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Students Corner - A Decade of Economic
Reforms in India - A Review

The conceived strategy of fiscal consolidation as reflected in various official pronouncements focused on compressing consumption expenditure and augmenting revenue. This is akin to ‘Type 1’ approach of fiscal consolidation experimented elsewhere as enumerated in Alessina and Perotti (1996). In terms of actual outcome, however, the adjustment was predominantly brought through cuts in capital expenditure. This is similar to Alessina and Perotti’s ‘Type 2’ approach, though the essential difference in the Indian case has been that household taxes have been reduced but the tax base has not widened significantly. The inability to effect a large cut in consumption component of expenditure resulted in an increasing proportion of borrowed funds being preempted by such expenditure. This could slow down future revenue growth. Inadequate returns on Government expenditure get reflected in rising debt-service obligations. This gives rise to the emergence of a vicious cycle of deficit and debt.

The detailed analysis of the fiscal performance during the reform period drew attention to the downward rigidity in current expenditure. In the face of sluggish revenue growth, this results in a persistent increase in revenue deficit. This has been a critical factor in the resurgence of fiscal deficit during the latter half of the 1990s. Although the tax reform measures initiated have imparted rationality to the tax structure, the revenue buoyancy expected through a Laffer-curve effect has not come through. This is because cuts in indirect tax rates were not accompanied by removal of concessions and exemptions. Therefore, there has been neither significant increase in the tax base nor has tax compliance improved. With the result, the improvement in direct tax collection on account of an expansion of tax base and perhaps better compliance was not adequate to compensate the drop in customs and excise duty collections. Eventually, the tax-GDP ratio suffered deterioration during the reform period. The non-tax revenue of the Centre as a proportion to GDP recorded some rise, whereas the same in the case of States registered a decline during the 1990s. Poor cost recovery for the services provided by the Governments has been responsible for this trend. Inadequate progress in public sector restructuring, specifically reflected in the inability to raise user charges and continued low returns on investments, have also resulted in stagnation in non-tax revenue at, both, the Central and State Governments level. Thus, on the whole, reforms did not result in adequate pick up in revenue growth in relation to growing expenditure requirement during the 1990s.

The faster growth in committed expenditure like interest payments, wages and salaries and subsidies has imparted downward inflexibility in revenue expenditure. More importantly, expenditure on interest payments continued to grow unabated, reflecting the impact of sizeable outstanding liabilities contracted at higher interest rates in the first half of the 1990s.

Progress towards better fiscal-monetary coordination during the reform period was an important achievement. The major policy initiative in this direction was the elimination of automatic monetisation of Central Government fiscal deficit. This, together with structural and institutional reforms undertaken by the Reserve Bank in the 1990s, has strengthened the public debt management process enabling wider market participation in the Government securities market and significant reduction in the pre-emption of institutional resources by the Government to finance fiscal gap. The Government borrowings at market related rates have intended to provide level-playing field for the private investor. It was also expected to induce fiscal discipline. The overall reform experience has been that, while the public debt management has been made market-based, fiscal deficits remain unrestrained. Market based regime with unrestrained fiscal deficit could worsen the fiscal situation. The above development unfolds certain important issues for the Indian fiscal system.

The analysis shows that the level of fiscal deficit relative to GDP in India at present is higher than not only that of most internationally comparable benchmark levels ( e.g. the Maastricht Treaty requires fiscal deficit to be 3.0 per cent of GDP) but also the levels recommended by the Eleventh Finance Commission (6.5 per cent of GDP for Government sector, 4.5 per cent for Central Government and 2.5 per cent for States). Furthermore, the present level has also exceeded the levels witnessed on the eve of the 1991 crisis. Notwithstanding these developments, most other macroeconomic parameters have been sustainable. As a result, the higher fiscal deficit has not spilled over to the external sector. In this setting, questions have been raised whether the high fiscal deficit should be a matter of much concern. A judgement on this issue over a longer horizon would have to factor in the possibility of adverse movements in the interest rates and inflation rates.

An important observation that could be made from a comparative analysis of the finances of the Centre and State Governments is that deterioration of finances during the latter part of the reform period was much sharper for the States than that for the Central Government. Although the growth of revenue for the States and the Central Government was comparable, expenditure growth was much steeper for the States than that for the Central Government. Consequently, the rise in fiscal deficit of States was sharper than that of the Central Government. Data show that during 1996-97 to 2001-02, States accounted for more than half of the rise in the fiscal deficit of the combined Government. In this context, it is important to consider whether worsening fiscal situation of States is on account of their own operations or owing to the factors such as central transfers and rising interest payments, which are not fully under their control.

