48806301 impact of fiscal policy on indian economy

7/29/2019 48806301 Impact of Fiscal Policy on Indian Economy

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LOVELY PROFESSIONAL UNIVERSITY

Term Paper

School of Business Department of Management

Name of the Student: Azhar Shokin Regd. No.: - 11000968

Course Code: MGT511 Course Title: Business Environment

Course Instructor: Vishwas Chakranarayan Course Tutor: Vishwas Chakranaraya n

Class: MBA Semester: 1st

Section: S1001 Batch 2010-12

Students Signature

Azhar Shokin

Topic: - Impact of Fiscal Policy on Indian Economy


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Contents

IntroductionLiterature ReviewResearchArticleAnalysisData andMethodology

Main FindingsConclusionRecommendationsReferences


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Impact of Fiscal Policy on Indian Economy

Introduction

In economics, fiscal policy is the use of government expenditure and revenue collection to

influence the economy.

Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary

policy, which attempts to stabilize the economy by controlling interest rates and the money

supply. The two main instruments of fiscal policy are government expenditure and taxation.

Changes in the level and composition of taxation and government spending can impact on the

following variables in the economy:

y Aggregate demand and the level of economic activity;y The pattern of resource allocation;y The distribution of income.y

Stances offiscal policy

The three possible stances of fiscal policy are neutral, expansionary and contractionary. The

simplest definitions of these stances are as follows:

y A neutral stance of fiscal policy implies a balanced economy. This results in large taxrevenue. Government spending is fully funded by tax revenue and overall the budget

outcome has a neutral effect on the level of economic activity.

y An expansionary stance of fiscal policy involves government spending exceeding taxrevenue.

y A contractionary fiscal policy occurs when government spending is lower than taxrevenue.

However, these definitions can be misleading because, even with no changes in spending or

tax laws at all, cyclical fluctuations of the economy cause cyclical fluctuations of taxrevenues and of some types of government spending, altering the deficit situation; these are

not considered to be policy changes. Therefore, for purposes of the above definitions,"government spending" and "tax revenue" are normally replaced by "cyclically adjusted

government spending" and "cyclically adjusted tax revenue". Thus, for example, agovernment budget that is balanced over the course of the business cycle is considered to

represent a neutral fiscal policy stance.


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Methods offunding

Governments spend money on a wide variety of things, from the military and police toservices like education and healthcare, as well as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

y Taxationy Seignior age, the benefit from printing moneyy Borrowing money from the population or from abroady Consumption of fiscal reserves.y Sale of fixed assets (e.g., land).

All of these except taxation are forms of deficit financing.

Borrowing

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged

securities. These pay interest, either for a fixed period or indefinitely. If the interest and

capital repayments are too large, a nation may default on its debts, usually to foreign

creditors.

Consuming prior surpluses

A fiscal surplus is often saved for future use, and may be invested in local (same currency)

financial instruments, until needed. When income from taxation or other sources falls, asduring an economic slump, reserves allow spending to continue at the same rate, without

incurring additional debt.


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Literature Review

Economiceffects offiscal policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, inan effort to achieve economic objectives of price stability, full employment, and economic

growth. Keynesian economics suggests that increasing government spending and decreasingtax rates are the best ways to stimulate aggregate demand. This can be used in times of

recession or low economic activity as an essential tool for building the framework for strong

economic growth and working towards full employment. In theory, the resulting deficits

would be paid for by an expanded economy during the boom that would follow; this was the

reasoning behind the New Deal.

Governments can use a budget surplus to do two things: to slow the pace of strong economic

growth and to stabilize prices when inflation is too high. Keynesian theory posits that

removing spending from the economy will reduce levels of aggregate demand and contract

the economy, thus stabilizing prices.

Economists debate the effectiveness of fiscal stimulus. The argument mostly centers on

crowding out, a phenomena where government borrowing leads to higher interest rates thatoffset the simulative impact of spending. When the government runs a budget deficit, funds

will need to come from public borrowing (the issue of government bonds), overseas

borrowing, or monetizing the debt. When governments fund a deficit with the issuing of

government bonds, interest rates can increase across the market, because government

borrowing creates higher demand for credit in the financial markets. This causes a lower

aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.

Neoclassical economists generally emphasize crowding out while Keynesians argue that

fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding

out is minimal.

Some classical and neoclassical economists argue that crowding out completely negatives

any fiscal stimulus; this is known as the Treasury Vie, which Keynesian economics rejects.

The Treasury View refers to the theoretical positions of classical economists in the British

Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same generalargument has been repeated by some neoclassical economists up to the present.

In the classical view, expansionary fiscal policy also decreases net exports, which has a

mitigating effect on national output and income. When government borrowing increasesinterest rates it attracts foreign capital from foreign investors. This is because, all other things

being equal, the bonds issued from a country executing expansionary fiscal policy now offera higher rate of return. In other words, companies wanting to finance projects must compete

with their government for capital so they offer higher rates of return. To purchase bondsoriginating from a certain country, foreign investors must obtain that country's currency.

Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand

for that country's currency increases. The increased demand causes that country's currency toappreciate. Once the currency appreciates, goods originating from that country now cost more

to foreigners than they did before and foreign goods now cost less than they did before.Consequently, exports decrease and imports increase.


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Other possible problems with fiscal stimulus include the time lag between the implementationof the policy and detectable effects in the economy, and inflationary effects driven by

increased demand. In theory, fiscal stimulus does not cause inflation when it uses resourcesthat would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who

otherwise would have been unemployed, there is no inflationary effect; however, if the

stimulus employs a worker who otherwise would have had a job, the stimulus is increasing

labour demand while labour supply remains fixed, leading to wage inflation and thereforeprice inflation.

Fiscal Straitjacket

The concept of a fiscal straitjacket is a general economic principle that suggests strict

constraints on government spending and public sector borrowing, to limit or regulate the

budget deficit over a time period. The term probably originated from the definition of

straitjacket: anything that severely confines, constricts, or hinders. Various states in the

United States have various forms of self-imposed fiscal straitjackets.

