Economy: Ideas for the Budget of the Future

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ABOUT: India is already the seventh biggest economy in the world today when measured by nominal GDP. It is also the fastest-growing major economy. And it is expected to be the world's third-biggest economy by 2050, or perhaps even earlier. But just becoming a big economy is no good if you do not know how to balance your budget. In this column, former deputy chairman of the Planning Commission, Montek Singh Ahluwalia, prescribes what the governments of the future should aim for, in terms of deficit, expenditure and raising of resources.

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Twenty five years is a horizon over which serious structural change is really possible. So here is my wish list for what future Budgets, and Budget processes, should be.

Fix the FRBM Act

India's fiscal deficit (Central and state governments combined) is about seven per cent of GDP, whereas the average of the G-20 emerging market countries was 2.7 per cent of GDP in 2014. The Fiscal Responsibility and Budget Management (FRBM) Act 2003 was meant to bring deficits under control, but it has not worked. The Act became effective in July 2004 and worked well for the first few years when the combined fiscal deficit declined from 8.9 per cent of GDP in 2003/04 to 4.1 per cent in 2007/08. The government resorted to a fiscal stimulus following the global financial crisis of 2008, and this raised the fiscal deficit to 8.4 per cent of GDP in 2008/09. The initial stimulus was, perhaps, justifiable, but it should have been reversed by 2010/11 because the economy had recorded a growth of 8.6 per cent in 2009/10. It was not reversed as it should have been, and we are still way off the target.

The FRBM can work only if Parliament is vigilant about ensuring fiscal discipline. Unfortunately, finance ministers know that they will be applauded for tax cuts and also for announcing increases in expenditure, and what this does to the deficit does not receive the scrutiny it deserves in Parliament. It is noticed only in the business press, if that. The FRBM Act is also deeply flawed because it makes no allowance for flexibility in the fiscal deficit target to respond to short-term considerations. This problem can only be solved by scrapping the present FRBM and introducing a modern legislation. What would a modern FRBM look like? It would have a fully stated rationale for the fiscal deficit trajectory instead of the arbitrary target of three per cent of GDP used thus far, and it would have a built-in mechanism for flexibility in modifying the fiscal deficit.

The rationale for the fiscal deficit target must come from an explicit targeting of the debt to GDP ratio, which is what financial markets worry about when they assess macroeconomic health. At present, India's debt to GDP ratio is about 66 per cent, whereas that of the average of G-20 emerging markets is 42.5 per cent. It would be reasonable to target a reduction in the debt to GDP ratio to say 50 per cent, to be reached by a particular year (say 2020). Since the fiscal deficit in any year is equal to the addition to the total debt at the end of the year, a particular trajectory for the fiscal deficit as a percentage of GDP, with some assumption about the growth of nominal GDP, yields a particular trajectory for the debt to GDP ratio. The Central government should determine a path for the consolidated fiscal deficit which yields the desired consolidated debt to GDP ratio, allocate some part of the consolidated fiscal deficit to the states and take up the residual borrowing for itself as the Centre's fiscal deficit. However, this will help only if there is a mature realisation that high fiscal deficits have damaging effects on the economy.

Turning to the issue of year-to-year flexibility in fiscal targeting, we need to ensure that a temporary fall in the growth rate of nominal GDP, either because real growth has fallen below the structural "potential" or because inflation is temporarily lower, does not force a reduction in the fiscal deficit in absolute terms, simply to meet the target fiscal deficit as a percentage of GDP. The solution lies in defining the target in terms of the "structural deficit", which is calculated on what would have happened if GDP had equalled the potential real GDP, and inflation had been on target. The realised fiscal deficit can then be higher than targeted, as long as the structurally adjusted deficit is on target. This does not mean that repeated shortfalls in growth can justify repeatedly exceeding the fiscal deficit target. If, over time, growth keeps falling short of the originally assumed potential growth rate of GDP, it will be necessary to acknowledge that the growth potential has changed and the fiscal deficit trajectory must then be revised.

This raises the question whether Parliament should just rely on the finance ministry's assessment of underlying trends in structurally adjusted fiscal deficits. The issues are complicated and need expert analysis, but relying on the finance ministry presents an obvious conflict of interest. In the US, for example, the Congressional Budget Office provides independent assessments of the impact of the Budget to the US Congress. Perhaps the CAG should be tasked with doing this analysis at the time of the budget and the mid-year reviews, and presenting a report to Parliament. It would need to set up a special cell with fiscal experts and macroeconomists who can deal with these complex issues and answer questions on these issues.

Level of Expenditure

Many people worried about high fiscal deficits tend to argue that expenditure should be cut. While this may be necessary in an emergency, the correct approach is to determine the level of expenditure that we need and then, given the fiscal deficit that is acceptable, try to raise revenues to cover the expenditure. From this perspective, it is clear that we are not spending enough compared with other countries. India's consolidated government expenditure, as a percentage of GDP, is 26.6 per cent, which is significantly lower than the average of the G-20 emerging market countries which is 31.7 per cent. These countries are of course at much higher levels of GDP per capita; but if we are looking 25 years ahead, we should assume that government expenditure (Centre and states combined) should be at least 4 to 5 percentage points of GDP higher. This is actually a fairly modest estimate since it is widely accepted that we need to spend an additional 2 percentage points each on health and education.

There are many other areas where additional expenditure is needed which can only be accommodated if some expenditure items are cut. Obvious candidates for pruning in the Centre's Budget are subsidies on fertilisers which should be converted into a cash subsidy per acre of land cultivated, as has recently been done in Sri Lanka. The JAM platform enables this to be done.

