Is India's Fiscal Consolidation at Hand?

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Image“What you don’t touch, for you lies miles away. (…) What you don’t coin, you’re sure is counterfeit.” These sophisms are voiced by Mephistopheles, under the guise of the Court Fool, in Goethe’s Faust. He aims to convince the Emperor to mint more coins, for money buys everything: parks and palaces; breasts and rosy cheeks. The Commander-in-Chief accompanies the scene and speaks his mind: “The Court Fool is wise, for he promises benefits to all.”

Economic theory, in contrast to the Commander-in-Chief, the Court Fool and other populists, states that all government handouts come at a cost – regardless of whether they are distributed in the form of subsidies or direct transfers. Financing them is only possible by raising taxes and getting into debt (or creating more money… and inflation).

The figure below shows that India’s fiscal deficits and its ratio of public debt to GDP are very high in comparison to other developing countries. The credibility of the needed fiscal adjustment is essential to anchor longer-run expectations about government solvency. The fiscal deficit close to 10% of GDP in 2008-09 partly reflects special outlays, such as debt forgiveness of small farmers and the cost of the Sixth Pay Commission (which meets every decade or so). In the last three months of 2008, public consumption grew over 50% compared with the previous year. Payment of wage arrears to legions of employees proved timely in response to the impact of the international financial crisis. Yet, the unbalanced budget threatens to crowd out private investment as the recovery takes hold.

As India exits successfully from the 2008-09 international financial crisis, the main challenge for fiscal policy is to develop credible strategies to strengthen public finances. Investors and consumers expect positive signals from the budget to be announced on February 26, 2010. The budget should indicate whether the government is eager to push forward on policy reforms.

Reasons for optimism spring from forthcoming reforms in 2010. They are:

(1) Consolidation of Public Sector Deficit
The government can take the first step towards reducing the deficit to more sustainable levels, by cutting the expenditure share in GDP by 1 percentage point and by increasing the tax share in GDP.

(2) Streamlining of Indirect Taxes
The government has already announced its intention to transition to a consolidated nationwide goods and services tax (GST) system from the current system of different types of indirect taxes and multiple rates of indirect taxes. The new law will cover a wider base including all goods and services. The current system taxes production whereas the GST will aim to tax consumption. Indeed, current law levies taxes on movement of goods from one state to other – effectively creating borders within borders. It distorts the allocation of resources and inhibits productivity growth. Transition to GST will be an important milestone.

(3) Direct Tax Reforms
The Ministry of Finance has already put out a draft of new code for direct taxation. The thrust of the new code is to improve efficiency and equity in direct tax system by eliminating distortions in tax structure, introducing moderate levels of taxation and expanding the tax base. For broadening the tax base, the code will minimize exemptions. The new code will simplify the language and law to reduce litigation and tax evasion.

(4) Divestment of State-Owned Enterprises and Acceleration in Infrastructure Spending
Since the formation in May 2004 of the coalition government led by the United Progressive Alliance, the pace of the divestment in state owned enterprises has been slow. The total proceeds from divestments during the five years ending March 2009 were just US$3.1 billion while the value of government stakes in the listed state-owned enterprises are estimated at about US$320 billion. The divestment program can play a role in reducing public debt or in boosting government resources for investment in areas, such as rural infrastructure. Infrastructure spending could start rising in national highways and in implementation of electricity projects. With credit markets improving and capital markets normalizing, private infrastructure spending should pick up.

How optimistic are you about fiscal consolidation in India leading to public-private-partnerships in infrastructure investments?




Eliana Cardoso

Former Acting Chief Economist

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