India’s fiscal situation is in its best shape since the mid-1990s. That is the good news. The not-so-good news is that India’s fiscal deficit, at an estimated 6.8% of gross domestic product (GDP), remains one of the highest in the world. The bad news is that it is likely to only get worse from here.
First, the good news. There have been some real gains in tax receipts. Revenues have been growing by 25% over the past four years, well above nominal GDP growth of about 14%. The composition of revenue growth has also been desirable, with direct taxes (corporate + income) growing at nearly 1.5 times the rate of overall taxes, even as previously high customs duties and excise rates have come down. High economic growth since 2003, with the economy growing above potential, has been an important factor, as revenues tend to grow faster than GDP in a cyclical upturn. However, the buoyancy in revenues well above that of GDP growth also shows improved administration and widening of the tax base. A significant chunk of the gains can be attributed to administrative reforms, especially the launch of the tax identification network system and the broadening of the service tax and income tax bases.
(Imagery: Malay Karmakar/Mint)
At the state level, revenue gains have been no less impressive. The extension of the value-added tax to nearly all states, a jump in stamp duty collections due to rising land prices, more transfers from the Centre, and better administration have all been important factors underpinning revenue growth.
On the expenditure front, a lowering of interest rates has helped contain the rise in expenditures, even as outlays on several large Central schemes and capital spending have increased significantly.
As a consequence, the fiscal deficit has declined measurably from nearly 10% of GDP in FY02 to under 7% in FY08. The contribution to this consolidation is roughly 70% from the revenue front and 30% on the expenditure front. The revenue deficit of the states (the difference between revenues and current expenditures) has been nearly eliminated.
And now, the bad news. Even after recent gains, India’s overall fiscal deficit is still one of the highest in the world. The government’s borrowing absorbs around 30% of total credit, keeps interest rates high, and prevents credit from reaching the more dynamic private sector. Fiscal consolidation has stalled over the past three years as the deficit is not coming down even after record income-tax collections, as expenditures have risen concomitantly. Among Brics (Brazil, Russia, India and China), India’s government finances remain the weakest. Further, after four years of nearly 9% GDP growth, India’s total debt at more than 75% of GDP remains high and a source of vulnerability.
The outlook for government finances does not look rosy due to significant pressures on the horizon from fuel and fertilizer subsidies, election-related spending, and the 6th Pay Commission.
Election-related spending: With the general election due by May 2009, this is the last full Budget of the present government. As such, political considerations can be expected to dominate Budget preparations. Historical precedents suggest that fiscal deficit tends to increase by nearly a full percentage point in election years. Given politicians’ predilection for grandiose plans, we can expect more spending pressures due to these. The pre-announced extension of the National Rural Employment Guarantee to all districts will cost about 0.4% of GDP yearly.
Subsidies: The subsidy bill on oil and fertilizers continues to increase, as rising import prices have not been passed through to consumers. We estimate that subsidies on this amount to some 2% of GDP, most of which are off-budget. Fertilizer subsidies have been growing at more than 30% over the last three years, as the increase in import prices hasn’t been passed through to retail prices. Oil subsidies, too, have increased to 1% of GDP. We expect these?subsidies to?continue this year.
Public sector wage hikes: The 6th Pay Commission for public sector employee wages is expected to announce wage hikes in the next few months. The last pay commission awarded an increase of 30%, which consequently put the Central and state finances in great peril. If the 6th Pay Commission were to award a similar increase, our estimates show an increase in expenditure by 0.8% of GDP due to the impact on the wage and pension bills. A major chunk of these liabilities will be borne by the states.
Taken together, these suggest significant expenditure pressures this year. Goldman Sachs’ expectations that revenue growth has peaked and will moderate point to the fiscal situation deteriorating. Our view that overall growth will slow to below potential this year and corporate earnings will come off, suggests a deceleration in the rate of revenue growth, as tax receipts tend to fall more when growth is below trend. At the state level, a rationalization of the stamp duty structure will also negatively affect collections.
The implications of a rising fiscal deficit are that it would boost aggregate demand, thus adding to inflationary pressures, and contribute to greater real exchange rate appreciation and a loss of competitiveness. These are exactly the consequences that the government does not want in an election year.
An expansionary fiscal policy would also not allow the Reserve Bank of India the space to meaningfully reduce interest rates as growth moderates. Thus, we continue to expect only a 50 basis point reduction in the repo rate in 2008.
Given the high growth rates and generally benign environment over the last few years, one would have expected deeper reductions in the deficit and debt. A tighter fiscal policy would have also allowed for greater absorption of capital inflows. Wage hikes, fuel and fertilizer subsidies, and grandiose schemes, all of which require funding year after year, reduce flexibility in the Budget.
This inflexibility, along with a high budget deficit, reduces the room to manoeuvre and, importantly, the ability to respond to adverse shocks to the system. Further, the government’s large borrowing requirement continues to lead to a suboptimal allocation of credit. Perhaps that is the economic price that India has to pay to keep political tensions about unequal distribution of gains from growth at bay.
Tushar Poddar is an economist with Goldman Sachs. Comments are welcome at email@example.com