Better expenditure management will accelerate growth

Following is the text of the keynote address by the Andhra Pradesh Governor, Dr. C. Rangarajan, at a conference on ``India: Fiscal policies to accelerate economic growth" held in New Delhi on May 21.

PUBLIC FINANCE impacts the economy in many ways. The impact is both direct and indirect. It is felt in the short run as well as in the long run. The level and pattern of expenditures as well as the means through which the resources are raised have a direct effect on the income and expenditure stream and have, therefore, significant effects on the economy.

Fiscal policy can, therefore, be a powerful instrument for accelerating growth. For this to happen, public authorities must utilise efficiently the resources raised and the tax structure must be such as not to cause distortions and inefficiencies in the economy. Growth must go with stability. Stability will require that inflation is low and the balance of payments situation is under control. Ecologists talk of sustainable development as ``development that meets the needs of the present without compromising the ability of the future generations to meet their needs". This is true of fiscal policy as well. What we do today should not impose an undue burden on the future. Inter- generational issues are particularly relevant with respect to borrowing.

Fiscal deficit and its implications

There is no single indicator which can measure adequately the fiscal health of a country. In recent years, fiscal deficit as a proportion of GDP has emerged as a key indicator. Since it is measured as the difference between aggregate disbursements and revenue and non-debt capital receipts, it summarises in a way the total gamut of public finance covering expenditure and revenue. Needless to say, the impact of fiscal deficit will vary depending on the composition of fiscal deficit and the way in which the deficit is financed.

One subset of fiscal deficit is revenue deficit which takes into account only the revenue expenditures and revenue receipts. Borrowing to fill revenue deficit implies that current consumption of the Government is financed by private savings, even though in some cases, revenue expenditures as defined in the budget documents may lead to the creation of assets. Fiscal deficits are being driven more and more by deficits on revenue account. There was a time when revenue deficits were a rare phenomenon in India's public finances. In fact, revenue budgets used to generate some surplus to finance capital expenditures.

The turning point for the Centre came in 1979-80 and for the States taken together in 1986-87. Since then, revenue budgets of governments at both levels have been showing deficits of varying order every year.

In 1990-91, revenue deficit formed less than 50 per cent of the Centre's fiscal deficit. In 1999-2000, the proportion had touched 67.5 per cent. A similar deterioration has occurred in the States. A caveat must be added here.

The argument that borrowing by the Government for the purpose of capital expenditures which create assets causes no harm, loses much of its validity in the Indian context, as the financial return on these assets is nowhere close to the rate of interest paid on the borrowing. This has had the effect of only increasing the revenue deficits in the subsequent periods.

Despite much `sound and fury' made about fiscal deficit, the combined fiscal deficit of the Centre and the States has not shown a decline since 1990-91. There was some reduction in the combined deficit in 1991-92 and 1992-93. Since then it has started rising. The combined fiscal deficit at the end of the decade was the same as at the beginning at around 10 per cent of GDP. The reduction in fiscal deficit at the Centre which has also followed a zig-zag path has been offset by a rise in the fiscal deficit of the States.

The adverse impact of a large fiscal deficit on the economy should not he underestimated. Despite some initial beneficial effects of deficits, many studies have highlighted the vicious cycle that is set in motion because of rising debt, rising interest payments, fall in the growth rate of development expenditures and the consequent impact on growth rate. It has serious balance of payments implications, if the Government dissaving is not adequately matched by private saving to meet investment.

However, this is not an argument for balanced budget or fiscal balance at zero deficit. The attempt should be to maintain the fiscal deficit at a level at which the adverse impact on the system is minimal.

This is in no way inconsistent with Keynesian ideas. However, the original Keynesian framework did not clearly specify how the deficit was to be financed and, therefore, what the impact of the mode of financing would be on the system. The Eleventh Finance Commission has indicated that it will be desirable to stabilise the debt-GDP ratio at 55 per cent. It has also argued that a combined fiscal deficit of 6.5 per cent is sustainable, if the economy grows at a nominal rate of 13 per cent.

Deciding factors

Broadely speaking, there are two factors which are relevant in determining appropriate level of fiscal deficit. First is the private savings of the economy and the second, the ratio of Government revenues to GDP. A higher level of private savings and a higher ratio of Government revenues to GDP can permit higher fiscal deficit, without producing an adverse impact of `crowding out' and keeping the interest payments as a proportion of revenues within limits. That is why inter-country comparisons are difficult to make. It is like comparing the current account deficit as a proportion of GDP without taking into account the size of the external sector in relation to GDP.

