Fiscal Correction

Introduction'Fiscal correction', defined as the reduction of the fiscal deficit with respect to GDP, has now become the sine qua
non of any stabilization program. In the context of macroeconomic stabilization in India too, the fiscal deficit has become an important variable and policy target. Reduction of the relative size of the FD is now a basic policy objective, and increases in this indicator are viewed with serious concern. Concept of Defict-In bringing about fiscal adjustment or, in other words, restoring fiscal balance, three types of deficit need to be considered. [Chelliah (1996)] The first is the fiscal deficit, which is the best available summary indicator of the macroeconomic impact of the budget. The FD, defined to mean the excess of government expenditure over current revenues, is synonymous with net borrowing by the government. It is necessary to monitor and regulate the FD because it impacts immediately upon domestic demand and the BoP. Excessive Government borrowing crowds out private investment and if government borrowing is used to finance current expenditures, there will be displacement of capital formation in the economy, resulting in Iower rates of growth. Even if private investment is crowded out by public investment (rather than consumption), there is a loss in terms of growth, if, as is often the case, private investment is more productive than public investment. Further, borrowing by the government adds to public debt, and an increasing debt GDP ratio is known to have harmful macroeconomic consequences. The second concept of deficit is the revenue deficit, which is the difference between revenue expenditure and revenue receipts. This deficit is measured to ascertain whether the recurrent expenditures of the government on account of public consumption and current transfers are fully met out of current revenues. Of course, some lumpy types of expenditure and the part of current expenditure that might lead to future benefits (such as that on health and education) could be met out of borrowings. However, current expenditures should largely be met out of current receipts. Ignoring this concept could lead to serious consequences, as is evidenced by the present condition of government finances in India. At the Central Government level, a dangerously large proportion (approximately 48%) of government's net borrowing is now used to finance the revenue deficit. The third type of deficit that is important from the policy point of view is the monetized deficit, viz. RBI credit to the Government. This concept indicates the quantum of additional money created as a consequence of credit extended to the Government. The proportion of the FD financed by net RBI credit rose from less than 16% in the early 1970s to nearly 33% during the latter half of the1980s. For many years it was believed that it was only this concept of deficit that had serious policy consequences since it represented an addition to money supply, seen as the prime cause of inflation. Yet, all three concepts of deficit are important in their own way. To avoid inflationary pressures the monetized deficit of the Center should be kept within control. With a reduction of the revenue deficit, the growth of net interest payments will be cut, making way for the growth of other developmental expenditures. The significance of regulating the fiscal deficit has been discussed earlier. To reiterate very briefly, government borrowing tends to crowd out private investment (by 1991, the government was absorbing around 81% of household savings), it adds to public debt, which in turn adds to future current expenditures and deficits, and, if The borrowing is used for non-productive purposes, capital formation suffers, leading to lower rates of growth, both present and future. Rising fiscal deficits in India have been the outcome of poor performance and indiscipline on both fronts, revenue and expenditure. To borrow a Malthusian analogy, taxes have grown in arithmetic progression, while expenditures have grown in geometric-progression, a surefire recipe for disaster! In terms of both rates and overall tax take, India is a relatively high-tax country given her per capita income level. So although the tax base should undoubtedly be increased, fiscal adjustment should come mainly from expenditure and non-tax revenue. Trends in Public Expenditure:There have been 4 distinct phases in real public expenditure (PE) since the 1970s. [Mundle & Rao (1997)]a) Phase 1 (mid 1970s-1981): During this first phase, real PE was growing at about 7% p.a. Both current and capital expenditure were growing at about the same rate and they were growing faster than revenues. Yet borrowing was modest, and the size of the FD was non?threatening, at about 5% of GDP.b) Phase 2 (1981 - 86): The annual rate of growth of PE rose to about 10%; current expenditure was increasing at about 11% while capital expenditure continued to grow at 7%. Current expenditure also rose faster than current revenues so that the government was now borrowing to finance both revenue and capital expenditures. The FD rose to an uncomfortable 9% of GDP. c) Phase 3 (1987 - 90): saw some attempt to rein in PE. Unfortunately, the brunt of this reduction was borne exclusively by

