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Reforms in India - A Review

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A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 2 - Economic Reforms & Fiscal Policy-Concluding Obsevations

The analysis and assessment in the preceding sections clearly revealed that the significant fiscal consolidation in the immediate aftermath of the fiscal reforms was essentially brought about through cut in investment expenditure, as rise in committed revenue expenditure could not be curtailed. Within a short span, it became increasingly obvious that the Indian approach to fiscal correction was not sustainable. While reduction in investment spending affected future growth prospects with consequent slowdown in revenue receipts, the interest payments and public debt continued to grow, resulting in reversal of fiscal consolidation process in the latter half of the 1990s. Downward rigidity in the revenue deficit, which amounts to dissaving by the Government sector, has significant implications for the growth target of 8 per cent set in the Tenth Five Year Plan. This would require an investment rate of about 32 per cent, whereas, over the years, the investment rate has stagnated at around 24 to 25 per cent of GDP. Acceleration of saving and investment rate would critically depend upon the efforts to restore balance on the revenue account of both the layers of Governments.

The key factors underlying the growing resource gap across the States are uneconomical level of user charges particularly in the power sector, sluggishness in the Central transfers due to low buoyancy of Central taxes and the rising interest payments. Restoration of revenue balance both at the Central and the State level would require that user charges are adequately raised, the tax collection machinery is overhauled to achieve better tax compliance, returns on Government investment in PSUs are raised through appropriate pricing policies eliminating implicit subsidies and the burden on the fisc is lowered through phasing out of unviable public sector units. The introduction of VAT should eliminate the practice of competitive tax concessions, which has seriously dampened tax buoyancies.

The sizeable outstanding liabilities contracted at higher rates during the late 1980s and the early 1990s and the resultant mounting interest payments have contributed to the widening fiscal gap. The scheme of swapping States’ outstanding liabilities to the Central Government on account of small savings could make a major dent in the growth of interest payments. For the Central Government, aggressive restructuring and divestment in unviable public sector units could bring in sizeable resources to redeem a part of outstanding liabilities and consequent reduction in interest payments.

The elimination of automatic monetisation and reduction in pre-emption of institutional resources by the Government has provided a conducive environment to generate market liquidity and softening of interest rates in the economy. However, with a widening of the fiscal gap, it would be increasingly difficult to maintain a softer interest rate regime. In such an eventuality, it would not only crowd out the private investment initiative, but would also make public debt highly unstable given the level of returns on Government investments.

The institutional support in the form of fiscal rules should be the prime mover of future agenda of fiscal consolidation programme. Such fiscal rules could prescribe quantitative limits for elimination of the revenue deficit, reduction in the fiscal deficit and the public debt over a specific period in a phased manner. Advocates of expansionary fiscal policy have, however, cautioned against the stringent fiscal rules to avoid impairment of future growth prospects (Rakshit, 2001; Patnaik, 2001, Shetty, 2001). In a recessionary environment along with low inflation, growing forex reserves and comfortable level of food stocks, there is a definite role for the expansionary fiscal policy. The apprehension is that the stringent fiscal rules may hinder appropriate steps by the Government. However, it may be noted that such rules generally make a clear distinction between public consumption and public investment expenditure while envisaging a complete elimination of revenue deficit. Rule based fiscal policy would facilitate the path for durable fiscal consolidation through mandatory fiscal discipline, enhanced accountability and improved transparency in fiscal operations.

In the above context, it may be mentioned that the RBI Annual Reports 2000-01 and 2001-02 have set out a policy prescription for further fiscal consolidation. According to these Reports, the path of durable fiscal consolidation is through fiscal empowerment i.e., by expanding the scope and size of revenue flows into the Budget. Furthermore, a fiscal strategy based on revenue maximisation would also provide the necessary flexibility to shift the pattern of expenditures and redirect them productively. Revenue maximisation requires that the tax system be reformed through widening the tax base, simplification of tax rules, review of exemptions/incentives and strict tax compliance.