However, even in relation to private household savings, what is relevant is private saving in the form of financial assets which is sometimes referred to as `transferable savings'. While gross savings by the household sector in India are reasonably high, with an average of 19 per cent, the transferable savings are only half of that. The household sector savings in financial assets in the Nineties on an average have been around 10 per cent of GDP. Central and State governments' fiscal deficits taken together have been approaching this figure.

Pressures on interest rate are inevitable in such situations, particularly when there is, in addition, a strong corporate demand on private savings. In fact, the most serious impact of rising levels of fiscal deficit and debt-GDP ratio has been the steady increase in interest payments as a proportion of revenue receipts. Continued growth of deficits leads to the preemption of a large proportion of government receipts by interest payments. The balance left may be inadequate for meeting the required expenditures under various heads.

What may be useful in the Indian context is to work towards a fiscal deficit which stabilises the proportion of interest payments to revenue receipts at a reasonable level. The Eleventh Finance Commission had proposed for the Centre a norm of 35 per cent as the desirable proportion of interest payments to revenue receipts as against the existing proportion of 51 per cent.

It is sometimes argued that monetisation of debt will solve some of the problems. While expansion in money supply may help, there is a limit. Monetisation beyond a point can only lead to rising prices which will accentuate fiscal deficit. In a period of rising prices, the gap between revenues and expenditures widens. Expenditures tend to grow at a faster rate than revenues because many components of expenditures such as employees' compensation are closely linked to variations in prices. This is apart from other effects which rising prices will have on the economy.

In the final analysis, the only enduring way of bringing down the nominal interest rate is by keeping the inflation rate low and by breaking inflationary expectations. The impact of alternative ways of meeting fiscal deficits has been analysed by many writers.

We need to go beyond fixing the appropriate level of fiscal deficit. The same level of deficit can be achieved at varying levels of revenue and expenditure. Since certain levels of expenditures will have to be maintained particularly in the social sectors, we need to supplement the norm relating to the fiscal deficit by the desirable ratio of revenue to GDP. The two together, as I had argued earlier, would provide the basis for a sound fiscal system. In fact, the Eleventh Finance Commission in its restructuring proposals has followed this route.

Between 1999-2000 and 2004-05, the ratio of total expenditure as percentage of GDP remains pegged at the level of 27.50 per cent. A shift in the composition of expenditures between revenue and capital is, of course, suggested. The fiscal deficit during this period is to be brought down by 3.34 per cent to reach 6.5 per cent. This automatically implies a rise in the proportion of the revenue receipts by a similar percentage.

The composition of the fiscal deficit also undergoes a change. As revenue receipts go up and revenue expenditures come down, the revenue deficit drops quite substantially by almost 6 per cent. The Fiscal Responsibilities and Budget Management Bill imposes a more onerous restructuring. It envisages as far as the Central Government is concerned the complete elimination of revenue deficit over a five year period.

Expenditure management

Given that the deficit is caused by revenue falling short of expenditure, fiscal consolidation can take place either through revenue enhancement or expenditure management or a combination of the two. To meet the enormous need to step up outlays on infrastructure - both physical and social - as well as on operation and maintenance of existing facilities, total government expenditures as a proportion of GDP at the minimum will have to be maintained at the present level. There is, in fact, a case for this proportion to go up, particularly at the State levels.

Expenditure management must, therefore, focus on changing the composition of expenditures. Over the last several years, the proportion of capital expenditures to the total has shown a sharp decline.

For the Central Government, this proportion has declined from 24 per cent in 1992-93 to 15 per cent in 2000-01. Correspondingly, there has been an increase by 9 per cent in the proportion of revenue expenditures. Even though the classification of expenditures into revenue and capital in the budget documents does not correspond to economists' concept of revenue and capital, these trends do provide an indication of what types of expenditures are increasing.

The Eleventh Finance Commission has projected a reduction in the proportion of revenue expenditures over a five year period by 2.37 per cent with a corresponding increase in the proportion of capital expenditures. Within revenue expenditures, salaries and wages have shown a sharp increase. Several studies by NIPFP indicate that the actual benefits of the subsidies' programmes may be at variance with our implicit understanding of what they should be.

In a poor economy like ours, subsidies are a must. What is, therefore, required is to create a consensus among all on the most essential subsidies and on how to target beneficiaries better. Every rupee of public funds spent must be monitored to evaluate the ``value of money" obtained.

