The supply-side failure

Print edition : December 27, 1997

The Finance Ministry is faced with a collapse in revenue and a rise in the deficit. It has little else to blame but its own strategy for this crisis.


WHEN the United Front Ministry resigned and mid-term elections were announced, Finance Minister P. Chidambaram and his advisers in the Finance Ministry may secretly have rejoiced. This political turn in the middle of the fiscal year permits them to virtually wash their hands of a fiscal and economic crisis they have engineered. Figures now available for the first seven months of fiscal year 1997-98 (April to October) show that tax collections have grown far less than warranted even by the lower- than-expected rate of growth of the economy. To be specific, direct tax collections have grown by just 1.7 per cent when compared with the corresponding period of the previous year, excise collections by 3.5 per cent, and service tax revenues by 73.2 per cent, while customs duty collections have, in fact, fallen by 3.5 per cent. These figures are way short of the revenue growth projected in the so-called 'watershed' budget for 1997-98, which provided for increases of 15.6 per cent, 13 per cent, 121.7 per cent and 18.3 per cent respectively under these tax heads. To add to the Finance Ministry's woes, poor market conditions have not allowed it to mobilise any 'revenues' from the sale of equity of the Government's best public sector enterprises. The budget, on the other hand, had made an initial provision of Rs.4,800 crores under this head.

These early signs of a virtual collapse in additional revenue generation suggest that, even if the Government can restrict its expenditures to that projected in the budget, the fiscal deficit would touch 6.5 per cent of the Gross Domestic Product(GDP), as compared with the target of 4.5 per cent Chidambaram had set himself. It could no doubt be argued that direct tax collections tend to bunch at the end of the year and that the rupee value of imports, and therefore revenues from customs duties, would rise because of the devaluation of the rupee since early November. However, higher customs duties on this count, even if realised, are an unexpected bonanza that fiscal policy cannot be held responsible for. Further, these higher revenues and any end-year increase in the rate of growth direct tax revenues are likely to be neutralised by just one item of unbudgeted expenditure, namely the larger than projected outgo resulting from the implementation of the revised Pay Commission recommendations.

It is true that Chidambaram had announced a package of measures to cover this additional expenditure. The package consisted of new indirect taxes, an additional Rs.2,200 crores from privatisation and a substantial cut in expenditures. The first of these, as in the case of indirect taxes in general, would yield less than expected. The second would yield nothing at all, as established by the Government's decision to withdraw the planned issue of GDRs against shares of the Gas Authority of India Ltd. And the third, as past experience suggests, would not have yielded the expected results even in normal times, and would definitely not do so in a situation where the announcement of elections have triggered unplanned expenditures like that on the North-East Development Fund.

Finance Minister P. Chidambaram and senior Ministry officials, including Finance Secretary Montek Singh Ahluwalia and Chief Economic Adviser Shankar Acharya, at a conference in New Delhi.-ANU PUSHKARNA

THE Finance Ministry is thus faced with a collapse in revenues and a rise in the deficit. But it has little else to blame but its own strategy for this crisis. If there was anything distinctive about the fiscal strategy under Chidambaram as compared with his predecessor, it was his belief that the best route to augmenting tax revenues was to reduce tax rates. A sharp reduction in tax rates, it was argued, would result in greater compliance and higher growth, contributing thereby to higher revenues. This perception was based on three premises. First, that there exists a relationship between tax rates and tax collection, captured by the much-discussed Laffer curve, in which tax collection rises with the tax rate up to some critical level and declines thereafter. This premise was adopted despite the fact that both theory and experience suggest that the Laffer curve had no basis. Secondly, that tax rates in India were much higher than that critical value, so that a reduction in tax rates would increase collection substantially. And, thirdly, that reduced direct and indirect taxes would spur investment and consumption demand, and therefore lead to higher income and expenditure, which would further increase tax collection.

It was on the basis of these flawed perceptions that Chidambaram in his budget for 1997-98 resorted to a massive, across-the-board cut in tax rates. Personal income taxes were brought down by 30 per cent across all slabs, corporate taxes on domestic and foreign firms were reduced by 8 per cent, the Minimum Alternate Tax scheme was substantially diluted, and non-resident investors in stock markets were provided capital-gains tax concessions. It has taken little more than half the financial year to show up the disastrous implications of this strategy. To start with, even with the assumption that concessions would not affect tax buoyancy, the target of 4.5 per cent set for the fiscal deficit to GDP ratio meant that additional resources available with the government for its expenditures were limited. A slower rate of growth of government expenditure has, in the past, meant a slower rate of growth. However, under the supply-side ideology that currently dominates the Finance Ministry, it was believed that liberalisation combined with tax concessions would serve as the new stimuli for growth.

The hollowness of that ideology is revealed by the worsening industrial recession in India. Industrial growth during the first half of this fiscal period (April to September) has more than halved to 4.7 per cent, as compared with the 10.7 per cent recorded during the corresponding period of the previous year. This deceleration in industrial growth combines with a slower rate of agricultural growth to result in an overall rate of GDP growth which is much less than projected. The budget document assumed that the growth in nominal GDP in 1997-98 would work out to 15.2 per cent. It now appears that that figure would be much lower, about 9.5 per cent. The slower rate of growth resulting from restricted government expenditure affects the government's revenues as well. At any assumed level of tax-buoyancy, lower growth implies lower tax collections.

But taxes have not reflected even that degree of buoyancy that the lower rate of growth of nominal GDP warrants, because of the cut in tax rates. Based on its "voodoo economics", the Finance Ministry had projected that despite the substantial direct tax concessions provided in the budget, direct tax collections would rise (by 13.2 per cent) almost in proportion with nominal GDP (15.2 per cent). This implies that with growth in nominal GDP closer to 9.5 per cent, the growth in direct tax revenues should be well over 8 per cent as compared with the dismal 1.7 per cent rise recorded during the first seven months of the year. This suggests that a substantial part of the concessions have just been eaten up and have not served as the carrot to encourage taxpayers to pay proportionally more taxes. A similar situation prevails with regard to customs duties, with the shortfall in customs revenues during the first seven months being much greater than that warranted by the rate of growth of the rupee value of imports (9.8 per cent).

The setback to revenue generation as a result of these factors has been estimated at close to Rs.9,000 crores. That shortfall, together with a lower level of nominal GDP than projected in the budget, is what explains the projected rise in the fiscal deficit to 6.5 per cent of GDP, as compared with 5 per cent in 1996-97. In the past, as in 1993-94, a higher fiscal deficit has been associated with a higher rate of industrial growth. But that was when the higher deficit was due to higher expenditures. The Finance Ministry chose to reduce taxes on the assumption that it would stimulate growth without increasing the fiscal deficit. The vacuity of that assumption is amply established by the fact that while its unwarranted fiscal deficit target would be exceeded by a large margin, the Finance Ministry has managed to engineer a recession in India's industrial sector.

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