Another issue which emerges in the context of downward rigidity exhibited by the fiscal deficit is the rise in debt-GDP ratio. It needs to be reviewed whether the fiscal stance and the debt accumulation process is sustainable or not. This is particularly so as the debt-servicing of market loans now accounts for more than 70 per cent of the gross market borrowings

As stated earlier, the underlying objective of improving monetary-fiscal co-ordination by eliminating automatic monetisation and reducing pre-emption of institutional resources was to contain crowding-out arising from pre-emption of funds by the Government and, thus, allow level-playing field to the private investor. Although the Government at present borrows from the market on equal terms with private borrowers, the crowding-out effect of Government borrowings still remains a critical issue in view of the high fiscal deficit.

In the context of role of fiscal policy in reinvigorating growth, it needs to be recognised that the fiscal stance affects output itself as well as the variability of output. Imbalances between aggregate demand and aggregate supply feed back into the realised fiscal deficit. Given this simultaneity, an important question is to examine the design of fiscal policy to see whether fiscal policy automatically smoothens the business cycle or discretionary interventions are required. This aspect is usually examined by looking at built-in automatic stabilisers and by decomposing the actual fiscal deficit into a structural component (unresponsive to cycles in the economy) and a cyclical component (responsive to cycles). Previous research has shown that fiscal deficits in India have been predominantly structural with cyclical component almost negligible (RBI, 2002). This suggests that discretionary policy had an important role to play in counter-cyclical measures in the Indian context.

Of the above issues, three viz.,

1. macroeconomic impact of fiscal deficit,

2. worsening of State finances and

3. debt-sustainability are addressed in remaining part of the section.

The high fiscal deficit and sharp increase in the size of outstanding liabilities of the Government during the 1990s did not have any adverse macroeconomic impact as witnessed in the beginning of the 1990s. This has led to the revival of the view that higher fiscal deficits should not be a matter of much concern. It is argued that fiscal deficits would be inflationary only if the system is at full employment or is characterised by supply bottlenecks in certain sectors. Given the fact that there is excess industrial capacity along with large food stocks, large foreign exchange reserves and low inflation, a monetised deficit is not only non-inflationary, but virtuous from the point of view of growth (Chandrasekhar, 2000).

At the first look, the argument appears plausible as it could be observed that the spill-over effect of the high fiscal deficit in the external sector did not occur. However, this period was marked by dampened investment demand from the private sector with recessionary conditions. The overall saving-investment gap was narrowed as a result and this was reflected in low current account deficit. Furthermore, the recessionary conditions coupled with the availability of sizeable forex reserves, large food stocks and downward trend in global prices helped in containing inflationary pressures in the Indian economy. Continuing foreign exchange inflows and the recessionary conditions enabled the Reserve Bank to move to a softer interest rate regime in spite of a rising fiscal deficit.

It has, however, been shown that while public investment spending crowds in private investment and is expansionary in nature, consumption spending by the Government causes economic contraction (RBI, 2002). In fact, considerable scepticism has been expressed towards the success of expansionary fiscal policy, which does not consider the quality of expenditure (Chelliah, 2001). The Report of the Economic Advisory Council, Government of India, 2001 stresses that a high fiscal deficit, by raising real interest rates, crowds out private investment as Government borrowing is predominantly used to finance the revenue deficits. Relying on the reduced form evidence pertaining to the 1990s, fiscal expansion in the Indian context is observed to be contractionary (Khatri and Kochhar, 2002). It may be added that fiscal consolidation in the first half of the 1990s was accompanied by high income growth. Also, a deterioration in fiscal position in the second half of the 1990s occurred along with deceleration in income growth. It has also been shown that in India, during the eleven year period since 1986-87, an increase in the Central Government’s fiscal deficit (inclusive of oil pool account) by one per cent of GDP was associated with a reduction in private corporate investment by one per cent of GDP (Srinivasan, 2000).

It needs to be recognised that the fortuitous conditions that have restricted the adverse macroeconomic impact of high fiscal deficit are transitory in nature. With a revival of economic activity, spurred by a pick-up in the private investment demand, rise in fiscal deficit could raise the saving-investment gap and eventually raise interest rate and widen current account deficit. The problem could be compounded if inflationary pressures reemerge due to buoyant economic activity or some exogenous shock. In view of this, sustainability of deficit and debt and fiscal consolidation continues to be a matter of serious concern.