These developments necessitate further strengthening of fiscal consolidation as a part of the next phase of reforms to address the inherent limitations in the fiscal system. Dissaving arising from the revenue deficit of the Government not only reduces the overall saving and investment capacity of the economy, but also results in a continuous fall in the share of capital expenditure, which impacts investment in the infrastructure sector thereby threatening the growth potential of the economy. The phased elimination of revenue deficit of the Government ought to receive focused attention. Domestic saving could be increased by turning around public sector dissaving to a positive rate of at least 2 per cent of GDP. This will help in making feasible the growth target of 8 per cent set in the Tenth Five Year Plan by enabling an investment rate of around 32 per cent (from the present level of around 24-25 per cent of GDP). The two- pronged strategy in this direction is to arrest the growth in consumption expenditure on the one hand and to step up the tax-GDP ratio on the other. Prioritisation of expenditure is necessary in the process of containment of expenditure. In particular, subsidies could be pruned further and Government administrative machinery could be streamlined and downsized. A reduction in fiscal deficit will also progressively reduce the debt service burden thereby releasing expenditures for public goods provision, at the same level of overall expenditure. Efforts to step up the tax-GDP ratio should be through rationalisation of the tax structure, widening of tax base by phased reduction in tax breaks/ exemptions and bringing more and more services within the tax net.

8.38 Deterioration of finances during the latter part of the 1990s was much sharper for the States than for the Central Government. Although the growth in revenue of the States and the Central Government were comparable, a steeper rise in expenditure in the case of States resulted in their accounting for more than 50 per cent of the rise in fiscal deficit of the combined Government during 1996-97 to 2001-02. A major bane of State finances is the poor performance of State public sector undertakings, particularly the SEBs and State Road Transport U ndertakings (SRTUs). An empirical exercise undertaken in this Report revealed that interest payments, sluggishness in Central transfers (arising from lower Central Government revenues), and low user charges leading to low returns on Government investments have been the prominent determinants of States’ fiscal deficit. Restoration of revenue balance at the State level, therefore, would require raising user charges, overhauling tax collection machinery to achieve better tax compliance, raising returns on Government investment in PSUs through appropriate pricing policies, eliminating implicit subsidies and lowering burden on fisc through phasing out of unviable public sector units. The introduction of Value Added Tax (VAT) should eliminate the practice of competitive tax concessions, which has seriously dampened the tax buoyancy across States.

The issue of growing public debt is another area of serious concern and it has a close bearing on the sustainability of fiscal policy. An assessment of the public debt in terms of both the ‘accounting approach’ and the `present value constraint approach’ indicates that continuation of current fiscal stance could make public debt of both Central and State Governments unsustainable unless corrective measures are undertaken to rein in fiscal deterioration. The persistent rise in interest payments particularly in the 1990s, has been a key factor for widening of fiscal deficit and consequent steep rise in public debt. The proposal to swap States’ outstanding liabilities to Central Government on account of small savings could make a major dent in the growth of interest payments. For the Central Government, aggressive restructuring and divestment in unviable public sector units could bring in sizeable resources to redeem a part of outstanding liabilities and consequent reduction in interest payments.

The policy initiatives undertaken for the development of the government securities market, phasing out of automatic monetisation and reduction in pre-emption of institutional resources have provided a level-playing field to the private investor. The widening fiscal gap, however, could hamper the maintenance of the soft interest rate regime, which is vital in the context of the revival of economic activity.

In such an eventuality, it would not only crowd out private investment, but would also make public debt highly unsustainable given the level of returns on Government investments. Adoption of rules based fiscal policies could facilitate the path for durable fiscal consolidation through mandatory fiscal discipline. Speedy implementation of the provisions of the proposed Fiscal Responsibility and Budget Management (FRBM) Bill is critical for achieving the goal of ensuring inter-generational equity in fiscal management and long-term macroeconomic stability. It should not only help in attaining sustainability, but should also enhance the level of accountability and transparency in fiscal operations of the Central Government. Similarly, efforts should also be initiated at the sub-national level towards rule based fiscal policies for long-term fiscal sustainability


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