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

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Index of Articles in
Module No: 1

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

Module: 2 - Fiscal Policy - International Experience

Overview of Fiscal Reforms

The external payments crisis of 1991 was, to a large extent, an inevitable consequence of the deteriorating fiscal situation during the 1980s. The 1980s, especially the second half, was marked by high and persistent fiscal deficits, accompanied by large revenue deficits. This had led to a significant enlargement of the debt-servicing obligations. In order to contain the burgeoning debt-service obligations, Government tapped financial surpluses of the household sector through statutory pre-emptions from financial intermediaries at below market clearing interest rates. This gave rise to a degree of financial repression. At the same time, increased financing of the Government deficit through automatic monetisation compromised the effectiveness of monetary policy and fuelled inflation. Against this background, when the Indian economy faced an unprecedented macroeconomic crisis in 1991, not surprisingly, fiscal consolidation constituted a major plank of the policy response.

The primary objective of the fiscal reforms as announced in the Union Budget 1991-92, was essentially to achieve a reduction in the size of deficit and debt in relation to GDP. It was envisaged that this would be achieved through revenue enhancement and curtailment in current expenditure growth while enlarging spending on investment and infrastructure so as to provide momentum to the growth process. These measures were also intended to curb the preemption of institutional resources by the Government and simultaneously to provide a level-playing field to the private investors. Accordingly, fiscal reforms in India were initiated in three distinct but interrelated areas:

restoration of fiscal balance;
restructuring of public sector; and
strengthening of the fiscal-monetary co-ordination.

The strategy for restoring fiscal balance comprised tax and non-tax reforms, expenditure management and institutional reforms. Public sector restructuring mainly involved divestment of Government ownership. Contemporaneously, the steps towards improving fiscal-monetary coordination encompassed deregulation of financial system, elimination of automatic monetisation, and reduction in pre-emption of institutional resources by the Government. At the sub-national level, fiscal adjustments began as a consequence of the deterioration in States’ finances, which exacerbated in the latter half of the 1990s. With a view to promoting State reforms, access to Central assistance as well as to guarantees for loans from multilateral agencies has been linked to their reform efforts.

The fiscal performance during the reform period, however, was characterised by a clear divide in the mid-1990s in the attainment of fiscal targets. There was evidence of the successful fiscal correction during 1991-92 to 1996-97 (except for 1993-94) in terms of a significant fall in the fiscal deficit and in public debt as a proportion of GDP. Since then, there has been a significant reversal of trend. Indeed, many deficit indicators presently are even higher than the levels prevailing at the time of the crisis in 1991. The revenue deficit has not only persisted, but has grown in size during this period. The resultant dissaving arising from the revenue deficit has reduced the aggregate saving and investment capacity in the economy. Consequently, there was a steady fall in the share of capital expenditure, impacting on the infrastructure investment and thereby threatening the growth potential of the economy. Several pointers indicate a reversal of the fiscal consolidation process in the recent years. These include decline in tax to GDP ratio, downward rigidity in current expenditure, steady deterioration in public investment in productive sectors, slow progress of Public Sector Undertakings (PSUs) restructuring and faster accumulation of public debt. A major drag on State finances has been the poor performance of State Public Sector Undertakings (SPSUs), particularly the State Electricity Boards (SEBs) and State Road Transport Undertakings (SRTUs). Thus, even after a decade of reforms, sustained fiscal consolidation remains unattained.

This module reviews the fiscal situation that emerged in the reform period and contrasts it with the 1980s. It also evaluates and identifies major constraints in the process of fiscal consolidation. The first article briefly sets out the international experience on fiscal reforms in order to situate the Indian fiscal reforms in an international perspective. The next two articles review the fiscal situation during the 1980s in terms of alternative fiscal indicators. In the backdrop of deteriorating fiscal indicators, this section explains the reform strategy adopted in the 1990s setting out key measures that were undertaken. The fiscal performance during the 1990s, broadly conforming to the reform period starting 1991, is examined in terms of various indicators in the 4th and 5th articles.. Achievements as well as shortcomings of the reforms are spelt out on the basis of these indicators. Drawing on the preceding sections, the 6th article makes an assessment of the fiscal reforms and identifies some of the emerging issues. Policy perspectives to further fiscal restructuring are set out as concluding observations in the last article (7th).

The external disequilibrium of the early 1990s was linked to the fiscal gaps of the 1980s. Deterioration of the fiscal position in the 1980s was manifest in all major indicators of Government finances. GFD-GDP ratio for the Central Government rose substantially in the 1980s. For the State Governments, the increase was relatively moderate due to restrictions placed on their borrowing. Particularly worrisome has been the emergence of revenue deficits in the accounts of the Centre and States. The combined liabilities of the Centre and States expanded to an unsustainable proportion on the eve of the crisis in 1991. Against this backdrop, module 2 presents the rationale, assessment and impact of fiscal reforms. The module details the areas of fiscal restructuring undertaken, as also the rigidities in the fiscal structure that have restrained progress in this area. This moduler analyses the factors responsible for deterioration of fiscal situation of the Centre and States during the 1990s. A key element for a sustainable fisc remains the size of internal debt and growing volume of interest payments. Formal evidence provided suggests that internal debt could become unsustainable, if adequate progress is not made in fiscal reforms. Unless the debt burden is lowered by innovative steps, especially through an accelerated disinvestments programme, the fiscal scenario would continue to be a cause for serious concern.

