For the last 16 years, India has shown a remarkable ability to prove the pessimists wrong. Despite continued problems and not-infrequent policy mistakes, it seems to have achieved an unstoppable growth momentum. Nevertheless, history teaches us that policies and economies can go badly wrong. Witness Japan’s lost decade of growth as it failed to deal with the consequences of its burst asset bubble, or the chaos in Indonesia when cumulative corruption intersected with external financial shocks. Therefore, academically informed policy debates in India may still have an important role to play in nudging policymakers and I hope to participate in those debates through this new column.
It is fitting that I begin with the Budget. For more than a decade, I have been analysing India’s public finances, particularly their political economy and their federal dimensions. Everyone agrees that this year’s Budget will be driven by the general election in 2009, as well as earlier, or coincident, state assembly elections. In particular, agricultural debt forgiveness schemes and other expenditures targeted at rural India will be used to build goodwill and win votes for the ruling party.
In practice, of course, it is known that such populist attempts to retain power often fail. The people who are the ostensible beneficiaries often receive little or nothing because of poor targeting and poor implementation. Even those who benefit are not necessarily swayed, since their voting is based on a deeper and longer-run assessment of political performance—voters are smarter than politicians publicly acknowledge. Of course, one of the main reasons for expenditure schemes is that they allow politicians at different levels to take a cut, or reward their cohorts. Changing this pattern will require a major overhaul of the federal dimension of India’s public finances— that is something for the 13th Finance Commission to consider, and a topic for a future column. However, a reasonable summary of the past four years has been that the structure of the ruling coalition has led to a continual use of expenditure schemes—in which case, this Budget will merely maintain that pattern. In other words, it will likely not be any more populist than its predecessors on this front.
In fact, rising tax revenues and expenditure that has lagged behind plans for spending have together helped reduce India’s budget deficit over the last few years. However, the official figures hide the problem of off-budget subsidies for oil and fertilizers, where prices are held below market equilibrium. These subsidies mainly help the relatively well off, and are understandable as a means of retaining support from those beneficiary groups—not as pro-poor measures.
The problem is, these implicit expenditures crowd out more productive private and public investment spending, and ultimately will negatively impact growth. Off-budget deficits also make the central bank’s task of inflation control harder, since loose fiscal policy constrains monetary policy to an extent. None of these issues will be tackled in the new Budget.
Given the constraints on fiscal decision making imposed by India’s political economy, it is surprising how much has been accomplished. In particular, the tax regime has followed a path of continued rationalization. After significant reform of direct taxes in the 1990s, indirect taxes have more recently been restructured in ways that reduce allocative distortions and improve tax administration. One might even hope that the gains from indirect taxes would allow further rationalization of direct taxes, including coverage and rates for companies and individuals. Even small steps would help, and marginal tinkering is possible, though repeal of the cumbersome fringe benefits tax is unlikely. In general, the finance minister has leaned too heavily on what seem like clever ways to collect revenue, or discriminate among groups with respect to tax treatment. Bureaucrats tend to favour such schemes as well. This approach raises compliance costs and makes decision making more distorted, but cannot be expected to change in this Budget.
In sum, three characteristics of budget making are well established in the current regime (and to some extent, have a long history). First, politics drives spending programmes that are designed to benefit politicians and their cronies. Second, clever bureaucrats and a clever finance minister use approaches to taxation that add unnecessary complexity. The third is what gives cause for hope. There is?an increasing reliance on the?first principles of economics and international best practice to reform government finances, particularly on the revenue side. The relatively recent overhaul of indirect taxation is a good example. India’s economy grows faster when the government increases its own efficiency. Its expenditure side has not changed much in this respect. Recent budgets laid out an agenda for change, including civil service reform and outcome monitoring, but not much has happened. One can approve of more spending if the money is actually put to good use. That would actually get more votes. Once the political leaders realize this, pessimism will be passé.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org