FISCAL SYSTEM AND POLICY SINCE 1952

FISCAL SYSTEM AND POLICY SINCE 1952 India is a federal democratic republic with a multilevel parliamentary system of government. The Constitution of India mandates, since 1993, three levels of government (central, state, and local) with specification of the powers and functions of each tier, through lists set out in schedules seven, eleven, and twelve. India's fiscal policy, emanating ultimately from the cabinet, must be approved by the Parliament and by the legislative assemblies of the states.

Article 112 of the Constitution requires the government to lay before both houses of Parliament—the Lok Sabha (the lower "house of the people") and the Rajya Sabha (the upper "council of states")—an annual financial statement every year. The statement sets out estimates of expenditures separately for sums required to meet expenditures charged on the Consolidated Fund of India, including: the emoluments and allowances of the president and other expenditures of his or her office; debt charges for which the government of India is liable; salaries, allowances, and pensions of the judges of the Supreme Court; and expenditures declared by the Constitution or the Parliament to be so charged. Estimates of such expenditures are not open to voting in Parliament and can only be discussed. Estimates of all other expenditures must be presented in the form of demands for grants to the Lok Sabha for approval. Once the demands are approved, a bill has to be introduced for appropriation of moneys required to meet the grants for expenditures.

India's fiscal year begins on 1 April and ends on 31 March. The proposals for expenditures, taxes, and borrowings set out in the budget for the year commencing in the following April are presented to Parliament on the last working day of February every year. Parliament can be approached with proposals for supplementary, additional, or excess grants when the sums already authorized prove insufficient or when need arises for supplementary or additional expenditures on some new service not previously contemplated. Along with detailed accounts of the receipts and expenditures of the government for the year to come, budget documents contain information on receipts and expenditures for the year about to end as well as the preceding year, constituting a rich source of data on India's public finances.

The budgets are accompanied by statements by the finance minister reviewing the performance of the economy and announcing the intent of the government on various matters affecting the economy and the life of the people. The budget session of Parliament constitutes an important public event in India and is preceded and followed by intense lobbying and by discussions in the press and among the public, testifying to the vibrancy of India's democracy. Similar procedures are followed in the states, with the difference being that the state budgets are usually presented in their respective legislative assemblies after the Union budget has been unveiled.

The expenditures contained in the budget proposals for a given year on approval by the legislature are meant to be appropriated in the year in question; any excess requires ex post approval, while shortfalls are not allowed to be carried over to the subsequent year. In order to ensure that the expenditures incurred in a year are within the limits approved by Parliament (in the case of the Union), a detailed verification and scrutiny of the expenditures incurred is undertaken after the year's end by the comptroller and auditor general of India, an authority mandated in the Constitution with statutory protection. The audit reports of the comptroller are submitted to the president, who then causes them to be laid before each house of Parliament (Article 151). The comptroller is also required to audit the accounts of the states; the state audit reports are submitted to the governor of each state, who thereafter transmits them to the state assemblies. There are also parliamentary committees to undertake the verification and scrutiny of government expenditures and accounts, including the Estimates Committee, the Public Accounts Committee, and the Committee on Public Undertakings, and there are standing committees for every ministry.

Taken together, the budget process thus provides a comprehensive fiscal system to ensure that the finances of government are run according to the wishes of the people, articulated in Parliament by their representatives. Public funds should be used efficiently, irregularities duly detected, accountability enforced, and corrective measures taken. Government budgets are debated openly before they are adopted by Parliament. Their implementation also comes under close scrutiny, and yet the actual operation of the system is marked by shortcomings that have tended to undermine fiscal discipline and efficiency.

The scrutiny of expenditures at the parliamentary stage is not as thorough or detailed as one might expect, partly because the accounts are not always transparent. Factors that make the budget nontransparent include: the multiplicity of budget heads for classification, such as "developmental" and "nondevelopmental" and "plan" and "nonplan." Parliamentary scrutiny is also often perfunctory, inasmuch as large chunks of expenditure are "guillotined" in Parliament, without any discussion, for lack of time. Moreover, as the budgets are framed only for one year, supplementary budgets are routinely presented to Parliament and the state assemblies, as there is a tendency to underestimate expenditure in the original budget.

Until recently there was no legal constraint on the central government to borrow either from the Reserve Bank of India (RBI) or from the market. As a result, deficits in government budgets that were not covered by borrowing from the market or from abroad were met ultimately by borrowing from the RBI through short-term borrowing instruments called "Treasury bills." Since 1997, by virtue of an understanding entered into with the RBI, recourse to Treasury bills by the Union government has been discontinued. Cash flow problems are met through ways and means advances from the RBI. Similar provisions exist for the states. However, this budgetary constraint is often evaded through off-budget borrowing (e.g., borrowing through state-owned enterprises guaranteed by the government). Parliament has recently taken measures to restrain the tendency to finance deficits with improvident borrowing, passing in 2003 the Fiscal Responsibility and Budget Management Act to compel the Union government to reduce its deficits to stipulated levels. The law also requires the government to place before Parliament statements setting out its medium-term fiscal policy, fiscal policy strategy, and macroeconomic framework.

