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Persistent Fiscal Deficits and Political Economy Transitions in India

An Empirical Investigation

Amarendu Nandy (amarendu@iimranchi.ac.in) teaches at the Indian Institute of Management, Ranchi. Abhisek Sur (abhisek@jgu.edu.in) is a senior research associate at Jindal Global Law School, O P Jindal Global University. Santanu Kundu (santanu.kundu@gess.uni-mannheim.de) is a doctoral candidate at the University of Mannheim, Germany.

The Indian economy has been suffering from a persistent fiscal deficit for the last four decades. With the transition to coalition politics in the 1980s, the country’s political economy characteristics have significantly affected its fiscal policies and outcomes, but this has received scant attention in the literature. The impact of macroeconomic and political economy factors on India’s fiscal deficit between 1978–79 and 2016–17—a period when the country witnessed simultaneous economic and political structural transformations—has been investigated in this study. It finds evidence of a close link between electoral cycles and fiscal populism and between government fragmentation and fiscal profligacy. Additionally, it finds that a strong opposition does not necessarily mitigate the fiscal populism of incumbent governments.

The authors are extremely grateful to EPW’s anonymous referee for their insightful comments and suggestions.
 

Fiscal deficit, which has been a perennial feature of the Indian economy, has become even more pronounced over the last three to four decades. India’s experience of a high and sustained fiscal deficit indicates an extraordinary record of fiscal profligacy when compared to similar economies around the world (Acharya 2016). The phenomenon has been invariant to the changes in the country’s economic growth paradigm and political economy transitions. Thus, high growth phases in the economy have not necessarily led to the better management of fiscal balances nor have stable political regimes necessarily improved fiscal prudence in India (Bijukumar 2004).

The extant literature suggests that the impact of the fiscal deficit on the Indian economy conforms to the neoclassical view that such deficits have been detrimental to growth (Karnik 2002; Carrère and de Melo 2012), consumption (Ghatak and Ghatak 1996), and investments (Rangarajan and Srivastava 2011). Additionally, the widening of the fiscal deficit has exacerbated inflationary risks (Khundrakpam and Pattanaik 2010a) and worsened trade deficits. As the impact of the prolonged fiscal deficit on the Indian economy has been net negative, it makes for an interesting case to understand the factors that have contributed to the sustained gross fiscal imbalance in the economy.

In explaining the persistence of the fiscal deficit in India, existing studies have overwhelmingly focused on macroeconomic factors (Rangarajan and Srivastava 2005; Rangarajan and Srivastava 2011; De 2012). However, an understanding of the phenomenon remains incomplete if the analysis is delineated from political economy factors, given the country’s democratic set-up (wherein economic policies are heavily influenced by electoral cycles) and the framework of fiscal federalism.1 Studies examining the political economy determinants of India’s fiscal deficit are scant and restricted to understanding the impact of limited factors like government fragmentation, that too only at the state level (Lalvani 2005; Dash and Raja 2012).

The high degree of political fragmentation since the 1980s, when single-party governments gave way to a generation of both weak and strong coalition governments at the centre, resulted in the rise of competitive electoral populism. Such transformations in the political landscape had certain critical implications for the Indian economy, including how it affected India’s fiscal outcomes both at the national and subnational levels.

Given this context, the objective of this paper is to analyse the macroeconomic and political economy factors affecting India’s fiscal deficit between 1978–79 and 2016–17. This time period encompasses simultaneous transitions in the economic and political landscapes in India and therefore provides the appropriate context for the analysis.

The paper contributes to the existing scholarly literature in a few important ways. First, besides macroeconomic factors, the paper considers political economy factors in explaining the phenomenon of persistent fiscal deficits in India. It also describes the impact of critical political economy factors like the onset of elections and government fragmentation on fiscal deficit. This approach is distinct from the extant studies. Second, the paper provides crucial insights on whether the opposition’s strength vis-à-vis that of the incumbent government played any role in influencing fiscal outcomes in India.

