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Tuesday, December 7, 2010

Overall fiscal scenario needs austerity measures

 “The test of our progress is not whether we add to the abundance of those who have much. It is whether we provide enough to those who have little.”- Franklin D. Roosevelt by Kartik

The main aim of every Government is to ensure the welfare of all its citizens. To achieve this end, the Government constantly works and reworks its overall policy objectives to meet various demands and changing environmental situations. Among other policies objectives, one of the important being the Fiscal Policy, which implies a policy with regard to the revenue, expenditure and borrowing programme of the Government. This Policy has four major objectives, namely, Growth, Stability, and Allocation of resources and Reduction of inequalities. The fiscal reforms were initiated in the 1990’s as a part of the economic liberalization. These reforms included expenditure reforms, tax reform measures, and public sector restructuring and systematic reforms in the government’s borrowing process. The reforms were aimed at raising the rate of savings and investments, which further enhances the productivity of public expenditure. Fiscal consolidation (a policy aimed at reducing government deficits and debt accumulation) began in the 1990s with fiscal deficit declining from 6.6 per cent of the GDP in 1990-91 to 4.1 per cent in 1996-97; however, the situation took an ugly turn during 1997-98 and reached a level of 6.2 per cent of the GDP in 2001-02. It was in this backdrop that the Fiscal Responsibility and Budget Management Act of 2003 (FRBMA) assumed significance. This Act has been emulated from the successful experience of a similar legislation in New Zealand. The FRBM Act was enacted by Parliament in 2003 to bring in fiscal discipline and the government had notified the FRBM Rules in July 2004. The rules included:
Progressively bringing down the revenue deficit beginning 2004-05 by 0.5 per cent per annum so as to bring it down to zero per cent by 2008- 09
Progressively bringing down the Fiscal deficit beginning 2004-05 by 0.3 per cent per annum so as to bring it down to not more than three percent by 2008-09.
Additional borrowings of the government should not exceed nine percent of the GDP with a progressive reduction by one per cent every year upto 2008-09
Government should present before the parliament its fiscal health every year in terms of Revenue deficit as a percentage of the GDP, Fiscal Deficit as a percentage of the GDP, Tax-GDP ratio and the total borrowings as a percentage of the GDP.
Government should take corrective action if the Revenue Deficit and the Fiscal Deficit exceed 45 percent of the budget estimates and non debt receipts fall short of 40 per cent of the budget estimates.
Change in accounting procedures, if any, must be reported to the parliament. The Act makes it obligatory for the Central Government to bring about Fiscal Consolidation, Fiscal Stability and Accountability of the Central Government to the Parliament for parameters like Fiscal deficit, Revenue Deficit, Total borrowings, Tax-GDP ratio etc. The adherence to the fiscal discipline for a period of five years ending 2007-08, the Indian Economy grew at 8.8 percent thereby reaping the benefits of fiscal consolidation.
However, owing to the economic slowdown in 2008-09, there was a sharp deterioration in the fiscal position leading to abandoning the targets set under the Act in 2004. The slowdown resulted in a fall in the tax revenues as a percentage of GDP thereby forcing the Government to borrow from the market to counter the downswing and trigger recovery.  The borrowings were mainly used by the government to fund crucial stimulus measures, known as ‘Pump Priming’ which is aimed at generating not only employment, incomes and demands but also pushing up the rate of investment, both by the Government itself as well as by way of motivating the private sector as economy starts showing signs of recovery. To revive the economy, the Government of India, like most other economies hit by the recession, announced a slew of stimulus packages earmarking Rs 20,000 crore ($200 billion) for infrastructure, industry and export sectors. The stimulus package had continued the highly expansionary fiscal policy, boosting demand with tax cuts and spending increases on the rural sector. Complimenting the stimulus package, the Reserve Bank of India, with a prudent monetary policy, took steps to pump in sufficient liquidity in the financial system asking the banks and other financial institutions to ease the cost of funding, signaling the lenders to lower their interest rates. It is due to these initiatives that the Indian economy fared much better than other countries of the world thereby registering a growth rate of 6.7 percent. (2008-09). The Government of India, in its first full year budget (2010- 11) since the resounding victory in May 2009 elections, aimed at achieving a growth rate of 9 percent thereby temporarily abandoning fiscal consolidation. In fiscal year (FY) 2010/11 (ending in March 2011), the government is attempting to direct fiscal policy prudently. The government continues targeted spending on key areas such as infrastructure, agriculture, health, and education, while reducing oil and other