After profligacy, a return to fiscal prudence

After profligacy, a return to fiscal prudence
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First Published: Fri, Feb 26 2010. 12 07 AM IST

DK Srivastava, Director, Madras School of Economics. Photo: K Ganesh / Mint
DK Srivastava, Director, Madras School of Economics. Photo: K Ganesh / Mint
Updated: Fri, Feb 26 2010. 12 07 AM IST
DK Srivastava, Director, Madras School of Economics. Photo: K Ganesh / Mint
With the economy showing definite signs of upturn and tax revenue showing prospects of remaining buoyant, the Budget is likely to announce a return to the path of fiscal prudence. The extent of reduction of the fiscal deficit relative to the gross domestic product (GDP) will depend on three critical considerations: the government’s assessment of growth and inflation, the recommendations of the 13th Finance Commission (TFC), and the provision that the Centre may have to make for compensating revenue losses to the states if the goods and services tax (GST) is implemented during the next fiscal.
The growth prospects for 2010-11, in the background of a robust recovery of the industrial sector, appear to be around 8.5%. There is a likelihood that agriculture would emerge out of the cyclical trough and the service sector growth would be stable at around 9%. If the recovery of the industrial sector is sustained, we will be well on our way to resuming the 9%-plus growth path in a couple of years.
With inflation breaching acceptable thresholds, the government will also pre-empt any possibility of unhealthy overheating of the economy. The macro situation warrants that the government bring down the fiscal deficit to GDP ratio from its high levels of the last year in a calibrated way. This calibration will take into account whether any significant additional transfers have been recommended by TFC. It has been the case with some of the previous finance commissions that the first year of their award represents a step increase in the transfers to the states, whether by an upward revision of the share of states in Central taxes or additional conditional and unconditional grants. It is also expected that TFC may have proposed a scheme of compensating revenue loss to the states for implementing GST.
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The government has departed significantly from the stated norms of the Fiscal Responsibility and Budget Management Act (FRBMA) during the last two years due to elections followed by the need for a countercyclical policy in the wake of the global slowdown. The Central fiscal deficit during 2008-09 and 2009-10 was 5.6% and 6.8% of GDP, respectively. This, on average for the two years, is nearly 100% above the FRBMA target of 3% that should have been achieved by 2008-09. The quality of the fiscal deficit was also bad, as more than two-thirds of borrowing was used for current expenditures.
As a result, government liabilities and, correspondingly, interest payments have also been high. With the increased salary and pension burden following the recommendations of the Sixth Pay Commission along with high interest payments, the room for adjustment may be limited, and a reduction of at least 1.25 percentage points in the fiscal deficit to GDP ratio may happen this year. This may be partly facilitated by an active disinvestment policy.
What is equally important is that the government should make a conscious effort to reduce the revenue deficit by a bigger margin, say, by 2 percentage points of GDP, so that most of the borrowing is spent on capital expenditure, particularly much-needed infrastructure that may facilitate growth and make it more sustainable. Since additional transfers recommended by the Finance Commission will be on the revenue account, correction of revenue deficit will be an uphill task.
With the direct tax code and GST kicking in in a year or two, the at least two decades old pursuit of tax reforms will reach a satisfactory conclusion. The government may try to unify the core rate for Central value-added tax for goods and the service tax rate at one level, say, 10%. This can garner additional resources and prepare the ground for a comprehensive GST, where at least the Central GST part would largely be in place. But one might expect that on the revenue side, there will be greater reliance on disinvestment and non-tax revenue to reduce the fiscal deficit.
With GST in place, the government will neither have the need nor justification to tinker with the tax side of the budget every year. The tax system would be stable. The active part of the budget will then be the expenditure side. The government’s approach to healthy management of expenditure may well be spelt out during the current year. A good way to do this would be to follow the golden rule of ensuring that the revenue account remains in balance so that the entire fiscal deficit is used for asset formation. This should be supplemented by ensuring that nearly two-thirds of the revenue budget is allocated for education and health, which would also be investing in human capital. This will improve the quality of budgets enormously by ensuring that the government focuses on the provision of public goods and merit goods which the private sector cannot provide.
In order to take advantage of the demographic dividend, there is a clear need to impart to the progressively growing sections of youth the necessary training and skills so that they become productively employable. Budget 2010 should clearly signal the government’s commitment to health and education by significantly increasing the outlays on these. If the revenue deficit is limited to, say, 2% of GDP and the fiscal deficit is brought down to 5.5% of GDP, the bulk of the remaining borrowing—amounting to 3.5% of GDP—should be spent on infrastructure and required capital outlays for the health and education sectors. If TFC has also recommended some special earmarked grants for health and education, the Budget should not only provide for these, but also for adequate monitoring for the productive use of the higher outlays on these sectors.
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First Published: Fri, Feb 26 2010. 12 07 AM IST