Fiscal Deficit and Developments in Political Economy

In the last four decades, India has experienced high and sustained levels of fiscal deficit, both at the central and state levels. Since the early 1980s, although India has achieved an average growth rate of about 6%, its record on fiscal discipline has been abysmal, with the consolidated gross fiscal deficit (GFD) averaging 7.7% of the gross domestic product (GDP). Also, at over 75% of the GDP, India’s public debt is significantly higher than that of its peer middle-income countries (58%) (Rao 2017). It may, therefore, be instructive to review the fiscal deficit trajectory, and in the process, understand how the interplay of economic and political developments has resulted in profound fiscal profligacy over the decades.

In the first three decades after independence (1947–77), India adopted a planned development strategy characterised by public sector-driven industrialisation processes. The coercive tax system ensured that government deficits were fairly under control. The GFDs were contained to within 3.5% of the GDP until the mid-1970s, when the government ran a revenue surplus (De 2012). Nevertheless, anaemic economic growth (the average output growth between 1950 and 1980 was only around 3.75% per annum) and systemic inefficiencies necessitated expansionary fiscal policies. Further, the turmoil in the political economy in the 1970s (Indo–Pakistan War in 1971 and Emergency Rule in 1977) exacerbated the fiscal problems.

Subsequently, reforms in certain key sectors of the economy, and modifications in the tax system were initiated in the early 1980s. However, the overarching protectionist approach necessitated large-scale government expenditures, particularly capital expenditures. The share of the central GFD alone in the GDP increased from 5.7% in 1981 to a peak of 8.4% in 1987. The gross debt also increased rapidly from 49% of theGDP in 1981 to 72% of theGDP in 1990. The rapid deterioration of fiscal balances during the period is also attributed to high levels of non-planned revenue expenditure, particularly on interest payments and subsidies. The revenue deficit increased from 1.4% of theGDP in 1981 to 2.9% in 1987. As Table 1 suggests, the average levels of theGFD, revenue deficit, and central government debt escalated in the 1980s as compared to the late 1970s. Fiscal mismanagement in the 1980s was further exacerbated by rising oil prices and political instability at the centre, which led to a severe balance of payments (BoP) crisis in the early 1990s (Joshi and Little 1994; Singh and Srinivasan 2004).

About the time when fiscal imbalances began to grow in India, that is, the 1980s, a paradigm shift also occurred in the political landscape. The dominance by a single political party—the Indian National Congress (INC)—began to be challenged by new political forces. Regional political parties, representing local aspirations in terms of identity, statehood, autonomy, and development started to emerge. Thus, although the INC emerged as the single-largest winning party in the 1989 general elections, a weak coalition government was formed. The party to which the then Prime Minister belonged commanded just over a quarter of the seats required to form the government (Table 1). The inherent political instability of coalition governments led to the short tenure of successive governments, thereby having a severe impact on the incumbent government’s ability to take a systematic approach in addressing fiscal imbalances.

Following the BoP crisis in 1991, India embarked on the path of liberalisation. A series of stabilisation programmes, including tax reforms, were initiated under the Washington Consensus. The tax reforms aimed to increase the relative share of direct taxes decrease the share of trade taxes and decrease the share of interest payments and subsidies. However, owing to the high levels of debt, interest payments remained high, though the share of subsidies was radically reduced. The share of subsidies in the total revenue expenditure fell from 15% in 1990 to 10% in 1997; in parallel, the revenue deficit improved from 3.2% of the GDP in 1990 to 2.3% of the GDP in 1997 (RBI–DBIE 2017).

Another key aspect of the New Economic Policy was initiating the disinvestment of several public sector enterprises. This not only reduced capital expenditures, but also increased capitalreceipts. Thus, the primary deficit fell substantially, from about 4% in 1990 to 0.5% in 1997. As a result of such initiatives, the menaceof the fiscal deficit was tackled to a certain extent, and the share of theGFD to theGDP fell from a high of 7.8% in 1991 to 5.4% in 2000.

However, such radical economic reforms had crucial political ramifications. The neo-liberal reforms initiated in the early 1990s led to economic growth, but they alienated a section of the population who were disadvantaged by the reforms process. Thus, successive coalition governments at the centre resorted to expansive expenditure plans to tackle the political risks arising from the skewed impact of radical economic reforms.

