Reforms in India’s Fiscal Policy and Its Performance

Reforms in India’s Fiscal Policy and Its Performance!

Fiscal policy is a critical component of the policy framework pursued since the initiation of economic reforms in India in 1991 to achieve the objectives of economic growth, price stability and equity.

To achieve these objectives, it was necessary to raise more resources through taxation and restrain the growth of unproductive and non-plan expenditure.

During the mid-nineties there was set back in this policy when Fifth Pay Commission’s recommendations of sharp hike is wages and salaries were accepted resulting in large increase in non-plan government expenditure and consequently rise is fiscal deficit.

But since 2001-02, the Central Government has continued to follow prudent fiscal policy comprising:

(i) Balanced tax structure of direct and indirect taxation based on moderate tax rates with minimum exemptions covering a wider class of tax payers and

(ii) An expenditure policy that aims to restrain the growth in non-developmental expenditure and adequately provide for pressing social and infrastructure needs of a developing economy.

In the last some budgets, especially the budgets for the years 2005-06,2006-07, 2007-08,2010-11, 2011-12 and 2012-13 the fiscal strategy for achieving the above stated objectives has been primarily revenue led without expenditure compression. However, within the limits of fiscal deficit set under Fiscal Responsibility and Budget Management (FRBM) Act passed in 2003-04, there has been reprioritization of public expenditure along with revenue-ted strategy of fiscal consolidation.

To raise more revenue for achieving growth with macroeconomic stability, tax-GDP ratio has been sought to be raised. As a result of tax effort made for mobilisation of tax-GDP ratio rose to 12.6 per cent (for both the centre and states combined) in 2007-08. For this purpose various tax reforms both in the spheres of direct and indirect taxes have been carried out. It is felt that while the policy of moderate tax rate; have to be followed, the base of taxation has to be broadened.

With this end in view the tax reforms undertaken since the beginning of nineties have sought to bring about a compositional shift in the structure of the tax system away from the excessive dependence on regressive indirect taxes to progressive direct taxes for raising resources for accelerating economic growth with stability. Besides, to ensure competitiveness of the products of Indian industry excise duties and custom duties have been reduced so that rapid growth of Indian exports is possible.

Moreover customs duties were reduced to open up the Indian economy and to obtain gain from free trade. To compensate for this and realizing that more than per cent of India’s GDP came from services, service tax was levied which has now become an important source of Government revenue. In 2013-14 service tax was expected to yield Rs. 1.30 lakh crore (BE).

However, as stated above, to achieve fiscal consolidation (i.e., reduction of fiscal deficit) for controlling inflation and ensuring release of resources for economic growth and employment generation, raising revenue from taxation has been given priority along with improving the quality of public expenditure (that is, restraining the growth of non-developmental expenditure and raising plan expenditure).

Since, much of public expenditure is of committed nature such as interest payments for servicing past public debt, expenditure on defence, pensions and wages and salaries of government employees, there is very little room for compression of expenditure in the short run, the objective of accelerating growth and employment generation have to be achieved by raising revenue and improving the quality of expenditure.

However, in the financial year 2012-13 in order to contain fiscal deficit, Finance Minister, Mr. Chitambram reduced planned expenditure by Rs. 90,000 crore which worked to reduce rate of economic growth. In what follows we first explain the reforms in both direct and indirect tax systems that have been undertaken in the last two decades.

Reforms in Direct Taxation:

It is important to note that over the last two decades, there has been a significant reform in the tax system so that it can make larger contribution to resource mobilisation for economic growth and at the same time serves the objective of achieving equity as well. First, in the sphere of direct taxation rate of income and corporation taxes have been lowered to moderate levels.

With lower tax rates revenue buoyancy from these taxes can be achieved through better compliance and minimal exemptions. Until the early eighties, direct tax rates were exorbitant, evasion of these taxes was rampant which gave birth to the enormous black money in the Indian economy.

It was realised that moderate rates of these taxes would yield more revenue by increasing tax compliance. Lower rates of direct taxes also provide incentives to work more, save more and invest more as lower rates increases after-tax returns on work, saving and investment. Long-term fiscal policy announced in 1985 rightly emphasised that “a broader base of taxation combined with moderate rates of taxes and strict enforcement, can yield better revenue results”.

