government finance-union and states

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UNIT 19 GOVERNMENT FINANCE: UNIONAND STATES

Structure

19.0 Objectives

19.1 Introduction

19.2 An Overview of Combined Finances of Union and States19.3 Finances of Union/Central Government

19.4 Finances of State Governments

19.5 Improving the Finances of Union and States

19.6 Let Us Sum Up

19.7 Exercises

19.8 Key Words

19.9 Some Useful Books

19.10 Answers or Hints to Check Your Progress Exercises

19.0 OBJECTIVES

This unit is concerned with Union-States finances. While going through thisunit, you will be able to:

describe the structure of budget;

explain the various concepts;

discuss the finances of Union Government;

examine the finances of State governments;

analyse the issues and concerns of finances of both Union and States; and

relate the remedial measures for improving the financial health of theGovernment.

19.1 INTRODUCTION

The fiscal position of the Governments both Centre and States has beenunder stress since the mid-1980s. The stress stems from the inadequacy ofreceipts in meeting the growing expenditure requirements. Reflecting thefiscal stress, the expenditure for developmental activities, which are directlyrelated to growth, has suffered. On the other hand, expenditure on non-developmental purposes, largely committed, has witnessed a steady rise. The

crucial issue, therefore, is to bring about improvement in the finances with aview to restructuring the expenditure in favour of developmental expenditurein order to enable higher growth.

That the state of finances of the States is in disarray is beyond dispute. TheState finances have not been properly managed not only by the States but also

by the Planning Commission and the Central Government, which includeeconomists who do not see States as autonomous, responsible organisationswhich have to take care of the debt by themselves. Today, one of the majorobstacles in the way of reviving growth is the sorry state of State financessince they could not do the minimum that they should do. They have no


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money to invest. Apart from the persistent problem of unacceptable revenuedeficits and high fiscal deficits, many State governments are now faced withthe problem of mounting debt, particularly the burden of contingent liabilitiesin the form of outstanding guarantees.

Mandating fiscal responsibility for the Government through the statute is anidea which is yet to receive active political endorsement in India. But thefiscal environment for the Central and State governments has already become

perilously grave. The subject cannot brook any further delay. Fiscal sickness

is a grave problem in India. Many State governments are already technicallybankrupt while many others are just short of being terminally ill. The UnionGovernment finances are under great strain; interest on public debt eats awayhalf of revenue receipts and even current consumption expenditure is financed

by borrowing. Both the Central and State governments continue to spendrecklessly and do not take any serious steps to mobilise resources andstreamline revenue collections. Fiscal indiscipline is rampant. The total debtof the Central and State governments is currently estimated at above 80 percent of GDP. Recent years have seen a very sharp upsurge in the indebtednessof the centre as well as the states. Ultimately, budgets are an exercise in

political brinkmanship, balancing considerations of fiscal prudence withpolitical strategy. The whole issue of over-emphasis on fiscal compression asa matter of public policy needs to be visited, especially in the current contextof India facing a high fiscal deficit. Much as one may bemoan it, it is onlycrises that bestirs us into action.

19.2 AN OVERVIEW OF COMBINED FINANCESOF UNION AND STATES

Trends in Pattern of Revenue

Taxes on goods and services are levied in India in various forms and atdifferent levels of Government, Centre, states, and local bodies. Among the

taxes that are leviable on goods and services, are customs andexcises leviedby the Centre andsales taxes levied by the states. These three taken togetheraccount for about 70 per cent of the total tax revenue and over 80 per cent ofthe aggregate revenue from indirect taxes.

Indirect taxes are taxes on goods and services have for a long time been thedominant source of Government revenue in India, and their significance hasgrown sharply after Independence. The increase that has taken place in thelevel of taxation in the Indian economy over the past five decades from 6.3

per cent of GDP in 1950 -51 to nearly 16 per cent at the end of century isattributable almost wholly to indirect taxes. While direct taxation hasremained at around 2.3 to 3.6 per cent of GDP, the ratio of indirect taxes has

risen from 4.0 to over 12 per cent. Predominance of indirect taxes is a well-known characteristic of Indias tax structure. Factors responsible for this are:(i) dominance of the unorganised sector, (ii) poor literacy level, (iii) absenceof standard accounting practices, (iv) low level of per capita income, and (v)

problems inherent in the economy which create many administrativeproblems. Therefore, governments usually fall back on taxes on foreign trade,on the one hand, and on domestic production and trade, on the other, to meetthe revenue requirements.


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Table 19.1: Tax Revenue of Centre, States & Union Territories as Proportion of GDP

Taxes/years 1950-51 1980-81 1990-91 2000-01 2003-04(BE)

Direct Taxes 2.33 2.27 2.16 3.43 3.64

Indirect Taxes 3.99 11.53 13.27 11.18 11.42

Total Tax Revenue 6.31 13.80 15.43 14.61 15.06

Source: Indian Public Finance Statistics 2003-2004, Government of India, Ministry

of Finance.Direct taxes of the combined Government sector (Centre and States puttogether) which constituted about 27 per cent, on an average, of the total taxrevenues during the three decades of the fifties to seventies, eroded to about15 per cent during the 1980s and remained at around 16 per cent, on anaverage, during the 1990s so far (Table 19.1). One of the major problems inGovernment finances pertains to the constraints in raising resources throughtax and non-tax measures. With the ongoing fiscal reforms there has beensome improvement in direct tax collection. Non-tax revenue has not shownany noticeable increase. Moreover, the non-tax revenue generation process ishampered by the high quantum of subsidies both hidden and explicit.

Public Expenditure Trends

The expenditure pattern of the Government sector has been generally guidedby the concern about the role of the State in the economy, both as investor andas provider of basic public services. As a result, Government expenditureshave, over the years, shown steady growth. On the whole, the overallexpenditure of both the states and the Centre is rising at a faster rate thannational income; there is actually a rise in both revenue and capitalexpenditure as a percentage of total income. The aggregate of both theCentres and States expenditures accounts for about 35 per cent of thecountrys GDP. This share has risen by three percentage points since 1993-1994, when it was 32 per cent.

According to Sudipto Mundle andM. Govinda Rao an analysis of the growthof real public expenditure since the mid-1970s reveals four distinct phases:

i) During the first phase, from the mid-1970s to 1981, real expenditureincreased at the rate of about 7 per cent, and its current (revenue) andcapital components were growing at similar rates. Expenditure wasoutstripping revenue, but the recourse to internal and external borrowingwas still relatively modest.

ii) In the second phase (1981-86), the growth of Government expenditureaccelerated to about 10 per cent. This was entirely attributable to the

growth of revenue expenditure, which had accelerated to over 11 percent, the growth of capital expenditure remaining more or less constant atunder 7 per cent. The growth of revenue had also accelerated during this

period, but growth in expenditure was running well ahead of it. As aconsequence, the size of the fiscal deficit widened from under 5 per centearlier to over 9 per cent, requiring increasing recourse to borrowed fundsto finance the deficit. Also, by the end of this phase, revenue expenditureexceeded revenue receipts, implying the emergence of a revenue accountdeficit. In other words, the Government was now beginning to borrowmoney to finance not just capital expenditure but also a part of itscurrent expenditure.