Successive multiparty coalition governments came to power in the latter half of the 1990s, and were all predominantly short-lived, leading to massive uncertainty in the Indian political scenario (Table 1). The weakening of the national parties and the simultaneous rise of regional parties led to a lack of consensus on the optimal direction and pace of economic policies. Coupled with this, the declining capacity of weak governments to accommodate various interest groups led to competitive electoral populism in India (Bijukumar 2004), worsening the fiscal position of the centre and the states. Consistent with insights from the empirical literature on political budget cycles in other contexts (Brender and Drazen 2005; Dubois 2016; Gootjes et al 2019), in India too, the propensity towards economic populism appeared to be closely linked to electoral cycles (Winer et al 2018). This was particularly evident when the opposition’s strength matched that of the incumbent government.

Due to these developments in the political economy, the fiscal deficit resurfaced in the 2000s, severely endangering India’s debt sustainability. In 2002, the centralGFD was 6.2% of theGDP, and the revenue deficit was about 4.3% of theGDP. The government’s outstanding liabilities were estimated at 72.5% of theGDP; interest payments accounted for 35% of the total revenue receipts; and primary deficit hovered at around 2%–3% of theGDP (Buiter and Patel 2010).

This drove the central government to pass a landmark fiscal legislation, the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. With a coalition government at the centre at that time, the fiscal deficit was reduced initially. The linking of states’ tax relief to their fiscal performance, and other tax reforms likethe implementation of value added tax (VAT), helped lowersubnational deficits by forcing the states on to the path of fiscal prudence (Chakraborty and Dash 2017).2 Thus, by 2007–08, just before the global headwinds arising from the United States (US) financial crisis struck, the consolidated fiscal deficit was just about 4.5% of theGDP as against the target of 6%, revenue deficit was just about 0.5%, and there was a primary surplus of 1% (Rao 2017).

Such fiscal discipline was, however, short-lived. TheFRBM targets were significantly breached in the years that followed. Attempts to insulate the Indian economy from the contagion of the global financial crisis of 2007–09 led to the adoption of countercyclical expansionary fiscal measures like stimulus andtax sops. Further, following the political budget cycles, increased expenditures on wages and subsidies in the pre-election and election years by the incumbent government resulted in the consolidated fiscal deficit reaching 10.6% of theGDP in 2009 (Vaidya and Kanagasabapathy 2014).

In more recent times, we continue to see further evidence of fiscal profligacy. The revised fiscal deficit for 2017–18 stood at 3.5% of theGDP, the same as in 2016–17. The budgeted deficit for 2018–19, at 3.3% of theGDP, is substantially higher than the target rate of 3% of theGDP. The trend towards competitive electoral populism that emerged with the onset of politicalfragmentation in the 1980s continues unabated, with incumbent governments at the centre and in the states resorting to extravagant expenditures to increase their chances of re-election,3
severely jeopardising the economy’s fiscal balances.

To summarise, fiscal outcomes in India have been closely related to both economic and political economy factors. In particular, the type of government (whether single-party majority; weak or strong coalition), the extent of government fragmentation, the strength of the opposition, and the propensity towards electoral populism have inevitably affected fiscal deficit levels in the economy. Thus, apart from macroeconomic factors, this paper also considers such political economy factors in explaining a sustained fiscal deficit, an approach hitherto missing in the extant literature.

Variables and Data

The objective of this paper is to examine the effect of macroeconomic and political economy factors on India’s fiscal balance. The baseline empirical analysis comprises the GFD ratio, that is, the ratio of India’s GFD to GDP (GFD_GDP) as the dependent variable. The independent variables comprise a set of macroeconomic and political economy variables as described below.

Macroeconomic variables: Based on the extant literature, the paper considers the growth rate of the real GDP (RGDP), external shocks to the economy, and the depth of the financial system as three critical aspects of the macroeconomy influencing fiscal deficit.

Economic expansion can generate additional public revenues through increased tax collections, which in turn may aid deficit reductions (Dudine and Jalles 2018). However, it may also lead to higher fiscal deficits if the growth in public expenditure surpasses the growth in tax revenues resulting from higher economic growth (Woo 2003), which is generally the case for developing economies. The extant literature suggests that the relationship is context specific. As India’s fiscal deficit has persisted through both low- and high-growth phases, useful insights into the nature of the relationship can be obtained by considering the growth rate of theRGDP as a key explanatory variable.

