a difficult, if not improbable, means to reach economic goals. If not closely
monitored, the line between an economy that is productive and one that is
infected by inflation can be easily blurred. When inflation is too strong,
the economy may need a slow down. In such a situation, a government can
use fiscal policy to increase taxes in order to suck money out of the econ-
omy. Fiscal policy could also dictate a decrease in government spending and
thereby decrease the money in circulation. Of course, the possible negative
effects of such a policy in the long run could be a sluggish economy and high
unemployment levels. Nonetheless, the process continues as the government
uses its fiscal policy to fine tune spending and taxation levels, with the goal
of evening out the business cycles.
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Chapter 2
Background To Fiscal
Consolidation
Of late now, Indian economy has been in the spotlight. It has been among
the fastest growing economies during the last two decades. Wide ranging
economic reforms have taken place. It has undergone a significant structural
transformation. The economy is more resilient, less vulnerable to external
shocks and has opened up for more potentials. But the attention on the
economy is also because it has crossed one billion mark in population and
almost a third of the population remains below a modestly defined poverty
level. The debate on perspectives for the Indian economy is continuing. A
second wave of reforms is already underway. This chapter highlights macro
fiscal trends of the Indian economy with an overview of recent economic
reforms.
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of ’eighties.
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2.2.2 Expenditure
Central government’s revenue expenditure as per cent of GDP was 13.10 per
cent in 1999-2000. This had shown an increase over the previous 3 years but
was lower by about 0.6 percentage points when compared to the first half
of nineties and even during second half of eighties when, on average, it was
about 13.70 per cent. This level was at its historic high since early seventies.
” State governments’ revenue expenditure (BE) was 13.82 per cent of GDP
in 1999-2000. Though it was 1.5 percentage points higher over the previous
three years, the level was higher only by about 0.5 percentage point when
compared to early nineties or even during second half of eighties when it
was 13.16 per cent. This level was at its historic high since early seventies.
Appendix C shows the fiscal trends in Receipts and Expenditure in last two
decades.
(ii) Changes in the financing pattern of the fiscal deficits through borrow-
ings at market rates and reduced dependence on the system of monetising
the deficits.
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2.4 Outcome
Fiscal reforms were the integral and perhaps the most critical part of the over-
all economic reforms program. The fiscal consolidation measures taken imme-
diately after the crisis situation yielded significantly positive results in terms
of reduction in fiscal deficit, control in expenditure and marked changes in
the fiscal system particularly in the financing pattern of the deficits through
reduction in magnetization. However, the continued structural imbalances in
terms of falling tax buoyancy, nature of fiscal correction in terms of reduction
in investment expenditure, increased interest burden owing to borrowings at
market related rates, impact of enhanced salary of government employees,
compulsions of increased defense expenditure etc. were some of the major
factors which reversed the situation such that at the end of the decade the
combined fiscal deficit of Centre and States was almost at the same level as
was at the beginning of reform measures. The emerging situation has led
economist to suggest that the second generation of reforms should constitute
a program of action aimed at preventing another major economic crisis and
should stimulate rapid economic growth in the country during the new cen-
tury. In fact, in the strategy outlined by the Finance Minister in his budget
speech in Feb, 2000, declaring the next 10 years as ’India’s decade of de-
velopment’ one of the elements is to establish a credible framework of fiscal
discipline. Many economist in their surveys have even warned that unless
substantial fiscal consolidation is achieved continued fiscal deficits pose In-
dia’s greatest risk to future destabilization.
In the following chapter we will deliberate over the reforms and trends in
the area of fiscal consolidation for a decade of nineties.
8
Chapter 3
9
opening of the economy for foreign investment, financial sector reforms etc.
The fiscal reform measures thus need be sequenced, aligned and restructured
alongwith the reforms in all other sectors.
Given the wide range of fiscal sector reforms, particularly at micro level,
interms of changes in tax reforms and expenditure management, it is well
beyond the scope of this project to list out all the measures taken during
the last decade or so. An attempt, therefore, has been made in this part of
the chapter to highlight the major areas of reforms strictly confined to fiscal
consolidation at macro level.
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3.1.1 Tax Reforms
Tax reforms during ninties have been mainly guided by the report of the
Chelliah Committee on tax reform (1993). The main objectives have been
simplification of the tax system, rationalization of tax rates, fairness in tax
system, improvement in tax administration and above all providing a growth
promoting tax structure. The wide range of reform measures taken during
the last decade include - in the case of direct taxes: moderation of tax rates,
widening of tax base, incentives for development of infrastructure and hous-
ing and strengthening of enforcement, and - in the case of indirect taxes:
reduction in multiplicity of rates, rationalization of the rate structure, dras-
tic reduction in the scope for discretionary changes and uniform floor rates
for sales tax by the States, introduction of VAT. Further, rationalization and
improvements in tax administration, of course, is a continuing process.
