A Practical Approach To Fiscal Management

Written by S Narayan | Updated: Aug 18 2004, 05:30am hrs
After the Kelkar committee report on the implementation of the Fiscal Responsibility and Budget Management Act 2003, theres been considerable debate on its recommendations. The FRBM Act itself is a watered down edition of the one originally envisaged in 2000. Much drafting wisdom led to the presentation of a modified version to a parliamentary committee, and the diluted version, which emerged, is now the Act. Notwithstanding the dilution, its an important legislation for disciplining the deficit, and subjecting slippages and failures to judicial scrutiny.

Trends in the revenue deficit indicate a steady growth for over 20 years, which was arrested only after 2001. Decline in the revenue deficit has been steeper at the Centre than in the states. The fiscal deficit has been a feature of the economy from the 1980s but grew steeply after the fifth pay commission was implemented. The tax-GDP ratio is among the lowest of over 51 countries compared in the report. Finally, the contribution of the manufacturing sector is declining with non-petroleum excise revenues as a percentage of manufacturing GDP declining sharply. The problems in the states, the structure of the economy and the need to augment revenues, are all part of the concerns.

The reports recommendations have to be seen in the context of certain mandatory requirements of the Act that a medium-term fiscal planning process has to be set in place by the government; there has to be a fiscal strategy paper laid in Parliament along with other budget documents and the like. Rules under the Act require that revenue deficit comes down by 0.5 percentage points of GDP every year, and that the fiscal deficit in 2008-2009 must be lower than 3% of GDP.

In this years budget there is very little strategy in the strategy paper and planning more wishful than about implementation. Its interesting that there are two specific targets for the end of the second quarter that fiscal deficit should not exceed 45% of the budgeted figure and that revenue deficit should not exceed 40%. The documents say that corrective measures will have to be put in place if these targets are not reached. This puts a major responsibility on fiscal managers.

FRBM requires the revenue deficit be annually reduced by 0.5 points of GDP
Fiscal managers have a major responsibility for meeting end Q2 targets
Given the CMP, expenditures projected are unrealistically low
An important cornerstone of the report is the goods and services tax, under which the VAT principle would be comprehensively used to tax all goods and services in the economy. This requires the Centre and the states to come together on a common list of exemptions, threshold limits, treatment of imports and exports, and a clearing house mechanism to handle inter-state transaction credits and debits. We need this. It must be put in place.

But its important to recognise the difficulties which need to be overcome to carry this forward. First, a political consensus is required where states would carefully weigh their political constituencies. Second, the imbalance between goods and services exporting states, which are also exporting taxes like the central sales tax, and those like the north east, which are importing them. The issue of compensation for losses is yet unresolved in the state VAT discussions. Third, the methods, collection and accounting of service tax, particularly in areas where credit for earlier transactions will be very difficult. Finally, the administrative machinery for this will have to be very different from the one currently in use for central excise and for sales tax collections. In view of these difficulties, a step-by-step approach, which tackles the state VAT, integrates central excise with service tax and looks at integration of all these some years down the line, is more practicable.

The other major recommendations relate to income tax and fall into three boxes: Removal of deductions in resp-ect of personal income tax, removal of concessions to certain categories of economic activities, and achieving neutrality of the tax system to the form of organisation. Its clear from the media debate that there would be no consensus on the elements of these recommendations. Of these, the last premise, that the choice of organisational structure adopted by decisionmakers should be driven by efficiency and not tax considerations should be tackled first.

Irrespective of structure, all organisational entities should have a similar tax regime, with similar deductions and exemptions. Its interesting that even though corporate taxation is at 35% plus surcharge, actual realisation is only around 19% due to various deductions enjoyed. It makes sense to reduce the tax rates to, say 25%, while simultaneously removing all exemptions. Of the other recommendations, the ones relating to personal income could perhaps be pushed forward step-by-step.

The major lacunae are in the projections. A growth of 22% in tax revenues year on year is envisaged and expenditure projected unrealistically low, given the CMP. The twelfth finance commission is to recommend tax devolution to the states, and using these figures will not only be unrealistic, but also unrealisable. The gap between the devolution expected by finance commissions and those realised is growing and is affecting state finances. Last year was a great year for tax collections, but the gap between the devolution anticipated by the eleventh finance commission and the actual was close to Rs 40,000 crore. It is quite surprising that such estimates form the core of the measures to tackle fiscal deficit.

The tasks are immense, but the direction is the same, as can be seen from another report: Weak fiscal balance has been the major source of macroeconomic difficulties in the not too distant past. After extensive efforts through the reforms of the tax system and tax administration we have attained fiscal stability. Fiscal deficit, which was nearly 7% of GDP in the nineties, has declined to 3.3% in the current year. Revenue deficit has narrowed from 3% of GDP in the nineties to 0.2% and the primary balance has remained surplus for the last many years. The country is Pakistan.

The author is a former finance secretary and economic advisor to the PM