The Budget is always an important time in the Indian economic calendar. It is hard to escape all the attention and hype that surrounds it. Housewives are solicited for their opinions, economists spout wisdom, tax experts spring forth and give nuanced positions, business people ask for tax cuts, the socialists righteously demand higher taxes and commensurately higher spending on subsidies. Politicians, of course, don’t necessarily understand much of what is going on. But sensing a popular cause when they see one, get ready to jump on the bandwagon, depending on their political stripes. Learned experts walk the talk, and cartoonists have a field day, showing the FM as a magician, a common man, or just a conman.
Let’s try to deconstruct the Budget and government finances into more easily understandable concepts. First of all, the size of the Indian Budget is quite large, at $106 billion for FY 04-05. But when viewed from the receipt side, i.e., what the government actually pulls in, the number shrinks to $78 billion. The difference of $28 billion is the deficit the Government of India runs every year. In other words, the government spends roughly 40% more than it generates! It’s quite a large number, but expressed as a percentage of GDP (4.4%) makes it appear much more palatable and almost decent! Other equally surprising statistics — the government borrows roughly the same amount it pays out as interest cost every year, and this is when interest rates have fallen so steeply. Capital expenditure accounts for only a fifth of total expenses: interest, defence and subsidies eat two-thirds of all the government’s income. The total stock of government debt is about 65% of GDP. This explains why our sovereign credit rating is so low, despite our healthy external payments position.
It’s not a pretty picture. And there is not much the FM can really do about it, except tinker at the edges. Fundamentally, India’s tax/GDP ratio is very poor, at about 10%. Every 1% increase here will raise another $5 billion of revenues for the government, and a 5% increase will completely wipe out the fiscal deficit. The average tax/GDP ratio across emerging-markets’ countries is about 20% and that for the OECD countries is 37.5%. So why can’t the government simply raise taxes to international levels and plug the gap?
Taxes can go up through widening the tax net (agriculture and services are obvious examples), by process or structural improvements, or taxing existing payers at higher levels. Raising tax rates does not appear feasible and process improvements will only marginally improve collections and compliance. That leaves only structural improvements, such as implementing Vat, or widening the tax net. Both must be attempted aggressively. There continues to be less and less justification not to tax all those who can afford to pay taxes, regardless of which sector their income originates from. Plus, the services sector, which now accounts for 50% of the economy, contributes only 4% to overall tax collection.
The other way of improving the total receipts of the government and, frankly, the more preferred one, is by quickening the pace of economic growth. For this, sectoral reforms are a must. Not only will a better investment climate lead to higher productivity and, thereby, better utilisation of capital. It will also lead to higher amounts of capital, both domestic and FDI, flowing into various sectors. The latest sector to benefit from a better regulatory environment is aviation. I am sure the same will happen with real estate and retailing, when the rules of the game become a little clearer.
• The government runs a huge Budget deficit of $28 billion every year
• There seems little justification for not taxing those who can pay taxes
If the country can achieve an 8% plus rate of growth consistently, then the fiscal deficit will automatically reduce over time to manageable levels, provided expenditure is held in check. This may be far easier than raising new taxes and would be the most painless way for the government to be able to balance its books in the long run, which is a must if we are not to leave behind a mortgaged future for our children. The message for the government, therefore, is clear — focus on growth and sectoral reforms to get out of this mess.