subsidies. On the tax front, it lowers taxes for the middle class, and raises customs and excise taxes on petroleum products. It expands divestment and privatisation initiatives to increase government revenue receipts. The introduction of Goods and Services Tax, in April 2011, which subsumes the other indirect taxes such as cenvat, service tax, state level VAT, octroi etc, is expected to boost up the revenues. The new fiscal consolidation plan will reduce the central government’s fiscal deficit from a revised estimate of 6.7 per cent in the fiscal year 2009/10 to 5.5 per cent in fiscal year 2010/11. The budget of 2010-11 announced in February marks the country’s first step towards fiscal consolidation after two years of deteriorating finances. The main aim of the budget is to bring India’s growth level back to 9 percent and address the issue of distribution of wealth for the low income groups, particularly in rural areas, at the same time aiming at the reduction of fiscal deficits. On the would boost up the revenues due to re-distribution of the burden of taxation equitably between manufacturing and services bringing about a qualitative change in the tax system, bringing down the compliance cost and enabling the trade and industry to become more competitive leading to an increase in exports and lower prices for domestic consumers thereby increasing the demand and also raising the level of GDP.
The GST would have all the merits of VAT which includes minimizing tax evasion due to which the government may end up with a revenue surplus within a short period of time. On the expenditure side, the budget includes an increase in the allocation for infrastructure sector and a gradual increase in the social security sector. Thus the spending on the infrastructure and social security sector would encourage investments, create employment opportunities, increase demand and consumption thereby contribution to the overall growth of the economy.  On the other hand, while pursuing an expansionary fiscal policy (a net increase in the government spending), the government needs to exercise caution that the resultant fiscal policy does not become unmanageable by way of not only increased interest burden but also its impact on the liquidity and inflation in the economy which can make the fiscal policy counter productive to some extent. Also, massive borrowings by the government lead to an increased fiscal deficit. It is not the mere size of the fiscal deficit that is important but also the use to which this fiscal deficit is put, matters a lot. This raises the question of whether a high fiscal deficit can raise the rate of growth of the economy as all the affected governments in the global crisis have opted to go in for massive borrowings to reviving the economy. Most of the European governments and the United States of America at present have been running in high fiscal deficits, some of them even over 10 percent.
Despite such high fiscal deficits in the western countries, it has not caused alarm because most of the borrowings are by and large used productively. On the contrary, the Indian experience shows that more than 60 percent of the borrowings have been incurred on revenue items and thus it has only met the consumption needs of the economy rather than increasing the medium term productivity. As such, there is always a debate in India whether a high fiscal deficit is desirable and manageable to ensure that it leads to high growth. Hence, to achieve fiscal consolidation, thereby keeping the fiscal deficit under manageable limits, the government should focus on utilizing the borrowings to qualitative use so as to increase the productivity of the economy which determines the impact on growth. On the revenue front, one of the critical factors for India’s fiscal consolidation will be the timing and the details regarding the implementation of the nation-wide GST system. A successful implementation of the GST could pave the way for a structural improvement in budget revenues.
Also, the government should aim at a “calibrated exit strategy from the expansionary fiscal stance of 2008- 2009 and 2009-2010” as suggested by the 13th Finance Commission. Reforms to the Fiscal Responsibility and Budget Management Act should be brought in which will replace the current legislation that expired in March 2010. Therefore, the future of India’s fiscal policy should be aimed at consolidating the notable fiscal progress made in recent years and that would require a lasting consensus on a fiscal system capable of harmonizing macroeconomic stability with other public responsibilities in terms of growth and distribution. The focus should be on the efficiency, effectiveness and quality of expenditure. The expenditure should be directed towards social sector which would create employments and incomes on the one hand and increase the medium term productivity of the economy on the other. It must also be ensured that proper mechanisms are put in place through promoting the development of balanced and democratic fiscal institutions so that the impact of future global economic shocks might be prevented. Since public finances are at the heart of the democratic process, all efforts should be made to ensure that the tax payer’s money is put to effective and efficient use.

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