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

The need for comprehensive fiscal reforms in India was apparent during the late 1980s, as there was rapid deterioration in Government finances. During this period, the expenditure of the Central Government rose much faster than its revenue leading to a steep rise in the Centre’s fiscal deficit to GDP ratio. For the States, given the restrictions on their capacity to borrow, the increase in expenditure was relatively aligned to the corresponding rise in revenue. Consequently, the rise in the fiscal deficit of States was relatively less steep. The sharp increase in revenue deficit of the Central Government and the emergence of such deficits in State finances were the most worrisome developments in the fiscal scenario during the 1980s.

Reflecting these developments, there was a sharp increase in the outstanding liabilities of both Central and State Governments as ratio to GDP from 41.6 per cent and 16.7 per cent, respectively, in 1980-81 to 55.3 per cent and 19.4 per cent, respectively, in 1990-91. The growing size of liabilities eventually generated a considerable debt-service burden, with interest payments as ratio to GDP rising from 1.8 per cent to 3.8 per cent in case of the Centre and from 0.9 per cent to 1.5 per cent in case of States during the same period

The underdeveloped nature of the Government securities market and the heavy dependence of Small Saving collections on the level of income resulted in an implicit upper ceiling on Govenment’s access to the market resources. This necessitated a large order of monetary accommodation from the Reserve Bank with its attendant monetary implications. The outstanding net Reserve Bank credit to the Government as ratio to GDP rose from 11.4 per cent as at end-March 1981 to 15.6 per cent as at end-March 1991. In order to partially abate the inflationary pressure emanating from growing monetisation of fiscal deficit, discrete upward changes in Cash Reserve Ratio (CRR) were necessitated. With both CRR and Statutory Liquidity Ratio (SLR) approaching their statutory upper limits at the time of the onset of unprecedented macroeconomic crisis of 1991, and given the deleterious macroeconomic consequences of high fiscal deficit, the only option available was to adopt a quick fiscal restructuring programme along with other macroeconomic and institutional reforms.

While a move towards fiscal adjustment was discernible in the pronouncements made as a part of long-term fiscal policy announced in the mid-1980s, a comprehensive fiscal reform programme at the Central Government level was initiated only at the beginning of the 1990s as part of the economic adjustment programme initiated in 1991-92. On the other hand, in the case of States, efforts towards fiscal adjustment began only in the late 1990s. Fiscal reforms in the States were, inter alia necessitated by:

• growing fiscal imbalances

• sluggishness in Central transfers resulting from falling tax to GDP ratio;

• introduction of reform-linked assistance as a part of Medium-Term Fiscal Reform Programme on the basis of the recommendation of the Eleventh Finance Commission; and

• adjustment programme undertaken in some of the States which are linked to borrowings from multilateral agencies.

Fiscal reforms at the Centre covered tax reforms, expenditure pruning, restructuring of PSUs, and better coordination between monetary and fiscal policies.

(i) Tax Reforms

Restructuring of the tax system constituted a major component of fiscal reforms with the aim of augmenting revenues and removing anomalies in the tax structure. The main focus of the reforms was on simplification and rationalisation of both direct and indirect taxes drawing mainly from the recommendations of the Tax Reforms Committee, 1991 (Chairman: Raja J. Chelliah). Since the rates were very high and the structure of indirect taxes highly complex, it was considered undesirable to augment revenues merely by raising tax rates. The Committee had recommended adoption of a small number of simple broad-based taxes with moderate and limited number of rates, and with very few exemptions and deductions.

Accordingly, the tax rates were significantly rationalised and progressively brought down to the levels comparable to some of the developed economies. The key tax reforms have been:

• lowering of the maximum marginal personal income tax rate from 60 per cent in 1980-81 to the present level of 33 per cent (inclusive of 10 per cent surcharge on annual income of above Rs.8.5 lakhs, announced in the Union Budget 2003-04);

• widening of the tax base by way of a series of steps including introduction of presumptive taxes, adoption of a set of six economic criteria for identification of potential tax payers in urban areas and taxation of services.

• reducing the corporate tax rate on both domestic and foreign companies to the current level of 35 per cent and 40 per cent, respectively, from a level of 65 per cent and 70 per cent in 1980-81;

• unification of tax rates on closely held as well as widely held domestic companies;

• rationalisation of capital gains tax and dividend tax;

• progressive reduction in the peak rate of customs duty on non-agricultural products from a level of more than 300 per cent during the period just prior to reforms to the level of 25 per cent as announced in the Union Budget 2003-04; and

• reduction of 11 major ad-valorem excise duties to three viz., central rate of 16 per cent, merit rate of 8 per cent and demerit rate of 24 per cent in year 1999-2000, introduction of a uniform 16 per cent CENVAT effective from 2000-01, while retaining special excise duties on specified goods and in the Union Budget 2003-04 rationalisation of excise rate structure by proposing a 3-tier structure of 8 per cent, 16 per cent and 24 per cent which are, however, not applicable to goods attracting specific duty rates.