Research

The Indian Fiscal Situation (T. N. SrinivasanProfessor ofEconomics, Stanford

University)

Even before independence, there was a broad consensus, across the political spectrum,

that once independence was achieved, Indian economic development should be planned,

with the state playing a dominant role in the economy and achieving self-sufficiency across

the board as a major objective (Srinivasan 1996). Within three years of independence, a

National Planning Commission was established in 1950, charged with the task of drawing up

national development plans. The adoption of a federal constitution with strong unitary

features, also in 1950, facilitated planning by the central government. Several central

government-owned enterprises were established, and a plethora of administrative controls(the so-called license-quota-permit raj) was adopted to steer the economy towards its

planned path. At the same time, fiscal and monetary policy remained quite conservative, and

inflation relatively low the latter reflecting the sensitivity of the electorate to rising prices.

During 1950-80, Indias economic growth averaged a very modest 3.75 percent per year,reasonable by pre-independence standards, but far short of what was needed to significantly

diminish the number of poor people. The license-permit raj not only did not deliver rapidgrowth, but worse, unleashed rapacious rent-seeking and administrative as well as political

corruption (Srinivasan 1996). In the 1980s, Indias national economic policymakers begansome piecemeal reforms, introducing some liberalization in the trade and exchange rate

regime, loosening domestic industrial controls, and promoting investment in moderntechnologies for areas such as telecommunications. Most significantly, they abandoned fiscal

conservatism and adopted an expansionary policy, financed by borrowing at home andabroad at increasing cost. Growth accelerated to 5.8 percent during the 1980s, but the cost of

this debt-led growth was growing macroeconomic imbalances (fiscal and current account

deficits), which worsened at the beginning of the 1990s as a result of external shocks and led

to the macroeconomic crisis of 1991.

The crisis led to systemic reforms, going beyond the piecemeal economic reforms of the

1980s. An IMF aid package and adjustment program supported these changes. The major

reforms included trade liberalization, through large reductions in tariffs and conversion of

quantitative restrictions to tariffs, and a sweeping away of a large segment of restrictions


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on domestic industrial investment. Attempts were made to control a burgeoning

domesticfiscal deficit, but these attempts were only partially successful, and came to be

reversed by the mid-1990s.

Of the conference papers, Kochhar (2004), Rajaraman (2004), Roubini and Hemming (2004);

Hausmann and Purfield (2004); and Heller (2004) all provide qualitative and empirical

summaries of Indias fiscal situation. Several of these papers also put India in an internationalperspective. Other recent empirical evaluations include Mohan (2000), Lahiri and Kannan

(2002), Rangarajan and Srivastava (2003), World Bank (2003) and IMF (2003). All present

similar numbers, though with some minor differences.Table 1 summarizes the trends in

Central and State fiscal deficits since 1990. It shows that fiscal deficits began to rise in 1997-98 at both levels of government, though the rise was much greater at the State government

level. In fact, fiscal balances at both levels were severely affected by the large pay increasesgranted to Central government employees in 1997-98, followed by similar increases at the

state level the following year. Interestingly, the Centers balance has continued to deteriorateslowly after 1997-98, while the States aggregate position appears to have stabilized after the

one-time shock. Table 1 also shows that two other fiscal indicators have deteriorated since

1997-98. First, the revenue deficit (i.e., balance between current receipts and expenditures)

has grown as a percentage of GDP: current expenditures have not been controlled well

reflecting budgetary pressures such as subsidies, as well as the government pay hike.

However, an excessive emphasis on the revenue deficit is misplaced: current expenditures

include spending on health and education, which, if effective, is investment in human capital,

with significant social returns. Analogously, some capital expenditures include items that

should be deemed as current, because they are essentially maintenance expenditures, and

others that have negligible social returns. Second, the primary deficit (after taking out net

interest payments from expenditures) has grown, after the initial reduction in the early 1990s,

indicating that the problem is not simply growing interest payments, though these have also

gone up as a percentage of GDP. Clearly, Table 1 throws doubts on the future sustainability

of the current trajectory.


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Fiscal deficits financed by borrowing add to the government debt. Table 2 summarizes recent

trends in the general government debt. After some decline in the early 1990s, the stock of

government debt rose steadily after 1997-98, as a percentage of GDP. In fact, Buiter and

Patel (1992) had pointed out the unsustainability of Indias government debt in the sense that

the expected present value of future surpluses was inadequate to pay off the debt as of 1990.

In 1995 (Buiter and Patel, 1997) they updated their analysis and found that the problem

remained. The methodology in such analyses involves discounting and controlling for future

stochastic shocks: therefore the conclusions are dependent on specific assumptions aboutwhich there could be differences among analysts. Nevertheless, several authors, using

different data sets and varying detailed assumptions, have reached similar conclusions.


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Furthermore, as Lahiri and Kannan (2002) note, sustainability in a formal sense is not

enough: illustrative (non-stochastic) calculations assuming an interest rate of 5 percent,

growth rate of 6 per cent, and primary deficit of 5 percent of GDP imply that debt stabilizes

at 500 % of GDP.11 Clearly such a trajectory would collapse well ahead of reaching thisnotional limit, as the implied interest payments and required taxes are noncredible. A related

distinction Roubini and Hemming, 2004) is between sustainability and financeability: thelatter captures investors willingness to finance debt. It is conceivable that investors finance

debt that is unsustainable given publicly available information, either because their privateinformation about the future makes them believe it is sustainable, or because they are

irrational. It is also conceivable that investors refuse to finance what appears to be sustainabledebt. As Roubini and Hemming (2004) point out, currently investors seem to be willing to

finance a debt that appears unsustainable in the long run. If we rule out differential andcorrect private information, this situation, by construction, cannot continue forever, in the

absence of fiscal adjustment. Roubini and Hemming note, based on Early Warning System

(EWS) models that attempt to quantify such risks of crisis, that the estimated probability of a

sovereign debt crisis for India in the next 12 months is only 2%, but this could increase very

quickly with any rise in interest rates. We return to these issues of risk and possible response

in later sections.

