Thursday, March 26, 2015
Basics on Fiscal Policy
At the outset, it is important to clarify certain basic concepts. The most elementary is
perhaps the difference between revenue and capital flows, be they receipts or
expenditures. While there are various complex legal and formal definitions for these
ideas, presenting some simplified and stylised conceptual clarifications is deemed
appropriate. A spending item is a capital expenditure if it relates to the creation of an
asset that is likely to last for a considerable period of time and includes loan
disbursements. Such expenditures are generally not routine in nature. By the same logic a
capital receipt arises from the liquidation of an asset including the sale of government
shares in public sector companies (disinvestments), the return of funds given on loan or
the receipt of a loan. This again usually arises from a comparatively irregular event and is
not routine. In contrast, revenue expenditures are fairly regular and generally intended to
meet certain routine requirements like salaries, pensions, subsidies, interest payments,
and the like. Revenue receipts represent regular „earnings‟, for instance tax receipts and
non-tax revenues including from sale of telecom spectrums.
There are various ways to represent and interpret a government‟s deficit.
The simplest is the revenue deficit which is just the difference between revenue receipts and revenue expenditures.
Revenue Deficit = Revenue Expenditure – Revenue Receipts (that is Tax + Non-tax Revenue) A more comprehensive indicator of the government‟s deficit is the fiscal deficit. This is the sum of revenue and capital expenditure less all revenue and capital receipts other than 6 loans taken. This gives a more holistic view of the government‟s funding situation since it gives the difference between all receipts and expenditures other than loans taken to meet such expenditures.
Fiscal Deficit = Total Expenditure (that is Revenue Expenditure + Capital Expenditure) – (Revenue Receipts + Recoveries of Loans + Other Capital Receipts (that is all Revenue and Capital Receipts other than loans taken)) “The gross fiscal deficit (GFD) of government is the excess of its total expenditure, current and capital, including loans net of recovery, over revenue receipts (including external grants) and non-debt capital receipts.” The net fiscal deficit is the gross fiscal deficit reduced by net lending by government (Dasgupta and De, 2011). The gross primary deficit is the GFD less interest payments while the primary revenue deficit is the revenue deficit less interest payments. 3. India’s fiscal policy architecture
The Indian Constitution provides the overarching framework for the country‟s fiscal policy. India has a federal form of government with taxing powers and spending responsibilities being divided between the central and the state governments according to the Constitution. There is also a third tier of government at the local level. Since the taxing abilities of the states are not necessarily commensurate with their spending responsibilities, some of the centre‟s revenues need to be assigned to the state governments. To provide the basis for this assignment and give medium term guidance on fiscal matters, the Constitution provides for the formation of a Finance Commission (FC) every five years. Based on the report of the FC the central taxes are devolved to the state governments. The Constitution also provides that for every financial year, the government shall place before the legislature a statement of its proposed taxing and spending provisions for legislative debate and approval. This is referred to as the Budget.
The central and the state governments each have their own budgets. The central government is responsible for issues that usually concern the country as a whole like national defence, foreign policy, railways, national highways, shipping, airways, post and telegraphs, foreign trade and banking. The state governments are responsible for other items including, law and order, agriculture, fisheries, water supply and irrigation, and public health. Some items for which responsibility vests in both the Centre and the states include forests, economic and social planning, education, trade unions and industrial disputes, price control and electricity. There is now increasing devolution of some powers to local governments at the city, town and village levels. The taxing powers of the central government encompass taxes on income (except agricultural income), excise on goods produced (other than alcohol), customs duties, and inter-state sale of goods. The state governments are vested with the power to tax agricultural income, land and buildings, sale of goods (other than inter-state), and excise on alcohol. 7 Besides the annual budgetary process, since 1950, India has followed a system of fiveyear plans for ensuring long-term economic objectives. This process is steered by the Planning Commission for which there is no specific provision in the Constitution. The main fiscal impact of the planning process is the division of expenditures into plan and non-plan components. The plan components relate to items dealing with long-term socioeconomic goals as determined by the ongoing plan process. They often relate to specific schemes and projects. Furthermore, they are usually routed through central ministries to state governments for achieving certain desired objectives. These funds are generally in addition to the assignment of central taxes as determined by the Finance Commissions. In some cases, the state governments also contribute their own funds to the schemes. Non-plan expenditures broadly relate to routine expenditures of the government for administration, salaries, and the like. While these institutional arrangements initially appeared adequate for driving the development agenda, the sharp deterioration of the fiscal situation in the 1980s resulted in the balance of payments crisis of 1991, which would be discussed later. Following economic liberalisation in 1991, when the fiscal deficit and debt situation again seemed to head towards unsustainable levels around 2000, a new fiscal discipline framework was instituted. At the central level this framework was initiated in 2003 when the Parliament passed the Fiscal Responsibility and Budget Management Act (FRBMA).
