India’s current fiscal architecture: 3+4+5+6=18

Since the implementation of Goods and Services Tax (GST) in India, the Central Government is now a primary decision-maker on almost all the taxes in the country. With an effective veto power in the GST Council and its ability to set the income and corporate taxes and various custom duties, the Central Government now has a say on the rates at which taxes are levied across almost all commodities. Of the total revenues collected by the States and the Centre, around four-fifths of it is decided for by the Central Government. The taxes collected by the Central Government are then shared with the States in the ratios laid down by the Finance Commission (FC).

What this the practical application of the above mean? In FY2020, the total receipts collected by the Central Government is budgeted to be Rs 26 lakh crore (or Rs 26 trillion). If the budgeted number holds, Rs 8 trillion will be shared with them as part of the FC formula. This leaves the central government with receipts of Rs 18 trillion.

The committed revenue expenditure of the Central Government is Rs 18 trillion. To make it easy to understand and remember, just think of this as 3-4-5-6. The Central Government is committed to spending Rs 3 trillion on subsidies (food subsidy being the largest, followed by fertilizer), Rs 4 trillion is spent on social development (agriculture, rural development, health and education), Rs 5 trillion goes in pay and pensions (and the latter is increasingly a larger share of the total pie), and Rs 6 trillion is the interest paid on the loans outstanding against the Government.

With the revenues of the Central Government being already spoken for in the various running expenditure, anything to be spent on defense and on capital investment comes from the fiscal deficit, which is budgeted to amount to Rs 7 trillion for this year. There have been some concerns on whether the numbers budgeted as receipts are aggressive and whether they will be achieved in reality. There is practically no such concern on the committed expenditure. We hence have a situation where the government may have receipts of Rs 18 trillion but is surely committed to running expenditure of Rs 18 trillion. This leaves very little margin for error if investments in defense and capex are to be done.

Sometimes if the Governments are surprised with the actual results of its receipts or of its expenses, it uses the ‘cash-flow’ nature of accounting of its finances to help tide over the difficulty. By not paying out expenses or by collecting more revenue and not returning the excess, Governments can show a healthier fiscal picture. Governments hope – and possibly plan – that when the times change, they will reverse the situation. If the Governments were to move to an ‘accrual accounting method’, this method of smoothing the fiscal situation would possibly not work out. In any case, markets tend to build their own estimate of the ‘real fiscal deficit number’.

On a different note, note that Rs 7 trillion is collected directly by the States as their part of the GST. Coupled with the Rs 8 trillion received from the Centre and their own collections on account of duties on goods outside of the GST (like alcohol and petroleum, etc.) and stamp duties, all States put together cumulatively have a much similar receipt and expenditure budget as the Centre. While we will not go in to the numbers for the States here (their Budget documents will come with a lag), the States are also broadly locked in a similar fiscal position. While States do not have to spend on defense, there are a large number of social and public goods that the directly under the control and purview of the States.

With the expenditure of both the Central and the State Governments already committed, any slight imbalance in revenues or expenditure can lead to a dramatic change in the resultant fiscal deficit. It is not a surprise that even small changes in tax rates or compliance are so highly sought after. Any incremental monies received by either levels of Government (as taxes or transfers) can create some buffer for spending or simply, help keep the deficit in control.

Both Central Government and all State governments put together spend around Rs 25 trillion each. This spend of Rs 50 trillion or so, on an economy with a GDP of Rs 200 trillion, makes Government a quarter of the GDP. No wonder that whenever there is a whiff of an economic slowdown, there is intense demand for the Governments to boost spending. The aforementioned tight management of finances means that Governments practically constrained in making a meaningful difference – without upsetting the overall balance in the economy.

There is a need to build a more stable fiscal architecture which allows the Government some leeway in increasing or decreasing its role in the economy. As the economy races to be US$5 trillion strong (or say Rs 400 trillion, at an exchange rate of Rs 80/US$), this doubling of the size of the economy offers the Governments a chance to re-imagine their budgets. In the next article, we will look at a short-term and a long-term idea on how to make this happen.

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