The path to durable fiscal consolidation is through fiscal empowerment

Extracts from the Reserve Bank of India’s Annual Report, 2000-01:
Fiscal Policy Issues

Fiscal policies announced by the Central and State Governments for 2000-02 have renewed a commitment to stronger fiscal consolidation through expenditure management, revenue augmentation, and restructuring of PSEs. Fiscal stability is crucial for achieving the targets being envisaged for the Tenth Five Year Plan (2002-07). Public sector saving of 4.6 per cent of GDP and reduction of the combined fiscal deficit to 3.3 per cent of GDP during the Plan period are key fiscal indicators consistent with Plan targets. Gross budgetary support for the Plan would need to be raised to 5 per cent of GDP by the terminal year of the Plan. The Plan’s fiscal strategy would envisage reduction in the number of Government employees with all additional requirements met through redeployment and rationalisation. It is obvious that fiscal corrections at the Centre and States are critical to reach the target for growth indicated in the Approach Paper to the Tenth Plan.

The Fiscal Responsibility and Budget Management Bill 2000 proposes the legal and institutional framework for initiating the consolidation. In this context, it is important for fiscal reforms to percolate to the States where the quality rather than the quantity of adjustment is under evaluation.

The path to durable fiscal consolidation is through fiscal empowerment i.e., by expanding the scope and size of revenue flows into the budget. A fiscal strategy based on revenue maximisation would also provide the necessary flexibility to shift the pattern of expenditures and redirect them productively; on the other hand, fiscal adjustments based predominantly on expenditure reduction involve welfare losses and risk the danger of triggering a downturn of overall economic activity. There has been some progress in restructuring the tax system; however, the leakages in the tax base through exemptions continue to pose problems. A major medium-term challenge would be to arrest the declining trend in the tax-GDP ratio—from 16 per cent in the late 1980s to 14 per cent in 1999-2000—and raise to the level of about 18 per cent by the terminal year of the Tenth Plan Period, as suggested by the Planning Commission. Higher tax revenue should be achieved mainly through buoyancy and expansion of the tax base. A central issue remains the co-ordination of central excises (CENVAT) with a State-level VAT, with the objective of structuring a national VAT. In this context, the issue of a State-level VAT that includes inter-State trade assumes critical significance. It is also imperative to introduce comprehensive taxation of services at the central level with appropriate assignment to States and local bodies.

Revenue maximisation covers not only taxes but also non-tax revenues, especially cost recovery in respect of all commercial services directly (i.e., water) or indirectly (i.e., power) in which investments have been made. The non-tax revenue/GDP ratio has stagnated at around 2.5 per cent in the 1990s. Improvement in setting and collection of user charges, extension of user charges to non-merit goods and improvement in cost recoveries are essential to raise the contribution of non-tax revenues and the elimination of the revenue deficit which emerges as the medium term objective. The issue in regard to PSEs is not merely their profit or loss, but also return on investments made by Government to cover the cost of capital after meeting the maintenance cost. Adequacy of returns on investments already made by the Government is the key to fiscal empowerment. This is also needed to overcome overhang issues relating to accumulated burden of expenditure commitments in the power sector, public enterprises, the financial sector and the carrying costs of food stocks. Therefore, the problems associated with ‘flow’ of return would need policy changes and that with ‘overhang’ would need structured solutions spread over a period.
In the area of expenditure management, the Union Budget, 2001-02 has effected some of the recommendations of the Expenditure Reforms Commission relating to financial assistance to states to procure foodgrains for Below Poverty Line (BPL) families, phased programme of complete decontrol of urea by April 1, 2006 and downsizing of staff. In any approach to containment of expenditures, it is necessary to recognise the constraints as well as the consequences. Since a predominant part of the budgets, especially at the State level, is committed in the form of interest, pensions and salaries, there is often a reduction in non-committed expenditure which may actually be essential in nature. It is, therefore, necessary to assess the impact of expenditure containment on the level and quality of delivery of public services. The primary responsibility of Government in terms of providing public goods and essential public services can be discharged effectively when tax as well as non-tax revenues are enhanced, non-merit subsidies are eliminated and tax expenditures are eschewed.