capital expenditure. Revenue expenditure continued to grow at about 10%, while overall growth of PE was 8%. A new aspect of the increase in revenue expenditure was the burgeoning interest payments. Past transgressions in terms of high revenue expenditure growth in the second phase began to impact severely upon the entire budgetary process. The growth of capital expenditure was now less than 1% in real terms and public investment in social infrastructure began to stagnate. Almost half of fresh borrowing was used to finance current expenditure and the country was in a fiscal mess. d) Phase 4 (post 1991): At the behest of international lending steps were initiated to control the FD. Again the sacrificial lamb was Capital expenditure. For a substantial part of the 1990s, growth of capital expenditures was actually negative, while the growth of revenue expenditure continued almost unabated. There was also a sharp drop in Central, transfers to State governments especially on the capital side of the budget. FD was cut to about 7% of GDP but was back to 9% by 1993-94. The burden of debt has assumed gigantic proportions. Interest payments increased from 4.31% of GDP in 1991 - 92 to 4.68% in 1997-98. Currently interest payments appropriate a share of the GDP that is larger than that of the defence expenditure of the Government! Features of PE in recent timesIt is clear from the above discussion that current expenditures are spiraling out of control. This is despite awareness of the urgency of the need to control the deficit. Why is this? Some possible explanations are listed below. [Goyal (1999)]The huge workforce in the public sector is often blamed for deteriorating government finances. Public employment and wages rose rapidly over the 1980s and undoubtedly there is tremendous overstaffing in public sector, with wages and salaries constituting a large proportion of GDP. Yet, evidence suggests that this accusation may be too harsh for the 1990s. Although the compensation of employees has risen in absolute terms, the ratio of employee compensation to GDP has actually fallen through this decade. Thus, contrary to popular belief, public sector employees as an interest group have not been powerful enough to protect their share in GDP after initiation of the stabilization process. Arresting further growth of the Wage bill will require pay restraint and mainly, a freeze on new employment. A rough calculation by Joshi (1998) shows the potential saving in this regard to be around 0.6% of GDP even without direct retrenchment.Two important reasons for the ballooning of revenue expenditures are - the growth in interest payments and the uncontrolled expansion of subsidies.Interest on public debt as a ratio of GDP has grown continuously, but the increase has been more pronounced and relentless since the 1980s. The rise accelerated in the 1990s, following the freeing of interest rates.In respect of the second item, viz. subsidies, the Ministry of Finance has estimated the total non-merit subsidies of Central and State government to be a mind-boggling 9.86% of GDP for 1994 - 95. This is more than the combined FDs of the Central and State governments! Combined subsidies are estimated to be almost 15% of GDP. Some Important Consequences of the Growth in Revenue ExpendituresThe unchecked growth of the revenue element of PF has had some very deleterious effects on the Indian economy.It has led to a drop in the rate of capital expenditure. Current expenditure affects immediately, and is an obvious way, the levels of living of some groups, and cuts in such expenditure are thus likely to be resisted by those who are powerful enough to do so. On the other hand, the effects of capital spending are long drawn out and are felt more in the future than in the present. Essentially future generations are easily bypassed, since they have no "voice". It is for this reason that fiscal 'correction' is often accompanied by a disproportionate reduction of capital as opposed to current expenditures on government account. This is a very serious consequence, as there are large parts of social infrastructure that can only be publicly financed. This would include rural and many urban roads, irrigation and power projects, and investment in human capital.Another outcome has been a high interest rate regime where increased government borrowings have tended to push up interest rates (particularly long-term ones) and fuel inflationary expectations, a factor that has undoubtedly contributed to industrial stagnation.The rate of growth of Central government transfers to State government has also seen a decline. So just at the time when the need for such transfers is greatest, and when the need for fiscal decentralization is felt most strongly, the amount of resources that can actually be transferred is dwindling.The feedback effects of high deficits into high interest rates, vvhich then lead to higher costs of deficit financing and then still higher deficits, are well known.There is another important consequence of high deficits and borrowing. As government borrowings rise to very high levels, the climate for the conduct of monetary policy worsens. Firstly, Part of the deficit may be monetized. This then leads to erosion of the independence of monetary policy from fiscal policy. Second, as mentioned above, the higher interest rates fuel higher inflation rates. It then becomes a struggle to maintain the value of the real interest rate as well as the real exchange rate.It appears that the current budgetary stance of the government is non-sustainable. If a concerted effort is not made to bring current expenditures in line with current revenues, the Government's path to bankruptcy will be hastened, by higher interest rates, slow industrial growth and growing fiscal stress at both levels of government.

