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Fiscal Adjustment: Rhetoric and Reality

article examines the fiscal adjustment that the Union Budget 2007-08 aims at. It also looks at how the growth momentum of the economy can be maintained by, among other things, easing infrastructure bottlenecks and reviving a sagging agricultural sector. After examining the tax revenue trends in the economy, the article comments on the tax measures proposed in the budget.

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Fiscal Adjustment: Rhetoric and Reality

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Economic and Political WeeklyApril 7, 20071253budget, although the practice of centrallending to the state governments wasdiscontinued, the fiscal target was notadjusted. In other words, central borrow-ing which was used to on-lend to the statesin the past was taken into the central accountitself and this amounted to 0.4 per cent ofGDP. More important is the deficit in theoil pool account and the issuance of oilbonds partly cover the losses of publicsector oil companies. The more appropriatefiscal variable to be considered from theviewpoint of macroeconomic stability isthe public sector borrowing requirements(PSBR). This has also been recommendedinthe report of the Committee on Fuller CapitalAccount Convertibility [India2006].Equally important is the fact that theadjustment has failed to bring about areduction in revenue deficit to the desiredextent. The FRBMA mandates that therevenue deficit should be phased out by2008-09. The revised estimate for revenuedeficit for 2006-07 is placed at 2 per centand in 2007-08, this is supposed to furtherdecline to 1.5 per cent. This implies thatto achieve the FRBMA target, the revenuedeficit will have to be reduced by 1.5percentage points of GDP in a single year,2008-09. In fact, in the last three years thecumulative reduction in revenue deficithas been just about 1.5 percentage pointsand the rate of reduction in the revenuedeficit achieved so far does not infuseconfidence in reducing the revenue deficitby 1.5 percentage points in oneyear.How has the fiscal adjustment achievedso far come about? There is a widespreadimpression that the revenue deficit reduc-tion has come about mainly due to highbuoyancy of tax revenues, particularlydirect taxes, and there has been very littleadjustment on the expenditure side. Simi-larly, it is believed that fiscal deficit re-duction has been achieved mainly due toincreased tax revenues and partly by com-pressing capital expenditures. A closescrutiny of the fiscal developments de-tailed in Table 1 brings out a differentstory. The analysis shows that since theenactment of the FRBMA, the tax revenuerelative to GDP increased by 2.2 percent-age points from 9.2 per cent in 2003-04to 11.4 in 2006-07. As non-tax revenuesdeclined by 0.9 percentage points duringthe period, there was a net revenue increaseof 1.3 percentage points. Interestingly, therevenue deficit too declined by the samemagnitude and it is tempting to attributethe entire adjustment to revenue increase.However, it is notable that transfers tostates during the period also increased by1 percentage point, requiring compressionof the centre’s own expenditures by thatmagnitude. Besides, schemes involvingexpenditure of over 1 per cent of GDP wereinitiated during the period. Until 2002-03,all transfers to autonomous bodies andlocal governments from the centre had tobe channelled through the consolidatedfund of the states. However, since 2003-04, the funds are directly transferred to theautonomous bodies. Although these ex-penditures are classified as central expen-ditures, funds are transferred to state/dis-trict level autonomous bodies for imple-mentation. Thus, fiscal adjustment achievedsince 2003-04 has involved an increase inrevenues by 1.3 percentage points andcompression of direct expenditure by thecentre by 2.3 percentage points of which,almost 1 percentage point was due to lowerinterest payments. Not surprisingly, highertransfers and the centre directly taking upseveral schemes (such as rural roads, SarvaShiksha Abhiyan, National Rural Employ-ment Guarantee Scheme, SampoornaGrameen Rozgar Yojana and Indira AwasYojana) have helped the states in signifi-cantly improving their finances.The above analysis has significant im-plications for fiscal federalism, servicedelivery and accountability. Surely, thehigh buoyancy of tax revenue and substan-tial increase in the transfers to states havehad a favourable impact on state finances.As there has been a substantial increase inthe outlay by the central government onitems of expenditure implemented byautonomous bodies which are predomi-nantly in the states’ domain, the statescould save their own spending on theseservices. The examples include the centre’sinterventions through Sarva ShikshaAbhiyan, National Rural Health Mission,Prime Minister’s Gram Sadak Yojana,Indira Awas Yojana, National UrbanRenewal Mission and various povertyalleviation programmes in rural and urbanareas. An equally important feature of thisdevelopment is that the share of non-formulabased transfers has shown a sig-nificant increase in undermining the roleof systems and institutions in the transfersystem. In fact, even under the transfersfor state plans, normal assistance which isgiven according to the Gadgil formulaconstituted less than 48 per cent. Thus, wehave