Expenditure management must be strengthened by a greater stress on performance audit. It has to be ensured that the allocated money bas been spent in the most cost-effective manner and that the physical targets have been achieved. We must continually evaluate the performance of the various programmes to find out whether the underlying objectives of the allocation were achieved or not.

Revenue enhancement

The other dimension to fiscal consolidation is revenue enhancement. One of the unhappy experiences of the post-reform period has been a decline of the tax to GDP ratio. A major reversal of this trend is critical for restructuring fiscal policies to accelerate growth with macro-stability.

To some extent, a decline in the tax-GDP ratio was expected in the initial period. There was a substantial reduction in the customs duty rates and this was bound to have a negative impact. The direct taxes have shown a higher buoyancy despite or because of reduction in tax rates. However, the increase in the buoyancy in direct taxes did not compensate for the decline in the growth rate of indirect tax revenues.

The most disturbing element in the performance of indirect taxes has been with respect to the excise duties. The Indian experience of tax reforms in this regard has been in contrast to the general experience of the countries which had introduced tax reforms in the Eighties.

Most of these countries experienced improvement of tax-GDP ratio of two to four percentage points within a few years of introduction of tax reforms. Perhaps one of the reasons for Indian experience differing from others appears to be the Indian tax system retaining most of the exemptions and concessions even after reducing and rationalising the tax structure.

There is little scope for raising tax rates. The tax rates appear to be more or less in line with those of other countries. Thus, the increase in tax revenues has to come from better tax administration, better tax laws and fewer exemptions. Little is known about compliance cost of direct and indirect taxes in India.

The NIPFP is currently conducting a study of compliance cost of direct taxes. Tax laws and administration have to be improved to bring down leakages and cut down on compliance cost.

The current strategy is to increase revenues through the widening of tax base. This has two dimensions. First is to bring in more of the eligible people under the tax net and the second is to bring in more of unreported and underreported income in the purview of taxation. Both these require better tax laws and tax administration.

Indirect taxes do not at the moment cover adequately services. Much of the acceleration in GDP growth during the Nineties is attributed to the expansion of the services sector. The GDP from this sector grew between 1993 and 2001 at an annual rate of 8.2 per cont.

While the share of the services sector in income generation has increased phenomenally, its contribution to tax revenue has been meagre. There has to be a better integration of the services sector with the tax regime, even as the whole system of the commodity taxation is revamped into a value added tax.

A word of caution is necessary here. Taxation of services must be viewed only as a transitional measure. It must eventually lead to an efficient and integrated system of goods and services taxation. Unless brought within the umbrella of VAT, stand-alone taxes on services will result in cascading, especially when the services that are taxed are not of final consumption but are used in business.

There is a clear need for a close scrutiny of the tax exemptions granted by the Centre and the States. The States have made some progress by phasing out sales tax exemptions. Much more remains to be done in the field of income and excise duties.

Non-tax revenues

There is considerable scope for improving non-tax revenues, particularly in the States. The low growth of non-tax revenues is related to the insufficient cost recovery through user charges and is responsible for the rising bill of `implicit' subsidies. Improved quality of service is a prerequisite for any adjustment of charges. Some States have made headway in the area of irrigation charges through the setting up of water users' associations.

While best practices need to be documented and emulated all over the country, there is need for generating support at all levels for improving non-tax revenues in the States for the necessary expansion of various services. Without building such a consensus, the task may become self-defeating.

Accelerating growth with price stability or low inflation and sustainable balance of payments is the need of the hour. Fiscal policies will have to be restructured not only to facilitate, but play a pivotal role in bringing about this acceleration in growth with macro-economic stability. Public spending in areas such as roads, water supply, power, primary education and primary health will need to be stepped up to provide the appropriate physical and social infrastructure necessary for growth of 6 per cent and more.

The problem would have been a simple one, had there been some fiscal space for augmenting such expenditure. This unfortunately is not the case. The challenge lies in finding ways of augmenting such expenditure while reducing the overall fiscal imbalances at the same time. Failure to step up expenditure on the necessary items will dampen the growth momentum of the economy. Failure on the fiscal consolidation front, on the other hand, will entail risks on the inflation and balance of payments front.

The main elements in a programme of fiscal restructuring to accelerate growth with macro-economic stability are: expenditure reprioritisation and better expenditure management, improved tax administration and better tax laws, widening the tax base and reducing reliefs and exemptions and improvements in non-tax revenues.

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