The chickens have come home to roost. The unseemly squabbles between the states and the Centre on a variety of issues—indexing rural employment guarantee wages to inflation or cutting taxes on petroleum products—stem from inadequate expenditure reforms.
In a fiscal when tax revenues of both the states and the Centre have exceeded expectations, the constant refrain is that their fiscal policy space has shrunk on account of rigid expenditure commitments.
To begin with, both sides raised indirect tax rates in the last budget. Subsequently, growth in tax collections outstripped budgetary estimates. Despite unexpected collections, the political economy of spending has ensured government finances remain a mess.
Spending is a source of patro-nage and pay-offs for support from special interests. India has reached a situation where expenditure reforms cannot be put off.
Tax rates, especially those of indirect taxes, are high. There is little room to keep raising them. Currently, the states and the Centre do not have to face a popular backlash on indirect tax rates as few people are aware that the combined tax incidence is in the mid-20s for many goods. Once the country transitions to goods and services tax, it will no longer be possible to be opaque about the real tax incidence as all tax will be collected at the point of sale and will be clearly specified.
Both the states and the Centre are hamstrung by a large magnitude of committed expenditure. Typically, the Union budget does not leave a finance minister with discretionary power of more than Rs20 for every Rs100 the Centre spends. Add to this, the institutional rigidity which allows the Centre to lock the states into Centrally sponsored welfare schemes, the space for discretionary spending by the states is tighter.
So expenditure reforms in India necessarily have to be carefully paced. All of which makes it imperative for governments to start working on it immediately. The Centre, for its part, has made a formal commitment to steer towards fiscal consolidation over the next few years by using expenditure reforms as a launch pad. Pious intent, but the real test will come in the next fiscal when the finance ministry will be asked to loosen the purse strings to mitigate the loss of political capital in the wake of corruption allegations.
Fiscal consolidation is not a linear process. Unfavourable economic conditions can derail a few years of progress, which is what happened to India in 2008. Governments have thus far tended to take growth and attendant revenues for granted. It is a dangerous path to tread. Expenditure reforms cannot be put off any longer.
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