Mobilising Tax Revenue

If expenditures have to increase by four to five percentage points of GDP and the fiscal deficit must also fall by around three percentage points, then revenues as percentage of GDP must increase by around seven to eight percentage points of GDP. Contrary to the widespread impression among business circles that India is over-taxed, the fact is that India's consolidated revenues are less than 20 per cent of GDP, whereas the average of G-20 emerging market countries is 29 per cent! These countries have much more substantial social security expenditures which are financed by contributions which form part of government revenues. There are pressures in India to increase social security payments and these are objectively justifiable, but they can only be sustained if additional revenues are generated.

If the additional revenue target is set at seven to eight per cent of GDP it can be divided into an additional five per cent of GDP for the Centre and two to three per cent for the states. This implies that the Centre's budget-making must move decisively to mobilise tax revenues and other revenues to this extent over the next five years. What does this imply for tax administration?

First, we must acknowledge that revenues from customs duties should be expected to shrink. This is because our customs duty rates are higher than those in other developing countries and in a globalising and increasingly integrated world, it does not make sense to have duty levels much above those of other countries. Besides, we are signatories to the ASEAN Free Trade Area, (and are negotiating with RCEP) and under the ASEAN agreement, duties on a wide range of imports from these countries will be gradually reduced over the next few years. It makes no sense to grant low or zero duty access to imports from these countries, while maintaining high levels of tariffs for other countries. Any feared loss of competitiveness for our domestic manufacturers is much better corrected by having an appropriate exchange rate. The Real Effective Exchange Rate of the rupee, according to the RBI's index, shows a significant appreciation in real terms which perhaps needs to be corrected.

The fall in customs revenues should not cause concern because customs should not be seen as a source of revenue, but as a means of preventing contraband and illegal imports. The revenue loss can be offset by a strong domestic indirect tax system. The GST is the key element in this context. There is a broad political consensus that a sound GST will help boost revenues by countering leakages and also increase efficiency and thereby raise growth. There are political differences that are as yet unresolved, but hopefully these will be resolved soon and the GST will be put in place.

There are many ideas in the world of direct taxes that should find their way into future budgets. As far as Corporation Tax is concerned, it has already been announced that the rate of corporate tax will be gradually reduced from 30 to 25 per cent with an elimination of exemptions. This is desirable and it will bring our corporation tax rates closer to international levels, but they will still be above the average. In the area of personal income tax, the main thing to worry about is that the level of income after which tax begins to be charged is too high. It is almost three times the per capita GDP, whereas the same multiple is lower in most other countries. It is probably not practical to lower the existing limit, but it would be desirable to fix a level in relation to per capita GDP and then freeze the present level for zero taxation until the rising per capita GDP brings it to the declared level as a multiple of per capita GDP. Thereafter, the level can be adjusted upward periodically.

Modernising Tax Administration

The present structure of the Revenue Department, with two separate Boards one for indirect taxes and another for direct taxes, is completely out of line with international practice. It is based on the old British practice which was given up in the UK some years go. Some future Finance Minister should give thought to the need to integrate the two Boards into one. There are many synergies in revenue administration that would emerge if this were done. There will be resistance from the existing cadres because of the usual turf issues, but this can be overcome with sufficient advance planning. The integrated Board should be chaired by a revenue service officer as principal secretary, reporting directly to the finance minister. The present system where an IAS Officer heads the Revenue department should be abandoned. Given the specialised nature of Revenue administration, it is difficult to believe that a generalist from the IAS, acting as an interface with the Minister, can add value.

The integration of revenue administration into a single Board should be accompanied by the creation of a strong tax policy and a unit outside the Board, but within the finance ministry, responsible for tax issues. Tax policy is a finance ministry function, but it should not be dominated, as it is today, by the tax collection machinery. The tax policy unit should be well-staffed with revenue service officers and other specialists such as economists, lawyers, chartered accountants, etc. The unit should include a representative of the Chief Economic Adviser in the finance ministry. In the UK, this unit also has sociologists and psychologists advising on how tax issues will be perceived and how they should be sold to the public. The revenue administration should of course have the right to propose changes in tax policy, but their proposals should be considered by the tax policy unit which should make recommendations to the finance minister."

An important change which is overdue would be to abandon the present system of Budget secrecy. It serves no purpose other than blocking serious discussion of complex issues before the budget for fear of violating budget secrecy. There would need to be an understanding with Parliament that the abandonment of budget secrecy would not be a breach of Parliamentary privilege.

Abandon Separate Rail Budget

The practice of presenting a separate Railway Budget is an anachronism that should be got rid of. Ideally, the Railways should be made into a separate public sector corporation and operate with the flexibility which this involves instead of as a department of government which is the case at present. Railway workers and their unions need to be persuaded that they will not lose in any way. If necessary, all existing workers may be given the option of continuing as government servants until they retire. China took this step a few years ago and even abolished the erstwhile ministry of railways. We need not go that far, as the railway minister needs to be the interface with Parliament answering Parliament questions on Railway performance, but converting Indian Railways into a public sector corporation would give the Railways much more freedom.

Finally, I hope that in the years to come, the Budget will not be seen as the principal vehicle for announcing reforms as it has become. Reforms should be an ongoing process with public discussion on how to proceed in different areas, through the year. The Budget should focus much more on the macro-economic health of the economy, and the establishment of a tax system that embodies global best practice. ~