Steady liberalisation in India has made the economy prone to various global shocks. External shocks, particularly through trade channels, are a potential source of fiscal instability as changes in export and import prices can significantly worsen the public sector balance. In line with Woo (2003), we define external shocks to the economy (EXT) as the growth rate of terms of trade multiplied by trade openness. As greater external shocks lead to a deterioration in the terms of trade, we expectEXT to have a positive relationship with theGFD.

Certain institutional factors like the increased financial depth of a country enhance its growth potential by promoting financial innovation (Ho et al 2018), aiding growth, and enhancingresilience in light of financial and macroeconomic shocks. Lack of liquidity in the financial sector is indicative of financial repression and is associated with the government monetising its budget deficits or practising restrictive credit policies to benefit select industries or both (Mishkin 2004). We thus expect a negative relationship between financial market depth and theGFD. Following Diokno (2007), we define financial depth as the ratio of liquid liabilities of the financial system to theGDP (M3_GDP).

Political economy variables: We investigate the influence of the political economy on India’s fiscal health in terms of the four variables described below. The strength of the government is often regarded as a critical factor for good fiscal management. Studies in different contexts have shown that single-party governments exercised greater fiscal prudence compared to coalition governments (Roubini and Sachs 1989; Alesina et al 1997; Woo 2003). Over the years, the political changes in India have led to an era of coalition governments—both strong and weak. Between 1980 and 2017, nine coalition governments and two single-party minority governments have governed India. To account for the varying nature of coalitions and the strength of incumbent coalition governments, we have devised two measures.

The first variable, SEAT, is defined as the ratio of the number of seats held by the single-largest party in the lower house of Parliament to the size of the legislature.4 It is assumed that the higher the number of seats held by the single-largest party in the lower house, the more stable the government will be. Weexpect stable and strong governments to strictly adhere to fiscal discipline and, hence, lower deficit levels, implying a negative relationship between theGFD andSEAT.

AlthoughSEAT broadly captures the influence of a government’s stability on theGFD, in a fragmented polity like India, a more nuanced understanding of a government’s strength is essential. There were at least two instances when the incumbent government was not the single-largest party or even the second-largest party in the Lok Sabha. The coalitions survived on the external support of other smaller parties.5 Thus, we introduce another variable, government strength (Gov_str), and classify governments as either strong or weak to assess how theGFD is affected by the strength of the government.

A government is considered strong if the single-largest party of the Lok Sabha or the single-largest party of the coalition alone holds three-fourth or more of the seats required to form the government; otherwise, the government is considered weak. In the former case, the government’s dependency on its coalition partners reduces, thereby potentially reducing financial indiscretion; the effects are vice versa in the latter case. We use a dummy variable to demarcate the two types: 1 for weak governments and 0 for strong governments and expect a positive relationship betweenGFD and government strength to emerge.

Next, we introduce an election year dummy (ED) to capture the phenomenon of competitive electoral populism practised by the incumbent government(s). We observe that populist extravagance to enhance the chances of re-election generally peaks in the election year, leading to a deterioration of the fiscal health of the economy (Table 1). Hence, we expect a positive relationship between fiscal deficit andED.

The role that the opposition plays in a democracy is also crucial and merits attention in such a context. Generally, a strong opposition in a democratic set-up can potentially act as a counteractive force against the fiscal profligacy of the incumbent government. By holding the government accountable for fiscal outcomes and highlighting fiscal mismanagement in front of electorates, the opposition can increase the political risks associated with fiscal deficits.

However, it is also possible that the presence of a strong opposition will result in tough political competition, which may push the incumbent government towards populist fiscal expenditures to increase its chances of getting re-elected. We hypothesise that a strong government with a weak opposition will not be pressured by political competition and, hence, will be fiscally disciplined, but a weak government with a strong opposition is more susceptible to fiscal indiscipline, leading to higher deficits. Weak governments are generally multiparty coalitions, where the stability of the government often rests on external support. Such governments generally face political compulsions to cater to varied interest groups and are hence likely to deviate from the path of fiscal discipline.