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progress on disinvestment process. Various fiscal reform measures relating
to Central Public Enterprises (CPEs) undertaken by the Central government
have shown some noticeable improvements in the finances of these enterprises
during the decade (1990s). In particular, it needs to be noted that budget
support (plan+non-plan) to CPEs as a per cent of GDP has come down to
only 0.5 per cent in 1998-99 from 1.5 per cent in 1990-91 and CPEs deficit
GDP ratio has come down to 1.3 per cent in 1998-99 from 3.0 per cent in
1990-91. Moreover, profitability trends have shown a distinct improvement.
The profit after tax, as per cent of net worth, for CPEs, had increased to
10.4 per cent in 1997-98 from 3.9 per cent in 1990-91.
• The decline in private sector interest rates due to the move to market
borrowing indicates that overall costs of private borrowings are likely
to have declined.
12
Nevertheless, the study points out that Central and State government
finances are in precarious condition due to large non-market debt, unfounded
liabilities and contingent liabilities.
• To suggest a road map for reducing the functions, activities and ad-
ministrative structure of the Central Government.
• To review the framework of all subsidies, both explicit and implicit for
maximizing their impact on the target population and minimize cost.
• To review the framework for determination of user charges of Depart-
mental and Commercial activities : suggest an effective strategy for
cost recovery.
• To review the adequacy of staffing under Central government Min-
istries, attached offices etc. ” To review the procedure for setting up of
government funded autonomous institutions.
• To consider any other relevant issue concerning expenditure manage-
ment in government and make suitable recommendation.
The main objective of the program is to wipe out the revenue deficit in
the State budget in the medium term. The program components are:
13
• Reduction in Non Plan Revenue Expenditure
• Pricing/subsidy reforms
• Institutional reforms
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3.1.8 Fiscal Responsibility Act
On December 11, 2000 the Government has introduced a Bill in the Par-
liament titled as ”The Fiscal Responsibility and Budget Management Bill,
2000”. The proposed legislation is to provide for the responsibility of the Cen-
tral Government to ensure inter-generational equity in fiscal management and
long-term macro-economic stability by achieving sufficient revenue surplus,
eliminating fiscal deficit and removing fiscal impediments in the effective con-
duct of monetary policy and prudential debt management, consistent with
fiscal sustainability, through limits on the Central Government borrowings,
debts and deficits, greater transparency in fiscal operations of the Central
Government and conducting fiscal policy in a medium-term framework and
for matters connected therewith or incidental thereto.
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A closer look at the different measures of deficit would reveal perhaps a
more worrisome trend in that the fiscal deficits are being driven more and
more by deficits in the revenue account of the budget. Thus revenue deficit
of the Central government which accounted for about 40 per cent of the fiscal
deficit in the budget in 1991-92 is now about 68 per cent. Much more so in
the case of state budgets, where the increase in revenue deficit to fiscal deficit
ratio is from about 28 per cent in 1991-92 to about 62 per cent in 1999-2000.
These trends simply show that the government is increasingly borrowing to
finance non-asset creating expenditure from where no returns are expected.
Further, the trends in primary deficit, show that increasing interest burden
alone, is not the contributory factor in higher level of deficit. Latest avail-
able estimates indicate that the combined primary deficit in 1999-2000 (RE)
at 4.2 per cent of GDP was highest during 1990s except for the crisis year
(1990-91) when it was 5.0 per cent. Another important trend on deficits is the
increasing number of State governments with higher levels of deficit. Thus
in 1999-2000, 13 out of the 25 state governments had faced fiscal deficit level
of more than 7 per cent of their respective state domestic product, compared
to 6 states in 1990-91, 4 states in 1995-96 and 8 states in 1998-99.
With regard to gross tax revenue of the Central government the trends
show that between 1990-91 to 1998-99 the tax-GDP ratio declined by 2.6
percentage points from 10.8 in 1990-91 to 8.2 per cent in 1998-99. This is
partly attributable to the change in the structure (sectoral composition) of
the real economy where the share of industrial sector has fallen and services
sector has increased significantly without being brought in the tax-net in a
significant way.
16
Some of the other features of trends in tax revenue are as follows:
• Tax revenue, on an average, could finance about 60 per cent of the cen-
tre’s revenue expenditure during the eighties. The proportion during
nineties, however, was about 55 per cent only.
• Continuing reforms and rationalization of the tax structure, have re-
sulted in a structural shift in composition of tax revenue
• A fall in the share of indirect tax collections from about 80 per cent of
total tax revenue in eighties to about 70 per cent in the nineties could
not be fully compensated by the increase in direct tax revenue.
• On the states’ side, the dip in tax buoyancy occurred as revenue from
sales tax, the principal component of their own tax revenue, showed a
declining growth trend owing to tax competition among the States to
attract trade and industry.
Results of a study (NIPFP) for the year 1995-96 and 1996-97 has shown
that recovery rates were as low as 8.4 per cent of the costs for social services
provided by the Centre and 16.6 per cent for economic services implying
subsidization varying from 91 to 83 per cent of the costs. The level of cost
recovery is still lower in the case of States. It is 2.15 per cent for social
services and 10.75 per cent for economic services.
17
• Central Government’s total budget expenditure (Revenue+capital) as
a proportion to GDP is lower at 15.72 per cent in 1999-2000 (RE)
compared to 17.85
• Even revenue expenditure ratio was lower at 12.16 per cent of GDP
during the second half of nineties compared to 13.69 per cent in the
second half of eighties.
