India Economic Reform

FISCAL POLICY

1991 Economic Reform

The root problem with India's macroeconomic started in the early eighties when its revenue surpluses were starting to turn into deficits mainly because of the lack of fiscal policies. To finance its investment and current consumption, the government had to borrow externally from multilateral lending institutions, other government external aid, capital market, and non-resident Indians (NRIs). Coming into the 1990s, the external debt had tripled from $22.8 billion in 1983-84 to $69.3 billion in 1990-91. Also by 1990-91, the gross fiscal deficit had grown to about 10% of GDP, of which 4.3% of GDP was for interest payment.

In addition, in 1990, the external investors, including the NRIs, started to lose their confidence in India's economy and political stability. The political instability in 1990 shown by two changes of prime minister within a year led to the lack of confidence in government's ability to build and manage any improvement in the economy. Two external events also played major roles in triggering withdrawal of capital and deposits in Indian banks by investors and NRIs. First, the steep rise in oil price during the Gulf crisis in 1990 put pressure on the exchange rate, thus causing expectation of rupees devaluation. Second, the collapse of the Soviet Union fueled the call for reconsideration of India's economic strategy that was largely inspired by the Soviet Republic. As one of the result of this lack of confidence, the foreign exchange reserves had gone down to the level of less than the cost of 2-1/2 months worth of imports.

These serious macroeconomic and balance of payments crisis prompted the creation of 1991 economic reforms with the following agendas: fiscal consolidation and limited tax reforms, removal of controls on industrial investment and on imports, reduction in import tariffs, creation of a less unfavorable environment for foreign capital, prudent management of movements in the exchange rate, making the rupee convertible for current account transaction, and opening energy and telecommunication sectors for private investment.

Fiscal Deficit

The implementation of 1991 reforms had resulted in significant improvements in India's economy. Almost all programs included in the reforms showed promising achievements, with the exception of the fiscal consolidation and tax reformation plans. The shortfall in the fiscal consolidation was reflected in the unsustainable decline of the central government fiscal deficit as shown in the figure X below:

The fiscal deficit went down initially from 6.6% of GDP in 1990-91 to 4.1% of GDP in 1996 only to steadily rise again to 6.1% of GPD in 2001-02 . Two main factors affecting the increase of the fiscal deficit from 1996-97 to 2001-02 are reduction in the total tax revenue, which fell from 10.1% of GDP in 1990-91 to only 8.2% of GDP in 2001-02, and the inefficient expenditure restructuring / management.

As a reaction to the continuing increase of the fiscal deficit, the Fiscal Responsibility and Budget Management Bill was proposed in 2000. The bill, however, took some time to be passed, while the situation got worse before the bill finally was passed as an act (FRBMA) and implemented in mid 2003. In summary, FRBMA was created to: provide a legal and institutional framework to bring down the fiscal deficit, contain the growth of public debt and stabilize debt as a proportion of GDP, and bind future government to a pre-specified path of fiscal consolidation. The latter was an important tool to overcome the political situation in India that is characterized by instability due to the change in the ruling government party every 5 years. In order to measure the progress and the success of the FRBMA, two major fiscal parameters were targeted: elimination of revenue deficit and progressive reduction of fiscal deficit to less than 2% of GDP within 5 years, and reduction of total liabilities to less than 50% of GDP within 10 years after the implementation of the FRBMA.

To reduce the fiscal deficit, the government prioritized three main programs in purpose of increasing the tax revenue:

I. Increase the indirect tax revenue from service tax

The number of services liable for taxation was gradually increased from three in 1994 to six in 1996, and gradually increased to 99 services in 2006. The service tax rate was also increased from 5% in 1994 to 8% in 2003, and finally 12% in 2006. As a result, the service tax revenue increased from 407 crore in 1994 to 1,059 crore in 1996, and ~34,500 crore in 2006.

II. Implementation of Value Added Tax (VAT)

At macro level, the introduction of VAT could help address the fiscal deficit problem since the revenues collected actually mean lowering of the fiscal deficit burden for the government. If properly implemented, VAT can ultimately lead to a reduction in overall rates