There are two additional arguments going in opposite directions. The first, pointing to theexistence of substantial off-budget items and contingent liabilities, says that the situation is

even more unsustainable than that implied by conventionally measured fiscal deficits. The

second argues that Indias fiscal situation is in fact sound, and many analysts (including us

and the authors of conference papers), have exaggerated the problems. The first argument is

straightforward. There are indeed large and growing off-budget items that represent currentor future claims on the governments revenues, and these make the fiscal situation even more

unsustainable. The World Bank (2003, Chapter 2), estimates the general government debt at

85% of GDP, with the debt of public sector enterprises adding another 10% of GDP, and

contingent liabilities from guarantees in support of loss-making public enterprises at a further

12% of GDP.All three components as well as the total, at 107% of GDP are significantly

greater in magnitude relative to GDP than they were in 1991. While losses of public sector

enterprises raise somewhat different policy issues than government budget deficits, they are

clearly part of the governments immediate problem. EWS models, and even credit rating


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agencies, may not be fully informed of these non-budget liabilities and hence mayunderestimate crisis probabilities. Another significant problem in the medium and long run

arises from the governments pension schemes, some of which are defined benefit schemeswith fundamental structural imbalances (Gillingham and Kanda, 2001; World Bank, 2001;

Heller, 2004; Howes and Murgai, 2004; Kochhar, 2004;13 Roubini and Hemming, 2004).

Heller identifies several other sources of major long-run challenges to Indias fiscal policy,

which involve a great deal of uncertainty, but the contingent liabilities associated with thecurrent pension systems are predictable as well as worrisome.

The second view, if correct, would call for different policy responses. One strand of this

view, echoed by Indias Finance Minister (Business Standard, 2004), is that sustained high

growth and low interest rates will take care of any future problem. It is certainly true that

India has so far managed to avoid any fiscal crisis that growth rates have exceeded interest

rates despite the deterioration in the fisc, and also that interest rates have recently been quite

low by historical standards. We, and many other analysts, would argue that the cost of Indias

high fiscal deficit has been growth that is below potential. A full justification of this argument

would require a well-specified growth model, which is beyond the scope of the paper, though

we provide some pointers in Section 5. A second strand, which we discuss in Section 4, isthat the fiscal deficit is not of great concern since Indias current external situation is

comfortable: unlike in 1991, foreign exchange reserves are ample, the size and compositionof external debt are more favorable, and foreign trade appears to be more robust.

A third strand is that Indias government debt to GDP ratio is not high by internationalstandards (Rakshit, 2000, p. 35), and thus is not indicative of a potential crisis. However,

Indias ratio is low only in comparison to the upper tail of the distribution of the ratio acrosscountries, including those that have not had a fiscal crisis. In comparison to similar emerging

market economies, Indias debt ratio is relatively high (e.g., Roubini and Hemming, 2004,

Figure 1, and Hausmann and Purfield, 2004, Table 1). Furthermore, even if the level of debt

is not high (however measured), the potential debt dynamics are still cause for concern in the

short run. Finally, even if a crisis is many years away indeed, even if it never occurs the

costs of the current fiscal stance, in terms of forgone growth, may well be substantial.

Rakshit (2000, pp. 43-44), however, argues that low private savings (household and

corporate) rather than high and growing public consumption has constrained growth in India.

Related arguments from Rakshit and others against crowding out, inflationary impacts of

monetizing the government deficit, and negative impacts of financial repression are all rooted

in what we may term a structuralist/Keynesian view of Indias economy (that it is an

economy constrained by deficient aggregate demand rather than by capacity resources and by

market imperfections). We will address these in subsequent sections.

One point that does emerge from this debate is the importance of levels of, and trends in, taxrevenues in affecting the course of fiscal deficits, but these trends have been highlighted by

many economists, independently of any structuralist assumptions (e.g., Rao, 2000; Singh and

Srinivasan, 2002; World Bank, 2003; Rajaraman, 2004; Hausmann and Purfield, 2004). Be

that as it may, there are enough indicators, in our view, of the unsustainability in Indias

public finances, and we focus in the rest of the paper on policies (particularly those relating tofinancial and external sectors) that lead away fromslow growth and risks of crisis, whilerespecting legitimate distributional concerns and political constraints.


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Article

Sustainable Fiscal Policyfor India(Peter S. Heller and M. Govinda Rao 2007)

The fiscal policy assumes centre stage in policy deliberations asthe continuous fiscal

imbalances and rising levels of public debt poserisks to the prospects for macroeconomic

stability, and acceleratingand sustaining growth. Appropriate and timely fiscalpolicymeasurescan promote growth by setting efficient and effective use of scarceresources

and by creating the right incentive signals. The welldesigned fiscal strategy would help tomove an economy like Indiatowards a higher growth path without high inflation or

intergenerationaltransfers of the burden of public debt. Indias democraticsystem and federal structure present

challenges to fiscal policy thatare also common across all federal democracies and are wellrecognised in theoretical terms. The fiscal experts in India and outsidecontributed from time

to time in revealing the strengths andweaknesses of the Indias fiscal policy and suggested

future courseof action. Set against the above backdrop, the book under review,which is a

selection of 10 papers presented in a conference jointlyorganised by the International

Monetary Fund and the NationalInstitute of Public Finance and Policy highlights variousaspects ofIndias fiscal policy, its sustainability and its impact on the othersectors of the

economy and draws lessons and priorities taking intoaccount the international experiences.

The book examines how Indias fiscal situation evolved overthe years, the role played by

reforms, Central-State fiscal relations,risks of high public debt and the critical areas for

reforms. It exploresways of meeting challenges including reduction of public debt and

adoption of sound fiscal policies which assumes critical role inrealising the economic

ambitions. Interestingly, Indias economy hasgrown rapidly since the beginning of the 1990s

despite a large andgrowing fiscal imbalances and debt levels and it would be of greatinterest

to examine whether India has found a way to reconcilesustained expansionary fiscal policieswith relative macroeconomicstability. The analysis indicates that the Indias fiscal

policyrequiresimmediate attention in order to have sound and sustainable fiscalsituation in

the long run as high growth and low interest rate may notbe able to take care of the problemof long term debt sustainabilitynor risks of a crisis in the short and medium term. The focuson thebudget deficit alone may be misleading as the problem of off-budget and contingent

liabilities is serious and needs to be addressed.Keeping in view the growth implications inlong run, there is a needto examine public consumption, investment, taxation and deficits in

a framework that recognises that these are all endogenouslydetermined, along with the

growth rate.As the fiscal imbalances continue to exist and debt level isrising, the reforms

mainly aimed to enhance government revenuesare critical. While there is ample room for

improving the structure ofindirect taxes, in particular, improved tax administration and

enforcement remains one of the most critical areas for reform. Taxreform is an essential step

towards increasing government revenue,as well as reducing microeconomic distortions. On

the expenditureside, the quality of expenditure at both Centre and State level hasdeteriorated,

and the same needs to be addressed on priority basis.Institutional reforms such asimprovements in the intergovernmentaltransfer system, borrowing mechanisms for State

governments, andbudgeting practices and norms are all technically possible and maywell be

politically feasible.