Causes of Fiscal deteriorationThe fiscal distress that the country is experiencing today is the outcome of several factors acting simultaneously. While some of the ultimate causes are exogenous and beyond the control of the government (e.g. oil price shocks of the 1970s, Gulf War of 1991, etc.), It is the manner in which the government chose to respond to these exogenous factors that are the proximate and immediate cause of the fiscal crises. Let us examine these contributory factors in greater detail.First, Political compulsions seem to have contributed significantly to the growing revenue deficits in the budgets of both Central and State governments. In a heterogeneous democracy like ours, budgetary actions are the result of pressures exerted by vested interests and the desire of the political class to nurture their constituencies and 'vote banks'. Government budgetary considerations are susceptible to lobbying by special interest groups, which have always been able to wring concessions and benefits out of governments. Budgetary outcomes are thus seriously influenced by the reality of political economy. Secondly, it seems that governments in the past have failed to adjust prices whenever they have faced a supply shock such a drought or an oil shock (both of which were features of the 1970s). This may have been motivated by a desire to shield "poor voters" from higher prices. The prices of a large variety of public goods and services were thus fixed over the years, leading to a lowering of quality and investment in the production of these goods. This further reduced the capacity of the State to tax, invest and provide services. The truth of this claim can be seen in the case of electricity, telephone services, railways, irrigation, education, etc. To take only one example, Irrigation - the subsidy for canal irrigation is almost 100%. At the same time the cost of providing water through public canals has risen steeply and quality of supply has fallen. Farmers are willing to pay higher rates for irrigation that is more flexible adapted to their needs; they have shown this by switching to tube well irrigation, even though they have to pay for the latter. Theproliferation of private tube wells (that run on subsidized electricity) has had negative externalities as well, such as lowering of the groundwater table. Total consumption of groundwater resources has risen from 4 million hectare-meter (MHM) in 1970 to 54 MHM in 1998. It is expected to exceed the recharge level of 67 MHM by 2005.These examples can be repeated ad nauseam. What they demonstrate is the picture of prices held constant in the face of cost surges; attempts at cross-subsidization that have proved unsuccessful in the long run; and budgetary losses combined with falling investment and quality. Deterioration in the quality of services has been the result of, and also contributed to, the fiscal problem.Thirdly, the cost shocks of the 1970s triggered off a cumulative decline in government finances. The uninterrupted and rapid growth of public debt in India since the late 1970s is a manifestation of this decline. The rise in interest payments from this period also bears testimony to the fact of increased government borrowing in this decade. By 1990?91, the internal debt of the Government of India stood at 50.2% of GDP, and for the Center and State governments taken together, the figure was a horrifying 67.4%.The fiscal crisis and the attendant exponential growth of public debt has arisen, not merely because revenue expenditure has been running ahead of revenue receipts, but also because capital expenditures financed by borrowings have not yielded adequate returns.Fourth, rising current expenditures per se do not pose much of a problem, provided they can be financed out of current revenues. But the government was the inability to raise taxes, partly because of the state of the Indian economy, and partly as a result of political compulsions. Fiscal deterioration can thus be attributed to The political economy of India's public finances. 1. 2. 3. The widespread fall in the quality of services, Rise in borrowing after the period of major cost shocks, and The inability to raise taxes.