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iii) The third phase of Government expenditure (1987-90) was marked bysome attempts to rein in its growth. The brunt of this attempt atexpenditure compression was borne by capital expenditure, resulting in asteep deceleration in the growth of capital spending. However, revenueexpenditure continued to grow at over 10 per cent. At the end of this

phase total expenditure amounted to about 29 per cent of GDP while thetotal deficit amounted to about 9.9 per cent. The revenue deficit had risento 4.4 per cent, implying that almost half of all fresh borrowing was beingused to finance revenue expenditure.

iv) The fourth phase covers the period after 1991, during which Indiapursued an adjustment programme. Fiscal correction was an importantcomponent. However, revenue expenditure continued to grow faster thantotal expenditure, thereby crowding out capital expenditure. Theimbalance in expenditure growth has led to reduced importance of theinfrastructure sectors, particularly social sector which is highly growth-inducive in nature. The combined Government expenditure on socialsector (comprising mainly, education, medical facilities, public health,family welfare and sanitation) has remained stagnant over the years as percent of GDP. Social sector expenditure showed steady deterioration fromabout 7.9 per cent of GDP during the late eighties to 7.5 per cent of GDPduring the post-reform period. The deterioration in the allocations undersocial sector is sharper in the case of Centre than States. This is adverselyreflected on the quality of fiscal adjustment pursued since 1991-92.

Fiscal Imbalance

The persistent rise in resource gap has led to a growing volume of public debt.The central feature that emerges is a serious fiscal imbalance, arising from theinability of the Government to control the growth of revenue expenditure.Taking the long view, revenues have risen from only 8.4 per cent of GDP in1950-51 to the current 19 to 20 per cent. However, expenditure has grownfaster after starting from a larger base. It has risen from 9.5 per cent of GDP in

1950-51 to around 29 per cent at present. Hence, the fiscal balance hasremained in deficit throughout and the deficit has grown to over 9 per cent ofGDP. The revenue account deficit has, however, arisen only since the mid-eighties, resulting in a progressive crowding out of Government capitalexpenditure from around that time (Table 19.2).

Table 19.2: Share of Government Revenues, Expenditures and Deficits in GDP

(Percentage)

YearsRevenue

ExpenditureCapital

ExpenditureTotal

ExpenditureTotal

RevenueRevenueDeficit

FiscalDeficit

1950-51 7.7 1.8 9.5 8.4 0.7 -1.1

1960-61 9.5 6.0 15.5 10.7 1.2 -4.8

1970-71 13.3 4.9 18.2 13.6 0.3 -4.6

1980-81 17.4 8.2 25.6 17.5 0.1 -8.1

1990-91 23.0 5.6 28.7 18.5 4.4 9.9

2000-01 24.0 2.0 25.9 17.5 6.5 9.21

2003-04 25.0 2.8 27.7 18.4 6.6 9.22

Source: Various publications of RBI.


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The overall deficit has led to a number of adverse effects on both short-termmacro-economic outcomes as well as the longer-term growth prospects of theIndian economy. Financing a large and growing deficit has resulted in theaccumulation of a huge public debt. The public debt GDP ratio has risen

from under 30 per cent in 1981-82 to over 75 per cent at present, and thereare serious concerns now regarding the sustainability of the debt. The intereston public debt is now the fastest growing component of revenue expenditure,which, in turn, is the principal component of total expenditure responsible fordriving up the deficit. Financing the deficit requires fresh borrowing, whichexpands the stock of debt. This leads to further increase in the expenditure oninterest payments, further expanding the deficit.

A major weakness of Government finances has been the inability to curtailrevenue expenditures. The structural character acquired by revenueimbalances during the 1990s has been a critical factor underlying the rigidity

of fiscal imbalances and explains as to why fiscal correction has not been

durable during the 1990s. Thus, the combined fiscal deficit at the end of thedecade was the same as at the beginning at around nine per cent of the GDP.

The sharp increase in the debt-GDP ratio, reflective of burgeoning interestpayments, essentially represents the overhang of outstanding liabilitiescontracted at a high interest cost in the past. There is a structural rigidity in thedownward adjustment in the combined domestic debt of the Governmentsector to GDP ratio (Table 19.3).

Table 19.3: Combined Liabilities and Debt-GDP Ratio

Outstanding Liabilities Debt to GDP Ratio

Year Centre States Combined Centre States Combined

(End-March) (Rupees crore) (In per cent)

1 2 3 4 5 6 7

1990-91 3,14,558 1,10,289 3,50,957 55.3 19.4 61.7

1996-97 6,75,676 2,43,525 7,73,629 49.4 17.8 56.5

2001-02 13,66,409 5,89,797 16,32,084 59.5 25.7 71.1

2003-04 (BE) 17,80,064 5,39,908 23,19,972 59.9 29.1 74.2

Check Your Progress 1

Note: i) Space is given below each question for your answer.

ii) Check your answer(s) with those given at the end of the unit.

1) Give an overview of combined finances of Union and States in foursentences.

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2) Which factors are responsible for predominance of indirect taxes in Indiastax Structure?

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19.3 FINANCES OF UNION/CENTRALGOVERNMENT

Trend and Pattern of Revenue

The composition of tax revenues at the Centre has changed significantly withdirect tax as a proportion of total tax revenues rising from 19.1 per cent in1991 to 41.4 per cent in 2003-04, resulting in a corresponding decline in the

proportion of indirect tax revenue from 78.4 per cent in 1991 to 57.9 per centin 2003-04. At the same time, tax revenue as a percentage of GDP is almoststagnant; in fact, it is declining, the figure being 10.1 per cent in 1991 and 9.2

per cent in 2003-04. This is in spite of the addition of service tax toGovernment revenue at 0.3 per cent in 2004-05.

The Centres total tax collection stood at Rs. 3,03,856 crore for the fiscal year2004-05. The indirect taxes mop-up at Rs. 1,71,131 crore saw a growth of 16

per cent while there was a 26.3 per cent growth in direct tax, which stood atRs. 1,32,725 crore. Customs collections for 2004-05 stood at Rs. 57,645 crore,which is an 18.58 per cent growth and service tax at Rs. 14,134 crore was anincrease of 79.12 per cent. Personal income tax collection grew by about 17

per cent to touch Rs. 48,321 crore in 2004-05. Though the service taxcollection ticked over 79 per cent growth during 2004-05, it still constituted asmall percentage of total tax collections. The mop-up from wealth tax and thenew securities transaction tax accounted for Rs. 823 crore, merely Rs. 600crore coming from Securities Transaction Tax (STT) in six months of itsintroduction from October 1, 2004.

A closer scrutiny of the tax realisation figures over the years show thatcollection of corporation tax, income tax and service tax as percentage ofGDP has gone up. Corporation tax collection as percentage of GDP increasedfrom 1.4 per cent in 1995-96 to 2.3 per cent in 2003-04. During thecorresponding period, income tax collection improved from 1.4 per cent of

GDP in 1995-96 to 1.5 per cent in 2003-04. There has been gradualimprovement in tax collection as far as direct taxes are concerned. The

problem becomes manifest when one looks at the collection pattern of indirecttaxes. Excise duty realisation as percentage of GDP was 3.4 per cent in 1995-96. It slipped to a low of 3.1 per cent in 1998-99 before showing someimprovement. In the 2004-05, it has been estimated at 3.5 per cent of GDP.The problem has been with regard to customs collection. It was 3.0 per cent ofGDP in 1995-96. Thereafter, there had been continual decline in share incustoms collection as percentage of GDP. It dipped to 1.7 per cent in 2004-05.The collection of service tax is going up but it is too insignificant to make up

for losses of custom revenue. As percentage of GDP, it was 0.1 per cent in1995-96. It touched 0.3 per cent in 2004-05 (Table 19.4). The single mostimportant factor which is responsible for dip in tax-GDP ratio is customs

duty. This is the cost of lowering customs duties to the Association ofSoutheast Asian Nations (Asean) levels and meeting the World TradeOrganisation (WTO) commitments. Signing of Free Trade Agreements(FTAs) and like treaties is also having an adverse bearing on customscollection. More recently, the decision of the Government to reduce customsduties on crude oil and petroleum products to contain inflation will also meanlesser duty realisation.