a situation where the grants systemhas become predominantly purpose spe-cific with a cobweb of conditionalitiesspecified by various central ministries.Furthermore, quite a considerable propor-tion of grants which used to be given tothe states now directly goes to autonomousagencies. This raises questions about thecapacity to deliver public services by theseautonomous agencies, mechanisms toaugment the capacity and as the funds donot pass through states’ consolidated funds,of accountability.IIGrowth ImplicationsGiven the focus of the budget on easingthe infrastructure bottlenecks to keep upthe growth momentum in the economy, itwas expected that capital expenditures oninfrastructure sectors would be increasedsignificantly. Furthermore, in keeping withthe finance minister’s concern about thestagnancy of the agricultural sector, signi-ficant measures to create conditions forincreased capital formation in the agricul-tural sectors was expected.The analysis of expenditure, however,does not provide any indication to theeffect that infrastructure constraints arelikely to ease in the near future. Theaggregate capital expenditure excludingTable 1: Fiscal Trends of Central Government from 2001-02 to 2007-08Per Cent of GDPPercentage PointChange between2001-022003-042006-07 RE2007-08 BE2001 and2003 and20062006Gross tax revenue8.209.2011.3611.983.162.17Non-tax revenue2.972.781.881.80-1.09-0.90Gross revenue11.1711.9813.2413.792.071.27States’ share in taxes2.352.442.963.150.610.52Grants to states1.891.802.232.310.340.43Net revenue to the centre8.839.5410.2810.631.460.74Transfers to autonomous agenciesnana1.091.071.091.07Net direct expenditure by the centreof which:11.3211.298.998.81-2.33-2.30Interest payment4.714.493.553.48-1.16-0.94Revenue deficit4.393.552.031.56-2.36-1.53Fiscal deficit6.184.463.703.30-2.48-0.76Source: Budget documents of the central government (various years).
Economic and Political WeeklyApril 7, 20071255corporate tax, have shown spectacularbuoyancy. This is true of service tax aswell. A detailed examination shows thatimprovement in the revenue productivityof service tax has come about mainly dueto extension in the coverage of servicesunder the tax. There are quite a few ser-vices such as railway fares and freights thatare still excluded from service taxation andcomprehensive coverage will increase thebuoyancy of the tax system further. Thiswill also help in making the creditsystemunder value added tax muchcomprehensive.It is interesting to go into the reasons forthe spectacular improvement in therevenueproductivity of direct taxes. Since2001-02, revenue from direct taxes in-creased at an annual average rate of 26.6per cent due to good performance of bothpersonal income tax (which increased at20.6 per cent) and corporate tax (at 31.4per cent). Not surprisingly, the share ofdirect taxes, which was less than 35 percent of total tax revenue in 2001-02,increasedsteadily to constitute almost 50per cent by 2006-07 (Figures 1 and 2).The sharp increase in the revenue pro-ductivity of direct taxes cannot be ex-plained merely by the acceleration in thegrowth of manufacturing and service sec-tors – there are other important interven-tions. More specifically, there has been animportant initiative in reforming tax ad-ministration. Entrusting the creation of thetax information network (TIN) to theNational Securities Depository is an im-portant initiative, which has helped en-hance tax compliance. TIN is a comput-erised information system and when fullydeveloped should be able to ensure signi-ficant improvement in voluntary compli-ance of tax. In this, the entities making thetax deduction at source are required to filea computerised return, a copy of which issent to the central processor. This is matchedwith the information obtained from thebanks to ensure the payment of tax by theseentities. From this, files for individualpermanent account number holders can becreated. When this is supplemented withthe information received from the bankson interest income, information on largevalue transactions (houses, cars, etc), datafrom credit card transactions, informationfrom the intelligence wing of the depart-ment and third party information and eachindividual file is posted with these data,it is possible to significantly increase theprobability of detection. The system is stillbeing developed and at present only theinformation from the TDS is put in placein over 500 cities and towns but thecoverageis being expanded. This impliesthat the high buoyancy of tax in the lastfewyears will continue and tax compliancewill further improve as the informationsystem is developed.In contrast to the progress in direct taxes,the information system relating to unionexcise duties has not been developed. Infact, the National Informatics Centre whichhas been entrusted with the task of deve-loping the information system is ill-equipped and has failed to create a systemthat could increase tax compliance. In-deed, the government is ill-equipped tomanage an information technology (IT)company as it cannot pay market salariesto competent professionals. The lesson fromthe experienceof computerising the in-come tax system is that the department ofrevenueshould outsource the informationsystem in excise duties to a competent ITfirm immediately. This could enhance therevenue productivity of the union exciseduties as well.The important point