In India demands for government spending are much higher than its ability to raise revenue. As a result, public debt has risen steadily. Covid-19 has aggravated the issue, with calls for much higher spending even from hitherto conservative voices.

Central direct taxes peaked at 6 per cent of GDP in 2018-19. The average over the last decade was 5.5 per cent — it rose to 6 then fell. Buoyancy was low partly because growth stagnated. Indirect taxes peaked at 5.6 per cent in 2016-17 and after implementation of GST fell to a low of 4.7 per cent, then rose to in 5 per cent in 2020-21. The 15th Finance Commission (FC) estimates the feasible improvement of tax/GDP ratio is 0.7 percentage points each for the Union and the States by 2025-26. This will still keep the overall tax ratio for India at 21 compared to above 30 for AEs.

In comparison, expenditure of the Centre alone is estimated at 15.6 per cent of GDP in the Budget estimates for 20-21, of which interest payments at 3.6 per cent are the highest component. Subsidies are at 1.5 per cent; education at 0.4 per cent; health at 0.3 per cent. With a nearly $3 trillion economy, however, absolute revenue is quite large at ₹35 lakh crore. But it needs to be carefully spent.

The literature on fiscal federation suggests it is efficient for elastic taxes such as income tax to be collected by the Centre, since migration could reduce States’ tax base.

Stabilisation should also be with the Centre. When the Centre unconditionally bailed out States, they over-borrowed. Macroeconomic outcomes were very poor, for example, periods of hyperinflation in Argentina and Brazil. Therefore limits are required on States ability to borrow. Market discipline also works to improve finances if state risk premiums are allowed to rise with higher debt, which is not the case for India at present.

Redistribution should be shared by the Centre and States. In India Finance Commission awards are constitutionally mandated to ensure uniformity in basic public services through the country.

Past choices

But the choice of building capital intensive industry in the public sector and welfarism at low per capita incomes vitiated government finances. Enterprises made losses and pervasive recurring subsidies for a one billion plus population proved very costly.

As a result expenditure on health, education, physical and social infrastructure was inadequate. This hurt the poor more. India had political but not economic inclusion. Human development indices remained low. Cost shocks that were not passed on in higher prices further reduced the quality of public services. East Asia that was careful to invest in raising productivity and keep food prices stable, as long as the share of agriculture was high, did much better.

Good local public goods such as health and education are one of the most sustainable ways to redistribute. In addition to central transfers these can be financed through user charges and benefit taxation such as on property, but this requires decentralisation to and capacity building in the 3rd Tier. Research shows transfers to States, even after controlling for tax capacity and other variables, reduced tax effort of States. The 15th FC has made some conditional transfers that can improve incentives.

As capital expenditure fell to accommodate higher current transfers and revenue deficits, bottlenecks intensified and pushed up costs of production. First, administered prices and now indirect taxes on oil kept domestic prices much above international, further increasing costs and inflation. Policy tightening to reduce inflation largely reduced output growth, while supply-side aggravations keep inflation high.

In the Covid-19 context demands for higher government spending suggest either higher deficits, financed by borrowing or monetisation, or higher taxes on the rich. Urban employment support could have been higher but only marginally, since there are real limits on borrowing and monetisation. Ability to borrow is constrained since a large share of revenue already goes for interest payments.

High interest rates crowd out private sector activity. Since inflation is still volatile, the income of the poor is not indexed and in an open economy rating downgrades can raise all borrowing costs, monetisation of deficits also has its dangers. Raising direct taxes would weaken the effort to raise private investment and create more jobs. No one wants again the economic stagnation high pre-reform marginal rates of taxation contributed to. Moreover, when government stimulus is required to raise demand, raising taxes has the opposite effect.

Feasible options

The quality and composition of Centre and State spending can be improved by restructuring expenditure towards raising capacity and lowering costs. Direct benefit transfers are reducing leakages.

Since past decisions have left the government with large resources that are poorly monetised, asset monetisation can help transform the expenditure profile to supporting quality public goods and services. This is part of arriving at intelligent combinations of public and private effort that can improve governance as well as delivery. Limits on state capacity have been a major cause of privatisation, but are rarely recognised.

Indirect taxes are regressive. Input taxes raise costs. Therefore, the share of direct taxes has to rise but in a fair way. Better coordination through the GST Council would help. Income tax payers are still disproportionately low, comprising largely of the salaried, but even so the share of households in direct taxes has risen to 75 per cent. Greater international mobility of capital has reduced its contribution to taxes. But the movement to lower base erosion and profit shifting is producing results and should eventually allow taxing of MNC profits where they are earned. Technology and databases can be used to increase the tax base, while keeping rates reasonable, even as tax-payer compliance costs, harassment and litigation are reduced.

Industrial policy that uses taxes/tariffs/subsidies to promote activity must be time-barred and conditional with strict sunset clauses. Local taxes and user charges have to rise as part of empowering the 3rd Tier and will be more acceptable to the extent they are linked to clear benefits.

In an active democracy where multiple interest groups are contesting to increase their share of government spending, while paying less taxes, relatively conservative fiscal policy focused on reducing supply-side costs works better. It allows monetary policy to be growth supportive, even as central bank independence keeps inflation expectations well-anchored.

The writer is Emeritus Professor, IGIDR.