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A major weakness of the Indian tax system that has contributed to the slippagein tax-GDP ratio during the nineties vis--vis eighties has been the continueddependence on indirect taxes. The collection of Union excise duties (whichform a predominant proportion of the indirect taxes) is largely dependent onthe industrial activity. The growth in Centres gross indirect tax collectionshas decelerated from 16.9 per cent in the eighties to 10.1 per cent in thenineties. There has also been a compositional shift in the tax structure with theshare of indirect taxes in gross tax revenue declining from 80.3 per cent in theeighties to 70.7 per cent in the nineties. These structural shifts would indicatethat the tax structure is becoming increasingly vulnerable to the industrial

performance.

Table 19.4: Ratio of Central Taxes to GDP(Percentage)

YearGross TaxRevenues

CorporationTax

IncomeTax

Customs ExciseDuties

ServiceTax

1995-96 9.4 1.4 1.3 3.0 3.4 0.1

1996-97 9.4 1.4 1.3 3.1 3.3 0.1

1997-98 9.1 1.3 1.1 2.6 3.2 0.1

1998-99 8.3 1.4 1.2 2.3 3.1 0.1

1999-00 8.9 1.6 1.3 2.5 3.2 0.12000-01 9.0 1.7 1.5 2.3 3.3 0.1

2001-02 8.2 1.6 1.4 1.8 3.2 0.1

2002-03 8.8 1.9 1.5 1.8 3.3 0.2

2003-04 RE 9.2 2.3 1.5 1.8 3.3 0.3

2004-05 RE 10.2 2.8 1.6 1.7 3.5 0.5

Source: Chandra Shekhar, 2005.

Expenditure Trends and Pattern

Total expenditure of the Centre has risen twice as fast as total revenue,although much of this reflects rising interest payments. Revenue expenditure

consists of interest payments, subsidies, public administration, and defenceexpenditure. The non-plan expenditure of the Central Government formsalmost three-fourths of the aggregate expenditure, with the revenuecomponent constituting a significant proportion. The principal non-plancomponents are interest payments, defence, subsidies and non-plan grants toStates and Union Territories (UTs) on the revenue side, and non-plan loans to

States and UTs on the capital side. While the rates of growth in defence and

subsidies were contained substantially, the interest expenditure continues to

strain Central finances.

Furthermore, interest expenditure, on an average, absorbed 28.6 per cent ofthe revenue receipts during the eighties as compared with 46.4 per cent in the

nineties. This reflects the mounting pressure on Centres finances arising outof debt accumulation. Another major item of expenditure which exerted

pressure on the Centres finances is the non-plan loans to States and UTsagainst small savings. Thus, the earmarking of an increasing proportion ofCentres resources towards meeting non-plan expenditure has resulted inreducing the leverage of the Central Government in directing financialflows towards developmental needs. The inability on the part of theGovernment to raise larger revenue receipts in view of the growingexpenditure commitments constituted yet another structural weakness of theCentral finances (Table 19.7).


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A rigid distinction between developmental and non-developmentalexpenditure with regard to their contribution to growth is somewhat difficultsince certain non-developmental expenditure items such as expenditure onadministrative services also exercise some influence, although of an indirectnature, on economic development. Within the developmental expenditure, therelative importance of social services has increased even though its share intotal expenditure has been broadly stable. This outcome is due to a steadydecline in the share of expenditure on economic services in total expenditure.There is little doubt that the countrys infrastructure remains woefullyinadequate. Even then, the Central Governments expenditure oninfrastructure as a percentage of total expenditure is on the decline.Expenditure on infrastructure gets broadly classified under the head of capitalexpenditure. For the Centre, capital expenditure accounted for as little as 23.5

per cent of its overall expenditure, with the rest of the expenditure gettingcovered under revenue expenditure, accounting for 76.5 per cent of totalexpenditure. There was a large drop in the Centres capital expenditure from2000-2003. From 24 per cent during the early 1990s, it dropped by ten

percentage points during 2000-2003. But it has now recovered to its originallevels. As far as the Centre goes, 13 per cent of the total share of 17 per centin GDP goes as revenue expenditure while the remaining 4 per cent gets

counted as capital expenditure.

There is probably little room to cut capital expenditures. Of course, in thefuture, the private sector rather than the Government should meet most of theenormous infrastructure needs of a growing economy. Further progress isneeded in reductions in each of the four main areas of current spending.

Borrowings

The widening fiscal gap led to a steep rise in the outstanding liabilities of theCentral Government. The outstanding domestic debt of the CentralGovernment as a ratio to GDP is budgeted to rise. According to a report by theComptroller and Auditor General of India (CAG) aggregate fiscal liabilities of

the Government rose but its average growth rate has been decelerating overthe years. Internal liabilities constituted the bulk as external debt comprised

just over 11 per cent in 2003-04 and grew at an average annual rate of 11.88per cent from 1992 to the financial year 2004. Of internal liabilities, domesticdebt accounted for around two-thirds of total liability in 2003-04 and grew atan annual average growth rate of 16.81 per cent from 1992 to 2003-04, while

public account liabilities had the lowest growth rate of 10.79 per cent.Aggregate fiscal liabilities GDP ratio peaked during 1991-92 when itreached 65.43 per cent of GDP. In the last two years, while the ratio of fiscalliabilities to GDP rose to 62.69 per cent in 2002-03, it came down to 59.87 percent in 2003-04, close to the long-term trend levels. The long-term tendencyof the ratio of fiscal liabilities to GDP ratio was of acceleration at an average

annual rate of shift of 0.17 per cent during 1985-2004. If various componentsof fiscal liabilities in 1985-86 are set to 100, the index value of internal debt,external debt and total liabilities in 2003-04 would be 1,607; 691 and 1,137respectively (The Economic Times, May 7, 2005).

Borrowing would not in itself be a serious source of concern if it could servethe purpose of developmental requirements. But borrowing to meet currentconsumption cannot necessarily ensure adequate return to meet the interest

burden and repayment of loan liabilities. The distortions created by the presentfiscal structure would lead to an unsustainable accumulation of theGovernment debt. When is debt sustainable? Although economic theory has


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no answer to what the prudent debt/GDP ratio should be, it is well understoodthat a continuously rising ratio can lead to a situation where the Governmentcan default on its debt obligations. A high debt ratio is a long-termconsequence of a Government running high fiscal deficits. The rising debtservice burden has already started crowding out productive Governmentexpenditure. What is the debt being used for? The use of debt for consumptionmakes servicing difficult in the future.

Fiscal Reforms at the Central Government Level

Fiscal reforms at the Centre covered tax reforms, expenditure pruning,restructuring of PSUs, and better coordination between monetary and fiscal

policies.

i) Tax Reforms: The main focus of the reforms was on simplification andrationalisation of both direct and indirect taxes drawing mainly from therecommendations of the Tax Reforms Committee, 1991 (Chairman: RajaJ. Chelliah). Accordingly, the tax rates were significantly rationalised and

progressively brought down to the levels comparable to some of thedeveloped economies. The concern with tax rationalisation has beenreflected in the appointment of a number of committees to review the tax

system in the last few years. The Advisory Group on Tax Policy and TaxAdministration for the Tenth Plan, 2001 (Chairman: Parthasarathi

Shome) recommended deletion of a number of exemptions and deductionswhich have become redundant and are not in harmony with a modern taxregime (Government of India, 2001a). Similarly, theExpert Committee to

Review the System of Administrative Interest Rates and Other Related

Issues, 2001 (Chairman: Y.V. Reddy) recommended the withdrawal of taxconcessions available on small savings. Furthermore, the Task Force on

Direct Taxes and Indirect Taxes, 2002 (Chairman: Vijay Kelkar) hasreiterated the need to withdraw exemptions and concessions to widen thetax base. Base widening can be done in two ways: first, bringing in alarger number of potential taxpayers into the tax net, and second,

eliminating the numerous exemptions and deductions provided incomputing taxable income to serve non-tax objectives.

