Is fiscal consolidation a distant mirage?

Is fiscal consolidation a distant mirage?

Though the budgets have adhered to the targets of fiscal deficit, but what worries are the receipts coming from one-off inflows to reduce this fiscal

Is fiscal consolidation a distant mirage?

With added impetus on the fiscal consolidation, Finance Minister Arun Jaitley, in the recent Budget emphasised on reducing the fiscal deficit.  Targeting fiscal deficit of 3.5% in the Fiscal Year 2016-17, Jaitley said, “Consequently, the fiscal deficit in RE 2015-16 and BE 2016-17 have been retained at 3.9% and 3.5% of GDP, respectively.”

Fiscal consolidation was a priority in the previous Budget too. Last year, the government focused on divestments for reducing the fiscal deficits. This year, the government will be focusing of the receipts from the spectrum auction. There is an serious underlying worry in these measures, which has got hidden under the wrap of fiscal consolidation. These measures are ad-hoc in nature. These measures don’t reflect any structural reform to contain deficit, but focuses more on the one-off reciepts.

“While meaningful structural reforms remain elusive, the fiscal deficit is being plugged by increasing uncertain one-off inflows from divestment and sale of spectrum for wireless communications at the federal level (1% of GDP according to Budget estimates in FY2017),” says Rajan Govil, Managing Director of Marketnomix.

Contrary to IMF Approach

The receipts coming from one-off inflows like divestments are meant to be considered as financing items, as per the IMF’s Government Finance Statistics Manual. “In fact, if divestment receipts of Rs 56,550 crore in FY2017 are treated as financing items and not as receipt, as under the internationally accepted IMF’s Government Finance Statistics Manual, fiscal deficit would be higher by 0.4% of GDP,” says Govil, who was an economist with the International Monetary Fund (IMF) for over eight years now.

Govind Rao, Member of Fourteenth Finance Commission is of a similar opinion. “The attitude towards fiscal consolidation by successive governments has been ambivalent,” says Rao. “Up to 2007-08, thanks to high buoyancy in income tax revenues, due to the induction of technology through tax information network and service tax due to wider coverage coupled with buoyant economy, there was considerable reduction in both revenue and fiscal deficits. However, after 2008-09, there has been a slippage due to increased spending on subsidies and transfers and inability to adjust the prices of petroleum products commensurate with rise in crude oil prices,” he adds.

Rao, seconding Govil’s point of view, goes on to say, “The concept of fiscal deficit followed in the Indian context varies from the one adopted by the IMF, where disinvestment proceeds and sale of licence fees are below the line and are not considered revenues. In addition, given that the government follows cash accounting, in any given year, it can delay payments or take advance taxes to adjust its fiscal deficit.”

Govil and Rao are not the only people sharing this opinion. “The Budget has successfully adhered to fiscal rules and the fiscal deficit has been contained at 3.9% of GDP in 2015-16 and is budgeted lower at 3.5% in 2016-17,” says Charan Singh, Reserve Bank of India Chair Professor at Indian Institute of Management (IIM), Bangalore. “Similar is the trend in revenue and primary deficit. It is obvious that capital expenditure, investment-oriented, will record lower growth. The increase in receipts is mainly due to non-tax revenue, accounted by one-time spectrum charges,  and dependence on disinvestment,” adds Singh.

Rajan also highlights the increasing expenditure by the states. “At the same time, the central and state governments are taking on additional debt through recapitalisation of banks and large bad loans of state electricity companies. Finally, the recurring increased payments to central civil servants of close to 0.7% of GDP beginning in FY2017 and another 0.7% to state government employees in FY2017/FY2018 would increase the pressure on the fiscal front at a time of slower GDP growth and consequently revenue growth,” he says.

Curb the spendings

Vivek Moorthy, Professor of Economics and Social Sciences at IIM, Bangalore, is very critical about government spending. “While the deficit needs to be controlled, there is something far more important and fundamental — the need to control the very high level of government spending, much of which is wasteful,” says Moorthy.

Moorthy, who was formerly Senior Economist with Federal Reserve goes on to add, “The framing of India’s Fiscal Responsibility Act paid too much attention to the deficit measures, in line with IMF recommendations, and not enough on cutting spending. Empirical studies have shown that the deficit reduction is more likely to be sustainable when it is achieved by cutting spending, not by raising taxes.”

Moorthy is very skeptical about increasing the taxes. “Instead of trying to raise taxes (some of which were rolled back) to match high spending, it is far better to target lower government spending. Taxes, especially indirect taxes, raise the cost of doing business and lower growth,” he says. “Indirect taxes are very high in India although direct (Income) taxes are low compared with developed countries. We are not an undertaxed nation, overall. Oil prices are one of the highest in the world because of high excise duties. If instead we cut spending, and also cut indirect taxes, the lower cost of doing business can over time boost growth and incidentally also ensure that fiscal deficit does not get too high,” he adds.

Rao also highlights the fallacies of raising borrowings through Special Purpose Vehicles (SPVs) to finance the deficit. “More importantly, it can create SPVs and borrow funds which is not counted in the fiscal deficit. Borrowing through SPVs like India Infrastructure Finance Company (IIFC), National Bank for Agriculture and Rural Development (NABARD), and National Highways Authority of India (NHAI) are cases in point.

Given that the household sector’s financial savings is just about 7.7% of GDP, with total government borrowing of the Union and States estimated at 6.5% (3.5% + 3.0%), if additional borrowing through special purpose vehicles is 1%, there is hardly any money available for lending to the private sector,” he says. This will prove to be counter-productive for RBI’s vision of transmition of monetory policy. “Thus, even if the RBI reduces the policy rate, this may not be transmitted in terms of lower lending rates unless the RBI indulges in open market operations which is essentially monetising the deficit,” says Rao.

RBI’s perspective

RBI, on its part, has accredited the fiscal consolidation to the indirect tax collections and non-tax revenues. “Despite a large shortfall vis-à-vis projected disinvestment, the buoyancy in indirect tax collections and non-tax revenues helped in meeting the fiscal deficit target. The combined fiscal deficit at 6.5% of GDP in 2015-16 is Budgeted to have improved in relation to a year ago at 7%,” said RBI in its Monetory Policy Report in April, 2016.

RBI, in its study of Budgets for 2015-16, calls for expenditure reform to improve fiscal consolidation. “In the context of fiscal consolidation, expenditure reform can improve the efficiency of spending even without pruning the level of expenditure by freeing resources to help meet new needs and improve governance and transparency. In this regard, reallocation of total spending in favour of infrastructure and education has a positive impact on long-term growth while a deficit financed increase in public expenditure has negative effects,” it says.

Singh calls for the review on direct and indirect taxes. “There is need for review of direct and indirect taxes, with only about 3.5 crore of income tax payers in the country. The gross tax collection around 10% of GDP is also very low compared with global standards of above 25% in many countries, including advanced and emerging nations. Hopefully, the introduction of GST will help, but that may take some time to be implemented,” he says.

He gives brownie points to the government on not undertaking fiscal reforms on a large scale. “In the present circumstances of an uncertain and volatile economy — domestic and global — probably, the government could not undertake large-scale fiscal reforms though the government has announced a review of working of Fiscal Responsibility and Budget Management Act,” Singh goes on to add.

So is the concept of fiscal consolidation a mirage? Probably, the government needs to rework on its ways to address fiscal deficit. There needs to be more emphasis on the structural reforms rather than the ad-hoc measures. As increasing the taxes might be tough ask for the government, so as Moorthy suggests, the government should rather focus on cutting down the public expenditure.

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