The concern with tax rationalisation has been reflected in the appointment of a number of committees to review the tax system in the last few years. The Advisory Group on Tax Policy and Tax Administration for the Tenth Plan, 2001 (Chairman: Parthasarathi Shome) recommended deletion of a number of exemptions and deductions which have become redundant and are not in harmony with a modern tax regime (Government of India, 2001a). Similarly, the Expert Committee to Review the System of Administrative Interest Rates and Other Related Issues, 2001 (Chairman: Y.V. Reddy) recommended the withdrawal of tax concessions available on small savings (Government of India, 2001b). Furthermore, the Task Force on Direct Taxes and Indirect Taxes, 2002 (Chairman: Vijay Kelkar) has reiterated the need to withdraw exemptions and concessions to widen the tax base (Government of India, 2002a; 2002b).

(ii) Expenditure Management

Successive Central Government budgets in the 1990s contemplated a host of measures to curb built-in growth in expenditure and to bring about structural changes in the composition of expenditure. These included subjecting all ongoing schemes to zero-based budgeting and assessment of manpower requirements of Government departments. This was sought to be achieved by reviewing norms for creation of posts and fresh recruitment and introduction of a Voluntary Retirement Scheme (VRS) for surplus staff. The process also involved review of all subsidies with a view to introducing cost-based user charges wherever feasible, review of budgetary support to autonomous institutions and encouragement to PSUs to maximise generation of internal resources. These measures, by and large, focused on downsizing Government and reducing its role and administrative structure. Further, as an institutional arrangement, the Government constituted an Expenditure Reforms Commission (ERC) to look into areas of expenditure correction. Areas identified by the ERC include, inter alia creation of a national food security buffer stock and minimisation of cost of buffer stock operations and rationalisation of fertiliser subsidies through dismantling of controls in a phased manner. It also included optimising Government staff strength by a ban on the creation of new posts for two years, introduction of VRS and redeployment of surplus staff in various Government departments and autonomous institutions, to which the Government provides budgetary support through grants. With a view to promoting transparency and curbing the growth of contingent Government liabilities, a Guarantee Redemption Fund has been set up as a part of expenditure management strategy. Steps undertaken in the light of above proposals included:

• dismantling of the Administered Price Mechanism (APM) in the petroleum sector and the Oil Pool Account effective from April 2002;

• restriction on fresh recruitments to 1 per cent of the total civilian staff strength over the 4 years beginning fiscal 2002-03; and

• introduction of a new pension scheme of defined contribution for new recruits in the Budget for 2003-04.

(iii) Restructuring of the Public Sector

During the reform period, there has been a distinct change in the public perception in favour of reducing the size of public sector and improving private participation. With these underlying objectives, a two-pronged strategy was adopted by the Central Government – reduction in budgetary support to the PSUs and privatisation of existing PSUs.

(iv) Fiscal-Monetary Coordination

Another important objective of the reform process has been to improve fiscal-monetary coordination. This involved steps to ensure wider participation in the Government securities market so as to facilitate elimination of automatic monetisation and pre-emption of institutional resources by the Government. During the 1990s, the Reserve Bank undertook a series of steps towards deepening and widening the Government securities market. Some of the major steps in this direction included aligning of coupon rates on Government securities with market interest rates, introduction of an auction system, introduction of primary dealers and setting up of Delivery versus Payment (DvP) system. Furthermore, following the ‘Supplemental Agreement’ between the Government of India and the Reserve Bank in September 1994, the abolition of ad hoc Treasury Bills was made effective from April 1997, thereby replacing the automatic monetisation of deficit by a system of Ways and Means Advances (WMA) to meet only the temporary mismatches in cash flows of the Central Government. Concomitant to these measures, Statutory Liquidity Ratio (SLR) was reduced to 25 per cent by 1997 and Cash Reserve Ratio (CRR) was reduced in phases to 4.75 per cent by November 2002.

(v) Institutional Measures

As an institutional mechanism to strengthen fiscal discipline, the Central Government is contemplating enactment of Fiscal Responsibility and Budget Management Bill (FRBM), 2000 (Government of India, 2000b). The Bill stresses on inter-generational equity in fiscal management and long-term macroeconomic stability. The original Bill envisaged a complete elimination of revenue deficit and reduction of the fiscal deficit-GDP ratio to 2 per cent by the Central Government by end-March 2006. The Bill also envisaged a reduction in total liabilities of the Centre to no more than 50 per cent of GDP by March, 2011. The Bill, introduced in the Parliament in 2000, was referred to the Standing Committee on Finance for examination and report. A revised Bill is expected to be introduced in Parliament soon.