For this study, a strong opposition is defined as one in whichthe major opposition party in the Lok Sabha alone garners more than two-fifths of the total number of seats held by the opposition in the lower house of Parliament. To represent such scenarios,we use dummy variables and separate the baseline case (a strong government with a weak opposition) from the two alternate cases (a strong government with strong opposition, and a weak government with strong opposition) and expect a positive
relationshipwith fiscal deficits for both alternate cases.

The data for all the macroeconomic variables were obtained from the Database of Indian Economy (DBIE) of the Reserve Bank of India (RBI). Data for the political economy variables were obtained from the Election Commission of India (2017). We have used annual data encompassing a period of 39 years—from 1978–79 to 2016–17.

Econometric Strategy

To trace the long-run equilibrium relationship between the  dependent variable (GFD_GDP) and the set of explanatory variables, it is necessary to establish a cointegrating relationship between the variables under study. We start with a baseline model (Model I) comprising of three macroeconomic and two political economy (explanatory) variables:

... (1)

We convert the variables to their natural logarithms and estimate the log-transformed variables.

To accommodate diverse political scenarios, we introduce the variable government strength (Gov_str) in Model II, and estimate the following equation:

... (2)

Again, following our discussion in the previous section, we incorporate the role of the opposition vis-à-vis the government in Model III, and introduce three scenarios. The baseline scenario is a strong government with a weak opposition. The two alternative scenarios are a strong government with a strong opposition (SG_SO) and a weak government with a strong opposition (WG_SO).

The stationarity of the dependent and the independent variables is checked by the Augmented Dickey-Fuller (ADF) and the Phillips Perron (PP) tests. Having established the order of integration of the variables, we use the two-step Engle–Granger procedure (Engle and Granger 1987) and the Johansen cointegration technique (Johansen 1995) to test the long-run cointegrating relationship among the variables.

To estimate the long-run equilibrium relationships, we adopt the efficient dynamic ordinary least squares (DOLS) method proposed by Stock and Watson (1993). The DOLS includes the leads and lags of the regressors in their first differences and thus accounts for the endogeneity of the regressors and serial correlation in the residuals (Égert and Kierzenkowski 2014). The general specification of the DOLS system is represented as:

... (3)

The estimates from DOLS are asymptotically unbiased and follow a blend normal distribution, allowing for asymptotic Chi-square and t-testing (Montalvo 1995; Stock and Watson 1993). Further, in small samples, the DOLS estimator outperforms the canonical cointegration regression (CCR) and fully modified ordinary least squares (FMOLS) estimators in terms of bias in the coefficient estimates and efficiency and produces the most reliable estimates (Cuevas 2018). In our case, the estimates of equation (2) by the DOLS method produces consistent estimates.6

Results and Discussions

The results from the unit root test (Table 2) suggest that neither the dependent nor the explanatory variables are stationary at their level form, but exhibit stationarity at their first difference. This implies that the variables, or a linear combination of them, are integrated of the same order.

The two cointegration tests indicate the presence of long-run cointegration relationships at conventional significance levels (Table 3). The unit root test for the residual series across the three models rejects the null hypothesis of the presence of unit roots under both the ADF and PP tests, thus indicating the presence of a long-term cointegrating relationship among the variables under study. Similarly, the results from the Johansen cointegration test (Table 3) also suggest the presence of at least one cointegrating relationship for each of the three models. Thus, from the two cointegration tests, we conclude that the variables are cointegrated in the long run.

The estimation results of Model I (Column 2, Table 4, p 39), which we found using the DOLS technique, suggest that all the economic and political variables significantly influenced India’s fiscal deficit for the period under consideration.

