IMC Journal (page 7; opens a pdf)
Long-term trends on revenues, expenses, and debt of Union government show (a) India’s path from subsidies to capex, (b) a more conservative fiscal stance, and (c) a potentially lower debt-to-GDP ratio
Since the interim budget did not, as expected, made many new announcements, we use the occasion to discuss longer-term trends on the fiscal dynamics of the Indian government.
For the purposes of this article, we looked at the last two decades. Twenty years is a long period to get a good handle on the stability of the trends or the changes therein. This era saw two regimes: both of which dealt with a large macroeconomic crisis each: the global financial crisis in FY2009 and FY2010 and the Covid-19 pandemic which significantly impacted FY2021 and FY2022. Macroeconomic crises leave their mark on government finances: they reduce revenues for the government (as growth slows or dips) or require the government to expand expenditure to alleviate stress, inevitably leading to higher debt. The best way to work off the higher debt is, not surprisingly, higher growth.
Inflows and outflows: Union government receipts, net of devolution to the states, have largely been stable in the range of ~9-10% of GDP over the last two decades. Most of the receipts (7-8% of GDP) are via tax collections, both direct and indirect. The expenditure of the government varies between ~13-15% of GDP. In years or crisis, two things happen: GDP comes down (especially during the pandemic) and the government needs to spend more for social welfare. This leads to a sharp rise in the expenditure to GDP ratios. However, a reasonable steady state ratio at 13-15%, leads to a Union government fiscal deficit of ~4-5%. We note that periodically a target of 3% fiscal deficit to GDP is set as part of fiscal responsibility legislation.
Naturally, financing fiscal deficits requires borrowing. Like everyone else, the government needs to find the cash to spend and for that it needs to find savers and investors willing to lend it money. Like the 3% fiscal deficit target, Finance Commission recommends that the debt-to-GDP ratio should be 40% and 20% for the Union and the States respectively. Due to a combination of higher expenses and lower GDP, Covid led to the combined debt ratio to rise close to 90% of GDP. In a steady state, an average of say 4% and 3% annual Union and States fiscal deficits respectively with 10% nominal growth (say, 6% real growth and 4% inflation) can bring down the debt-to-GDP ratio going forward. While a higher nominal growth can chip away debt-to-GDP ratio quickly (as happened in CY2011-14), it is best to keep inflation in check from a wide range of social cohesion perspectives.
Another way to keep debt low is to increase revenues, lower expenses, or improve the productivity of expenses. On the revenue side, increasing incomes, tech-enabled compliance, and tax reforms is leading to an increase in the number of assesses in both direct and indirect taxes. Over time, this could push up the tax-to-GDP ratio by a few notches. On its expenses, a large part of the Union’s budget is committed to central schemes (from NREGA to DBT, from Mudra to Sagarmala), interest, subsidies, and pensions. A recent RBI paper by Dr Patra, et al, noted that if India were to invest in energy transition, digitalization, and employment in productive sectors, India could bring down its debt-to-GDP faster.
Governments (largely all over the world) use cash accounting principles. This means that even monies invested on capital expenditure is treated as deficit. So, if the government commits to investing 3.4% of GDP in capital expenditure (when it targets 5.1% fiscal deficit in FY2025), it means that the benefit of this spending should be visible over many years. We note that subsidies as a percentage of total Union government expenditure went from 9% in FY2024 to 13% in FY2014 which is expected to contract to 7% by FY2025E. A transition of expenditure towards capex from subsidies is clearly visible.
Coming back to the quantum of borrowings, we note that the typical level of annual net borrowings of the Union government before the pandemic ranged in the INR 4-5 trillion a year. Pandemic spending (and a fall in revenues) led the government to borrow around INR 10-12 trillion annually over the last few years. Such a large increase in borrowings by the government was managed well by the markets with yields on government securities, and hence for the overall economy, not moving significantly, apart from some transmission of the policy rate increases. We are now in a situation where the absolute levels of government borrowing could come down (as the government reduces the fiscal deficit even further to below 4.5% in FY2026E) even as the GDP continues to grow strongly. This should create a larger space for the private sector to borrow.
With the addition of Indian bonds in the various global indices, a new set of players are expected to enter the market for financing government borrowings. This new supply of capital should also lead to the creation of a larger space of borrowing for the private sector as the government reduces, at the margin, the dependence on the local financial institutions like banks, insurance companies, and pension funds to subscribe to government securities.
Going forward, we would keep an eye out continued fiscal consolidation, leading to lower borrowings (which could possibly filter down into lower yields). As the debt-to-GDP reduces (as explained above), this could lead to a reduction in the proportion of government’s expenses going towards interest. Lowering of the interest-to-GDP burden can open fiscal space for new investment or welfare programs. We should continue to expect the government as a large player in capital investments. The implied assumptions in this are: (a) real growth remains high and inflation in check, (b) taxes, both direct and indirect, continue increasing as a percentage of GDP, and (c) capex continues to get priority over subsidies.
Well-managed fiscal dynamics of the government creates a stable macroeconomic environment. This increases the confidence of the private sector to invest and for foreigners to bring in capital.
The author is a public policy expert. Views are personal.
