Opinion India’s fiscal dilemma

The good news is that in many ways the fiscal situation has proved resilient to the successive shocks (see table). Tax collections as a per cent of GDP are actually marginally higher than they were in 2018-19. On the spending side, the composition has improved, as capital expenditure has soared from 1.5 per cent of GDP to a budgeted 3.5 per cent of GDP. And sizeable off-budget expenditures were brought back onto the budget two years ago in a major and laudable step to improve transparency. The fiscal deficit is now on a downward trajectory, budgeted to fall to about 6 per cent of GDP next year from a Covid peak of more than 9 per cent.

Tax collections as a percent of GDP are actually marginally higher than they were in 2018-19.

At the same time, there have been some mixed developments, particularly on the revenue side. Personal income taxes have shown an encouraging rise, but this has been accompanied by increases in exemption limits, meaning that taxation is now resting on a narrower base of taxpayers, even as prosperity grows and spreads to the middle class. Meanwhile, the GST’s promise has not yet been realised, as its collection ratio has remained essentially the same as it was five years ago, largely because efficiency gains have been offset by repeated reductions in rates. Furthermore, corporate tax revenues have declined significantly, again because tax rates have been reduced, in this case more than offsetting the returns from the improved profitability and market share gains of large corporations (at the expense of the informal sector).

The uncomfortable news is two-fold. First, there has been a notable increase in expenditures over the past five years. Here, one needs to be careful with the numbers because 2018-19 spending was understated, as certain transactions had been shifted off-budget. Even after this correction is made, however, the “true” increase in expenditure remains substantial, exceeding 1.5 percentage points of GDP. As a result, the structural fiscal deficit will amount to an uncomfortably large 6 per cent of GDP next fiscal.

The run of large deficits since 2018-19 has necessitated large amounts of borrowing, which have pushed up interest obligations to the point where they now absorb nearly half of the centre’s tax revenues. As we showed in a piece with Olivier Blanchard, this exceptionally high ratio increases India’s fiscal vulnerability while also squeezing out important social expenditures.

The second issue is centralisation. On the revenue side, the states will receive just 31 per cent of gross tax revenues next fiscal, compared with 37 per cent in 2018-19. This reflects the centre’s increasing use of cesses, which are not shared with the states, as well as the use of a considerable portion of tax collections (from the GST compensation cess) to repay the GST Council for the loans given to the states during the pandemic.

A subtler form of centralisation is taking place on the expenditure side. Non-interest, non-subsidy current expenditure is being compressed, by a sizeable 1 percentage point of GDP in 2022-23 and a further 0.5 percent of GDP next year. How is this being achieved? Various mechanisms are at work, but a key one is that the centre is scaling back its transfers to states for various centrally sponsored schemes. Some of the reduction can be justified because the economy has recovered from the pandemic. And some of it is aimed at forcing the states to improve their efficiency, not just in their spending but also in the way they manage their funds. That goal is laudable, especially if the states can be made to reduce their egregiously wasteful power subsidies. But the consequence is a major pressure on state government expenditures.

What does this mean for the fiscal performance of the country as a whole? We are not yet able to answer this question, because we don’t have current data for the states. But we do know a few things. For example, we know that despite the sharp increase in the centre’s capital spending, investment by the overall public sector has actually declined compared to 2018-19 because the states and especially public sector undertakings have reduced their outlays.

In sum, despite the centre’s prudence in avoiding a major fiscal stimulus during the pandemic, the fiscal situation has weakened considerably over the last five years. The centre’s structural deficit is larger, overall debt has risen to an uncomfortably high 85 per cent of GDP, and interest obligations have increased to exceptionally burdensome levels.

So, something needs to be done — and is being done. The centre’s consolidation strategy, however, relies heavily on centralisation, which has both limits and limitations.

The limits are clear. Even under an optimistic scenario, where centralisation leads to a long-needed improvement in state government efficiency, there is only so much consolidation that can be achieved in this fashion. Then, the centre will need to find other ways to reduce the deficit to its target of 4.5 per cent of GDP.

As for the limitations, if centralisation does not succeed in improving efficiency, it would simply result in a redistribution of resources from the states to the centre. In that case, states would either need to reduce the services they provide to their people. Or they would need to increase their borrowing, in which case the overall fiscal position might not improve at all.

And all of this assumes that the finances will play out as foreseen in the budget as the 2024 elections approach. On the other hand, if they are affected by the broader nationwide trend of aggressively competitive populism the overall fiscal picture would worsen.

Euphoria and pessimism are both unwarranted. But anxiety gnaws.

Subramanian is former chief economic adviser to the Government and Felman is principal, JH Consulting