The structural reforms in taxation and the economy-wide efficiency gainsachieved over the past few years are beginning to bear fruit. The gross taxrevenue of the Centre has grown at a compounded average annual rate ofnearly 18 per cent over the last three years, taking the tax/GDP ratio, forthe first time, near the 10 per cent mark. The introduction of a TaxInformation Network (TIN), along with reduction in tax rates, shouldfurther increase compliance and boost tax revenues. The thrust of the taxreform has been towards reducing rates and simplifying procedures, and,

of course, increasing compliance through measures like one-by-six

schemes. This buoyancy on the direct tax side provided the Governmentwith the necessary leverage to reduce indirect taxes, resulting in a

favourable shift in the composition of taxes. The share of corporate andpersonal income-tax, which constitute the bulk of direct tax, in the grosstax revenue of the Government is budgeted to increase from a dismal 20

per cent in 1990 to nearly 48 per cent in 2005-06. The Government needsto build on these gains through further tax reform, largely aimed atwidening the tax base.

However, what is significant to note is that though the exchequer is payingthe cost of reducing customs duties, it is not adequately reaping the


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benefits of a calibrated softening of import duties. One possible reason istax evasion. It is relatively difficult to evade customs than income tax andexcise duties. Thus, the loss in customs collection is not beingcompensated by gains accruing on account of increased industrial activity

and higher personal income. One of the realistic conclusions that may bedrawn after looking at the tax collections is that Indian taxation system ismore plagued with evasion rather than want of proper taxing strategy. The

dilapidated taxing apparatus is crying for attention of tax experts. The

need of the hour is not to make excise, customs and income tax inspectors

scapegoats for poor revenue collection, but to integrate them in the

overall strategy for checking tax evasion and improving tax-GDP ratio.

Tax, after all, is sovereigns due and not a voluntary contribution!

(Chandra Shekhar, 2005).

ii) Expenditure Management: Successive Central Government budgets inthe 1990s contemplated a host of measures to curb built-in growth inexpenditure and to bring about structural changes in the composition ofexpenditure. These included: (i) subjecting all ongoing schemes to zero-based budgeting and assessment of manpower requirements ofGovernment departments. This was sought to be achieved by reviewingnorms for creation of posts and fresh recruitment and introduction of aVoluntary Retirement Scheme (VRS) for surplus staff, (ii) review of allsubsidies with a view to introducing cost-based user charges whereverfeasible, (iii) review of budgetary support to autonomous institutions andencouragement to PSUs to maximise generation of internal resources.These measures, by and large, focused on downsizing Government andreducing its role and administrative structure, (iv) Further, as aninstitutional arrangement, the Government constituted an Expenditure

Reforms Commission (ERC) to look into areas of expenditure correction.Areas identified by the ERC include, inter-alia, creation of a national foodsecurity buffer stock and minimisation of cost of buffer stock operationsand rationalisation of fertiliser subsidies through dismantling of controls in

a phased manner. It also included optimising Government staff strength bya ban on the creation of new posts for two years, introduction of VRS andredeployment of surplus staff in various Government departments andautonomous institutions, to which the Government provides budgetarysupport through grants, and (v) With a view to promoting transparencyand curbing the growth of contingent Government liabilities, a GuaranteeRedemption Fund has been set up as a part of expenditure managementstrategy.

iii) Restructuring of the Public Sector: During the reform period, there hasbeen a distinct change in the public perception in favour of reducing thesize of public sector and improving private participation. With these

underlying objectives, a two-pronged strategy was adopted by the CentralGovernment reduction in budgetary support to the PSUs and

privatisation of existing PSUs.

iv) Fiscal-Monetary Coordination: Another important objective of thereform process has been to improve fiscal-monetary coordination.Furthermore, following the Supplemental Agreement between theGovernment of India and the Reserve Bank in September 1994, theabolition of ad hoc Treasury Bills was made effective from April 1997,thereby replacing the automatic monetisation of deficit by a system ofWays and Means Advances (WMA) to meet only the temporary


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mismatches in cash flows of the Central Government. Concomitant tothese measures, Statutory Liquidity Ratio (SLR) was reduced to25 per cent by 1997 and Cash Reserve Ratio (CRR) was reduced in phasesto 4.75 per cent by November 2002.

v) Institutional Measures: As an institutional mechanism to strengthenfiscal discipline, the Central Government enacted Fiscal Responsibilityand Budget Management Act (FRBM), 2003.




1) Explain the reasons for increasing trend in revenue expenditure of theCentral Government.

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2) Explain the various steps relating to fiscal reforms taken by the CentralGovernment.

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19.4 FINANCES OF STATE GOVERNMENTS

The Indian constitution provides for demarcation of functional responsibilitiesand finances between the Centre and the States. The provision of publicservices has been largely entrusted to the States. These mainly relate to lawand order, public health, sanitation, water supply and agriculture. The Stateshave to concurrently take certain functions in areas such as education,infrastructure. Their share in combined expenditure (Centre and States) onsocial services is about 85 per cent, while in the case of economic services, itis about 60 per cent. Thus, the States have the primary responsibility toundertake tasks pertaining to developing social and economic infrastructure.

However, their ability to undertake such developmental functions is criticallydetermined by their financial position.

The growing importance of state finances in the macro-economy is evidentfrom the fact that the total expenditures of State governments have evenundertaken those of the Centre. The size of overall development expendituresof the states has always been higher than that of the Centre and the differencehas got widened rather significantly in the 1990s.

Among the taxes that fall within the jurisdiction of the states, the mostsignificant from the point of view of revenue and economic impact are the


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sales taxes. Other significant taxes on goods and services levied by the statesare: excise duties on alcoholic liquor and narcotics contributing about 15 percent stamps andregistration duties (7 per cent), taxes on vehicles (5 per cent),electricity duties (4 per cent), taxes on passengers and goods (3 per cent), andentertainment tax (a little over 1 per cent). Substantial revenue from taxationofminerals also accrues to the states in the form of share ofroyalty andcess,

but these are sometimes classified in the budget as non-tax revenue. In somestates, cess on minerals like coal is included in land revenue.

Revenue receipts of the State governments comprising of both States ownrevenue receipts (i.e., tax and non-tax revenue receipts) as well as currenttransfers from the Centre have not exhibited the required buoyancy. This ismanifest in the stagnation in the tax-GDP ratio around the level of 7 to 8 percent of GDP since 1990-91. States own revenue receipts accounted for 61.8

per cent of total revenue receipts in 2003-04 (RE), while the balance 38.2 percent was contributed by current transfers from the Centre. In recent years,within current transfers from Centre, there has been a switch from taxes togrants.

There has been a steady deterioration in the quality of expenditure pattern of

State governments. The share of developmental expenditure in total

expenditure declined from 69.5 per cent in 1990-91 to 54.5 per cent in 2003-04 (RE), while that of non-developmental expenditure rose from 24.8 per centto 32.1 per cent over the same period. The rise in the share of non-developmental expenditure is mainly on account of committed items, such as,interest payments and pensions. This is a matter of concern as in the existingfederal fiscal arrangement, States have been entrusted with the basicresponsibilities of providing social infrastructure like health, education,sanitation, etc. In view of pre-emption of revenues to fund such committedexpenditures, the aggregate social sector expenditure of State governmentsdeclined from 6.6 per cent of GDP in the latter half of the 1980s to 5.9 percent of GDP in 2003-04 (RE). Capital outlay, which reflects the portion of

borrowing going for productive purposes, showed a secular uptrend. States

show a slight rise in their proportion of capital spending, even though it is stillquite low. At the state level, capital expenditure as a proportion of overallexpenditure is even lesser, at about 21 per cent, while revenue expenditureaccounts for 79 per cent of the total. The situation of states with regard tocapital expenditure is improving. The overall expenditure has increased fromabout 18 per cent to 21 per cent over the last 10 years. States show a slight risein their proportion of capital spending, even though it is still quite low. At thestate level, capital expenditure as a proportion of overall expenditure is evenlesser, at about 21 per cent, while revenue expenditure accounts for 79 percent of the total.