Fiscal Developments and Outlook inIndia, by Indira Rajaraman focuses on the factors

underlying thecontinued weak fiscal position during the previous one and halfdecades as wellas the prospects of recent fiscal reforms. The authoridentifies that the impact of trade

liberalisation measures and theirassociated loss of tariff revenue remained the major factorunderlyingthe weakened fiscal position since the early 1990s. Unlike othercountries which


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undertook tariff rate reductions, India did notcompensate the loss of revenue byacommensurate increase indomestic taxes. The author is of the view that buoyant growth in

India is essential for fiscal reforms to be possible and this requiresthat the kinds of physicaland social infrastructure should go up inboth quality and quantity. The author finds two

strands to the fiscalimbalance path in India. First, high interest rates on public debt which

started rising sharply in the 1980s and details the political economypressure that fuelled this

rise. Second, non-interest fiscal indicatorswhich worsened sharply in 1998 with the real wagehike introducedthat year for government employees and pensioners raising the

consolidated salary bill substantially. An econometric exerciseinvestigates whether this event

was endogenous to the politicaleconomy. The regression equations show an election year

response,which has become more marked in the last 30 years. The authorrecognises

theimportance of two major reforms, i.e., the reforms ofthe interest rates guaranteed under the

NSSF and passage of the FiscalResponsibility Legislation.The issues relating to the scope,

nature and conduct of fiscalpolicy, particularly in the context of maintaining macroeconomic

stability and enhancing growth, assume importance. The paper,

India:MacroeconomicImplications of the Fiscal Imbalances, by KalpanaKochhar examines

both the evolutions of fiscal imbalances and keydevelopments in major macroeconomicvariables in order to assess

the macroeconomic impact of the growing fiscal imbalances. Keepingin view the persistentfiscal imbalance and indebtedness, arguably,the fiscal situation is the single biggest threat to

macroeconomicstability. The rising fiscal imbalances and debt reflects a weakening inrevenue mobilisation, persistent deficit at Centre and State leveland narrowing of the gap

between real interest rate and growth rate.The author interestingly finds that on account ofhigh fiscal imbalancethere were hidden costs on the economy in terms of the

foregonepotential for even higher economic growth than that has recently beenexperienced.

The large and increasing fiscal deficit led to a crowdingout of productive public expenditure

and constrained the scope forfurther structural reforms and liberalisation and rooms

formacroeconomic policy manoeuvre adversely impacting the growthprospects. In order to

avoid the crisis, the author feels that there isstrong need of revenue mobilisation efforts and

reorientation ofexpenditure away from subsidies and towards physical and

socialinfrastructure projects. Indias medium term economic prospects,among others depend

critically on progress with the closelyintertwined tasks of fiscal consolidation and structural

reforms. Therising level of fiscal imbalances and resultant high level of debt maycreate a

vicious circle inducing a fall in the ratio of private to totalcredit, rising inflation and falling

economic growth. In this regard,William Easterly in his paper, The Widening Gyre: The

Dynamicsof Rising Public Debt and Falling Growth, examines that fiscal policyvariables

affect growth and finds suggestive evidence, in line withthe previous literature, that fiscalpolicy variables or variablesaffected by the fiscal policy such as budget deficit, inflation

and theshare of private in total credit do affect growth.Sustainability of public debt hasemerged as an important issuein public policy discussions and academic debates among

policymakers, economists, credit rating agencies and multi-lateralinstitutions. It has been

widely recognised that unsustainable debtoften tends to impact on Governments ability toundertakedevelopmental activities and also may crowd out the privateinvestment. RichardHemming and Nouriel Roubini in their paper,ABalance Sheet Crisis in India?, use abalance

sheet approach toassess Indias vulnerability to a crisis as a result of its high fiscal

imbalances. The authors explore the question of the financeability ofa country debt position,

the vulnerabilities associated with the wayin which Indias public debt is financed and the

experience from otheremerging market economies which face high debt ratios in recentyears.

The authors find that Indias debt is clearly financeable overthe short term, reflecting such

important strengths as modestrollover/liquidity risk, lack of currency mismatches and


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limitedliability dollarization, small current account imbalances and lowexternal debt,financial repression and capital controls. In principle,these are insulating factors to the large

deficit and high share ofdebt to GDP. The paper concludes that a failure to tackle fiscalconsolidation in the near term will only increase Indias vulnerabilityin the future.

PeterS. Heller in his paper, India: Todays Fiscal PolicyImperatives Seen in the Context of

Long-Term Challenges and Risks,provides an alternative perspective on why India needs to

move soonto address the fiscal imbalances. A continuation of current fiscalpolicies, the levelof fiscal deficits and character of governmentexpenditure, would put India on an

unsustainable course in terms ofthe constraints that it would impose, in the future, on the role

thatpublic sector would be able to play in effectively addressing theselonger term challenges.

The author emphasises on undertaking theappropriate reforms in order to placing fiscal house

in order today sothat India have sufficient fiscal leeway in the future to address thelong term

fiscal challenges including those of demographic developments in the population at large, the

demographics of civilservice and military pensions, the imperatives of social

insurancereforms and urbanization patterns and the effects of the globalization.