Policy SuggestionsWhat can be done to correct the situation? Since we have identified interest payments and subsidies as two of the major causes of the intolerable situation in respect of current expenditures, let us see what can be done to reverse the situation.A. Interest payments: Interest payments have been growing rapidly, both as a result of rising debt and also because of rising interest rates consequent upon financial liberalization. Interest payments are a committed expenditure, in respect of which the government enjoys no discretion. Thus the only way by which these expenditures can be controlled is by retiring existing debt and curbing the growth of new debt. Assuming there are limits on the latter due to the difficulty of reducing primary deficits, the only way out is to retire existing debt as quick as possible. This can be achieved by the sale of land and Public Sector Undertakings. One of the criticisms of the disinvestment program has been that capital proceeds (from the sale of shares of PSUs) are being used to finance current expenditures. If the disinvestment proceeds are used to retire government

liabilities then this criticism ceases to be valid. Joshi (1999) has estimated that a well-structured privatization programme could contribute fiscal savings of about 1.5% of GDP. B. Subsidies: In 1997, the Ministry of Finance placed a discussion paper on subsidies before Parliament based on a detailed study conducted by the NIPFP. The paper detailed three categories of goods and services where the government was providing either explicit or implicit subsidies. Public goods like defence, law and order, etc. are not amenable to the pricing mechanism and the expenditure incurred on them must necessarily be met out of tax revenues. Merit goodsinclude primary education, public health, sewage and sanitation, soil conservation, flood control and drainage, many social welfare schemes, roads and bridges, and agricultural and scientific research. The economic case for subsidizing merit goods is very strong, given the large social benefits arising out of their provision. All other goods and services that are subsidized by the Government have been termed as non-merit goods and services. For e.g, food, fertilizer and non?elementary education. In case of the first two, the element of externality is extremely limited. In such case, subsidies may have to be on grounds other than strong externality, viz. social and equity objectives.In the white paper, an estimate of the aggregate budget-based subsidies in India for 1994-95 revealed thatTotal subsidies stood at 14.40% of GDP, with merit subsidies at 3.69% and non-merit subsidies at 10.71% of GDP.Merit subsidies of both Centre and States amount to Rs. 35.193 crore - the Centre accounting for 19% and the State 81%.

Net Non-merit subsidies on the other hand, aggregated Rs.93,993 crore - the share of the Centre being 33.5% and that of the States 66.5%.At the Government of India level, economic services (industry, transport, etc) account for almost 93% of total subsidies, while at the State level economic services, (e.g. irrigation and power) claim 61% of the total subsidies.At the Central level, the recovery rate for economic services is a mere 11.7% of the cost, and for social services it is 18.1%. At the State level, the corresponding recovery rates are 12.9% and 4%.The recovery rate in case of the center was 12.1% for non-merit goods and services, while for the States the corresponding figure was 9.3%. At the aggregate level, the-recovery rate was 10.3%.

As mentioned above, another classification of subsidies is into explicit and implicit or hidden subsidies. Explicit subsidies are those where there is a direct expenditure or transfer by the government. In the case of implicit subsidies, the good or service is provided to the public and some part of the cost is recovered by way of fees, charges, etc. Explicit subsidies: Export subsidies were abolished when the rupee was devalued in 1991. The most important explicit subsidies that remain are food and fertilizer subsidies amounting to 0.5% and 0.6% of GDP respectively in 1995-96. The theoretical justification for food subsidy is poverty relief, but these subsidies are notoriously badly targeted; most of them go to the not-sopoor. It is also well known that a substantial part of the subsidy goes to covering the cost of the grossly subsidy bill to say 0.3% of GDP, without hurting the poor. Fertilizer subsidies also reach the very poor to a negligible extent. They are partly subsidies to the inefficient parts of the industry and partly to farmers. If the subsidy were abolished overnight, half the industry would probably collapse. But that is no excuse for not reducing the subsidy by restructuring the industry and closing down high-cost units in a phased manner. Implicit or Hidden Subsidies: Explicit subsidies are only the tip of the iceberg. The combined Central and State Government subsidies on economic services alone amount to about 7% of GDP. Aligning charges with costs would obviously yield substantial fiscal savings and would also lead to more rational use of inputs such as water and electricity and help to correct the massive under-investment in these sectors. Nor would it hurt the poor, since they do not, by and large, benefit from these hidden subsidies.There are many Frequently Asked Questions in respect of subsidies. Some of these are discussed below. Are subsidies in India provided for the right reasons? Subsidies can be justified when there are significant positive externalities in the public provision of non-public goods (for e.g. elementary education), or if there is a significant distributive objective to be achieved. For e.g. it is to serve a distributional objective that food subsidies are advocated for BPL families. Similarly subsidizing kerosene or LPG helps poor households, subsidizing irrigation and fertilizers helps poor farmers, and so on. In India, however, in all these cases, subsidies have historically been extended to all households or farmers, rich and poor alike and the distributional objective has rarely been served. There is also a lot of self-serving subsidization: subsidized travel for railway and road transport employees, subsidized loans and housing for government and bank employees, There is no valid justification for such subsidies.