Acting on the long-term fiscal policy V.P. Singh in his 1985-86 budget cut the maximum marginal rate of income tax to 50 per cent and reduced personal income tax slabs from eight to four. Seven years later Dr. Manmohan Singh reduced the maximum marginal income tax rate to 40 per cent in his budget for 1992-93 and reduced the personal income tax slabs to only three. Mr. Chidambaram in his dream budget 1997-98 further reduced top marginal rate of income tax to 30 per cent. Moreover, education cess of 3 per cent has been levied on both income tax and corpo­ration tax.

As regards corporation tax, acting on the Chilliah Committee recommendations Dr. Manmohan Singh attempted rationalisation of corporate taxation and cut the corporation tax rate to 40 per cent and reduced exemptions in 1994-95 budget to broaden the base of the tax. Three years later Mr. Chidambaram further reduced corporation tax to 35 percent in his budget for 1997-98 and again as Finance Minister in UPA Government he further reduced the corporation tax rate to 33 per cent in 2004-05 budget.

However, to broaden the base of corporation tax so as to increase tax revenue he lowered the depreciation allowance from 25 per cent to 15 per cent in 2007-08. Besides, to raise revenue from corporate taxation, fringe benefit tax (FBT) was levied payable by corporate employee.

Besides, Minimum Alternate tax (MAT) which was fixed at 7.5 per cent to 10 of book profits of the corporate companies has now been raised to 18.5 per cent in 2011-12 budget and long-term capital gains have been included in the book-profits. Further, securities transaction tax (STT) has been levied on the sale and purchase of shares/securities.

It is thus evident from above that in the last over two decades, efforts have been made to move to moderate direct tax rates and broaden the base of direct taxation by withdrawing certain exemp­tions. This has improved the compliance to pay taxes and resulted in increase in revenue from direct taxes. However, there is still a vast potential for revenue buoygency of direct taxes since there are still a large number of exemptions, for example, in case of various types of financial savings and exports.

As recommended by the Task Force headed by R. Vijay Kelkar, more resources can be mobilized from direct taxes if a large number of existing exemptions which have outlived their utility are withdrawn and direct tax system is simplified and made transparent. It is now proposed to implement direct tax code without much exemptions which is now awaiting the approval of parlia­ment.

An important outcome of fiscal policy pursued after 2002-03 was decline in fiscal deficit till 2007-08 which helped to keep inflation rate at around 5 per cent per annum as measured by WPI of all commodities. It will be seen from Table 33.1 that fiscal deficit which was 6.2 per cent of GDP in 2001 -02 fell to 2.5 per cent in 2007-08, but again rose to 6.5 percent in 2009-10 due to fiscal stimulus package adopted to prevent slowdown of the Indian economy due to global financial crisis. High fiscal deficit of the order of 6 per cent and more is bad and against fiscal prudence.

Fiscal deficit can be either financed by the Government monetisation, that is, printing of new money by RBI or by borrowing from the market. Monetisation of fiscal deficit is avoided as it leads to inflation in the economy. The excessive Government borrowing is also had because it causes increase in public debit which raises the burden on future generations. Besides, excessive Government borrowing from the banks dries up banking resources for the private sector, that is, reduces the availability of credit for the private sector.

Further, Government borrowing from the market tends to raise interest rate. Higher interest rate causes increase in cost of credit for the private sector which impinges on their profit margins. Therefore, on the recommendation of IMF, Fiscal Responsibility and Budget Management (FRBM) Act was passed in 2003-04.

After this, fiscal deficit consistently declined to 4.0 per cent of GDP in 2005-06 and to 2.6 per cent in the year 2007-08. This decline in fiscal deficit in these years was achieved by reducing revenue deficit from 4.4 percent of GDP in 2001-02 to 2.5 percent in 2005-06 and further to 1.1 per cent in 2007-0& on the one hand and restraining the growth of expenditure (See Row 6 of Table 33.1), especially non-plan expenditure.

Under Fiscal Responsibility and Budget Management Act (FRBMA) it was planned to eliminate revenue deficit completely by 2008-09 and fiscal deficit to be reduced to 3 per cent of GDP in 2008-09. This was expected to release more resources for economic growth and social sector development.

However, fiscal deficit rose to 6.0 per cent of GDP in 2008-09 and to 6.5 per cent of GDP in 2009-10. This is because to fight economic slowdown following the intensification of global financial crisis in 2008, the Central Government came out with fiscal stimulus programmes wherein Government expenditure had to be increased and indirect taxes reduced to keep the momentum of economic growth.

However, it was reduced by the 4.8 per cent in 2010-11 and to 4.6 per cent of GDP in 2011 -12, but it again rose to 5.7% of GDP in 2011 -12 and 5.1 % in 2012-13. In his budget for 2013-14, the Finance Minister has set the target of fiscal deficit for 2013-14 at 4.8% of GDP.