emerging from thetrends is that it once again emphasises theimportance of the information system inenhancing the tax compliance. The infor-mation system enhances the probability ofdetection and advances in IT presentenormous opportunities for creating ascientific system. Reforming the infor-mation system and administration are doneoutside the budget. This, however, shouldnot be taken to mean that the reform ofthe tax structure is not important in aglobalising economy for minimising dis-tortions while generating revenues isequally important to create a competitiveenvironment. It is therefore, important toanalyse whether the various measuresintroduced in the budget 2007-08 helpadvance tax reforms towards creating anefficient tax structure. In addition, thefinance minister in his previous budget hasannounced that measures will be taken tointroduce a coordinated consumption tax– the GST in 2010.IVTax MeasuresThe budget for 2007-08 introduces anumber of measures to change the struc-ture of the tax. There are a number ofdesirable measures which help to expandthe tax base and enable better fulfilmentof horizontal equity. At the same time, thebudget has continued selectivity in taxpolicy by selecting some sectors forspecialtreatment. It is also important toexamine the extent to which the plan ofintroducing the GST in 2010 has beenfurthered in this budget. These arediscussedbelow.An important measure introduced in thisbudget is the reduction in the peak customsduty rate from 12.5 per cent to 10 per centand reduction in the duties of someessentialconsumer goods including fooditems and intermediates with a view toreducing the prices of these goods. Thisis in line with expectations and was re-quired to bring down the protection levelto the Association of South-East AsianNations countries as promised in the pre-vious budgets. The measure would alsohelp in achieving immediate reduction inthe cost of imported items needed forcurrent consumption and in the context ofincreasing inflation, this is an importantanti-inflationary measure.The increase in dividend tax from 12.5per cent to 15 per cent in this budget hasbeen an issue which has not gone downwell with the corporate sector. Neverthe-less, this is an important measure from thepoint of view of equity. It is often arguedthat taxation of dividends amounts to doubletaxation, once in the hands of the companyand again in the hands of the shareholder.In fact, from the viewpoint of the investor,dividend income, like interest income isthe income he receives for the investmenthe makes and therefore is liable to tax. InIndia, instead of taxing dividends in thehands of recipients, it is taxed at thecompany level for administrative reasons.The dividend recipients generally belongto the highest income bracket and there-fore, a marginal increase in the tax rateshould not be grudged.Withdrawal of exemptions undersection10A and 10B in minimum alter-native tax (MAT) and bringing the em-ployees stock options within the ambit ofthe fringe benefit tax (FBT) are other mea-sures in the budget that have attractedcriticism, somewhat unfairly. Generally,providing exemptions and preferences incorporation tax results in reducing theeffective tax rates. Ideally, it would bedesirable to rationalise tax preferencesitself but since that could not be done, theMAT was imposed. However, the regimeof exemptions invaded MAT, defeating itsvery purpose. Withdrawal of these exemp-tions is in the nature of expanding the taxbase. In particular, these exemptions aremainly for IT companies for undertaking
Economic and Political WeeklyApril 7, 20071256to have been led by investment rather thanconsumption demand, immediate steps willhave to be taken to ease infrastructurebottlenecks. In this scenario, the budget for2007-08 should be judged from the pers-pective of maintaining the growth mo-mentum while ensuring macroeconomicstability, easing infrastructure bottlenecksand furthering the reform process towardsevolving a coordinated system ofconsumptiontax in the country.The good news is that the FRBMA targetsof fiscal deficit reduction are on course andare well within the reach of being achieved.This is by no means a small achievementand has required commendable effort bythe government. However, a substantialproportion of deficits is concealed underthe public enterprise account and it is timeto target the PSBR rather than sticking tothe fiscal deficit targets. An issue of greaterconcern is that the government is likely tomiss the revenue deficit targets. Lookingat the trends in the recent past, it wouldbe well neigh impossible to phase outthe revenue deficit in 2008-09 from thebudgeted level of 1.5 per cent of GDPin 2007-08.While the budget speech extols the needfor increasing capital formation in theagricultural sector in order to achievebalanced and inclusive growth, the initia-tives taken in the budget do not add up tomuch. Hopefully, initiatives will be takenoutside the budget by both central andstate governments to effect policy andinstitutional changes to increase capitalformation in agriculture and enhanceproductivity. But in the budget itself,there isvery little that could trigger thetransformation.Similar concerns can be expressed withregard to the task of easing infrastructurebottlenecks. Indeed, maintaining the growthmomentum would require significant ini-tiatives to ease infrastructure constraintsand