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January 21, 2019

Indian Economy|Development Strategy

Development Strategy & The Budget

By Nitin Desai


On February 1, 2019 the finance minister will present the final budget of this administration. It should be an interim budget as this is an election year and the regular budget for the 2019-20 should be presented after the general election. However, Mr. Jaitley will use this occasion the present a report card on the management of fiscal policy over the past five years. Judging by recent pronouncements, in a departure from established practice for pre-election budgets, he will also use the occasion to make some announcements of expenditure proposals and policies designed to win electoral support.

The report card on fiscal policy will focus on the goals announced in the two key policy statements on medium term fiscal policy and on fiscal policy strategy that form part of the budget documents.  Looking at the text of these statements over the past several years it would appear that the primary goals of fiscal policy are a steady reduction in the fiscal deficit as a proportion of GDP, a rise in the Tax/GDP ratio, simplification of the tax structure and improved compliance. The budget this year will undoubtedly present suitably calculated numbers to show that the finance minister’s five budgets have delivered on these goals. The question that needs to be asked is whether these goals are enough.

The Tax/GDP ratio is a crucial component of grand development strategy. But there is little discussion on the pace at which this ratio needs to rise.   Pressures for public spending on social security, health, education, and urban infrastructure will increase as the economy industrialises and urbanises and as rising prosperity raises people's expectations of the quality of public services they expect. Hence a medium and long-term assessment of desirable levels of public spending should be part of the publicly articulated fiscal strategy. These public spending responsibilities devolve on the centre, the states and local authorities. Hence the long-term vision for fiscal devolution must also be a part of the strategy.

A long term vision for public spending can also help in a constructive use off short-term fiscal compulsions. A fiscal stimulus required for macroeconomic reasons can be an opportunity for supporting long-term development strategy. For instance, when a fiscal stimulus was required after the 2008 global crisis China raised spending by 3% of GDP and South Korea by 5% of GDP to accelerate research and development of industries based on technologies such as artificial intelligence, smartphones, solar panels, electric cars and wind turbines.  This is now providing them with a strong capacity to challenge Western technological dominance.   We on the other hand used the post 2008 fiscal stimulus to simply scale up spending on established welfare-oriented programs.

Development strategy does seek to narrow income inequalities. Fiscal policy affects the income distribution mainly through the direct tax rate structure and the concessions and subsidies in the budget. The stated policy of the government on direct taxes is “to broaden and deepen the tax base while maintaining a moderate tax rate and gradually phasing out exemptions.” The basic 10-20-30% rate structure of the income tax has been around for over two decades now and has replaced the more progressive tax structure that prevailed before the liberalisation of the nineties.  Over this period personal income tax collections as a percentage of non-agricultural GDP rose from around 2% in 2003-04 to 3% into 2013-14 and further to around 3.5% during the tenure of the present administration.

This does not suggest any dramatic improvement in compliance because of demonetisation as has been claimed by some. Moreover, the impact on income redistribution would be minimal even if all of the income tax collection were available for transfers to the poor. The fiscal concessions given to the taxpayers, the generous treatment of dividends and capital gains and the total absence of an inheritance tax suggests that neither this nor previous administrations have used the tax system for redistribution. The only instrument they have sought to use for this purpose are price subsidies and welfare programs.

Sudipto Mundle and Satadru Sarkar of NIPFP have estimated that subsidies which cannot be justified on redistributive grounds constitute about 6% of GDP and the tax concessions about 4% to 5% of GDP in 2015-16. Income supplements, and subsidies on merit goods and services like food, basic education, health, water supply and sanitation, amount to only about 2% of GDP. There is now some talk of replacing the product and service specific subsidies with direct income transfer and we may well see a beginning in this direction in this year’s budget. But it will not make much difference to the income distribution unless the unmerited subsidies and the direct tax concessions are drastically reduced, and income supplementation raised well above the 2% of GDP that is today the extent of the fiscal redistributive effort.

The other dimension of fiscal strategy that requires attention is calibrating taxes and subsidies to correct differences between social and private benefits and costs. One example of this is the free immunisation provided for communicable diseases which can be justified on the ground that reducing the pool of infection extends the benefit beyond the immediate beneficiary to the community at large. Another example is the Rs.400/tonne coal cess which can be justified as a tax to cover the social cost of carbon emission, particularly as the cess is supposed to be used for clean energy. There are many other examples where a differentiation of tax incidence between competing products is desirable for environmental, health or other social grounds e.g. plastics vis-a-vis other packaging products.

Pigouvian taxes and subsidies that seek to correct for externalities will inevitably imply differences in the rate of taxation of competing products.  This will fly in the in the face of the commitment to have a single GST rate for all but a few products.  The answer may lie in a complementary cess/subsidy structure based on a systematic assessment of the extent of difference between private and social costs and benefits.

Fiscal prudence, compliance and simplification are undoubtedly desirable. But it is too narrow as a focus for policy design. The link between fiscal policy and the grand strategy of development gets lost in this approach   We also need to pay greater attention to the impact of fiscal policy on income distribution and on consumption and production choices that affect matters like environment, sustainability of resource use and health.

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