Taxes are the main source of government revenues. Direct taxes are so named since they are charged upon and collected directly from the person or organisation that ultimately pays the tax (in a legal sense).2 Taxes on personal and corporate incomes, personal wealth and professions are direct taxes. In India the main direct taxes at the central level are the personal and corporate income tax. Both are till date levied through the same piece of legislation, the Income Tax Act of 1961. Income taxes are levied on various head of income, namely, incomes from business and professions, salaries, house property, capital gains and other sources (like interest and dividends).3 Other direct taxes include the wealth tax and the securities transactions tax. Some other forms of direct taxation that existed in India from time to time but were removed as part of various reforms include the estate duty, gift tax, expenditure tax and fringe benefits tax. The estate duty was levied on the estate of a deceased person. The fringe benefits tax was charged on employers on the value of in-kind non-cash benefits or perquisites received by employees from their employers. Such perquisites are now largely taxed directly in the hands of employees and added to their personal income tax. Some states charge a tax on professions.
Most local governments also charge property owners a tax on land and buildings. 2 Economic theory indicates that the incidence of a tax depends on various factors. In the case of commodity taxes these include the respective elasticties of supply and demand. 3 A capital gain (or loss) arises when a person sells off a capital asset. The gain (or loss) is the difference between the price at which the asset was purchased and the price at which it is sold and represents an appreciation (or fall) in value. Often an adjustment to the basic value of the asset is made to include factors like cost inflation or economic depreciation due to wear and tear. 8 Indirect taxes are charged and collected from persons other than those who finally end up paying the tax (again in a legal sense). For instance, a tax on sale of goods is collected by the seller from the buyer. The legal responsibility of paying the tax to government lies with the seller, but the tax is paid by the buyer. The current central level indirect taxes are the central excise (a tax on manufactured goods), the service tax, the customs duty (a tax on imports) and the central sales tax on inter-state sale of goods. The main state level indirect tax is the post-manufacturing (that is wholesale and retail levels) sales tax (now largely a value added tax with intra-state tax credit). The complications and economic inefficiencies of this multiple cascading taxation across the economic value chain (necessitated by the constitutional assignment of taxing powers) are discussed later in the context of the proposed Goods and Services Tax (GST).
Evolution of Indian fiscal policy till 1991 India commenced on the path of planned development with the setting up of the Planning Commission in 1950. That was also the year when the country adopted a federal Constitution with strong unitary features giving the central government primacy in terms of planning for economic development (Singh and Srinivasan, 2004). The subsequent planning process laid emphasis on strengthening public sector enterprises as a means to achieve economic growth and industrial development. The resulting economic framework imposed administrative controls on various industries and a system of licensing and quotas for private industries. Consequently, the main role of fiscal policy was to transfer private savings to cater to the growing consumption and investment needs of the public sector. Other goals included the reduction of income and wealth inequalities through taxes and transfers, encouraging balanced regional development, fostering small scale industries and sometimes influencing the trends in economic activities towards desired goals (Rao and Rao, 2006).
In terms of tax policy, this meant that both direct and indirect taxes were focussed on extracting revenues from the private sector to fund the public sector and achieve redistributive goals. The combined centre and state tax revenue to GDP ratio increased from 6.3 percent in 1950-51 to 16.1 percent in 1987-88.4 For the central government this ratio was 4.1 percent of GDP in 1950-51 with the larger share coming from indirect taxes at 2.3 percent of GDP and direct taxes at 1.8 percent of GDP. Given their low direct tax levers, the states had 0.6 percent of GDP as direct taxes and 1.7 percent of GDP as indirect taxes in 1950-51 (Rao and Rao, 2006). The government authorised a comprehensive review of the tax system culminating in the Taxation Enquiry Commission Report of 1953. However, the government then invited the British economist Nicholas Kaldor to examine the possibility of reforming the tax system. Kaldor found the system inefficient and inequitable given the narrow tax base and inadequate reporting of property income and taxation. He also found the maximum marginal income tax rate at 92 percent to be too high and suggested it be reduced to 45 4 The Indian financial year commences on the 1st of April of a calendar year and ends on the 31st of March of the next calendar year. 9 percent. In view of his recommendations, the government revived capital gains taxation, brought in a gift tax, a wealth tax and an expenditure tax (which was not continued due to administrative complexities) (Herd and Leibfritz, 2008).