The cumulative impact of the steadily rising level of Gross Fiscal Deficit

(GFD) is reflected in the growing outstanding liabilities of the Stategovernments which increased from 19.4 per cent of GDP (Rs. 1,10,289 crore)in 1990-91 to 29.1 per cent of GDP (Rs. 8,07,131 crore) in 2003-04 (RE).Such high level of outstanding liabilities has, in turn, resulted in large interest

payments, preempting about a quarter of revenue receipts of the States.

The fiscal position of the State governments has been under stress since themid-1980s. The stress stems from the inadequacy of receipts in meeting thegrowing expenditure requirements. The low and declining buoyancies in bothtax and non-tax receipts, constraints on internal resource mobilisation due tolosses incurred by State public sector undertakings, electricity boards and


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decelerating resource transfers from the Centre have resulted in rising fiscaldeficit of the State governments with an accompanying surge in theoutstanding stock of debt. Haseeb S. Drabu (2002) has observed that there aresystemic factors in this deterioration rather than state-specific reasons. Theoverall picture does not reveal the vast inter-state variation in fiscal position.Reflecting the fiscal stress, the expenditure for developmental activities,which are directly related to growth, has suffered; on the other hand,expenditure on non-developmental purposes, largely committed, haswitnessed a steady rise.

The acute concerns expressed about the financial health of State governmentsby the RBI, repetitively by the successive finance commissions and inliterature on the Indian fiscal system, have originated in the conceivably largeand growing explicit subsidies allowed to users of power, water and publictransport facilities. Vast losses incurred by state electricity boards, unduly lowirrigation charges and uneconomic transport fares have all combined to

produce unduly low returns on decades of past investments, which, in turn,have adversely affected further investments in irrigation, power and transport,and have also hurt the required expansion in education and health and othersocial services (EPWRF, 2001).

The severe mis-match in the budgetary operations of the States primarilyemanates in the form of structural imbalance in the revenue account whicheventually seeps into debt accumulation (Table 19.5 & 19.6).

Table 19.5: Total Receipts of State Governments

(Rupees Crore)

AverageItem

1990-95 1995-00 2000-02 2004-05 BE

1 2 3 4 5

Total Receipts (1+2) 5,42,295

(16.1) (15.2) (16.6) (17.4)

1. Total Revenue Receipts (a+b) 3,67,428

(12.1) (10.9) (11.3) (11.8)

(a) States Own Revenue 2,30,991(7.3) (6.9) (7.1) (7.4)

(i) States Own Tax 1,82,982

(5.4) (5.3) (5.6) (5.9)

(ii) States Own Non-tax 48,009

(1.8) (1.6) (1.5) (1.5)

(b) Central Transfers 1,36,437

(4.9) (4.0) (4.2) (4.4)

(i) Shareable Taxes 77,343

(2.6) (2.4) (2.4) (2.5)

(ii) Central Grants 59,094

(2.3) (1.6) (1.8) (1.9)

2. Capital Receipts (a+b) 1,74,867(4.0) (4.2) (5.3) (5.6)

(a) Loans from Centre 33,852

(1.2) (1.0) (1.0) (1.1)

(b) Other Capital Receipts 1,41,015

(2.9) (3.2) (4.3) (4.5)

BE: Budget Estimates.

Figures in brackets are percentages to GDP.

Source: RBI Bulletins.


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Table 19.6: Expenditure Pattern of State Governments

(Rupees Crore)

Item Average

1990-1995 1995-2000 2000-2002 2004-2005 BE

1 2 3 4 8

Total Expenditure 5,42,824

1+2 = 3+4+5 (16.0) (15.3) (16.6) (17.4)

1. Revenue Expenditure 4,15,687

of which (12.8) (12.6) (13.9) (13.3)

Interest Payments 91,648

(1.7) (2.0) (2.6) (2.9)

2. Capital Expenditure 1,27,137

of which (3.2) (2.7) (2.7) (4.1)

Capital Outlay 56,629

(1.6) (1.4) (1.5) (1.8)

3. Development Expenditure 2,80,823

(10.8) (9.6) (9.8) (9.0)

4. Non-Development

Expenditure

1,99,065

(4.3) (4.9) (5.9) (6.4)

5. Others 62,936

(0.9) (0.7) (0.9) (2.0)

BE: Budget Estimates.

Figures in brackets are per centages to GDP.

Source: RBI Bulletins.

Fiscal reforms in the States were, inter-alia, necessitated by:

i) growing fiscal imbalances;

ii) sluggishness in Central transfers resulting from falling tax to GDP ratio;iii) introduction of reform-linked assistance as a part of Medium-Term Fiscal

Reform Programme on the basis of the recommendations of the Eleventhand Twelfth Finance Commissions; and

iv) adjustment programme undertaken in some of the States which are linkedto borrowings from multilateral agencies.

States differ not only in terms of the quantum of fiscal deficit, but also interms of the quality of fiscal deficit which can be best measured in terms ofthe ratio of revenue deficit to fiscal deficit. Lower the ratio, higher the

proportion of fiscal deficit deployed to fund capital expenditure. A one-sizefits all approach is not applicable in respect of States.

State Level Fiscal Reforms

Measures initiated by the States may be broadly grouped under revenuemobilisation, expenditure containment, public sector restructuring and

institutional reforms. In addition to States own efforts, the Centre has alsotaken initiatives to strengthen the reform process at the State level.

i) Tax Reforms: Recognising the need for strengthening their finances,States have initiated measures towards enhancement/restructuring ofvarious taxes within their fold, such as, land revenue, vehicle tax,


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entertainment tax, sales tax, electricity duty, tax on trades, professional taxand luxury tax. With a view to harmonising inter-State taxes andultimately switch over to State-level Value Added Tax (VAT), Statesintroduced uniform floor rate during 2000. Currently, Value Added Tax(VAT) has been introduced in 21 states in April 2005.

ii) Non-tax Measures: States have also undertaken measures to enhancenon-tax revenues by reviewing/rationalising the royalties payable to them,including those on major and minor minerals, forestry and wildlife,

revision of tuition fees, medical fees, irrigation water rates and tariffs onurban water supply. The issue of raising user charges commensurate withthe cost of public services rendered, however, has not been given seriousconsideration yet. Recognising this aspect, the Medium Term FiscalReform Programmes finalised by several States have emphasised the costeffectiveness and raising of user charges of services rendered by them.

iii) Expenditure Management: The State governments measures to containexpenditure, inter-alia, include restrictions on fresh recruitment/creation ofnew posts, review of manpower requirements and cut in establishmentexpenses and reduction in non-merit subsidies through better targeting.

iv) Public Sector Restructuring: Several States have shown interest inundertaking a comprehensive review of the functioning of the State PublicSector Undertakings (SPSUs), including the possibility of closing down ofnon-viable units after providing for suitable safety-nets to the employeesincluding VRS. States such as Tamil Nadu, Kerala, Haryana, Karnataka,Himachal Pradesh, Goa and Orissa have encouraged private sector

participation in the transport and power generation sectors. In order tostrengthen the administrative machinery, many States have initiatedmeasures to computerise their records as well as their day-to-dayfunctioning. Several States have also initiated measures to reform the

power sector, which is crucial for the fiscal reforms.

v) Institutional Reforms: The institutional reforms undertaken by the Statesare also aimed at facilitating the fiscal consolidation process. States haveinitiated proposals to provide statutory backing to the fiscal reform processthrough enabling legislation. In recent years, initiatives have been taken bysome States to enhance transparency of budgetary operations.

vi) Centres Initiatives: In pursuance of the recommendations of theEleventh Finance Commission (EFC), an Incentive Fund for State fiscalreforms has been set up at the Centre.

vii)Reserve Banks Initiatives: In the recent past, the Reserve Bank hasinitiated a close and intensive interaction with State governments on a

regular basis and on a wide range of issues.