Debt management strategies of the public sector need to consider sustainability of budgetary operations at various levels. In this context, the size of Government borrowings is only one element in public debt management. It is necessary to monitor the behaviour of the components of public debt. In particular, it is important to track the growth in other liabilities. One of the structural weaknesses of the fiscal system is the ballooning of the pension liabilities of the public sector. The Union Budget for 2001-02 noted with concern that pension liabilities have reached unsustainable proportions and constituted a High-Level Expert Group to provide a roadmap for pension reforms. The Eleventh Finance Commission underscored the need for some viable scheme of pension funding. In this context, a new pension scheme based on defined contributions for Central Government employees entering service after October 2001 has been announced. Contingent liabilities arising on account of formal guarantees extended by Central and State Governments need to be considered within strategies to ensure the sustainability of public debt. The quality of financial assets in terms of ownership in PSEs and Government-owned financial entities need to be assessed keeping in view the health of their balance sheets as a whole, since the Government is the owner. In addition, a holistic view of the assets and liabilities as well as incomes and expenditures of the public sector as a whole would add to the quality of fiscal adjustment and the health of public finances.

The growing interest burden in the budget has been a matter of considerable concern. Several options to address the problem are available. Some of these actions are aligning interest rates on small saving instruments with those on similar instruments offered by banks and financial institutions, gradual elimination of tax exemptions on small savings and harmonisation of tax exemptions for all saving instruments, repayment of interest and principal on the Special Deposit Scheme, and issue of callable loans, floating rate bonds and inflation-indexed bonds. An expert committee set up by the Government of India is currently reviewing the system of administered interest rates. The tax exemptions on small saving instruments have been under review. On the repayment of interest and principal on the Special Deposit Scheme, a gradual phasing is the preferred approach. Initiatives have recently been taken to establish an efficient and reliable benchmark rate for the issuance of floating rate bonds through the recent rationalisation of the treasury bill issuance structure.

The prohibition of direct borrowings by the Central Government from the Reserve Bank under the Fiscal Responsibility and Budget Management Bill, except by way of advances to meet temporary cash needs in certain circumstances, is of particular relevance to the flexibility in the conduct of monetary policy consistent with its objectives. The exit of the Reserve Bank from the primary market does not prohibit participation of the Reserve Bank in the secondary market and does not eliminate monetisation; however, the scope for private placement of debt or devolvement of auctions of public debt on the Reserve Bank is eliminated. Thus, the extent of monetisation and terms of such monetisation would depend on the judgement of the Reserve Bank in regard to overall stability. Such operational freedom is essential to assure the system that conduct of monetary policy balances the three relevant elements, viz., the fiscal needs of government, the compulsion of a deregulated interest rate regime and requirements of a more open external sector. In fact, separation of functions of a public debt manager from that of monetary authority needs to be viewed in this context.

The proposals in the Fiscal Responsibility and Budget Management Bill and the policy announcement made in regard to separation of public debt functions from the Reserve Bank should be viewed in this context as medium-term goals. Such separation is no doubt predicated on a manageable level of fiscal deficit and government borrowings. In view of the complex nature of linkages, co-ordination between fiscal and monetary policies should be consistent with the overall macroeconomic objectives. Operating procedures of monetary and fiscal authorities, especially debt and cash management, have to be consistent and mutually reinforcing. Harmonious implementation of policies may require that one policy is not unduly burdening the other for too long and for this purpose, credibility of both monetary and fiscal policies is critical.

The strategy of fiscal empowerment is of special significance for States since the bedrocks of socio-economic welfare, i.e., law and order and social services are in the State sector. There is considerable merit in emphasising the quality aspects of fiscal adjustment in the process of reduction in the fiscal deficit and this means fiscal empowerment rather than fiscal enfeeblement as an appropriate strategy.

As regards the growing interest burden of States, the Group of State Finance Secretaries on Interest Burden of States is discussing draft recommendations which merit consideration. States would need to undertake reduction of fiscal deficits and the elimination of the revenue deficit. Another recommendation is renegotiation of existing loans from the Centre either by restructuring terms of existing loans on the basis of prevailing market rates or by repaying earlier loans through fresh borrowings from the market. With regard to future loans from the Centre, interest rates are sought to be related to weighted average costs of borrowings of the Centre with the minimum spread. The Group also envisaged flexibility in the selection of projects as well as deployment of existing staff in respect of Centrally Sponsored Schemes, issue of securities of different maturities and the development of a liquid and vibrant retail debt market.