Themes > Features

11.01.2000

Taxes and Deficits : Where are the Real Problems

Ever since Chidambaram's dream-turned-to-nightmare Budget of 1997-98, the Central Government's Budgets have been characterised not only by an unwillingness to raise more taxes, but also by a subsequent inability to reach the levels projected in the Budget in terms of actual tax receipts. Indeed, the failure of revenues to reach the Budget targets has been a significant feature of Yashwant Sinha's Budgets as well. This year promises to be no exception, if current trends are accurate indicators. In the first eight months of the year, tax revenues were well below expectation, and even lower than for the corresponding period in the previous year, which was finally marked by a very substantial shortfall over the whole year. Of course, data just released by the Ministry of Finance do suggest that there has been some increase in tax receipts in December, which would cause the picture to be less gloomy.

Chart 1 shows the picture for various types of tax receipts over April-December 1998 and 1999 respectively. The month of December alone experienced a 28 per cent increase in total tax collections over December 1998, and this has contributed to a very respectable increase of 17 per cent over the entire period April-December 1999 over the same months of the previous year.
 
As Chart 1 shows, this increase has been spread across the various categories. Indirect taxes show the highest rate of increase, but it should be noted, however, that much of the increase in indirect taxes has come about simply because of the rise in international oil prices, which has allowed for higher duty payments at a given ad valorem rate.
 
However, even corporate taxes, which had hitherto been rather flat, have increased by 13 per cent. Predictably, this news has been hailed by official spokespersons as being positive on two levels : first, because it suggests that industrial recovery is now under way; and second, because more revenue intake presumably implies a lower fiscal deficit, which is currently seen as unambiguously good in official circles.
 
But even though the current level of tax receipts represents a substantial improvement over last year's performance over these months, it is still much short of the Budget projections. The latest data available from the office of the Controller General of Accounts, which is the final authority on Indian fiscal information, covers only the period to November 1999. But this suggests that the gap between projected and actual receipts in the current year is still at least as large as it was last year, when a major shortfall was ultimately the result.

Chart 2 displays the revenue receipts of the Central Government over April-November 1999, relative to the Budget estimates. Especially for net tax revenue, in the first eight months of the financial year, receipts were less than half of the Budget expectation. In Chart 3 the per cent of actual receipts to Budget estimates is shown for the period April-November for the current and previous fiscal years. It is clear that even in comparison to a famously "bad" year in terms of failure to meet tax revenue targets, the first eight months of the current year have been no better.

The recovery in December 1999 is likely to make this picture only slightly better overall. This is because December is in any case typically a month in which tax collections pick up, and even in 1998-99 there was an increase especially in this month. This is evident from Chart 4 which shows the monthly pattern of tax collection.

The inability of the government to manage to receive the taxes that it has planned on receiving has to do as much with false expectations as with the political lack of determination to enforce tax payment and punish tax evasion. The Budget estimates themselves were substantially based on assumptions of tax buoyancy which were not justified and have not been realised.
 
One of the more prominent fiscal myths of our time is the idea that lower tax rates necessarily encourage better compliance. It should be obvious that this is so only when the costs of non-compliance are high, or at the very least non-negligible. However, if it is possible to evade taxes on certain portions of income completely with relatively low risk of any penalty, then it is difficult to see how paying taxes even at a lower rate becomes more attractive. And since there have been no really serious and plausible efforts at better enforcement, it is not surprising that tax revenues themselves have not shown the expected buoyancy.
 
But even so, this discrepancy between Budgeted and actual tax outcomes obviously reflects more than mere ineptitude or lack of political will on the part of the government, although these are of course important. Low tax receipts are a typical feature of recessionary economic situations, and it is usually the case when the economy is experiencing a lower level of economic activity than expected, that tax collections will fall below target. In such situations, along with more serious effort at tax compliance, the effort should be to direct policy towards alleviating the recession, so that tax collections similarly can increase.
 
Instead, the government seems to have been far more focused on the problem of containing a fiscal deficit which threatens to balloon because of inadequate revenues generated so far. "Fiscal discipline", such as it is, seems to be entirely confined to certain parts of the Expenditure side of the Budget. Therefore, the government has been much more concerned with reducing its own expenditures, including its more productive ones.
 
One of the remarkable - and more depressing - features of the fiscal experience of the previous year was the extent of shortfall in various types of crucial plan expenditure by the Central Government. The gap between planned and actual spending was especially large in major areas like agriculture and rural development, power, transport and other infrastructure. This pattern seems about to be repeated in the current fiscal year as well.

As shown in Chart 5, there remains a large gap between actual spending so far and the Budget provisions. After two-thirds of the financial year was over, only just over half the budgeted amount had been spent in most areas. The smallest gaps, perhaps predictably, were in interest payments and non-plan revenue expenditure - that is, precisely the areas which are least effective or important from the point of view of growth and development potential.
 
Despite this excessive zeal on the part of the government to curtail its own expenditure, including such expenditure as has a direct bearing on future growth and current welfare of the citizens, the deficits which it is apparently bent on curbing show no signs of being controlled. Chart 6 plots the various deficits already achieved, as well as the Budget projections.

The fiscal deficit had already exceeded 80 per cent of its overall annual target by November 1999, while the revenue deficit had reached 84 per cent of the Budget projection. The starkest discrepancy is evident for the primary deficit (that is, minus interest payments) which was expected to be negative (that is, the primary budgetary account was meant to be in surplus) to the tune of around Rs. 8,000 crore. Instead, it is already in deficit of almost Rs. 15,000 crore.
 