The paper states that India now has a fiscal policy framework thatneither offers that futures

fiscal leeway, nor provides an appropriateexpenditure programme that is responsive to theobvious andimmediate needs of the economy of the coming decades. Currentfiscal policy is

recognised by most analyses as unsustainable. Animportant policy message may be drawnfrom the paper is that Indiashould be cautious about how it formulates new policy

commitmentsso as to avoid excessive preemption of future budgetary resourcesand therebyavoiding the mistakes of industrial economies.In order to enhance the revenue performance,

the strategiesfocusing on rationalisation of tax rates, better taxcompliance,improvedefficiency in tax administration and review of taxexemptions/incentives

would be helpful. Over the last decade, incometax rate at the Central Government level has

undoubtedly been madeinternationally comparable, central excise duties have been

convertedto a truncated VAT (CENVAT) up to the manufacturing stage andcustom tariffs on

imports have been sequentially scaled back toapproach comparable international level. The

various exemptions,

however, have affected the quality of tax administration and revenueperformance. For a

couple of decades, services sector has grownrapidly and now represent more than half of the

GDP. In view of itsincreasing role in GDP, the taxation of service sector assumesimportance.

It is imperative to introduce comprehensive taxation ofservices at the Central level and the

selected services should also beseriously considered for appropriate assignment for taxation

to theStates and local bodies. On taxation of services, India can drawimportant lessons from

Brazil, which was one of the first countriesto introduce a comprehensive Value added tax

(VAT) on both goodsand services in the mid-1960s. Parthasarathi Shome in his paperIndia:Resource Mobilization through Taxation finds that thoughthere have been significant

changes in the tax structures in the 1990s,however, the insufficiency in streamlining the wideprevalentincentives and exemptions has adversely affected the full potentialof revenue

productivity in both individual and corporate income tax.

It was recognised that competitive sales tax reductions byS

tates aimedatattractinginvestments had led to revenue losses withoutcommensurate gains. The authoremphasises on the reforms on bothtax policies and revenue administrations.In their paper,

Subsidies and Salaries: Issues in theRestructuring of Government Expenditure in India,

Stephen Howesand Rinku Murgai found that while there are ways to reduce subsidiesthrough

a combination of efficiency improvements and toughdecisions, however, attempts so far to

reduce subsidies have met withlittle success. The paper examines the agricultural power

subsidy asa case study and situates Indias growing subsidy bill within thecontext of a trend

towards agricultural protectionism. There is noassured path forward and sustained reduction


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in the expenses towardssubsidy will require institutional experimentation. Theauthorssuggestthat there is potential of decline of salary bill of Government sector(Centre and

State Governments) by 2 per cent of GDP over the nextdecades via both wage and hiringrestraint without sacrificingexpenditure quality. There is also a need to address the growing

pensions outlays. The usual emphasis on expenditure restructuringthrough subsidy reduction

is complemented in the paper by an equalemphasis on salary bill reduction. The authors are

of the view that areduction in the salary bill is not likely to come about by activedownsizing but by a combination of hiring and wage restraint. Withregard to the power

sector, the authors stress the importance ofprivatization as perhaps the only way to bring

commercial disciplineinto the rural segment of the power sector, however, at the same time

acknowledge the associated risks and difficulties.

Ricardo Hausmann and Catriona Purfield in their paper, TheChallenges of Fiscal Adjustment

in a Democracy: The Case of India,provide thought provoking views and find that Indias

tendency torun large deficit and accumulate debt has deep institutional roots

embedded in its highly decentralized democratic system. The papermainly studies

threeaspects of fiscal consolidation. First, it accountsfor the lack of symptoms of an

impending crisis by pointing to someaspects. However, the lack of symptoms is double-edgedsword: it

makes crisis less likely for any level of debt, but society is lessresponsive to fiscalimbalances,thus making the eventual problemsmuch larger. Second, it analyses possible implications of

the fiscalresponsibility legislation on Indias imbalances. Third, it studiesIndias federal system and the role ofStates in the fiscal adjustmenteffort. The authors find

that Indias ability to tolerate high deficitand debt without encountering the types of crisesexperienced bymany other emerging economies is a mixed blessing. It reflects

thecomparatively large and closed nature of its economy as well as itsdeep domestic capital

market and large, albeit captive, pool ofdomestic savings. The last has allowed the

Government to financedeficits with long term fixed rate debt instruments. The authors

recognise the recent institutional reforms based on legal backing.

The authors suggest a State level fiscal consolidation plan includingthose of imposition of

borrowing ceiling on States to constrain theirdeficits and reforms to the system

ofintergovernmental transfers togive a more stable and reliable source of revenue.In a federal

set up, stable and reliable sources of flow of fundshelps in formulating the future strategies at

sub national levelsgovernments. For sound fiscal management, however, the effortsshould be

undertaken by both the Central and State Governments.

The federal budgetary systems bring especially difficult challenges.For example, the

Argentina made significant economic progress ona wide range of issues in the 1990s.

However, the complicatedfinancial relations between the federal Government and provincescrucially undermined attempts at fiscal control as the provinces hadlittle incentives to control

their spending. Eduardo RefineppiGuardia and Daniel Sonder in their paper,FiscalAdjustment andFederalism in Brazil, draws the lessons from the another largefederal

Brazil. The authors emphasise that during the time of fiscaladjustment the fiscal-federal

system needs to be respected as anintegral element of policy design, though the system itselfmay needto be adapted if situation requires to maintain macroeconomicstability and toachieve the objectives of fiscal adjustment. Theauthors emphasise on major elements of a

fiscal-federal system andthe ways in which these were adapted in the context ofBrazil fiscal

adjustment experience during the late 1990s. Among others, theseinclude assignment

ofrevenue and expenditure responsibilitiesbetween the Centre and the States and the rules

determining thecontrol of sub-national debt. The paper assumes importance in thesense that it

sets priority for Indian policy makers to reconsider thescope for adapting their own system.