1) Do you think that the quality of expenditure pattern of State governmentshas deteriorated over the years? Give two reasons in support of youranswer.


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...

...

...

...

2) What measures have been initiated by the States to remove/reduce theirfiscal imbalance.

...

...

...

...

19.5 IMPROVING THE FINANCES OF UNIONAND STATES

Current imbalances in public finances lie not so much in the overall fiscaldeficit but more in the composition of Government expenditure (cutback in

public investment, inadequate expenditure on education and health) andmodes of financing (reliance on high cost borrowing instruments). Dr. RajaChelliah is of the view that the most important thing for restoring growthmomentum in the economy is to restructure the finances of the Stategovernments, which is even more important than controlling the fiscal deficitat the Centre. Expenditure Reforms have been neglected for long. They have

been postponed on one pretext or the other. Any fiscal management strategycannot ignore this. Expenditure outcomes must result in achievementinstead of activity. Union Ministry of Finance alone cannot achieve thisoutcome. Expenditure Reforms, however, must entail the following (N.K.Singh, 2005):

i) It must entail an objective evaluation of the ongoing portfolio, both Planand Non-Plan.

ii) Expenditure evaluation is largely predicated on achievement of physicaland financial targets. There is little emphasis on evaluating expenditurequality, more so the sustainability of the activities once the project lifecycle has been completed.

iii) Our expenditure management in practice is no more than incrementalexpenditure provisioning. This incremental expenditure approach is

divorced from examining the rationale and quality of ongoing portfoliosper se. Zero Based Budgeting has become a statistical compliancedivorced from the original purpose of subjecting the activity to a morerigorous evaluation.

iv) Expenditure control also involves calibration of subsidies, ensuringimproved targeting to intended beneficiaries. This is the easier said thandone. Identification of intended beneficiaries and alternative options forsubsidy delivery require careful consideration.

v) Re-organisation of Government has been postponed for long. Coalitionpolitics and the need to accommodate more ministers inhibits action. How


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else can we explain the presence of a separate department for mines whichdoes not include coal; or petroleum which does not include

petrochemicals; or industry which does not include steel or textiles; and

transport which does not include roads or shipping to name only a few

anomalies. Downsizing Government has also lost favour.

vi) Expenditure management requires a holistic approach. As the economygrows more rapidly and there are changes in expenditure pattern withemphasis on social and physical infrastructure and as public private

partnership grows, we need innovative institutional responses.

The bulk of the subsidies went to non-meritgoods like food, fertiliser andpetroleum products. There is clearly a need for an exit policy for the foodsubsidy. Until now it is only smaller subsidies such as those on the EPFinterest rate that have been addressed. The big challenge lies in the foodsubsidy.

Employment is Central to Tax Policy

Under taxation is at the root of the Indian fiscal problems. The availableevidence shows that the tax-GDP ratio in India is lower than the level itshould have for its per capita GDP by at least 2.5 per cent. It is, therefore,

important to focus reform efforts to increase the tax ratio. Of course, this doesnot mean that the strategy to increase the tax ratio lies in increasing the taxrates. The strategy is to reiterate that tax administration is tax policy. Allexemptions will not go. Politically, it is not possible. The world over, therewas a time when we thought that equity in tax policy meant reducing theincomes of the rich. But todays tax philosophy is that equity in tax policy isincreasing the incomes of the poor. The incomes of the poor cannot beincreased by reducing those of the rich, because the latter possess capital forinvestment and provide employment for the poor. To increase employment forthe poor, you do not need tax policy so much as expenditure policy. A 90 percent marginal tax rate will not bring in equity because you are dealing withless than 3 per cent of the population which actually pays the taxes and it does

not make much sense to talk about equity within this class (M. Gorinda Rao,2005).

The challenge is to devise a tax system that will get non-salaried individualsto file tax returns. The self-employed are active in: (i) unorganisedmanufacturing, (ii) construction, (iii) wholesale and retail trade, (iv) hotelsand restaurants, (v) non-railway transport, (vi) real estate, ownership ofdwellings and business services, and (vii) other services. It is important for theGovernment to recognise the limitations of taxing self-employed in a countrylike India with real issues of corruption. Taxation is not the onlyinstrumentality to benefit society at large or achieve top social goals. In thecurrent set-up, tax-evaders can default without fearing penalty. The otherimportant tax source is the services sector. The Government has to widen thenet to cover all-important services. Almost 50 years ago, Stanley Surrey, aneminent tax expert, cautioned that in developing countries too much

preoccupation with what to do (tax policy) may lead to too little attention onhow to do it. The primary task of improving tax administration is to drasticallysimplify tax structures. This calls for a simple, broad-based, low rated and lessrate differentiated tax structure. Prof. Indira Rajaraman, RBI Chair Professorat NIPFP, comments: At present rates of taxation, which are far lower thanthey were before reform, there continue to remain large areas of non-compliance. With fuller compliance, the taxation system will become more


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equitable, and revenues will be higher. If the barrier to better compliance is arate structure that is still too high, lowering rates to the compliance-maximising level will generate higher tax revenues. Whichever way it islooked at, a rise in the tax-GDP ratio is both possible and necessary, for morethan just a revenue consideration.

In designing a tax administration three important aspects must be considered.These are: (i) Architecture, (ii) Engineering, and (iii) Management. The

Architecture includes the legal framework and processes and procedures.

Engineering aspects deal with orgnisational structure and operating rules fortax administration andManagement aspects actually administer the taxes.Simple tax structure helps to have an unambiguous legal framework. Theintroduction of Tax Information Network (TIN) for administering the incometax by the Government is, in part, the realisation that real or effective taxsystem depends on how information is collected and processed. In countrieslike India, as Milka Casanegra put it, tax administration is tax reform andwe should focus our efforts to improve it. This is, however, possible onlywhen there is willingness on the part of the political classes to improve taxadministration and enforcement. Most reforms fail because politicians are acog in the wheel and resist effective reforms. If they are on the side of reforms,

the necessary condition is satisfied and sufficient conditions too will follow.

Enlarging Social Benefits

What the poor need is unemployment insurance in the unorganised sector, andold age pensions, maternity benefits, health, accident and life insurance for the400 million workers in the unorganised sector. Such schemes can bedeveloped and made self-financing, with only a little backstopping from theCentral and State exchequers (Prem Shankar Jha, 2005). Hard decisionswould not hurt ordinary people in as much as they hurt lobbies and vested

interests (Dr. Raja Chelliah). Unity in diversity and the principle of all for

one and one for all can help in dealing with a common challenge.

Check Your Progress 4Note: i) Space is given below each question for your answer.


1) State three important steps to improve the finances of Union and States.

...

...

...

...

19.6 LET US SUM UP

Persisting fiscal imbalance has been a major macro-economic concern topolicy makers in India. The remarkable downward inflexibility of fiscaldeficits and the steady upward pressure on revenue and primary deficits haveworried successive finance ministers. Despite their good intentions andefforts, success in achieving fiscal correction has been elusive. Thus, theaggregate fiscal deficit-GDP ratio, after declining from 9.3 per cent in 1990-991 to 6.3 per cent in 1996-1997, increased to over 9 per cent in 1998-1999


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and fluctuated around 9-10 per cent thereafter. The revenue deficit increasedfrom 3.6 per cent in 1996-1997 to 6.7 per cent in 2002-2003 and the primarydeficit during the period increased from 1.1 per cent to 3.4 per cent. The shareof the revenue deficit in the fiscal deficit increased from 50 per cent in 1995-96 to 67.5 per cent in 2002-2003.