The growth rate of the RGDP is significant at 1% level, and positively related to the GFD. While we expect that the increase in the RGDP would augment government revenues and close the revenue–expenditure gap in a growing economy, this did not happen in India. This could be because of the persistently low tax base and high incidences of tax evasion and avoidance in India. Historically, although personal and corporate tax rates in India have been consistently higher than those of peer nations, the tax-to-GDP ratio has been low, with only a small fraction of the population contributing to tax revenues. This low ratio has been a central feature of India’s fiscal problems. There have been some reforms to the indirect tax regime from time to time, like the introduction of modified value added tax (MODVAT) in 1986 (which was renamed CENVAT in 2000); VAT in 2005; and goods and services tax (GST) in 2017. Though some of these indirect tax reforms led to positive outcomes at the subnational level (Chakraborty and Dash 2017), the overall tax regime in India has remained less buoyant and has failed to enhance government resources. Moreover, the failure to rationalise government spending has only dampened any positive gains accrued during high-growth phases.

The EXT are significant and positively related to the GFD, implying that they had a negative impact on India’s fiscal health. EXT not only affected the overall macroeconomy, but also severely influenced fiscal policies in India. For instance, following the GFC of 2007–09, India’s GDP growth rate dipped sharply, from 9.3% in 2008 to 6.8% in 2009, before it recovered in the next two years, driven primarily by fiscal stimulus packages instituted to boost economic growth (Bajpai 2011). Such expansionary fiscal policies, coupled with limited avenues to boost revenues, exacerbated the fiscal imbalance and led to sharp increases in the GFD–GDP ratio. Moreover, although India’s overall BoP situation in the period running into the GFC of 2006–08 was quite robust, its trade balance deteriorated, and the current account deficit widened, from 1.5% of the GDP in 2007–08 to 2.6% in 2008–09. India’s export sector was most adversely affected by the crisis, primarily because of the dwindling of international trade finance and the slowdown in global demand. Merchandise exports declined by 3.6%, and import payments declined by 2.7% in 2009–10 (Kishore et al 2011). There were similar, though less dramatic, outcomes in the aftermath of the Asian financial crisis in 1997–98 (Gupta 2000). Thus, EXT has resulted in a deterioration in the terms of trade, leading to higher fiscal deficits.

Financial depth (M3_GDP) is positively associated with the GFD and is highly significant, which concurs with the findings of Woo (2003) and Aizenman and Noy (2003). Their studies found that low financial depth in developing economies is associated with poor fiscal health. In India, low financial depth has often led to seigniorage financing of deficit (Khundrakpam and Pattanaik 2010b). Such deficit financing has in turn led to a rise in inflation and interest rates, which have had a contractionary effect on growth, further exacerbating fiscal deficit.

Of the two political factors we considered in Model I, the ED is significant and has the expected sign—that is, it is positively related to GFD and indicates a propensity towards fiscal populism with the onset of elections. Generally, incumbent governments in India have resorted to expansive expenditures and populist policies, catering to different pressure groups and key constituencies, particularly in the run-up to general elections, thus worsening the fiscal deficit. This result is broadly consistent with the findings of Winer et al (2018), that the virtuous effect of development and electoral competitiveness on the provision of public goods and capital infrastructure is muted or reversed—particularly for low-income states in India—as there is greater emphasis on public expenditure for targetable private goods in order to retain electoral support. From the sample states in the Winer study, it may be interesting to note that such states were also late adopters of state fiscal responsibility legislations vis-à-vis the FRBM Act, 2003.

The other variable, SEAT, although significant, yielded counter-intuitive results, suggesting that governments led by the single-largest party with a relatively higher seat share did not necessarily lead to lower the fiscal deficit.7 Such counter-intuitive results are, however, not surprising in the Indian context; they can be explained by certain important developments in the political economy. During the study period, there were eight coalition governments, a majority of which failed to complete their full tenure. These coalitions lasted as less as 13 days, and five Prime Ministers could not even complete one year in office. Moreover, there were at least two instances when the single-largest party in the Lok Sabha did not form the government at the centre. Thus, the inherent instability of both weak and strong coalition-era governments, which arose out of ideological differences, meant that the incumbent governments had limited political space to embark upon the path of fiscal consolidation—they had to accommodate their partners’ various competing interests just to survive.