This excess of actual deficits in relation to Budget targets is even higher than for the corresponding period in the previous year, as Chart 7 suggests. The previous year was notable for the extent to which the deficits increased out of all proportion to the Budget estimates, but the data so far indicate that this record may even be exceeded in the current year.

What is even more striking is how the Central Government has chosen to finance these deficits so far. The entire deficit has effectively been financed by market borrowings, which as a result are way in excess of the planned total for the whole of the financial year already. As Chart 8 shows, the extent of market borrowings only in the first eight months of the financial year, at more than Rs. 67,000 crore was much above the projected total for the entire year. Clearly, this is one target that will definitely overshoot, unlike the targets for much needed plan and capital expenditure !

And this particular overshooting, which results on excessive dependence upon market borrowings alone to finance the deficit, in turn has an effect on future government deficits. The current year's experience provides more than enough indication of this. The Budget estimates have already projected interest payments of the central Government to amount to Rs. 88,000 crore over the entire year, that is 31 per cent of total expenditure or 37 per cent of revenue expenditure, which is an extremely high proportion. As the current year's fiscal deficit continues to be financed by market borrowings, it puts further pressure on future interest payments and adds to the unproductive part of government expenditure substantially.
 
We thus have a situation of extreme fiscal mismanagement, in which the inability to generate tax revenues has been accompanied by a curbing of government expenditure in necessary areas, and nevertheless the larger than anticipated fiscal deficit is being financed by expensive market borrowings which will inevitably put great pressure on the public fisc in future.
 
The real question, however, is not how high the deficits will be, but whether the amount of the deficits is all that should concern us. The current obsession only with the extent of the fiscal deficit, which characterises not only the Finance Ministry but also much of the financial press, completely misses the point of why government deficits are seen to be significant or problematic in the first place. For this reason, it also fails to realise that there are conditions under which more government expenditure or larger deficits can actually be positive for economic activity, growth and material living standards, and that these conditions are likely to be met at present. In the accompanying article, we consider this issue in more detail.

Fiscal deficits and economic activity
When faced with domestic economic recession, the standard response of governments for much of the postwar period was to increase expenditure and allow for a more expansionary fiscal stance. The Keynesian reasoning behind such an approach is straightforward enough : when there is unutilised capacity and unemployment in an economy, any increased expenditure creates additional demand in excess of the initial expenditure through multiplier effects, and thereby increases economic activity. This not only reduces or transforms a recession into growth, but also in turn contributes to increased tax revenues, so that the eventual deficit need not be as large as the initial expenditure.
 
The macro-management of capitalist economies based on this premise became increasingly limited not only because of the inflationary barrier which constrained the use of Keynesian-style policies. With the rise of finance in developed capitalist economies, government deficits were seen as inherently negative, either because they were seen as inflationary or because they were seen inevitably to "crowd out" private investment by drawing upon the available pool of savings, raising interest rates, etc.
 
Of course, this supposition too is flawed, implicitly dependent upon the assumption of full employment of resources which is hardly ever justifiable. Nevertheless it has achieved the status of dogma in much mainstream thinking. As a result, the need to restrain the fiscal deficit is seen as axiomatic not only by the IMF but also by governments anxious to attract private capital, and financiers generally.
 
But there are at least two very common situations in which fiscal deficits are not only justifiable but may even be necessary for a desired level of economic activity or a desired pattern of economic growth. The first is when there is unemployment/excess capacity in the economy, or it is undergoing a recession, in which a stimulus is required for economic activity in the manner described above.
 
The second relates to the pattern of the expenditure which constitutes the fiscal deficit. If this is in the area of productive capital expenditure which is necessary for future growth, then clearly any investment which contributes to increased output in future has a positive role. The basic rule of thumb here is that the expected social returns from such investment (not necessarily just the financial returns) should be higher than the prevailing rate of interest.
 
These are such basic and obvious ideas that it is difficult to realise how seldom they are expressed, even in the current Indian conjuncture where both such conditions hold. Thus, despite the presence of substantial unutilised capacity, large stocks of foodgrain currently in the public domain, and falling rates of crucial public investment in infrastructure and other important areas, the most common argument is that the government "does not have the money" to undertake the necessary expenditures. It is even more common to come across the perception that the most important problem in the economy today is the need to contain the fiscal deficit, even at the cost of lower growth and reduced public investment.
 
The consequence of such a view is twofold. First, it restricts the ability of the government to ensure a higher level of economic activity than we are currently witnessing, and to ensure a more definitive recovery from the recession. Second, and perhaps more important, it means that the government does not undertake important expenditures which impact directly on the welfare of most of the people because of the bogey of the large fiscal deficit.
 
The major negative effects of this are felt not only in physical infrastructure such as energy and transport, where private sector activity is simply inadequate for social requirement, but also in health and education which depend critically upon public expenditure. Similarly it prevents the expansion of rural public works programmes and other rural development schemes which could both raise employment generation and improve the availability of rural infrastructure. The important point here is that the obsession with containing the fiscal deficit primarily caters to finance - both domestic and international - which objects to such deficits and more generally to government expenditure. In doing so, it neglects the material interests of the large bulk of people in the country, who are adversely affected by the cuts in expenditure which are self-imposed by the government. The distributional effects of this process cannot be ignored for too long.