Changes in Taxation Structure: Increase in Share of Direct Taxes:

It is interesting to note that tax-GDP ratio which rose to 11.9 per cent in 2007-08 declined to 10.8% and 9.6 per of GDP in 2008-09 and 2009-10 respectively due to lowering of indirect taxes in 2008-09 and 2009-10 to prevent large economic slowdown. Besides, there has been also improvement in the taxation structure (See Table 33.2). While there has been decline in the share of regressive and resource-distorting indirect taxes in the revenue of the Central Government, there is rise in the share of direct taxes.

Thus, as will be seen from Table 33.2, whereas the share of direct taxes as per cent of GDP rose from 2.8% in 1995-96 to 5.9 percent in 2007-08, the share of indirect taxes (customs duties, excise duties and service tax) as per cent of GDP fell from 6.4 per cent in 1995-96 to 5.6 per cent in 2007-08 and further to 3.8% in 2009-10 but for 2012-13 it was budgeted to rise to 5% of GDP. On the other hand, the share of direct tax as percentage of GDP which was 3% of GDP rose to 5.6 per cent of GDP in 2012-13. This increase in share of direct taxes and fall in indirect tax in total tax revenue of Central Government has made the Indian tax system more equitable.

1. Direct taxes also include taxes pertaining to expenditure, interest, wealth, gift and estate duty.

2. The ratios to GDP at current market price are based on the CSO’s National Accounts 2004-05 series.

This change in tax structure a creditable achievement of mobilising resources from direct taxes, as this has been done despite the fact that rates of both personal income tax and corporation tax have been substantially reduced. This will also ensure equitable distribution of burden of overall tax among the people.

Reforms in the Indian Indirect Tax System:

The Indian indirect tax system as it existed in the early nineties had several drawbacks. First, the excise duties and sales tax were levied on inputs which had a cascading effect on raising prices of final products. In a way, there is ‘a tax on tax’. As regards sales tax which is levied by State governments, a uniform value added tax (VAT) is proposed to be levied. VAT tax will replace different rates of sales tax levied by the state governments. Legislation has already been enacted but its implementation was deferred due to protest by traders and due to general elections in April 2004.

Now, as per decision of UPA government VAT has come into effect from April 1, 2005. Implementation of VAT will eliminate the cascading effect of sales tax and also help in achieving price stability. The experience of Haryana and Delhi which have implemented VAT shows that government revenue increased when VAT was introduced.

Reforms in Excise Duty:

To rationalise the indirect tax system at the centre by removing distortion in the structure there is a need to remove multiplicity of tax rates of central excise duties on various goods and services. With tax reform initiated since 1991, this has been now achieved with few exceptions.

Now, there is a single excise duty called CENVAT (which is in the form of value added tax) at the rate of 16 per cent on all products which enter a production chain. The argument for a single 16 per cent CENVAT is that it will remove the distortions in the tax system as a result of multiplicity of rates of excise duties.

This is of course a correct approach in general but in the view of the present author the final consumption goods of the nature of income-elastic luxuries such as cars and air conditioners should be taxed at a much higher rate than CENVAT.

This will enable the government to raise more revenue without harming production incentives and will thus serve well the equity objective. To simplify the indirect tax system, it is now planned to introduce Goods and Services Tax (GST) in near future. This GST will replace the service tax Central CENVAT and states VAT and a uniform rate of GST by all states will be fixed.

Revenue Mobilisation through Service Tax:

While the revenue from existing three sources, namely, direct, excise and customs taxes, is expected to increase by ensuring greater tax compliance and withdrawal of exemptions, the government seeks to collect more revenue from service tax by bringing more services under its net. Over the last four decades there has been a structural change in the Indian economy with relative contribution of agriculture to GDP significantly decreasing and of services sector sharply increasing to 54 per cent of GDP.

With more services which have been brought within the service tax net in the last four budgets for the years, 2004-05, 2005-06, 2006-07, 2007-08 the total number of services on which service tax is levied has risen to more than 100. In the year 2013-14 service tax was expected to bring in about Rs. 1.80 lakh crore (BE).

It is now well recognized that for more revenue mobilisation as well as for achieving equity and price stability there is a need to look at the whole value addition chain covering both goods and services from the viewpoint of taxation. Government intends to expand the scope of taxation of services by not only bringing additional services within the tax net, but also covering a larger number of assesses under the service tax.