Are many wrong goods / services being subsidized? There is a long list of goods and services where continued subsidization is not warranted. For e.g. subsidies for fertilizers, for specific crops such as oilseeds and, pulses, for transport, chemicals, etc. cannot be justified. All these are a matter of purely private benefits where public payment is unjustified. Can subsidies be harmful?Some subsidies have the potential to damage the environment. For example over-subsidization of irrigation has led to careless use of water resulting in long-term destruction of soil fertility. Excessive subsidization of chemical fertilizers has led to their overuse and long-term destruction of soil fertility. Excessive subsidization of chemical fertilizers has led to their overuse and long-term destruction of soil fertility. Given that subsidies stand at nearly 15% of GDP and that few of them can be justified on economic or even equity grounds, one sure way of reducing fiscal stress In India is to target reduction of non-merit subsidies. In addition to the overall level of subsidies being reduced, the entire subsidy structure needs to be made more transparent, subsidies must be periodically reviewed and it should be made clear that subsidies are not meant to be permanent. Conclusion India has now reached a turning point in her economic history. Towards the middle of the twentieth century, many newly independent developing economies across the world opted for the State-dominated 'mixed economy' model pioneered by India. The State was supposed to compensate for various form of market failure under this institutional arrangement. In reality, markets were often suppressed or supplanted even in those spheres where they could have performed reasonably well. By the early 1970s it had become clear that the 'mixed economy' entailed a huge cost in terms of efficiency without much gain in terms of equity. It neither promoted growth nor eliminated poverty. With spreading disillusionment, several developing countries undertook market-oriented reforms, often triggered by external aid conditionally in rescue packages. In July 1991 India launched a major reform programme under similar crisis conditions. The programme has now been under way for a decade, its pace dampened by the pulls and pressures of electoral politics. A major component of the programme is comprehensive fiscal reform, including deficit reduction, expenditure control, tax reform and inter-governmental fiscal relations. The issue of deficit reduction begs the question of which deficit is to be reduced. While all reforms aim at the reduction of the Gross Fiscal Deficit, reduction of the Revenue deficit is equally relevant. This calls for a concerted attempt to raise direct tax collections while at the same time curbing current expenditures. The situation demands a judicious mix of expenditurereduction and expenditure-switching policies. Interest payments, which have reached alarming proportions, can be curtailed by retiring public debt as early as possible. The disinvestment proceeds of the government can be fruitfully used for this purpose. Subsidies, the other major component of current expenditures, can be reduced and better targeted, which will then help serve the objective of distributive justice. Subsidy programmes should be target-oriented, location and person-specific and should in no case be global in character. Untargeted subsidies are known to be costly. Wasteful and inefficient. A suitable tax - user charge- expenditure policy mix can generate potential extra public savings, which will leave room for muchneeded increases in public investment in agriculture, infrastructure and human resource development and in redundancy and poverty-related programmes, without which the reform are doomed. I would like to end with a small anecdote. In the 1930s, before Keynes wrote The General Theory, he was arguing strongly for public works programs and deficits as a way to get the British economy out of the Depression. After arriving at his new theory, however, he spent little time advocating fiscal policy, and in fact, never mentions fiscal policy in his magnum opus - The General Theory.When one of his followers, Abba Lerner. propagated fiscal policy at a seminar that Keynes attended, Keynes objected vociferously, leading Evsey Domar, another Keynesian, to whisper to a friend, "Keynes should read The General Theory". Why did Keynes oppose the policy implications of his work?Because he was also a student of politics and he recognized that economic theory can sometimes lead to politically unacceptable or more seriously, politically dangerous policies. In a letter to a friend he later said that Lerner was right in his logic, but he hoped the opposition did not realize what Lerner was saying. Keynes was more than an economist. He was a politician as well. [Colander (1994)]