In India, the demands for public spending are much higher than its ability to generate income. As a result, the public debt has steadily increased. Covid-19 has compounded the problem, with calls for much higher spending, even from previously conservative voices.

Central direct taxes peaked at 6% of GDP in 2018-2019. The average over the past decade was 5.5 percent – it rose to 6 and then declined. Buoyancy was low in part because growth stagnated. Indirect taxes peaked at 5.6% in 2016-17 and, after the implementation of the GST, fell to a low of 4.7%, then increased to 5% in 2020-21. The 15th Finance Committee (CF) estimates that the achievable improvement in the tax-to-GDP ratio is 0.7 percentage point each for the Union and the states by 2025-26. This will still keep the overall tax ratio for India at 21, compared to over 30 for AEs.

In comparison, the Centre’s spending alone is estimated at 15.6 percent of GDP in the budget forecast for 20-21, of which 3.6 percent interest payments are the largest component. Subsidies are 1.5 percent; education at 0.4 percent; health at 0.3 percent. With a savings of almost $ 3 trillion, however, the absolute revenues are quite large at 35 lakh crore. But it must be carefully spent.

The literature on fiscal federation suggests that it is effective for elastic taxes such as income tax to be collected by the Center, as migration could reduce the tax base of states.

Stabilization should also be the responsibility of the Center. When the Center bailed out states unconditionally, they over-borrowed. The macroeconomic performance has been very poor, for example the periods of hyperinflation in Argentina and Brazil. Therefore, limits are required on the borrowing capacity of states. Market discipline also helps improve finances if government risk premiums are allowed to rise with higher debt, which is not the case for India at present.

Redistribution should be shared by the Center and the States. In India, the Finance Commission awards are constitutionally mandated to ensure uniformity of basic public services across the country.

Past choices

But the choice to build a capital-intensive industry in the public sector and social assistance at low per capita incomes have vitiated public finances. Businesses have suffered losses, and the ubiquitous recurring subsidies for over a billion people have been very costly.

As a result, spending on health, education, and physical and social infrastructure was insufficient. It hurt the poor more. India had political inclusion, but not economic inclusion. Human development indices have remained low. Cost shocks that were not reflected in higher prices further reduced the quality of public services. East Asia, which was careful to invest in increasing productivity and keeping food prices stable, as long as agriculture’s share 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 fees and taxes on benefits such as ownership, but this requires decentralization and capacity building in the 3rd level. Research shows that transfers to states, even after controlling for fiscal capacity and other variables, have reduced states’ fiscal effort. The 15th CF has made some conditional transfers which may improve incentives.

As investment spending declined to cope with higher current transfers and revenue deficits, bottlenecks intensified and pushed up production costs. First, administered prices and now indirect petroleum taxes have kept domestic prices well above international prices, further increasing costs and inflation. Tightening policies to reduce inflation have largely reduced output growth, while worsening on the supply side keep inflation high.

In the context of Covid-19, demands for increased public spending suggest either higher deficits, financed by borrowing or monetization, or higher taxes on the rich. Support for urban employment could have been higher, but only marginally, as there are real limits to borrowing and monetization. Borrowing capacity is limited because much of the income is already going to interest payments.

High interest rates crowd out private sector activity. As inflation is always volatile, the incomes of the poor are not indexed and in an open economy, downgrades can increase all borrowing costs, the monetization of deficits also has its dangers. Raising direct taxes would weaken efforts to increase private investment and create more jobs. No one wants again the economic stagnation to which the high marginal tax rates before the reform contributed. Moreover, when government stimulus is needed to increase demand, higher taxes have the opposite effect.

Possible options

The quality and composition of central and state spending can be improved by restructuring spending towards increasing capacity and lowering costs. Direct benefit transfers reduce leakage.

Since past decisions have left the government with significant resources that are poorly monetized, asset monetization can help transform the spending profile to support quality public goods and services. This is part of securing smart combinations of public and private efforts that can improve governance as well as delivery. Limits in state capacity have been a major cause of privatization, but are rarely recognized.

Indirect taxes are regressive. Input taxes increase costs. Therefore, the share of direct taxes must increase, but in a fair manner. Better coordination through the GST Council would help. Income taxpayers are still disproportionately low, made up largely of wage earners, but even so, the share of households in direct taxes has risen to 75 percent. Greater international mobility of capital has reduced its contribution to taxes. But the movement to reduce base erosion and profit shifting is bearing fruit and should eventually allow multinational profits to be taxed where they are made. Technology and databases can be used to increase the tax base, while maintaining reasonable rates, even as taxpayer compliance costs, harassment and litigation are reduced.

Industrial policy which uses taxes / tariffs / subsidies to promote the activity must be limited in time and subject to strict sunset clauses. Local taxes and user fees should increase as part of the 3rd level empowerment and will be more acceptable as long as they are linked to clear benefits.

In an active democracy where multiple interest groups vie to increase their share of public spending, while paying less taxes, a relatively conservative fiscal policy focused on reducing supply-side costs works best. This allows monetary policy to support growth, even if central bank independence keeps inflation expectations firmly anchored.

The author is Professor Emeritus, IGIDR.