Fiscal developments and outlook in India

This paper aims to identify what elements of India’s fiscal situation give cause for concern and to examine whether fiscal reform measures address them adequately. It uses econometric techniques to identify the causes of changes in the fiscal deficit, the ways in which political economy drive fiscal policy, and the effects of fiscal reform.

The paper identifies the underlying cause of fiscal stress since economic reforms began in 1992 as the decline in trade tax revenues and the failure to compensate for this decline elsewhere in the budget. This has led to a fall in the tax/GDP ratio from 16 per cent in 1992 to 14 per cent in 2002, although there is provisional evidence of an upturn in 2003.

The paper also examines primary fiscal indicators for Central and state governments over the last fifty years for evidence of countercyclical fiscal policy (spending more in times of slow growth and less when the economy is booming, in an attempt to balance out the effects of business cycles) and election-year profligacy (overspending prior to elections). It finds that fiscal deficits have indeed risen in election years, and this effect has been larger during 1971-2001 than during 1951-71; and policy responses have been countercyclical.

Finally, the paper examines two major fiscal reforms initiated in 2000 which led to further decreases in revenue. Simulated outcomes show that without an improvement in efforts to increase revenues, the reforms will necessitate an extremely large decrease in government expenditure. If staff prove to be more resistant to expenditure cuts than maintenance and other expenditure, then there could be a very steep decline in the quality of government services and infrastructure; and the cuts could result in political turbulence. Given the paper’s finding that Indian governments spend more in election years, it predicts that such turbulence could put similar pressure on government to spend more, leading to a further worsening of fiscal discipline.

Thus the paper concludes that increasing revenues is key to fiscal reform, and that only buoyant growth can provide the necessary boost to revenues. It argues that, in turn, growth requires public investment in physical and social infrastructure. Although growth prospects for 2004 are good, future prospects hinge critically on finding room within the fiscal constraint for growth-promoting capital and current expenditure.