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In the concluding chapter, Fiscal Policy in India: Lessons andPriorities, NirvikarSingh andT.N. Srinivasan assesses Indias currentfiscal situation, its likely future evolution andimpacts

on the economy.The authors examine possible reforms of macroeconomic policy andbroaderinstitutional reforms that will bear on the macroeconomicsituation. The authors also take into

account the factors such as politicalfeasibility of possible reforms. They also examine both

medium andlonger run scenarios, fiscal sustainability and adjustment going

beyondconventional government budget deficits, to include off -budgetliabilities, both actualand contingent. The chapter concludes thatsome short run fiscal adjustments are clearly

necessary to avoid anypossibility of a crisis, but at the same time more

fundamentaladjustments- in the tax system, the structure of the expenditure andthe financial

sector must be on the agenda for reforms.The book, a major contribution to the fiscal

literature, isthoughtprovoking, timely and pertinent to Indias fiscal affairs. The

variousaspects of Indias fiscal policy, related issues, implications on growth,feasibility of

implementations of reforms in the existing democraticand federal set up are well recognised

and addressed. It providesadequate insights and suggests a road map, taking into fiscal

policyand its linkages with other macroeconomic policies, for a sound andsustainable fiscal

policy for India. The reforms in tax administration,expansion of tax base through moreservices in tax net,introductionof transparency in fiscal matters and channelization of

expenditurealongproductive lines among others reforms are suggested to beinitiated onpriority basis. Several fiscal policy measures have alreadybeen initiated in India during 1990s

covering most of these areas.Furthermore, the book provides very useful insights on theoptimallevel of fiscal decentralisation for India. The discussion on linkagesof fiscal policy

with other sectors and its implications including ongrowth is very relevant and will providevaluable inputs to the policymakers in India to further facilitate the fiscal reforms process

with a view to strengthening fiscal situation.Growth implications of the fiscal policy could

have beenaddressed more adequately taking into account the moredisaggregated information

and also simultaneously the impact oftaxation, expenditure and budget deficits components

on the growth.

The analysis on Indias fiscal situation with an internationalperspective and its linkages with

other sectors provides adequateinsights to policy makers and provokes researchers to take

furtherwork in this area. In this regard, a phase-wise analysis of variousaspects of fiscal

policy could have been more useful to understandthe strengths and weaknesses of policies in

different phases. Theissues like rigidities in bringing expenditure to a lower level or

inchannelizing it towards productive lines apart from sustainability ofpublic debt,

whichcontinue to pose problems for the on-going processof fiscal consolidation could have

been addressed adequately.Keeping in view the problems as highlighted in number of papers,

there needs to be some short run fiscal adjustment to avoid anyprobability of a crisis. In thiscontext, the future course of actionmeant for short run and long run could have beenprovided

adequatelykeeping in view Indias democratic and federal set up. Nevertheless,the bookremains an important contribution to the Indias fiscalliterature. It may be concludedthat the

book provides very usefulinsights for policy makers to undertake appropriate and timely

policymeasures in order to strengthen fiscal position and avoid any crisisin the short andmedium term and for sustainable fiscal situation inthe long run.


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Analysis

In response to the largest economic downturn since the 1930s, several countries around the

world implemented large fiscal stimulus to cushion the blow from the financial crisis andjump start the economic recovery. During the initial phases of the crisis, policy makers

concerns about the effectiveness of monetary policy, stemming from very low interest ratesto weak transmission mechanism, led to embark in sizable fiscal stimuli packages to offset

falling private sector demand. India was no exception to this. Despite the much shallower

slowdown in overall economic activity, industrial production growth fell markedly andoverall financing conditions tightened significantly during the acute phase of the crisis. The

Indian authorities undertook several measures to address the economic fallout from the crisis.On the fiscal front, the Indian government implemented large expansionary measures in

208/09 and 2009/10. As a result of the fiscal expansion, the deficit increased sharply and thecontribution of government consumption to GDP growth in the last two quarters of 2008/09

was sizable. This paper assesses the effectiveness of fiscal policy in India.

Even as large fiscal stimuli packages are being implemented around the world, theeffectiveness of fiscal policy to counter falling aggregate demand has been called

increasingly into question. In particular, the evidence on the magnitude of fiscal multipliershas become a hotly debated issue in academic as well as policy circles. Unfortunately,

theoretical models yield wide ranges of fiscal multipliers depending on assumptions aboutthe functioning of the economy (e.g., degree of price rigidity) and structural parameters

(labour supply elasticity), and to complicate matters further, empirical estimates of the

impacts of fiscal policy also vary significantly and are highly dependent on the methodologyemployed (Perotti, 2009). Nonetheless, as the Indian authorities have started to exit from

accommodative stance in a calibrated way, having estimates of fiscal multipliers is likely to

be useful.In addition, shedding light on the size of fiscal multipliers could also enhance our

understanding of other features of the economy and help assess the extent of crowding-out

going forward.

This paper analyses empirically the effectiveness of fiscal policy in India. We apply simple

structural and recursive vector auto regression (VAR) to gauge the effects of fiscal policy on

GDP and other macroeconomic variables. The data used span the period 1996-2009, covering


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a period of mild deficits and the fiscal consolidation phase during 2003-2007. Two VARs areestimated: a small VAR with spending, tax revenue, and GDP and a larger VAR which

includes inflation and short term interest rate (to control for monetary conditions).Our major findings can be summarized as follows:

Preliminary findings for India show that discretionary fiscal policy shocks have

economically significant effects on activity, with current government spending multiplier

estimated at one (on impact), declining to around 0.5 after four to five quarters, suggestingpartial crowding out of some private demand component.

Consistent with evidence for other countries, the development spending multiplier is

greater than 1, suggesting that composition of spending matters, with a persistent effect even

at 16 quarters.

Tax revenue multiplier is about twice as large as current spending (same order of

magnitude of development spending), and remains significant after 8 quarters. This is also

consistent with the cross-country evidence, which shows large tax multipliers, especially at

longer horizons.

The remained of this paper is organized as follows. Section II reviews the literature on fiscal

multipliers and the cross-country evidence on the impact of fiscal policy on economicactivity. In this section, we also motivate the need to uncover empirical evidence on fiscal

multipliers, since theoretical predictions from simple models are very sensitive to hard-to-estimate (unobserved) parameters. In other words, the quest for reliable evidence on fiscal

multipliers lies in the data.

Cross-Country Evidence on Fiscal MultipliersAs we show below, tightly parameterized economic models offer limited guidance to gauge

the magnitude of fiscal multipliers.2 For example, in a simple flexible-price DSGE model the

effect of a government spending shock on GDP depends on the elasticity of labour supply,

the coefficient of relative risk aversion of the representative agent, and the share of

government spending in GDP (Box 1). In a slightly more complicated model with money and

price rigidity, the effect of the spending shock depends on several additional parameters,

including the persistence of spending shocks.