Fiscal Policy: The First Three Decades

When India attained independence in 1947, the role of government was minimal, rarely extending beyond the maintenance of law and order and the provision of relief after calamities like droughts, floods, and famines. Some public works were undertaken from time to time, but their scale was limited. The proportion of gross domestic product (GDP) going into public spending was barely 9 percent. Current revenues (tax and nontax) were more than adequate to meet current expenditures. The gap between revenue and expenditures—the fiscal deficit—was less than 1 percent.

After independence, government activity expanded rapidly, driven by initiatives taken by India's leaders to promote economic development and the general welfare of the people. The aggregate expenditure of government (central and states combined) rose to over 15 percent of GDP in the first ten years and kept growing, reaching 22 percent in the 1970s. Capital expenditures increased from 1.7 percent to nearly 7 percent. Though the government resorted to borrowing for financing capital expenditures, the fiscal deficit remained moderate, no more than 4 or 5 percent of GDP. Current expenditures were financed entirely by current receipts; in fact the revenue budgets generated some surplus, which, though small, could be used for capital spending.

Given the objectives set for fiscal policy by India's policy makers, such expansion of government was to be expected. The strategy of planning that the government of India adopted for development envisaged a leading role for the public sector in lifting the country out of abject poverty and satisfying the legitimate aspirations of the people. At the same time, emphasis was on "democratic planning," allowing a large role to the private sector as well. The primary responsibility for raising the level of saving and investment in the economy—which was crucial for initiating development—was, however, assigned to the public sector. Since this was to be achieved within the framework of a mixed economy, it was recognized that fiscal policy, along with monetary and credit policy, would play a critical role. The other major objectives of planning, for which fiscal policy instruments were to be relied upon, were: to bring about a progressive reduction in inequalities and regional disparities; and to influence the level and direction of economic activity. These objectives were reiterated in successive plans, with varying emphasis.

Additional instruments, "quasi-fiscal" in nature, were also employed to serve the objectives of the plans. To secure the flow of private investment into priority areas, a regime of licensing and control was imposed, empowering the central government to exercise control over all substantial investments in the private sector. Further, large segments of the economy were brought directly into the public sector through nationalization. Control was exercised over the flow of investment into the private sector with the creation of development finance institutions in the public sector and nationalization of major commercial banks in 1969. Control was then exercised over the production, distribution, and pricing of several commodities, like sugar and steel, and a fraction of their output was preempted through "levy" at below market prices, mainly by invoking the Essential Commodities Act of 1956. Even so, fiscal policy continued to play a vital role in running the economy and was used extensively to subserve the objectives of the plans. The results, however, did not always meet expectations.

On the positive side, in less than ten years, the level of capital formation in India's economy rose from 10 percent of GDP to over 16 percent, and further to 23 percent at the end of the next two decades. Gross domestic saving increased from less than 10 percent of GDP to nearly 13 percent in the early 1960s and to over 20 percent during the 1970s. Even at fairly high levels of investment during the 1970s, the resource gap of the Indian economy (that is, current account deficit) remained mostly below 1 percent of GDP. Although the bulk of savings originated in the private sector, the public sector also made a significant contribution, forming in some years over 20 percent of the total. But that was far from adequate to meet the requirements of the public sector. Nearly 40 to 50 percent of investment in the economy took place in the public sector, and that required intersectoral resource transfers on a large scale. Fiscal policy was used to play a supportive role in this endeavor.

The fiscal system also provided support for investment in physical capital (plant and machinery, in particular) through liberal capital allowances in income tax. Also, there was tax holidays for new industrial undertakings in the early years. In view of their employment potential, concessional treatment was accorded to small-scale industries in both direct and indirect taxes. Along with quantitative restrictions on imports, customs tariffs were used to protect domestic industries and to help implement the policy of import substitution. Other objectives pursued through the tax system included environmental protection and encouraging the use of certain inputs in specified lines of production.

Equity too figured prominently among the objectives of public policy pursued with the help of fiscal instruments. Personal income and wealth were taxed at steeply progressive rates. Then there were estate duties on wealth passing on death and gift taxes on gifts made inter vivos. Indirect taxes were used in a big way to favor the poor by distinguishing between essentials and luxuries. Several public services were provided free or at prices well below cost, particularly power and irrigation water. Exports were liberally subsidized.

