India’s fiscal future: Lots done, more to do

While the capex bill has risen by 1.1% of GDP, current expenditure has increased by almost double that during that period.
While the capex bill has risen by 1.1% of GDP, current expenditure has increased by almost double that during that period.

Summary

  • While spending quality has increased, the fiscal deficit needs to be lowered further to support a new private capex cycle; the central government must lead the way in fiscal consolidation, and it may not be straightforward.

India’s fiscal finances are in better shape today than in the past in terms of spending quality. That’s because capital spending, like on roads and rails by the central government, has risen appreciably. At the same time, the states’ fiscal deficit is under control, and broadly at pre-pandemic levels.

And yet, some worries remain. Public sector borrowing is in double digits. Much of the planned fiscal consolidation by the central government— from 6.4% of GDP in 2022-23 to a 4.5% target in 2025-26—is pending. Past experience shows this gets harder in the outer years, as tough decisions need to be made. For instance, should capex be cut in order to lower the fiscal deficit? Meanwhile, some spending commitments have risen, for instance the extension of the free food scheme.

Let’s look first at the current year. There are several challenges that threaten to derail achieving 2023-24’s fiscal target of 5.9%, such as the high capex growth so far this year and pre-election spending. But surprisingly high direct tax collections and a cut in capex for the rest of the year could help. Alongside this, the spending quality by states has improved markedly this year.

Sounds good, so what’s the problem?

India’s GDP growth has been robust. It is forecast by the Reserve Bank of India (RBI) to be 6.5% for the current year, which is exactly where it was in the last ‘normal’ year before the pandemic (i.e. 2018-19). This begs the question that if GDP growth is back at pre-pandemic levels, why is the central government fiscal deficit much higher (5.9% target for 2023-24 versus 3.4%)?

The need to lower the deficit is well known. India’s interest bill exhausts 45-50% of its annual net tax revenue. India also stands out on the global stage for its high interest bill, deficit and debt, despite its annual growth being much higher than the world average. The fiscal excesses will perhaps be more noticeable when a new private capex cycle begins, and competes for funding.

What caused the high fiscal deficit? It wasn’t the states, as their deficit hasn’t widened very much since the pandemic. Yes, their revenues fell sharply, but they cut expenditure and thereby limited any fiscal slippage.

That leaves the central government. To understand this better, we compare the central government’s finances in 2023-24 with 2018-19, the last ‘normal’ year before the pandemic.

What we find is rather unexpected. While the capex bill has risen by 1.1% of GDP, current expenditure has increased by almost double that during that period. So perhaps the drive for fiscal consolidation should be focused there.

How can the central government’s fiscal deficit be lowered? First off, what does the central government’s fiscal deficit need to be lowered to? A useful goal, we believe, is to get the fiscal deficit back to the last normal pre-pandemic year’s level of 3.4% of GDP. This would mean almost 2.5 percentage points of GDP consolidation from 2023-24 levels.

We explore the various pathways for consolidation without cutting back on capex.

Can the central government’s gross taxes be raised? Tax revenue has been growing at a faster rate than national income this year. This seems to have come primarily from falling commodity prices, which have lowered production costs and raised corporate profits. But this boost may not last. As such, higher taxes can’t be the only tool for consolidation.

Can net taxes be raised? The central government’s tax devolution to the states has already fallen as a share of GDP over the last few years, with non-shareable tax revenues rising much faster than shareable tax revenues. This leaves limited room for a further fall in tax devolution and a rise in the central government’s net tax revenues.

Can disinvestment receipts, which are obtained when the government sells its assets, be raised? Obtained when the government sells its assets, these have disappointed over the last several years.

Can the subsidy bill be cut? India traditionally provided price subsidies for food, fertilizer and kerosene oil. In more recent years, it ventured into direct cash transfers, but this income support was added on to price support, rather than replacing it. As a result, overall subsidies are higher today than they were in 2018-19. And steps such as extension of the free food scheme for five years do not suggest the bill will be bought down rapidly.

Can ‘other current expenditures’ be cut? After a careful reduction in the number of central government sponsored schemes, these have been raised again in recent years. In fact, the Centre has recently made a rule that if the states do not spend the money quickly, they will have to pay an interest penalty. So if these schemes are being encouraged, it seems unlikely that they will be cut back soon.

So, if neither higher gross/net taxes, nor subsidies and other current spending cuts can be relied upon for a meaningful fiscal consolidation, what can?

Going back into history shows that one of India’s best periods of fiscal consolidation was between 2001 and 2007. That is also the period when growth averaged a strong 7%. Higher GDP growth helps raise tax revenues faster, while pressure on expenditure doesn’t rise at the same clip.

This time too, high economic growth may be necessary for the fiscal consolidation process. Alongside fast growth, a strong commitment to lowering the fiscal deficit will be equally if not more important.

All said, growth and intent will be needed to lift all boats.

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