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October 18, 2012

Development Strategy|Governance & Politics

The Long Term Fiscal Challenge

By Nitin Desai


The Kelkar Committee Report on fiscal consolidation focusses quite understandably on the next three years because it is the near term consequences of an uncontrolled fiscal deficit on inflation, and external confidence that is worrying the finance ministry.  This column deals with the longer term fiscal prospect which requires much more than the immediate fixes of subsidy rationalisation and better tax administration.

In the longer term the key goal has to be to raise the Tax-GDP ratio because public expenditure as a proportion of GDP is bound to go up, basically because of two trends which will tend to push up demands on the budget. The first is the need for social protection as traditional systems of family support get eroded and the second is the need to subsidise some parts of the urban infrastructure.  Every capitalist economy has had to do this and there is no reason for supposing that India would be exempt from this historical trend.

Social welfare expenditures in a broad sense are already a part of Central and State budgets in the form of schemes like NREGA, Sarva Shiksha Abhiyan and so on and the salaries and maintenance expenditures for schools, health centres, etc. In the 2010-11RE the expenditure of the Centre and the States together on the food subsidy, education, health, rural development and social welfare amounted to Rs. 593 thousand crores which is 7.7% of the GDP at market prices and 31.9% of public revenue expenditure. These ratios have risen from their 1990-91 level when these expenditures amounted to 6% of the GDP at market prices and 28.7% of revenue expenditure.

Social protection expenditures will only go up as we move steadily from discretionary delivery of assistance to entitlement based programmes where the expenditure commitment becomes open-ended.  There is of course the challenge of stopping leakages and corruption in these schemes. But the real need is for a complete restructuring of these expenditures into an organised social security system with clearly specified entitlements for things like old age and disability pensions, child allowances, scholarships or vouchers and other forms of  household level support for education, basic healthcare and health insurance, income support for the destitute and so on.

The other big demand on the public budget will come from the rapid pace of urbanisation.  In India the public expenditure (revenue plus capital) on housing and urban development rose from 1% of total public expenditure in 1990-91 to 2.8% in 2010-11RE. This does not include the heavy costs of urban rail transit systems, urban roads and flyovers and so on.   Practically any country with a liveable urban environment has had to provide public funding for a significant part of the cost of basic municipal services (water supply, sewerage, waste disposal), for low-cost housing and urban transport. Some part of this burden on the capital expenditure side can be met by finding ways of capturing the increase in urban land values for these purposes.  But there is no escaping the fact that the running costs of city infrastructure have had to be subsidised the world over.

It would be prudent to assume that these expenditures on social protection and urban services would amount to around 10% of GDP by the end of the decade. They are best financed by revenue resources rather than borrowings. There could be other upward pressures on revenue expenditures, which amounted to about 24% of GDP in 201-11RE. Hence an increase in the Tax-GDP ratio must be a key goal for the Finance Ministry. 

The Tax-GDP ratio for Central and State taxes together is 16.6% in the 2011-12BE. It had reached the 15% level by the mid eighties and has meandered up and down since then, falling to about 13% by 1998-99, rising to a peak of 17.5% in 2007-8 and falling since then. This recent fall is largely because the Tax GDP ratio for Central taxes declined by 1.5% of GDP. This has to change if the budget is to cope with the expenditure pressures that are ahead of us.

An increase in the Tax GDP ratio will require a closer look at rates and at compliance both for direct and indirect taxes.  On indirect taxes a lot hinges on the implementation of the GST and one hopes that this would happen soon enough.  With regard to direct taxes, the CAG audit report for direct taxes in 2008-09 has some disturbing information on the widening of the tax base. According to this report in 2008-09 the number of corporate and non-corporate assessees fell. It also points out that in 2008-09 more than half the PAN card holders did not file returns.

Income tax rates also need to be examined for their impact on the Tax GDP ratio. The peak income tax rate declined steadily from the mid seventies onwards till we reached the Chidambaran 30%-3 slab structure in 1997-98.  Since then the exemption limit has been raised by a factor of 5 and the level at which the peak rate applies has risen by a factor of 6.7, the latter increase having taken place after the UPA took over in 2004. This pace of upward adjustment in the income tax rates seems to be much more than what could be justified by the rate of inflation as the WPI in 2011-12 was about 2.2 times the WPI in 1997-98. 

In the case of the corporation tax the problem is not in the rate but in the cornucopia of concessions which amounted to a little over 1% of GDP in 2010-11 before adjustment for the Minimum Alternate Tax (MAT).  The MAT, much criticised by industry, has helped to raise the effective rate steadily since 2006-07, though its current level of 24.1% is still well below the statutory rate of 33.2%. 

The Kelkar Committee proposals are the least that we need to do to meet the immediate  fiscal challenge. But we also need a longer term fiscal strategy that takes a realistic view of expenditure demands and then calibrates the tax base and rates to match these. If we fail to do this, than we are heading for a fiscal meltdown which will make nonsense of all our ambitious growth targets.

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