The Centres recent attempts at fiscal reforms include the enactment of theFiscal Responsibility and Budget Management Act (FRBMA). The Act sets thetargets for the Centres revenue deficit-GDP ratio to be reduced from 2.5 per

cent in 2004-2005 to zero and fiscal deficit to be brought down from 4.3 percent to 3 per cent by 2007-2008, which has been since shifted to 2008-2009.The strategy to achieve the targets was explored by the Task Force headed byVijay Kelkar and more recently by the Twelfth Finance Commission (TFC).

Persisting fiscal imbalances have been attributed to several factors. Thereasons cited are:

i) the inability of domestic indirect taxes to offset the revenue loss from thereduction in customs. In fact, the former itself has declined over the years;

ii) rising pay and pension payments;

iii) increasing interest payments;

iv) poor productivity of public capital; and

v) more importantly, pressures of competitive populism arising fromcoalition politics. (M. Govinda Rao, 2005).

State finances have been the Achilles heel of Indias economy. This has beenhighlighted in many RBI reports. The States fiscal deficit is mostly structural.The States debt service obligations are on the increase, particularly becauseof the revenue deficit especially the problem of financing Electricity Boards.The States interest burden as a percentage of total revenue is as high as 25

per cent. There is the need to devote more attention to the efficiency ofGovernment expenditure. The crucial role of reforms lies in the system of

recoveries of user charges. The reason for high revenue deficit lies in theunder-recovery of user charges, particularly in power and irrigation. Health

and education also need to step up their recovery rates. The mismatchbetween the expenditure responsibilities and revenue raising powers of thestates is to be corrected through the Union budgetary transfers. On theaverage, about 40 per cent of the state revenue budgets are financed by suchtransfers. Comfortable Union finances will ensure higher level of transfersand, hence, better state finances. It would be useful if both the RBI and thePlanning Commission are actively associated with the union financeministrys conference since the three together can exert greater influence onthe states than each of them individually can hope to do. Much as one maybemoan it, it is only crises that bestirs us into action.

An important objective of the economic reforms initiated in the early 1990swas the consolidation and stabilisation of public finances in the country.While a measure of success has been achieved at the Centre, there has been asteep deterioration in the finances of the states especially since 1996-97. As aresult, the consolidated fiscal deficit of the nation has deteriorated to the pre-reform level by the turn of the century. The net effect of tax reforms at theCentre since 1993 has been a decline in the tax-GDP ratio by 2 percentage

points. Irrespective of the statutory requirements under the fiscal legislation,the Government should have the commitment to ensure deficit reduction andgrowth maximisation. The problem of fixing fiscal deficit targets is not with


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the economic logic, but with its practical political implications. India faces thechallenge of achieving fiscal sustainability within a decentralised federalsystem. Indian taxation system is more plagued with evasion rather than wantof proper taxing strategy.

19.7 EXERCISES

1) Examine the trends in the pattern of public revenue and the public

expenditure during the last fifty years. Also account for the predominanceof the indirect taxation in public revenue.

2) What do you mean by fiscal imbalance? What steps have been taken bythe Central Government to correct this situation?

3) Evaluate the different measures taken by the State governments toimprove their finances.

4) The fiscal position of the Governments both Centre and States hasbeen under stress in recent decades. What measures will you suggest toimprove the situation?

5) The fiscal position of the State governments has been under stress since

the mid-1980s. Comment.

19.8 KEY WORDS

Budget: A budget is a statement containing a forecast of revenues andexpenditures for a period of time, usually a year. It is a comprehensive plan ofaction designed to achieve the policy objectives set by the Government for thecoming year. A budget is a plan and a budget document is a reflection of whatGovernment expects to do in future. While any plan need not be a budget, a

budget has to be necessarily a plan. It shows detailed allocation of resourcesand proposed taxation or other measures for their realisation. A budget is,

however, not a balance sheet (exhibiting total assets and liabilities) of theGovernment on a particular date. It is a financial blueprint for action.

Revenue Budget: This consists of the revenue receipts of the Government(tax revenues and other revenues) and the expenditure met from theserevenues.

Tax Revenues: These comprise proceeds of taxes and other duties levied bythe Union.

Other Revenues: These receipts of Government mainly consist of interestand dividend on investments made by Government, fees and receipts for otherservices rendered by Government.

Revenue Expenditure: This is expenditure for the normal running ofGovernment departments and various services, interest charges on debtincurred by Government, subsidies, etc. Broadly speaking, expenditure whichdoes not result in the creation of assets is treated as revenue expenditure. Allgrants given to State governments and other parties are also treated as revenueexpenditure even though some of the grants may be for creation of assets.

Capital Budget: This consists of capital receipts and payments. It alsoincorporates transactions in the Public Account.


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Capital Receipts: The main items of capital receipts are loans raised byGovernment from public which are called market loans, borrowings byGovernment from Reserve Bank and other parties through sale of treasury

bills, loans received from foreign bodies and governments and recoveries ofloans granted by the Union Government to state and Union territorygovernments and other parties.

Capital Payments: These payments consist of capital expenditure onacquisition of assets like land, buildings, machinery, equipment, as also

investments in shares, etc, and loans and advances granted by the UnionGovernment to state and union territory governments, Governmentcompanies, corporations and other parties.

Demands for Grants: This is the form in which estimates of expenditureincluded in the annual financial statement and required to be voted in the LokSabha are submitted. Generally one demand for grant is presented in respectof each ministry or department. However, for large ministries and departmentsmore than one demand is presented.

Finance Bill: The proposals of Government for levy of new taxes,modification of the existing tax structure or continuance of the existing tax

structure beyond the period approved by Parliament are submitted toParliament through this bill.

Performance Budget: This is the budget of the ministry in terms offunctions, programmes and activities and gives appraisal reports separately inrespect of major central sector projects/programmes estimated to cost Rs. 100crore or more.

Appropriation Bill: After the Demands for Grants are voted by the LokSabha, Parliaments approval to the withdrawal from the Consolidated Fundof the amounts so voted and the amount to meet the expenditure charged onthe Consolidated Fund is sought through the Appropriation bill.

Budget Deficit: The receipts minus total expenditure on both revenue andcapital accounts.

Fiscal Deficit: The difference between revenue receipts plus non-debt capitalreceipts on one side and total expenditure including loans, net of repayments,on the other side. In other words, this is the budget deficit plus borrowings andother liabilities.

Primary Deficit: The fiscal deficit minus interest payments.

Balance of Payments (BoP): Statement of the countrys trade and financial

transactions with the rest of the world during the year.

Capital Gains Tax: Tax on the surplus obtained from the sale of an asset formore than was originally paid for it.

Convertibility: The extent to which one foreign currency or internationalreserve asset can be exchanged for some other foreign currency orinternational reserve asset.


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Countervailing Duty: A tax levied on an imported product which raises theprice of the product in the domestic market as a means of counteracting unfairtrade practices by other countries.

Direct Tax: Tax levied by Government on the income and wealth received byhouseholds and businesses.

Direct Investment: Any expenditure on physical assets such as plant,machinery and stocks.

Double Taxation: The taxation of incomes and profits, first in the country inwhich they arise and again when these incomes and profits are repatriated tothe income earners home country.

Effective Interest Rate: The interest rate payable on the purchase price of abond.

Fiscal Policy: An instrument of demand management which seeks toinfluence the level of economic activity in an economy through the control oftaxation and Government expenditure.

Indirect Tax: A tax levied by Government on goods and services.

AJ Curve Effect: The tendency for a countrys balance of payments deficit toinitially worsen following a devaluation of its currency before then movinginto surplus.

Monetary Policy: The tool of macroeconomic policy which involves theregulation of money supply, credit and interest rates in order to control thelevel of spending in the economy.

National Debt: The money owned by the Central Government to domesticand foreign lenders.