Whether or to what extent progressive taxation helped the cause of redistribution or regional equity is not clear. There is some evidence that estate duty and gift taxes served to restrain the concentration in the distribution of wealth. However, confiscatory income and wealth taxes were believed to have spawned a huge "black economy." A study carried out in the late 1980s revealed that around 40 to 50 percent of taxable incomes were probably concealed from tax authorities. Attempts to mitigate the ill effects of high rates of income and wealth taxes through exemptions and concessions weakened the potency of the taxes as instruments of redistribution, opening up loopholes and undermining the revenue potency of India's tax system. In any case, agricultural incomes remained outside the purview of central income tax by virtue of the constitutional plan of tax assignment. The weight of direct taxes in the country's tax structure declined from 37 percent at the time of independence to about 14 percent in the 1980s. Regional disparities too did not come down significantly, though they did not worsen.

The revenue productivity of indirect taxes suffered because of a plethora of exemptions and concessions. The revenue lost in this process was sought to be made up through high, multiple rates and by levying taxes on virtually all countries at all stages of production and sale, with excise levied by the central government and sales tax by the states, rendering the tax system complex, nontransparent, and distortionary. By virtue of an amendment to the Constitution in 1956, interstate sales were brought under taxation through parliamentary legislation (the Central Sales Tax Act). The states of origin were entrusted to administer the tax and retain the revenue. The tax structure that emerged as a result, rather than fostering an efficient, self-reliant economy, constituted a major source of distortion and inefficiency. Neither equity nor resource allocation was well served.

Regarding stabilization, the main concern of fiscal policy in macromanagement was keeping inflationary pressures in check, rather than acting as a stabilizer or stimulator of the economy. Fiscal policy, working in tandem with monetary policy, was remarkably successful in maintaining macrostability and keeping inflationary pressures in check, barring a few episodes of double digit inflation in the 1970s. Unlike many developing countries, India did not experience hyperinflation. Nor did it suffer the convulsions that rocked many economies during the oil shocks of the 1970s. In fact, for nearly three decades after independence, government finances were in reasonable balance.

The 1980s and Beyond

Things took a turn for the worse in the 1980s. The deterioration began in 1979–1980, as the central government's revenue budget for the first time went into the red and the consolidated fiscal deficit rose beyond 6 percent of GDP. Consolidated fiscal deficit crossed 10 percent in 1986–1987, and the average for 1985–1990 measured 9 percent. As a fallout of those deficits, the ratio of government debt to GDP went up to nearly 62 percent in 1990–1991, compared to 46 percent in 1980–1981.

The persistence of large fiscal deficits, together with a chronic imbalance in the external sector, led to a full-blown economic crisis in 1991. The crisis, triggered by the Gulf War, was marked by inflation of nearly 14 percent and a severe balance of payments problem. Foreign exchange reserves dwindled to a level sufficient for import cover of less than one month. The crisis compelled policy makers to undertake some radical reforms to stabilize the economy and launch a program of structural adjustment to correct the chronic imbalances and inefficiencies that had brought the economy to crisis. With liberalization as its keynote, India's economy was opened up; quotas were removed, industrial licensing was all but eliminated, and the financial sector was unshackled. Fiscal consolidation figured prominently in the reform program.

While the immediate task of reform was to reduce the fiscal deficit to manageable levels by compressing expenditure, the aim was to see that government finances were restored to health on a sustainable footing. Fiscal restructuring was undertaken with reforms on several fronts: reforms of the tax system to minimize inefficiencies while enhancing revenue productivity; reform of public expenditure management; and restructuring of the public sector. Institutional changes were also made to secure better coordination of monetary and fiscal policies.

Tax reform

Radical reforms were undertaken in both direct and indirect taxes to reduce heavy dependence on foreign trade taxes, turning more to taxes on income and domestic trade while minimizing their distortionary effects. The reforms that were initiated in 1991–1992 continued through the 1990s and are still in progress.

The strategy was to have a small number of broad-based taxes with moderate rates and few exemptions or concessions. The maximum marginal rates of personal income tax were brought down from 60 to 30 percent, and corporate income tax to around 35 to 40 percent, from 65 to 70 percent in 1980–1981. Presumptive taxation sought to widen the base, bringing selected services under taxation. Customs duties were reduced progressively from a peak of 150 percent to 25 percent. Rates of major ad valorem excise duties were compressed, and a three-rate structure of 8, 16, and 24 percent was introduced.

Expenditure management

Measures were taken to cut down and check the growth of government expenditure and to change its composition. These measures included: zero-based budgeting for ongoing programs, review of staff requirements of government departments and agencies, and the introduction of a voluntary retirement program. Subsidies were brought under scrutiny and reduced through cost recovery. An Expenditure Reforms Commission was appointed to identify specific areas for action. To contain the growth of pension payments, a partly funded contributory pension plan has been instituted for central government employees.