Evidence on the effects of fiscal policy on the economy is mostly based on three approaches:

The narrativeapproach, pioneered by Ramey and Shapiro (1998) involves isolating the

exogenous unanticipated component of fiscal policy changes and estimating reduced form

regressions of GDP on dummy variables corresponding to episodes of exogenous fiscal

policy changes.4 The event study may also focus on consumer or investment behaviour, as in

Shapiro and Slemrod (2003, 2009) and Barro and Redlick (2009). Evidence from such event

studies is consistent with some effectiveness of fiscal policy. For instance, the 2001 incometax rebates in the United States were found to be effective in boosting consumption, but the

multiplier was estimated at less than one. In the IMFs World Economic Outlook (October2008) the results from the event studies show that the levels of public debt and composition

of fiscal measures are important determinants of the effectiveness of fiscal policy; high debt

levels lower the multiplier because of fiscal expansions are associated with rising interestrates and spreads. The second approach is based on full-fledged structural models. The class of models used

range from the more traditional simultaneous equations models such as the one used by

Macroeconomic Advisers5 to fully-optimizing DSGE models with price rigidities as in

Taylor et.al. (2009). Not surprisingly, the authors find that the size of estimated multipliers is

not robust. They estimate a benchmark New Keynesian DSGE models and find that

multipliers are about 1/6 of the ones reported in the Romer and Bernstein (2009). Taylor et.al.

(2009) also show their results are robust to the inclusion of hand-to-mouth consumers in their


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model, a feature that many believe is critical to generating sizable multipliers. Results basedon other models in the DSGE tradition show that fiscal policy remains effective when

monetary policy remains accommodative, as can be seen in the IMF analyses in Box 2.1 inthe April 2008 World Economic Outlook and Freedman et.al. (2009). This point is

emphasized by Christiano et.al. (2009); they find that the fiscal multiplier is large (greater

than one for government spending) when the nominal interest is constant.

The third approach has been pioneered by Blanchard and Perotti (2002). It involvesidentifying fiscal policy shocks using VARs and simulating the dynamic impact of these

shocks on GDP and other variables of interest. Identification of the fiscal shocks is typically

achieved by assuming that government spending is predetermined within a quarter (such

assumption would not be reasonable with annual data). The VAR studies typically find a

larger effect of government spending on GDP and in some cases crowding-in of consumption

(e.g. Blanchard and Perotti, 2002, and Gali et.al., 2007). Other VAR studies find crowding-

out of consumption and a smaller but positive effect on GDP (see Perotti, 2009). Uhlig and

Mountford (2008) use less restrictive sign-restrictions to identify fiscal shocks and find much

smaller deficit-spending multipliers.6 Interestingly, several VAR studies tend to find very

large tax multipliers. This evidence is also consistent with the regression approaches ofRomer and Romer (2008) and Barro and Redlick (2009), particularly at longer horizons.

In the case of emerging markets, the evidence is relatively limited. Ilzetzki, Vegh and

Mendoza (2009) estimate fiscal multipliers for 45 countries based on the BP approach. They

find that multipliers that to be larger in high income countries, in countries with

predetermined exchange rates, in more closed economies, and in economies with lower

debt levels. The IMF October 2008 WEO also has a detailed analysis of fiscal multipliers

based on panel regressions. The results generally indicate small multipliers for both taxes

and spending. The analysis in the WEO also shows that credibility of policy framework anddegree of monetary accommodation is critical to the overall effectiveness of fiscal policy.


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Data and Methodology

DataThe data are quarterly and span the period 1996Q2-2009Q3. The variables included in the

estimation are the wholesale price index (WPI), real GDP at market prices, the NEER, the 3-

month nominal interbank interest rate, and foreign variables. The latter includes the world

oil price (average from the IMFs WEO) and the 3-month LIBOR. The GDP and WPI and

fiscal variables are seasonally adjusted. The fiscal variables used are based on the national

accounts (in the case of government consumption) or the CGA

(both current and capitalspending).

Baseline VAR Identification Schemes

As note in the previous section, the VAR methodology, which has been successfully applied

to identify monetary policy shocks, has been adapted by BP to simulate the effects of fiscalpolicy on the economy. The baseline identification assumption followed here is adapted from

BP.

In the small recursive VAR, variables are ordered from the most exogenous to the mostendogenous. In our case, this corresponds to the following posited ordering: G, Y, and T. In

this case: (i) government spending does not react (within a quarter) to shocks to GDP and

revenues, consistent with some stickiness in spending decisions but still allows for relativelyshort inside lags; (ii) GDP reacts contemporaneously to spending shocks (but not to tax

shocks); and (iii) tax revenues react to both spending and GDP shocks since revenues are

assumed to be the most endogenous of the three variables included in the small VAR. In the

case of the augmented VAR, the WPI is included right after GDP (but results are unchanged

if the ordering with GDP is reversed) and the interest rate is ordered last. In the augmented

(seven-variable) VAR with foreign variables, oil prices and the LIBOR are block exogenous.

In the indentified VAR timing remains critical for the identification strategy: it is assumed

that it takes longer than a quarter for discretionary fiscal policy to respond to a shock to GDP.

This is equivalent to saying that the systematic discretionary response of fiscal policy is

absent in quarterly data. Such an assumption is much harder to justify with annual data, but

given the lags in policy implementation and budget cycles, this seems a reasonable

assumption in our context. More generally, this type of timing assumption has beenextensively used in the VAR literature (including on monetary policy) since it is easy toimplement and it is consistent with different classes of models

As in the recursive VAR, government spending does not react contemporaneously to

structural shocks to taxes and GDP (note the restrictions on and ); in the augmented

VAR, spending responds contemporaneously to the WPI (it is imposed that governmentspending declines in real terms with an unanticipated increase in the WPI);


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GDP responds contemporaneously to shocks to both fiscal variables; in the augmentedVAR GDP does not react to price or interest rate shocks within the same quarter due to

stickiness in production plans; Tax revenues react contemporaneously to both GDP and spending shocks (they are

endogenous in part because they react to aggregate spending and because of the systematic

discretionary component of fiscal policy discussed above); moreover, the parameter is

estimated from the data, allowing shocks to spending to affect revenue shocksconsistentwith the view that revenues are determined after spending. The foreign interest rate and domestic output responds contemporaneously to the oil price

(or commodity prices) within a quarter, but the latter is not affected by the formercontemporaneously (zero restriction);

Domestic prices respond contemporaneously to oil price shocks (in the augmented VAR)and to output (the second restriction can be relaxed without affecting the results); also, in the

augmented model, the interest rate elasticity of tax revenue and government spending is set tozero, and the interest rate responds to all variables in the system.