The estimation results of Model II (Column 3, Table 4) indicate that variable government strength (Gov_str) is positively related with GFD and is significant at the 5% level. The positive relation suggests that higher fiscal deficits were associated with weaker governments at the centre, which tended to be multi-party coalition governments that depended on external political support. Out of political compulsion, such governments had to cater to the varied interests of external and coalition partners, often leading to myopic decision-making on fiscal matters. This in turn resulted in policy paralysis and the premature end of the governments, thereby disrupting policy continuity.

Column 4 of Table 4 show the estimation results obtained in Model III. It is evident that the variables strong government with strong opposition (SG_SO) and weak government with strong opposition (WG_SO) are positively related with the GFD, indicating that when the opposition is strong, incumbent governments, whether strong or weak, have been prone to fiscal profligacy. While a strong opposition is considered a crucial pillar of democracy that can restrain the government from deviating from the path of fiscal consolidation, such evidence is weak in India. A strong opposition’s political contestation has instead meant that incumbent governments have been more aggressive in their attempts to preserve their political constituency, by announcing expansive welfare schemes in the election or pre-election years, then signalling that such schemes can be implemented successfully only if they alone are re-elected. Our results resonate with the study of Winer et al (2018), which finds that with an increase in electoral competitiveness, there is an increase in the privateness of public expenditure, suggesting a greater drift towards fiscal populism.

To sum up, the cointegrating regressions point out that in the long run, besides economic variables, political economy factors have also significantly contributed to the persistence of the fiscal deficit in India. The adjusted R2 coefficients in Table 4 show that each cointegrating equation explains over three-fourths of the variation in the dependent variable (GFD–GDP). The standard errors of the regressions are low, and the Jarque-Bera test for normality points out that the residuals are approximately normally distributed in the regressions. The Durbin-Watson d statistics, along with the Breusch-Godfrey test, rule out the presence of serial correlation. The test of heteroscedasticity also rules it out as a problem.

Conclusions and Policy Implications

The results of this study indicate that apart from macroeconomic factors, political economy factors have also significantly contributed to the persistence of the fiscal deficit in India for the last four decades. In particular, we find that incumbent governments, whether weak or strong, take a fiscally populist stance closer to elections, thus widening the fiscal imbalance. Our study also establishes that concurrent with structural changes and fragmentation in the political landscape in India, the resultant competitive electoral populism has had a significant bearing on India’s fiscal deficit. Further, our finding that a strong opposition has not necessarily helped in checking the incumbent government’s laxity in arresting fiscal profligacy in India indicates that the propensity towardsfiscal populism increases commensurate topolitical contestation—leading to undesirable fiscal outcomes. Such findings are novel to our analysis and bear important policy implications.

First, the absence of a long-term road map for fiscal consolidation is quite evident. High-growth phases in the economy have not benefited the government exchequer, primarily due to the low tax base and poor tax buoyancy.8 The delay in the enactment of the indirect tax reforms suggests that implementing broad-based reforms in tax rationalisation and administration can be time-consuming and politically challenging in a fragmented democracy like India. Thus, while the government should put in all efforts to enact direct tax reforms—or the Direct Taxes Code—at the earliest, in the short term, it should focus on augmenting non-tax revenues by designing better pricing and utilisation strategies for public resources, to improve fiscal balances.

Second, policymakers need to fix financial accountability at both the national andsubnational levels, strictly adhering to the targets set under their respective fiscal legislations. TheFRBM Act, 2003 has failed to enforce long-term fiscal discipline, both in flow and stock terms. To make fiscal rules more effective, fiscal policy targets and budget operations need to be closely intertwined, with fiscal responsibilities clearly
defined and monitored across the tiers of the government. Since political budget cycles occur mostly in countries with non-binding fiscal rules—as international evidence suggests—creating an autonomous fiscal council, accountable to Parliament, can help achieve strict adherence and better fiscal outcomes (Gootjes et al 2019).

Third, it is possible that the success of the extant fiscal legislative framework is limited because the government has targeted too many policy objectives, likelowering the debt–GDP ratio, the fiscal deficit–GDP ratio, and revenue deficit–GDP ratio at the same time. These objectives have often turned out to be inconsistent with each otherover different phases of the business cycle (GoI 2017). This has allowed the government to habitually breach targets without any consequences. While the N K Singh Committee (whichwas formed by the Government of India in 2016 to review the FRBM Act and submitted its report in May 2017) rightly proposed the formation of a fiscal council to force the practice of fiscal prudence, the revised act still continues to advocate multiple fiscal goals in the earlier act.

