Views | Fiscal repairs now?

Fiscal repair seems to be finally engaging the attention of Indian policymakers.

The finance minister was recently reported to have said that the government will try to broaden the direct tax base in a bid to narrow the fiscal gap. This belated interest, expected earlier in the 2012-13 Budget, has been forced by several adverse developments unfolding in quick succession. Indeed, it has taken a ratings downgrade, steep currency depreciation, fleeing investors, slowing growth and much more for the impaired public balance sheet to finally get some notice.

Unsurprisingly, it is measures to raise revenues that are the focus for deficit reduction rather than controlling inessential spending that is typically aligned to potential political gains.

Broadening the tax base is driven by the need to counter falling tax buoyancy since 2008-09. Tax revenues are no longer rising at the same pace as gross domestic product (GDP): Overall tax buoyancy (direct plus indirect taxes) averaged just 1 from 2008-09 to 2012-13 compared to a healthy pre-crisis average of 1.6 (2002-03 to 2007-08). Moreover, the 2012-13 Budget estimates tax collections assuming a 7.6% growth in GDP, which appears unlikely under the prevailing macroeconomic conditions; lower-than-expected tax buoyancy upset the fiscal math in 2011-12 as well.

Slowing growth and high inflation are the main reasons why direct taxes are in focus for reducing the fiscal gap. Since fiscal consolidation measures reinforce the economic cycle, and thus exacerbate a growth slowdown, broadening the tax base is the best path for the government to take under the circumstances. Also, direct taxes are much more elastic than indirect taxes. Past trends for India show that tax elasticity – a concept close to tax buoyancy, except that it adjusts for discretionary tax changes so as to reveal the natural elasticity of revenues as GDP rises – of direct taxes ranges between 2-3 while that for indirect taxes is much lower (0.5-1.2). So broadening the direct tax base will yield more revenue as GDP rises without the need to tinker with the tax system.

Fiscal consolidation is desperately needed to increase the effectiveness of measures to attract higher foreign investments, which are especially sensitive to such imbalances. Recent research from the International Monetary Fund shows that the country-specific characteristics that define the vulnerability of an emerging economy to global risks are initial fiscal conditions, the degree of financial openness and the size of external imbalances. Nothing more need be said about India’s susceptibility on this count, but policy options need to be urgently regained in order to address external risks.

A fiscal consolidation strategy will reduce country-risk in the near-term. And the effort is relatively undemanding in the light of favorable factors like a negative interest rate–growth differential, which helps maintain a declining debt ratio and large government stakes in public firms (exceeding 10% of GDP, according to IMF’s Fiscal Monitor for April 2012). On the other hand, the gains would be considerable. India’s constrained policy space at a juncture of slow growth-high inflation-ebbing foreign capital flows is a stark contrast with its neighbor China, which has been able to defer its consolidation plans for 2012 in response to slower growth. Repairing public finances now will provide such headroom in the future.

Renu Kohli is a New Delhi-based macroeconomist; she is a former staff member of the International Monetary Fund and Reserve Bank of India.