--Exerpt from Fiscal Policy in India: Trends and Trajectory by Supriyo De January, 2012
The simplest is the revenue deficit which is just the difference between revenue receipts and revenue expenditures.
Revenue Deficit = Revenue Expenditure – Revenue Receipts (that is Tax + Non-tax Revenue) A more comprehensive indicator of the government‟s deficit is the fiscal deficit. This is the sum of revenue and capital expenditure less all revenue and capital receipts other than 6 loans taken. This gives a more holistic view of the government‟s funding situation since it gives the difference between all receipts and expenditures other than loans taken to meet such expenditures.
Fiscal Deficit = Total Expenditure (that is Revenue Expenditure + Capital Expenditure) – (Revenue Receipts + Recoveries of Loans + Other Capital Receipts (that is all Revenue and Capital Receipts other than loans taken)) “The gross fiscal deficit (GFD) of government is the excess of its total expenditure, current and capital, including loans net of recovery, over revenue receipts (including external grants) and non-debt capital receipts.” The net fiscal deficit is the gross fiscal deficit reduced by net lending by government (Dasgupta and De, 2011). The gross primary deficit is the GFD less interest payments while the primary revenue deficit is the revenue deficit less interest payments. 3. India’s fiscal policy architecture
The Indian Constitution provides the overarching framework for the country‟s fiscal policy. India has a federal form of government with taxing powers and spending responsibilities being divided between the central and the state governments according to the Constitution. There is also a third tier of government at the local level. Since the taxing abilities of the states are not necessarily commensurate with their spending responsibilities, some of the centre‟s revenues need to be assigned to the state governments. To provide the basis for this assignment and give medium term guidance on fiscal matters, the Constitution provides for the formation of a Finance Commission (FC) every five years. Based on the report of the FC the central taxes are devolved to the state governments. The Constitution also provides that for every financial year, the government shall place before the legislature a statement of its proposed taxing and spending provisions for legislative debate and approval. This is referred to as the Budget.
The central and the state governments each have their own budgets. The central government is responsible for issues that usually concern the country as a whole like national defence, foreign policy, railways, national highways, shipping, airways, post and telegraphs, foreign trade and banking. The state governments are responsible for other items including, law and order, agriculture, fisheries, water supply and irrigation, and public health. Some items for which responsibility vests in both the Centre and the states include forests, economic and social planning, education, trade unions and industrial disputes, price control and electricity. There is now increasing devolution of some powers to local governments at the city, town and village levels. The taxing powers of the central government encompass taxes on income (except agricultural income), excise on goods produced (other than alcohol), customs duties, and inter-state sale of goods. The state governments are vested with the power to tax agricultural income, land and buildings, sale of goods (other than inter-state), and excise on alcohol. 7 Besides the annual budgetary process, since 1950, India has followed a system of fiveyear plans for ensuring long-term economic objectives. This process is steered by the Planning Commission for which there is no specific provision in the Constitution. The main fiscal impact of the planning process is the division of expenditures into plan and non-plan components. The plan components relate to items dealing with long-term socioeconomic goals as determined by the ongoing plan process. They often relate to specific schemes and projects. Furthermore, they are usually routed through central ministries to state governments for achieving certain desired objectives. These funds are generally in addition to the assignment of central taxes as determined by the Finance Commissions. In some cases, the state governments also contribute their own funds to the schemes. Non-plan expenditures broadly relate to routine expenditures of the government for administration, salaries, and the like. While these institutional arrangements initially appeared adequate for driving the development agenda, the sharp deterioration of the fiscal situation in the 1980s resulted in the balance of payments crisis of 1991, which would be discussed later. Following economic liberalisation in 1991, when the fiscal deficit and debt situation again seemed to head towards unsustainable levels around 2000, a new fiscal discipline framework was instituted. At the central level this framework was initiated in 2003 when the Parliament passed the Fiscal Responsibility and Budget Management Act (FRBMA).
