February 28, 2005
First, given that NCMP has made promises that need higher spending over the next few years, it will be up to the Finance Minister to raise the resources for this expenditure. Since the Finance Ministry is unlikely to be able to resist the political pressure for raising spending, the most prudent policy will be to take it as exogenous and think about raising resources in the long term.
Unfortunately, an evaluation of the Budget is complicated by the fact that it is possible to perform well on short-term indicators including the revenue deficit, without having a long-term view. For example, the FM could raise more taxes from a tax amnesty scheme, but as has widely been debated, this offers wrong incentives to tax evaders.It may be good for the year’s tax collections, but is not the best way to increase the share of the white economy. The objective of the Finance Minister needs to be not merely to look at his revenues this year, but to initiate steps that will help him raise revenues in the next three years in a more efficient and more equitable manner.
Similarly, more taxes can be raised from the salaried sections who are captive tax payers by raising cesses and surcharges. This could show up in good tax collection targets and reduce revenue deficit numbers, but increasing the incidence of tax on a small section of the population is not good long-term fiscal policy. What needs to be done is to change tax rates and tax slabs, improving tax administration and lower the cost of compliance. It would make sense in this Budget, for example, to raise the exemption limit to Rs 1 lakh and to raise the rate at which the maximum rate sets in to Rs 2.5 lakh.
The Kelkar Task Force recommendation that there be two slabs with the maximum rate of 20% setting in at Rs 4 lakh needs to go with removing exemptions. The FM may not be ready to do this at one go. But, he needs to start the process of removing exemptions on savings by grandfathering existing schemes and bringing savings into the Exempt- Exempt- Tax system. The important point is to remember that even if everything cannot be implemented today because politics imposes constraints on him, Chidambaram’s responsibility as the country’s Finance Minister does not end with this year’s budget. If the political system is going to raise demands on the exchequer for increased social sector expenditure, his response should be to do it in a manner that is least distortionary and least harmful to the economy. He must improve tax administration and policy even if that yields him nothing this year, but is good only for the coming years.
The second element of the budget that will reflect whether the Finance Minister is thinking short-term or long-term will be the stance of fiscal policy. The need to prop up the economy by increasing government spending or giving tax breaks this year is not necessary because industrial growth is currently on an upswing. But if, in a year or two, as happens with every industrial cycle, the growth rate of industrial production starts slowing down, it may make sense to run larger deficits then. In other words, fiscal policy needs to be counter-cyclical. When the economy is booming, the government does not need to prop up the economy. This means spending must shrink and taxes must go up. Higher deficits can be harmful in an upswing as they can increase inflationary pressures in the economy. Thus when growth is high, the deficit must be smaller.
The FRBM rules have set targets that do not respond to the business cycle. But this approach does not take into account the fact that there have been structural changes in the Indian economy and industry is now much more influenced by cyclical behaviour as in a market economy, than it was when it was administered through quotas and industrial licences. Fiscal policy can no longer afford to be insensitive to the business cycle. This means that this year the revenue deficit should be reduced by more than the 0.5% required by the FRBM rules.
Reconciling the long-term requirements of the NCMP with the FRBM is difficult enough. Adding counter-cyclical fiscal policy to the FM’s plate makes his life even more difficult. All this requires significant tax and expenditure reform. Budget 2005 must indicate that the Finance Ministry is on the path of doing so.
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