the budgetary allocation does not giveany hope for removing the constraintsposed, particularly by the power sector.Again, the reforms required in the powersector go beyond channelling additionalinvestments. Much remains to be done inimproving governance and fostering pub-lic private partnerships. Hopefully, theinitiatives in the road sector – both high-ways and rural roads – will continue toprovide philip to the growth process. If thestates can also participate by making in-vestments in district roads and state high-ways, the economy will be poised tomaintain the growth momentum.work outside the country. While thesecompanies demand world class infrastruc-ture and a supply of professionals trainedin public institutions (at a reasonable cost),they should not grudge paying someminimum tax. Again, by any stretch ofimagination, employee ownership stockplans cannot be considered anything otherthan fringe benefits and their inclusion inthe tax base should be welcomed.Another important measure that needsmention is the reduction in the central salestax (CST) and the road map for its phaseout before the GST is introduced in 2010.This is important, but informed observershad hoped that the extent of the reductionwould be higher. In any case, this requiresagreement with the states and the financeminister cannot be faulted at the slow turnof events. The initiative to reform the CSTin itself is important.There are a number of tax measures inthe budget which are retrograde. First, theselectivity in choosing sectors for taxationor exemption should give way to rule-based tax policy, but the practice of selec-tivity and discretion continues. In the caseof customs, it is desirable to unify the taxrates to avoid large divergence betweennominal and effective rates of protection.Further, using tax policy for providingtemporary incentive for hotel constructionfor the Commonwealth Games and othersuch short-term objectives is not appropri-ate. There are other measures that can bedirectly used to provide incentives. Bothcustoms and excise duties have beenselectivelyaltered for various reasons.Another undesirable feature is the intro-duction of dual taxation of cement basedon the maximum retail price with a viewto reduce its price. The measure assumesthat price differences are merely due to theactions of the producers and dual taxationwill incentivise them to sell at a lowerprice. Price differences could also be dueto quality differences and this measurecould end up providing incentives to useinferior cement. The need of the hour isto convert the tax into ad valorem and unifyit in the central value added tax system.Instead, further differentiation of the dutyas is attempted is retrograde.The most disappointing aspect of thebudget 2007-08 is what it did not do ratherthan what it did. The decision to introduceGST in 2010 warranted some preparatorysteps in central excise and service tax. Infact, the opportunity should have beentaken to unify the two taxes to transformthe prevailing central excise duty andservice tax into a manufacturing stage valueadded tax on goods and services and thiscould have facilitated a smooth switchover to GST. This required the conversionof specific duties into ad valorem andunification of tax rates. Contrarily, themeasures taken in the budget would causefurther fragmentation of the tax rates. Thespecial treatment of biscuits, food mixes,umbrella, parts of footwear, plywood, waterpurification devices and cement are casesin point. In the case of service tax, it wouldhave been desirable to follow the recom-mendations of the expert group on servicestax [India 2001] which was reiteratedbytheKelkar tax force on indirect taxes[India 2003]. This required a non-selectiveinclusion of additional services to the taxnet but general taxation of all services andallowing tax credit for goods and services.In the next stage, the base and rate couldbe unified to evolve a manufacturing stagevalue added tax on goods and services.When the tax is extended toall services,the revenue neutral unification could havehelped reduce the tax on goods and unifyit with the tax on services at a level thatis lower than the present level.In contrast, the reforms undertaken inthe budget do not help the cause. First,continued selective fine tuning of the taxto serve a variety of purposes does not helpto unify the tax system. Second, raising theexemption limit for the small scale indus-try from Rs 1 crore to Rs 1.5 crore willcreatedistortions and create problems in theevolution of GST. Third, service taxationshould be made a general tax, the base andrate structure could be harmonised andmade creditable with the tax on goods.Finally, it is necessary to eventuallyachievethe convergence of the base andrate structures.VConcluding RemarksThe budget for 2007-08 is framed in thebackground of sound economic fundamen-tals as seen by high growth, buoyantexports, surging foreign exchange reservesand manageable current account deficit.Although the recent inflation trend hasraised fears of overheating of the economy,the Reserve Bank of India’s initiativesseem to be adequate to control the liquid-ity. Much of the price increase was mainlydue to sharp increases in prices of fooditems and the ability to control inflationwill depend upon the supply management.As the recent growth acceleration seems
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