Fiscal sector reforms have emerged as an integral part of the overall macroeconomic policy framework in several countries belonging to both the advanced economies and the developing world since the late 1970s. A shift in the thinking on the role of fiscal policy arose, inter alia, from the competitive pressures from growing international integration of goods and capital markets and the consequent need for maintaining lower rates of inflation, which had constrained the Government’s ability to raise taxes and monetise deficits. Recent evidence suggests that fiscal contraction can be expansionary for growth as fiscal multipliers could not only be small, but negative as well. Endogenous growth models show that Government’s tax and expenditure policies can affect steady-state growth rates in either direction. Evidence on expansionary fiscal contraction has given more weight to the need for fiscal consolidation.

The strategy of fiscal adjustment followed by different countries could broadly be categorised into two types, viz., ‘Type 1’ and ‘Type 2’ (Alessina and Perotti, 1996). ‘Type 1’ (followed by most of the European countries in the 1990s) relies primarily on cuts in expenditure on transfers, social security and Government wages and employment. Tax increases are not emphasised and taxes on households either are not raised or are even reduced. On the contrary, ‘Type 2’ adjustments (as followed by most of the European countries in the 1980s) rely mostly on broad-based tax increases, and often the largest increases are on taxes on households and social security contributions. Expenditure cuts are almost all on public investment, while Government wages, employment, and transfers are completely untouched, or only slightly affected. There are episodes of fiscal consolidation where countries (e.g., in Ireland and Italy), which began with ‘Type 2’ kind of fiscal adjustment later switched over to ‘Type 1’.

Empirical results show that for the same size of fiscal adjustment, ‘Type 1’ adjustments induce a more lasting consolidation of the budget and are also expansionary. ‘Type 2’ adjustments, on other hand, are often reversed soon due to further deterioration of the budget, which have contractionary consequences on the economy. In a study of 20 OECD countries for the period 1960 to 1994, it was observed that of the total 60 episodes of fiscal consolidation efforts during the period, only 16 were successful, and among the successful cases, 73 per cent of the cases of adjustment were on the expenditure side as against only 44 per cent in case of unsuccessful cases (Alessina and Perotti, op. cit). Similarly, of the 74 episodes of fiscal adjustment in 20 countries during 1970 to 1995, it was observed that out of the 17 cases where adjustment was of ‘Type 1’, little less than half the cases were successful, while out of 37 cases of ‘Type 2’ adjustment, only one out of six cases was successful (Mcdermott and Wescott, 1996)

Apart from the type of adjustment, the size of fiscal adjustment has been a crucial element in the success of the fiscal adjustment efforts. This is because the size of fiscal consolidation is related to the overall scope of the reform programme and enhances the credibility of the Government’s commitment to the consolidation. It was observed that fiscal consolidation was sustainable in those cases where fiscal correction in terms of reduction of fiscal deficit was higher (4.0 per cent of GDP in a two-year period). In other cases, where the extent of correction was smaller, fiscal consolidation could not be sustained (Mcdermott and Wescott, op. cit). It has also been found that fiscal corrections do not have intended effects if they fail to indicate a permanent and decisive change in the stance of fiscal policy (Giavazzi and Pagano, 1996).

A noteworthy feature of the process of fiscal consolidation carried out in the 1990s was the introduction of a sound fiscal framework supported by institutional reforms, intended to reinforce political commitment to fiscal restraint in the face of pressure for expansion. The main justification for these institutional reforms is that they strengthen fiscal discipline and transparency, and therefore, increase accountability for the design and implementation of fiscal policy, while minimising the problems caused by lax fiscal policy. The "Maastricht Treaty" followed by the "Stability and Growth Pact" in the euro area, operation of the golden rule - borrowing only to finance capital spending - in UK since 1997 and the Fiscal Responsibility Act of 1994 in New Zealand are some of the examples of institutional reforms accompanying fiscal consolidation. The key elements that these frameworks share include an explicit legal basis, an elaboration of the guiding principles of fiscal policy, a clear statement of the objectives, an emphasis on the need for a long-term fiscal policy, and requirements for fiscal reporting to the public leading to improvement in fiscal performance.

The cross-country experience suggests that several important issues arise in the context of fiscal adjustment. These include

the size of the fiscal adjustment to be made;
the composition of fiscal adjustment in terms of whether the adjustment needs to be carried out through cuts in expenditure or by raising revenue or a combination of both, and the components of expenditure and revenue to be adjusted;
the policy mix that must accompany a major fiscal adjustment;
concern for non-policy factors such as global economic growth which effects the consolidation process;
reversibility of the fiscal consolidation process;
the possible adverse macroeconomic impact of fiscal adjustment; and
adoption of appropriate accounting standards and adherence to a fiscal rule framework, that make for transparent and accountable budgeting.

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