Public sector restructuring

A major thrust of the reforms was aimed at restructuring the public sector by reducing its size and budgetary support. The aim was to downsize government by withdrawing from activities where the private sector could do better or equally well. The reforms also sought to establish better coordination between monetary and fiscal policies. The government of India entered into an agreement with the RBI to discontinue the issue of Treasury bills, which meant automatic monetization of deficits, relying instead on ways and means advances to meet temporary cash requirements. Large-scale preemption of bank deposits for subscribing government bonds through requirements of statutory liquidity ratio was reduced by cutting down the ratio to 25 percent from nearly 40 percent. Measures were taken by the RBI to widen and deepen the government security markets.

Reforms at state level

Initially, the reforms were primarily the concern of the central government. The second half of the 1990s witnessed moves toward reform at the state level as well, with greater efforts made for revenue mobilization, expenditure compression, and down-sizing of government through restructuring of the public sector. Prodded by the central government and realizing the need to reform archaic and inefficient sales tax systems and avoid tax competition among themselves, the states joined together to move toward a harmonized system of value-added tax in place of sales taxes. The process is, however, still to be completed. On the nontax side, state governments moved to reduce subsidies by raising user charges for public services. In public sector restructuring, the focus has been on reforms of the power sector, as the losses of the state electricity boards have been a major drag on state budgets. The central government sought to induce the states with various incentives to undertake reforms essential to the success of the reforms as a whole.

Outcomes and Outlook

The measures initiated toward fiscal correction in the wake of the crisis of 1991 produced some tangible results. The consolidated fiscal deficit of the central government and the states came down from 9.3 percent of GDP in 1990–1991 to 6.9 percent in 1991–1992, then to 6.3 percent in 1996–1997. The ratio of government debt to GDP also registered a decline of 3.7 percent by 1995–1996. The improvement, however, proved short-lived. The fiscal deficit started moving up again in 1996–1997, crossing the 9 percent mark in 1999–2000, and was estimated to be over 10 percent in 2002–2003. Primary deficit, after coming down from 4.9 per cent in 1990–1991 to 1.1 percent in 1996–1997, moved up again, measuring 3.8 percent in 2001–2002.

The debt-GDP ratio also moved up, standing in March 2003 at 75.5 percent. While this overstates the extent of the government's liabilities, in that a part of it (around 10 percent) is debt owed to the RBI, it does not provide a complete picture of the government's debt obligations, as it does not reflect the liabilities likely to arise from off-budget borrowings, such as guarantees extended by the government to borrowings of public sector undertakings and unfunded pension liabilities. As of March 2002, outstanding government guarantees measured 11.5 percent of GDP. A particularly worrying feature of the fiscal scene in the closing years of the 1990s was the growth of revenue deficits, that is, the deficits in the revenue or current budget. In 2002–2003 revenue deficit accounted for over two-thirds of the consolidated fiscal deficit, compared to two-fifths before the reforms.

At current levels, India's fiscal deficits are among the highest in the world and are a cause for serious concern. Given the buildup of foreign exchange reserves, capital controls, flexible exchange rates, and widespread ownership of banks, the economy may not be vulnerable to the kind of crisis that overtook the country in 1991. There are no symptoms of crisis associated with fiscal imbalance of this magnitude. However, it is generally agreed that these deficits, particularly the revenue deficits arising from growth of the government's consumption expenditure, need to be brought down.

Even after a decade of reforms, though the economy is much stronger than before, India's fiscal situation has yet to stabilize. While there is no case for adhering to rigid budget-balancing rules all the time—budgets must adjust to the emerging situation in a constructive way—some basic rules of the game, like raising the revenue ratio in a nondistortionary fashion to meet current expenditures and a hard budget constraint, are yet to gain general adherence.

In a way, the inability of the Indian government to sustain the fiscal consolidation that began in the early 1990s is traceable to the weaknesses of a periodically elected federal democracy. Profligate promises made to the electorate by some of the leading political parties, like the promise of free power to farmers in the 2004 general elections, would seem to corroborate this prognosis. Reflecting a recognition of this reality, prescriptions for fiscal discipline now rely more on institutions such as "rules," insulated from politics, which focus on the task of addressing structural imbalances, leaving the task of contracyclical action to automatic stabilizers. The Fiscal Responsibility and Budget Management Act, passed by India's Parliament in 2003, set out a road map for eliminating revenue deficits in the central budget by 2008, and progressively reducing fiscal deficits with targets set annually. Several moves have been initiated to achieve greater transparency budget. Besides, the transfer mechanism, with built-in incentives for prudent fiscal behavior, is being used increasingly to inculcate fiscal discipline among the states. Whether all these remedies succeed in curing the malady of India's chronic fiscal deficits, however, only the future will reveal.

Amaresh Bagchi

See alsoEconomic Reforms of 1991 ; Economy since the 1991 Economic Reforms ; Subsidies in the Federal Budget ; Taxation Policy since 1991 Economic Reforms

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