• The other major item of expenditure which has increased sharply is the
expenditure on pensions.
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took aggregate domestic investment from 22.5 percent of GDP in 1991-92
(to which it had dropped during the crisis) to a peak of 26.8 per cent of GDP
in 1995-96, without any undue stress on the external accounts. Of course
fiscal rectitude was only one of the cause of investment boom. Other factors,
such as the deregulation of industry and foreign trade, strong export perfor-
mance and the overall reform momentum were also at work. But it does seem
likely that the deficit reduction in the first half of the decade helped to nur-
ture the rise in gross savings and investment, which, in turn, helped propel
India’s growth to 7 per cent plus for three successive years in the mid-nineties.
The converse seems to have happened in the second half of the decade,
with a widening fiscal deficit contributing to a slowdown in investment and
growth. After 1995-96 (actually after 1996-97) the consolidated fiscal and
revenue deficits deteriorated steadily, with about half the worsening due to
the phasing in of decisions on the Fifth Pay Commission. Between 1995-
96 and 1999-2000 both the fiscal deficit and the revenue deficit increased by
three per cent of GDP. This sharp widening in deficits is fully reflected in the
decline of public savings from plus 2 per cent of GDP in 1995-96 to minus 1.2
per cent in 1999-2000. This, in turn, fully explains the drop in gross domestic
savings from its peak of 25.1 per cent of GDP in 1995-96 to 22.3 per cent in
1999-2000. Gross domestic investment fell by a similar magnitude over these
four years.
It has also been shown that in India, during the eleven year period since
1986-87, an increase in the Central Government’s fiscal deficit (inclusive of
oil pool account) by one percent of GDP was associated with a reduction in
private corporate investment by one percent of GDP.
It needs to be recognised that the conditions that have restricted the
adverse macroeconomic impact of high fiscal deficit are transitory in nature.
With a revival of economic activity, spurred by a pick-up in the private
investment demand, rise in fiscal deficit could raise the saving-investment
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gap and eventually raise interest rate and widen current account deficit.
The problem could be compounded if inflationary pressures re-emerge due to
buoyant economic activity. In view of this, sustainability of deficit and debt
and fiscal consolidation continues to be a matter of serious concern.
3.3.2 Observations
The above analysis and assessment clearly revealed that the significant fiscal
consolidation in the immediate aftermath of the fiscal reforms was essentially
brought about through cut in investment expenditure, as rise in committed
revenue expenditure could not be curtailed. Within a short span, it became
increasingly obvious that the Indian approach to fiscal correction was not
sustainable. While reduction in investment spending affected future growth
prospects with consequent slowdown in revenue receipts, the interest pay-
ments at public debt continued to grow, resulting in reversal of fiscal con-
solidation process in the latter half of the 1990s. Downward rigidity in the
revenue deficit, which amounts to dissaving by the Government sector, has
significant implications for the growth target of 8 percent; set in the Tenth
Five Year Plan. This would require an investment rate of about 32 per cent,
whereas, over the years, the investment rate has stagnated at around 24 to 25
per cent of GDP. Acceleration of saving and investment rate would critically
depend upon the efforts to restore balance on the revenue account.
The key factors underlying the growing resource gap across the States are
uneconomical level of user charges particularly in the power sector, sluggish-
ness in the Central transfers due to low buoyancy of Central taxes and the
rising interest payments. Restoration of revenu balance both at the Central
and the State level would require that user charges are adequately raised,
the tax collection machinery is overhauled to achieve better tax compliance,
returns on Governmer investment in PSUs are raised through appropriate
pricing policies eliminating implicit subsidies and the burden on the fiscal is
lowered through phasing out of unviable public sector units. The introduc-
tion of VAT should eliminate the practice of competitive tax concessions.
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investments.
The institutional support in the form of fiscal rules should be the prime
mover of future agenda of fiscal consolidation programme. Such fiscal rules
could prescribe quantitative limits for elimination of the revenue deficit, re-
duction in the fiscal deficit and the public debt over a specific period in
a phased manner. In a recessionary environment along with low inflation,
growing forex reserves and comfortable level of food stocks, there is a definite
role for the expansionary fiscal policy. The apprehension is that the strin-
gent fiscal rules may hinder appropriate steps by the Government. However,
it may be noted that such rules generally make a clear distinction between
public consumption and public investment expenditure while envisaging a
complete elimination of revenue deficit. Rule based fiscal policy would fa-
cilitate the path for durable fiscal consolidation through mandatory fiscal
discipline, enhanced accountability and improved transparency in fiscal op-
erations.
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Appendix A : Snapshot of Annual Budget
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Appendix B : Fiscal Trends: Deficit and Debt
23
Appendix C : Fiscal Trends: Deficit and Expenditure
24
Appendix D : Aggregate Budgetary Balance : Centre
and States
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Appendix E : Tax buoyancy : Centre and States
26
Appendix F : Trends in Expenditure : Central Gov-
ernment
27