Changes in fiscal policy over 50 years

by AARATI KRISHNAN
 
Indian tax laws are much simpler today than they were earlier.

India has drastically pruned its taxes and moved towards more sensible spending. But how much control really does the government have on its finances?

Anyone watching the annual Budget exercise, with its minor tweaks and corrections, would find it hard to believe that there is a grand design behind it all. Nor would a reading of the latest Finance Bill suggest that Indian tax laws are much simpler today than they were earlier.

But a study of India's fiscal policies since the 1950s shows that the country has actually come a long way in pruning tax rates and generally moving towards more sensible government spending.

Researcher Supriyo De, writing for the Finance Ministry in the working paper “Fiscal Policy in India,” (http://finmin.nic.in/WorkingPaper/FPI_trends_Trajectory.pdf) reaches these conclusions by recounting the complete history of India's fiscal policies since the 1950s. The eagle's eye view offered by this research paper, presents some heartening changes.

TAX REDUCTION

During a forty-year span, India has made a decisive shift from policies that imposed exorbitant and complicated taxes on a chosen few, to a more liberal tax regime that seeks to raise revenue through better compliance. Until the 1970s, fiscal policy was devoted mainly to re-distributing wealth from the private sector to the State, and taxing the ‘wealthy' to give to the poor.

The Shylock-like policies contributed to personal income tax rates as high as 77 per cent, and corporate taxes of 45-75 per cent in the mid-70s. Customs tariffs, even as late as the nineties, were as high as 400 per cent. The burden was made worse by dozens of tax categories and cascading levies. But with policymakers realising that high taxes lead to high evasion, they initiated several reforms. By 1997-98, these reforms had brought peak personal tax rates down to 30 per cent and corporate rates to a moderate 35 per cent.

Introduction of MODVAT credit (set-off of taxes paid on inputs against those due on final goods), simplified tariffs, and fewer categories also reduced indirect taxes for companies.These changes actually resulted in many benefits to the fiscal. Compliance improved, with the tax-to-GDP ratio rising from the single to the double digits. Direct taxes replaced indirect taxes as the key revenue generator for the government. Between 1970 and 2006, direct taxes improved their share in the revenues from 16 to 35 per cent, while indirect taxes reduced their share from 58 to 43 per cent.

EXPENDITURE REFORMS

But the ‘go easy on tax' policy called for changes to the expenditure side too. With the government resorting to more borrowings to fund expenditure, Budget surpluses turned into deficits. The gross fiscal deficit (and borrowings) began to climb steadily from the mid-70s to reach a crescendo in 1991, exposing the country to a full-blown balance of payments crisis during the Gulf War.

This jolt had the desirable effect of focussing policy attention on the dangers of foreign borrowings and persisting deficits. A concerted effort to curtail expenditure kicked off in the early nineties, culminating in the FRBM (Fiscal Responsibility and Budget Management) Act of 2003.

This set out an overall limit (3 per cent of GDP) to fiscal deficit and mandated regular review of government expenditure. Though FRBM targets had to be put forward during the 2008 credit crisis, ‘fiscal prudence and the desire to limit public debt', the author notes, had become ‘institutionalised in the policy matrix'.

FISCAL POLICIES

Overall, this paper, by taking a multi-decade view of the problem, does demonstrate that India's fiscal policies are generally changing for the better. But it does dwell much on the less-comforting aspects of these policies in recent times. For one, the disconcerting tendency of the government to ‘meet' its deficit targets by keeping certain items off the books. If it was oil and fertiliser bonds until 2010, it is the concept of “effective revenue deficit” in the recent Budget.

Two, the paper argues that the government has been on a consistent path of expenditure control and deficit reduction, but for unexpected bolts from the blue like the Gulf War and the Lehman collapse. It points to the good progress in curtailing the gross fiscal deficit to 3.3 per cent of GDP by 2007-08, before it ballooned once again. But facts suggest that it wasn't just the stimulus package unleashed after the crisis which impacted the deficit.

Populist give-aways, in the form of farm loan waivers, large pay revisions to government employees, and the NREGA payments, which have played a big role in ballooning government expenditure, flagged off before the credit crisis. That current deficits have been achieved after accounting for one-off receipts from telecom spectrum auctions and stake sales in PSUs, also raises questions of sustainability.

LIMITED CONTROL?

The impression created, therefore, is that despite good intentions, the government has had limited control on the fiscal situation in recent times. It has been able to neither increase its revenues nor curtail its expenditure, at will.

Increasing tax revenue has clearly depended on buoyant economic growth. And growth isn't guaranteed, with global factors intervening every so often. Reducing expenditure isn't easy either, given the policy priority to ‘inclusive' growth and political ramifications of tightening the purse strings.

(This article was published in Hindu on April 3, 2012)