Reforms in Customs Duties:

Since the early nineties revenue from customs duties as a percentage of GDP has been falling due to the reduction in customs duty rates following the policy of trade liberalisation. Dr. Manmohan Singh, the Finance Minister in his five budgets between 1991 and 1996 reduced India’s absurdly high customs duties.

He reduced peak tariff rates from over 200 per cent to 50 per cent and the import weighted average tariff rate from over 80 per cent to below 30 per cent. Since 1996, successive finance ministers further reduced the peak trifurcate (i. e. customs duty) first to 35 per, and then to 20 per cent in Jan. 2004.

The peak rate of customs duty has been further reduced to 15 per in 2005-06 and to 12.5 per cent in 2006-07 and to 10 per cent in 2007-08. But there are several exceptions to this peak rate. It is now planned to reduce the peak customs duties to the ASEAN level. Though India is committed to reduce tariff duties under trade liberalisation agreement of WTO, we should try to provide effective protection to some of our crucial industries such as textiles and agriculture by fixing higher customs rates than peak customs duty making a cause for their exceptional treatment.

It is quite surprising to note that Kelkar Task Force on implementation of Fiscal Responsibility and Budgetary Management Act (FRBMA) proposed a shift to a three rate structure on customs duties consisting of 5 per cent, 8 per cent and 10 per cent. In our view this is going too far in trade liberalisation. This will involve not only a loss of tax revenues but will also reduce effective protection to Indian industries.

Changes in Quality of Expenditure:

Changes in pattern of expenditure is also worth mentioning. It will be seen from Table 33.4 that prior to 2007-08 through the adoption of prudent fiscal policy the Government had been able to reduce total expenditure both revenue and capital, which as percentage of GDP fell from 17.3 per cent in 2001-02 to 15.4 per cent in 2004-05 and further fell to 13 .6 per cent in 2006-07, and rose marginally to 14.1% in 2007-08.

As compared to plan-expenditure which as a percent of GDP rose from 3.8 per cent in 2005-06 to 4.9% in 2008-09 and 5.3% in 2009-10 non-plan expenditure fell sharply from 12.3 per cent of GDP in 2002-03 to 9.7% in 2006-07 and to 10.3 per cent in 2007-08. It is only in 2008-09 and 2009-10 that due to need of increasing public expenditure to overcome recession or slowdown of the Indian economy and to keep the growth momentum that non-plan expenditure slightly increased to 10.9% and 11.3% in 2008-09 and 2009-10 respectively (See Row 6 (a) and 6 (b) of Table 33.1.

Further, as seen from Table 33.4 that Government has succeeded in restraining the growth of non-development expenditure incurred on interest payments, major subsidies and defense till 2007-08. It is only in 2008-09 and 2009-10 under well-designed contra-cyclical policy that Government increased its expenditure and borrowed heavily for this purpose to fight slowdown of the Indian economy and to keep the growth momentum.

This resulted in increase in expenditure on interest and subsidies. As plan expenditure represents development expenditure and non-plan expenditure represents non-development expenditure, the changes witnessed in the pattern of expenditure there­fore show improvement in the quality of expenditure.

For achieving 8 per cent rate of growth in GDP on a sustained basis, it is necessary to step-up public investment expenditure on agriculture and infrastructure. This requires to effect a shift in the composition of total expenditure in favour of capital expenditure. This can be done only if revenue deficit is bridged by raising more resources through taxation on the one hand and cutting non-plan expenditure on the other.

One of the major objectives of Fiscal Responsibility and Budget Manage­ment (FRBM) Act, 2003 was to eliminate revenue deficit by the year 2008-09. With revenue deficit reduced to zero, But in 2008-09 partly due to fiscal stimulus in which tax cuts were made and government expenditure increased to maintain the growth momentum and partly due to the populist programme such as waiving loans of farmers to the time of Rs.70,000 crore the target of zero revenue deficit was not achieved.

As a result revenue deficit which was lowered to 1.1 per cent of GDP in 2007-08 went up to 4.6 per cent in 2008-09. Therefore, the expectation that with zero revenue deficit, the government would be able to increase capital expenditure for investment in agriculture, industry and infrastructure was not realised. Large revenue deficit is quite bad because large expen­diture incurred on revenue account does not lead to creation of durable assets which are essential to sustain growth.