Main FindingsThe main results from the BP and the recursive VAR are broadly consistent with a reasonably

strong effect of fiscal policy shocks on GDP. The main results from the scaled impulse

response functions (IRFs) based on BP approach along with the IRFs 68 percent probability

bands can be summarized as follows:

Current Spending multiplier is slightly above one on impact, and declines to around 0.5

after 5 quarters, suggesting a rapid crowding out of some private demand component after a

couple of quarters. As in Uhlig and Mountford (2008), the deterministic component of the

VAR does not include a time trend. When a time trend is included the IRF shifts downwards

and becomes insignificant after 5 quarters. Another important result, consistent with some of

the findings in Perotti (2009), is that the identified government spending shocks are fairly

similar for the recursive and BP approaches.

In both approaches, tax revenues increase on impact by less than the increase in spending,

suggesting that the pure can be identified as a deficit-financed spending shock. In the caseof the sign-restriction approach, tax revenue does not increase at all in the first 4 quarters.Inflation increases gradually with the spending shock, with the effect peaking after 6 quarters.

Interest rates also go up, but the effect is not significant, suggesting that crowding outoperates through some other channel.

Development spending multiplier is greater than 1, suggesting that composition ofspending matters (consistent with cross-country evidence discussed above). The uncertainty

surrounding this multiplier is also large, probably reflecting the volatility of development


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spending. Interestingly, the effect persists even after 16 quarters, suggesting some crowdingin effects of that type of spending.

Tax revenue multiplier is about twice as large as current spending (same order of

magnitude of development spending), and remains significant after 8 quarters. Given that

spending does not react to the tax shock, the experiment can be interpreted as a

deficitreducing tax increase. The result is broadly in line with Uhlig and Mountford (2008)

and Romer and Romer (2008), which report very large tax multipliers. The former argue that

the distortionary effect of taxes shows up at longer horizons, underscoring the need for proper

dynamic scoring of tax cuts. Another interesting result concerning the tax shock is that theimmediate effect of the tax increase on GDP is the same as in recursive approach (when it is

restricted to zero). In the sign-restriction approach tax increases lower GDP onimpact.

Remarks on Crowding Out

The results above suggest that crowding out might dull the effects of fiscal policy. First, the

current spending multiplier is well below one after a few quarters, suggesting that the

increased spending reduces the availability of resources for the private sector, leading tocrowding out. The effect on growth over the longer term depends on which component of

demand declines, but given the relatively small size of the multiplier and the evidence (inother countries) that consumption of credit-constrained households is not very sensitive to

interest rates, it is likely that private investment declines following a deficit-financed increase

in government spending. Moreover, in India as in other developed and emerging economies,higher deficits are not always accompanied by higher interest rates. In the case of our model,the estimations were conducted with short term interest rates. But as seen recently, long term

interest rates (which are more relevant for investment decisions) have displayed sensitivity to

budget announcements. Thus the existence of a traditional crowding out effect with higher

long term interest rates causing a decline in private investment cannot be ruled out.

The credibility of the fiscal policy and the fiscal framework more generally are also important

determinants of the effectiveness of fiscal policy. While interest rates on government bonds

may not respond to bad news about the fiscal position, credit spreads may do the job, raising


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the cost of financing for corporates and households. Agca and Celasun (2009) find that publicexternal debt has a sizable positive impact on corporate syndicated loan spreads. Their

findings are consistent with the view that fiscal expansions and the associated debt buildupmay crowd out private accessto external markets by increasing spreads. In the case of India

since they also show that while increases in overallpublic debt raises private borrowing costs

in external markets, but the main driver of this relationship is externalpublic debt.

Additional Evidence from Indian States Data for the states can also be used to estimate fiscal expenditure multipliers. The evidence

above suggests that spending multiplier is around one, broadly consistent with the finding

above. The estimation of the states spending multiplier follows the cross-country empirical

literature (WEO, 2008 and Gupta et al. (2004). While it is hard to find credible instruments

for government spending (such as election cycles), GMM dynamic panel estimation is

applied to identify the causal impact of spending on economic activity. The results are

presented in the table below. As can be seen from the table, the estimated multipliers rangefrom 0.9 to 1.3, suggesting some crowding-out of private demand.

Concluding Remarks

This paper assesses the effects of fiscal policy on economic activity in India over the

last decade and half and finds that fiscal policy can play an effective countercyclical role. The

results also have implications for the design of fiscal consolidation plans going forward. Inparticular, our finding suggest that expenditure reform aimed at curtailing the growth ofspending may be preferable to tax increases because the latter may have larger (negative)

effects on growth over the longer term.The findings also shed light on the nature of crowding out and the need for careful dynamic

scoring of fiscal plans. The inclusion of debt in the empirical models and further analysis ofthe effects on fiscal shocks and announcedfiscal measures on aggregate demand components

are important issues for future research.


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Recommendations

1. Appropriate and timely fiscal policy measures can promote growth by settingefficient and effective use of scarce resources and by creating the rightincentive signals.

2. The well designed fiscal strategy would help to move an economy like Indiatowards a higher growth path without high inflation or intergenerationaltransfers of the burden of public debt.

3. India is essential for fiscal reforms to be possible and this requires that thekinds of physical and social infrastructure should go up in both quality and

quantity.

4. Keeping in view the growth implications in long run, there is a need toexamine public consumption, investment, taxation and deficits in a framework

that recognises that these are all endogenously determined, along with thegrowth rate.


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References

https://www.repository.utl.pt/bitstream/10400.5/.../ecbwp991.pdfscribd.com

http://en.wikipedia.org/wiki/Fiscal_policyOppapers.com

http://Jsbbc.imf.org/external/np/seminarstr.com

www.econlib.org/library/Enc/FiscalPolicy.html

rbidocs.rbi.org.in/rdocs/Publications/PDFs/82936.pdf

tutor2u.net/economics/.../a2-macro- fiscal-policy-effects.html

48806301 impact of fiscal policy on indian economy

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