Taxes are the main source of government revenues. Direct taxes are so named since they are charged upon and collected directly from the person or organisation that ultimately pays the tax (in a legal sense).2 Taxes on personal and corporate incomes, personal wealth and professions are direct taxes. In India the main direct taxes at the central level are the personal and corporate income tax. Both are till date levied through the same piece of legislation, the Income Tax Act of 1961. Income taxes are levied on various head of income, namely, incomes from business and professions, salaries, house property, capital gains and other sources (like interest and dividends).3 Other direct taxes include the wealth tax and the securities transactions tax. Some other forms of direct taxation that existed in India from time to time but were removed as part of various reforms include the estate duty, gift tax, expenditure tax and fringe benefits tax. The estate duty was levied on the estate of a deceased person. The fringe benefits tax was charged on employers on the value of in-kind non-cash benefits or perquisites received by employees from their employers. Such perquisites are now largely taxed directly in the hands of employees and added to their personal income tax. Some states charge a tax on professions.
Most local governments also charge property owners a tax on land and buildings. 2 Economic theory indicates that the incidence of a tax depends on various factors. In the case of commodity taxes these include the respective elasticties of supply and demand. 3 A capital gain (or loss) arises when a person sells off a capital asset. The gain (or loss) is the difference between the price at which the asset was purchased and the price at which it is sold and represents an appreciation (or fall) in value. Often an adjustment to the basic value of the asset is made to include factors like cost inflation or economic depreciation due to wear and tear. 8 Indirect taxes are charged and collected from persons other than those who finally end up paying the tax (again in a legal sense). For instance, a tax on sale of goods is collected by the seller from the buyer. The legal responsibility of paying the tax to government lies with the seller, but the tax is paid by the buyer. The current central level indirect taxes are the central excise (a tax on manufactured goods), the service tax, the customs duty (a tax on imports) and the central sales tax on inter-state sale of goods. The main state level indirect tax is the post-manufacturing (that is wholesale and retail levels) sales tax (now largely a value added tax with intra-state tax credit). The complications and economic inefficiencies of this multiple cascading taxation across the economic value chain (necessitated by the constitutional assignment of taxing powers) are discussed later in the context of the proposed Goods and Services Tax (GST).
Evolution of Indian fiscal policy till 1991 India commenced on the path of planned development with the setting up of the Planning Commission in 1950. That was also the year when the country adopted a federal Constitution with strong unitary features giving the central government primacy in terms of planning for economic development (Singh and Srinivasan, 2004). The subsequent planning process laid emphasis on strengthening public sector enterprises as a means to achieve economic growth and industrial development. The resulting economic framework imposed administrative controls on various industries and a system of licensing and quotas for private industries. Consequently, the main role of fiscal policy was to transfer private savings to cater to the growing consumption and investment needs of the public sector. Other goals included the reduction of income and wealth inequalities through taxes and transfers, encouraging balanced regional development, fostering small scale industries and sometimes influencing the trends in economic activities towards desired goals (Rao and Rao, 2006).
In terms of tax policy, this meant that both direct and indirect taxes were focussed on extracting revenues from the private sector to fund the public sector and achieve redistributive goals. The combined centre and state tax revenue to GDP ratio increased from 6.3 percent in 1950-51 to 16.1 percent in 1987-88.4 For the central government this ratio was 4.1 percent of GDP in 1950-51 with the larger share coming from indirect taxes at 2.3 percent of GDP and direct taxes at 1.8 percent of GDP. Given their low direct tax levers, the states had 0.6 percent of GDP as direct taxes and 1.7 percent of GDP as indirect taxes in 1950-51 (Rao and Rao, 2006). The government authorised a comprehensive review of the tax system culminating in the Taxation Enquiry Commission Report of 1953. However, the government then invited the British economist Nicholas Kaldor to examine the possibility of reforming the tax system. Kaldor found the system inefficient and inequitable given the narrow tax base and inadequate reporting of property income and taxation. He also found the maximum marginal income tax rate at 92 percent to be too high and suggested it be reduced to 45 4 The Indian financial year commences on the 1st of April of a calendar year and ends on the 31st of March of the next calendar year. 9 percent. In view of his recommendations, the government revived capital gains taxation, brought in a gift tax, a wealth tax and an expenditure tax (which was not continued due to administrative complexities) (Herd and Leibfritz, 2008).
--Exerpt from Fiscal Policy in India: Trends and Trajectory by Supriyo De January, 2012
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