Given India’s current growth trajectory, it may be worthwhile to focus on reducing the primary deficit on a priority basis, as the country continues to be an outlier compared to other emerging market peers. The objective of targeting the primary balance will also be consistent with the long-term debt trajectory that theeconomy may want to pursue (GoI 2017). As sovereign rating agencies attach paramount importance to fiscal indicators, strict adherence to a defined fiscal path assumes allthe more importance, particularly at times when external shocks may affect the fiscal balance—as our findings suggest.

Fourth, the significance of the political economy factors establishes a close link between electoral cycles and the persistence of the fiscal deficit in India. As our findings suggest, the extent of government fragmentation and political contestation can explain the incumbent government’s penchant towards competitive economic populism and fiscal profligacy, which peaks during elections. As fiscal virtue cannot be achieved through mere legislation alone, one way to accomplish it in a fragmented democracy is to enforce self-regulation by working out a common minimum programme that prioritises fiscal prudence as an important goal.

While our study advances the extant literature in several ways, this analysis can be furthered by considering deficits at both thenational andsubnational levels, involving factors such as centre–state relations, political alignment between central and state governments, and electoral cycles in the states.

Notes

1 The country’s federal structure ensures that the responsibilities pertaining to fiscal management are divided between the central and state governments. The Finance Commission provides fiscal guidance and lays down the basis of the transfer of revenues from the centre to the states. While the institutional arrangements have served well to decentralise fiscal powers, it has also created room for fiscal profligacy by state governments owing to electoral politics, and that of various central governments in favour of state governments politically aligned to them (Khemani 2002).

2 The lowering of subnational deficits, however, was primarily achieved by reducing the discretionary development spending to adhere to fiscal targets (Chakraborty and Dash 2017). As such an approach can be counterproductive for growth and development in the long run, adherence to fiscal rules and targets can be better driven by revenue-augmenting measures rather than relying entirely on reducing development expenditures.

3 For example, prior to the 2009 general elections, the incumbent central government wrote-off farmer loans of about $15 billion, costing an equivalent of 1.2% of the GDP. The trend was also evident across different states, which promised free resources to the electorate like television sets, mobile phones, gold for women getting married, vehicles, electricity, and waivers of all farm loans.

4 Here, the size of the legislature is defined as the total number of seats of the Lok Sabha for which elections were held in that particular general election.

5 The INC government (1984–89) was the last single-party government. Since 1996, all governments at the centre have been coalition governments. These coalition governments can broadly be classified into strong and weak coalitions. For instance, the previous coalition governments (National Democratic Alliance [NDA] 2014–19 and United Progressive Alliance [UPA] II, 2009–14) can be said to be strong coalitions. In the former case, the single-largest party in the coalition (Bharatiya Janata Party [BJP]) holds the majority seats required to form the government, and in the latter, the INC held more than three-fourths of the seats to form the government. In contrast to this, the previous NDA and UPA governments, that is, the BJP-led NDA coalition (1999–2004) and the INC-led UPA I (2004–09) were weak coalitions, with the BJP and INC holding about 66% and 53% of the seats required to form the majority in the Lok Sabha, respectively, and thus heavily depended on the coalition partners.

6 FMOLS and CCR estimates were also obtained; the results found and conclusions reached were similar. However, the DOLS estimates were most consistent and are therefore reported.

7 We also tested the hypothesis that defines SEAT as the number of seats held by the party to which the Prime Minister belonged, divided by the size of the legislature. We found similar results.

8 India fares poorly vis-à-vis its peers when it comes to garnering tax revenues. According to OECD (2017), as of 2014, the tax–GDP ratio in India stood at 16.8%, much lower than Brazil (33.4%), China (24.8%), Russia (28.2%), and South Africa (27.8%). Only 37 million out of a population of more than 1,250 million paid taxes in 2015–16, indicating that India has a low tax base.

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Updated On : 28th Mar, 2020

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