Thus, what is a matter of concern is the decline in capital expenditure which mostly represents investment expenditure in physical assets. As a proportion of GDP, fall in total government expenditure from a level of 17.1 percent in2003-04 to 14.4 per cent in 2007-08 was largely driven by the steep fall in capital expenditure with revenue expenditure remaining almost steady between 2004-05 and 2007-08 (see rows 5 and 6 in Table 33.1).

It may be however noted that revenue expenditure includes some expenditure on social sector (mainly elementary education and literacy) under Sarv Shiksha Abhiyan and Mid-day Meals; health and family welfare (National Rural Health Mission), rural employment, and physical infrastructure including rural roads which are also of developmental nature. Even accounting for these the fact remains that fall in capital expenditure is disturbing and must be reversed.

As regards expenditure on subsidies, the government’s recent policy is to make them targeted to the poor and weaker sections of the society. To ensure that benefits of expenditure on subsidies are not usurped by those not intended be the beneficiaries of these subsidies. Delivery mechanism for providing these subsidies should be improved and made more efficient.

Under NCMP, Govern­ment is committed to control inefficiencies that increase the food subsidy burden and to target all subsidies sharply at the poor and the truly needy like small and marginal farmers, farm labour and the urban poor. To reduce expenditure on subsidies government has raised the price of cooking gas and restricted its use by a family to 9 cylinders per year. Besides, it has decontrolled petrol and raising price of diesel by 50 paise every month. However, due to enactment of Food Security Bill, its expenditure on food subsidy will rise.

Reduction in Fiscal Deficit:

A large fiscal deficit has been a major macro-economic problem. It is persistent large fiscal deficits in the nineteen eighties that landed the Indian economy in a state of severe economic crisis reflected in the acute balance of payments problem.

This acute economic crisis compelled us to approach IMF for help to tide over the crisis. Fiscal deficit is the difference between the total govern­ment expenditure on revenue and capital accounts and the total sum of revenue receipts and non-debt capital receipts. Thus fiscal deficit measures the total borrowing from the market, net borrowing from the Reserve Bank of India (i.e. monetisation of deficit), small savings and external assistance (i.e. borrowing from abroad at concessional rate of interest).

For the achievement of macroeconomic stability, fiscal deficit should not exceed 3 per cent of GDP. Fiscal Responsibility and Business Management (FRMB) Act 2003 has prescribed to achieve the target of fiscal deficit to 3 per cent of GDP by the year 2008-09. This is generally called fiscal consolidation. But how this fiscal consolidation, that is, reduction in fiscal deficit is to be achieved so as to achieve economic growth with stability and equity. This can be done by raising tax-GDP ratio on the one hand and reducing non-plan expenditure on the other.

Tax-GDP ratio can be raised by widening the base of direct taxes, especially personal income tax and corporation tax. One important way of broadening the base of the direct taxes is to withdraw many of such exemptions which have outlived their utility and are merely used to evade these taxes.

As result of these exemptions, the effective rate of corporation tax is much smaller. Economic Survey 2005-06 found that 40 per cent of corporate companies pay only 10 per cent or less corporation tax as against 30 per cent levied on them. This has also been found by Task Force headed by Vijay Kelkar.

It is interesting to note that because of these exemptions Reliance Industries which made huge profits throughout its career did not pay any corporation tax for several years. Similarly, many other profitable companies also took advantage of these exemptions and did not pay any tax for several years. Therefore, the Central government enacted’ Minimum Alternative Tax (MAT) according to which these profitable companies which did not pay corporation tax would have to pay this minimum alternative tax.

The efforts have been to raise more resources through levying new taxes in order to reduce fiscal deficit. The introduction of service tax in 1994-95 ushered in a major change in indirect taxes in the (BE) form of wider base and facilitated the process of rationalization of excise duties resulting in lower tax burden on productive sectors. Over the years, the number of services subject to service tax has increased and now stands at around 114. However, a further reform in the indirect tax system in the form of Goods and service tax (GST) is to be introduced from April 2012.

It is also worth noting that long-term capital gains from shares has been exempted in the budget w. e .f. 2004-05 and has been replaced by Securities Transaction Tax. Along with it, short-term capital gains tax was reduced from 20% to 10%. This is quite contrary to broadening the tax base. Indeed, there is good economic case for imposing a tax on long-term capital gains on shares, its rate may be kept lower than the general income tax rate because of the risk involved in investing funds in equity capital.

The total abolition of capital gains tax on equity capital will introduce large distortions (relative to capital gains from other assets) and also results in loss of revenue for the government. This loss is unlikely to be made up by levying a small securities transaction tax.