Public Debt: National debt and other miscellaneous debt for which theGovernment is ultimately responsible. This would include the accumulateddebt of nationalised industries and local authorities.

Tax Avoidance: Efforts to avoid paying tax by legal means.

Tax Evasion: Efforts to evade the payment of tax by illegal means.

Tax Base: The total pool which tax authorities can tap when levying a tax.

Treasury Bill: Instrument of short-term borrowing for the Government.

Ad Valorem Tax/Duty: An indirect tax which is expressed as a proportion ofthe price of a commodity.

Specific Tax/Duty: A tax of an absolute amount levied per unit of acommodity sold or produced.

Value Added Tax (VAT): A general tax applied at each point of exchange ofgoods or services from primary production to final consumption. It is leviedon the difference between the sale price of output and the cost of inputs.


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19.9 SOME USEFUL BOOKS

Bagchi, Amaresh (1997); Taxation of Goods and Services in India: AnOverview (Included in Public Finance: Policy Issues for India Edited bySudipto Mundle), Oxford University Press, New Delhi.

, (2004); Taxing Services: The Way Forward, Economic andPolitical Weekly, May 8.

, (2005); Do Low Taxes Necessarily Mean More Taxes? BusinessStandard, February 17.

Bajpai, Nirupam & Jeffrey, D. Sachs (2000); Fiscal Policy in IndiasEconomic Reforms (Included inIndia in the Era of Economic Reforms, Edited

by Sachs, Varshney and Bajpai), Oxford University Press, New Delhi.

Chandra, Shekhar (2005); Low Tax-GDP Ratio: A Hard Nut to Crack, TheFinancial Express, February 8.

Drabu, Haseeb A. (2002); Sinha and the States,Business Standard, May 9.

EPW Research Foundation (2001); Finances of State Government of India,Economic and Political Weekly, April 14.

, (2001); Finances of State governments: A Time SeriesPresentation,Economic and Political Weekly, May 19.

, (2004); Finances of State governments: Deteriorating FiscalManagement,Economic and Political Weekly, May 1.

Joshi, Dharmakirti (2005); Dynamics of State Debt: A Tough Balancing ActAhead,Economic and Political Weekly, February 12.

Kurien, N.J. (2001); The States in Crises,Business Standard, August 31.

, (2002); No More Free Lunches, The Economic Times, July 15.

, (2003); Union Budget and State Finances, The Economic Times,February 21.

, (2004); Till Debt Do Us Part, The Economic Times, June 8.

Mundle, Sudipto and Rao, M. Govinda (1992); Issues in Fiscal Policy(Included in The Indian Economy: Problems and Prospects Edited by BimalJalan), Penguin Books, New Delhi.

, (1997); Public Expenditure in India: Trends and Issues (Includedin Public Finance: Policy Issues for India Edited by Sudipto Mundle), OxfordUniversity Press, New Delhi.

Ramanujam, T.C.A. (2005); Why Not a National Fiscal Commission? TheHindu Business Line, April 15.

Rao, M. Govinda (2005); Employment is Central to Tax Policy, BusinessStandard, February 11.


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, (2005); Fiscal Adjustment: What Prospects? Business Standard,May 4.

Reserve Bank of India, Reports on Currency and Finance, Annual Reports ofRBI, RBI Bulletins (Various Issues).

Venkitaramanan, S. (2005); RBIs Survey of State Finances: Lessons for the2004-05 Budgets, The Hindu Business Line, February 7.

World Bank (2004); State Fiscal Reforms in India: Progress and Prospects: AReport, Macmillan India Ltd., New Delhi.

19.10 ANSWERS OR HINTS TO CHECK YOURPROGRESS EXERCISES


1) See Section 19.2

2) See Section 19.2


1) See Section 19.3 under sub-head Expenditure Trends and Patterns.

2) See Section 19.3 sub head Fiscal Reforms at the Central GovernmentLevel.


1) See Section 19.4

2) See Section 19.4


1) See Section 19.5


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Table 19.7: Union Budget at a Glance (In Crore of Rupees)

2003-2004Actuals

2004-2005Budget

Estimates

2004-2005Revised

Estimates

2005-2006Budget

Estimates

1. Revenue Receipts 263878 309322 300904 351200

2. Tax Revenue (net to Centre) 186982 233906 225804 273466

3. Non-tax Revenue 76896 75416 75100 77734

4. Capital Receipts (5+6+7)

$

207490 168507 204887 1631445. Recoveries of Loans 672651 27100 615651 12000

6. Other Receipts 16953 4000 4091

7. Borrowings and Other Liabilities$ 123272 137407 139231 151144

8. Total Receipts (1+4)$ 471368 477829 505791 514344

9. Non-plan Expenditure 349088 332239 368404 370847

10. On Revenue Account of which, 283502 293650 296396 330530

11. Interest Payments 124088 129500 125905 133945

12. On Capital Account 655862 38589 720082 40317

13. Plan Expenditure 122280 145590 137387 143497

14. On Revenue Account 78638 91843 89673 115982

15. On Capital Account 43642 53747 47714 27515

16. Total Expenditure (9+13) 471368 477829 505791 514344

17. Revenue Expenditure (10+14) 362140 385493 386069 446512

18. Capital Expenditure (12+15) 109228 92336 119722 67832

19. Revenue Deficit (17-1) 98262

(3.6)

76171

(2.5)

85165

(2.7)

95312

(2.7)

20. Fiscal Deficit {16-(1+5+6)} 123272

(4.5)

137407

(4.4)

139231

(4.5)

151144

(4.3)

21. Primary Deficit (20-11) -816

(0.0)

7907

(0.3)

13326

(0.4)

17199

(0.5)

Source: Based on provisional Actuals for 2003-2004.Note:1 Includes receipts from States on account of Debt Swap Scheme.2 Includes repayment to National Small Savings Fund.$ Do not include Rs. 60,000 crore in BE 2004-05, Rs. 65,481 crore in RE 2004-05 andRs. 80,500 crore in BE 2005-06 in respect of Market Stabilisation Scheme, whichwill remain in the cash balance of the Central Government and will not be used forexpenditure.


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Appendix

SOME CONCEPTS RELATING TO GOVERNMENTFINANCE

1) The Budget and its Structure

The wordbudget originally meant the moneybag or thepublic purse, which

served as a receptacle for the revenue and expenditure of the state. In Britain,the term was used to describe the leather bag in which the Chancellor of the

Exchequercarried to Parliament the statement of the Governments needs andresources. Later on, the term came to imply the documents which werecontained in the bag, i.e. plans for Government finances submitted for theapproval of the legislature.

A budget is a statement containing aforecast of revenues and expenditures fora period of time, usually a year. It is a comprehensive plan of action designedto achieve the policy objectives set by the Government for the coming year. A

budget is a plan and a budget document is a reflection of what Governmentexpects to do in future. While any plan need not be a budget, a budget has to

be necessarily a plan. It shows detailed allocation of resources and proposedtaxation or other measures for their realisation. A budget is, however, not abalance sheet(exhibiting total assets and liabilities) of the Government on a

particular date. It is a financial blueprint for action and is, therefore, of greatadvantage to Government departments, legislatures and citizens. The budgetof a Government expresses its total activity in figures. A budget reflects whatthe Government is doing or intends to do.

An Instrument of Policy

The budget has become a powerful instrument for fulfilling the basicobjectives of Government. More recently, there has been a wave of interest in

the budget as a work of programme with emphasis on relating costs of theseprogrammes to performance. A Government budget has four major functions:(a) allocation; (b) distribution; (c) economic stabilisation, and (d) long-termeconomic growth. The budget thus has not one goal. It has a multiplicity ofgoals: allocation of resources, economic growth, distribution of income andwealth, stabilisation of prices and promotion of full employment, and securingan acceptable balance of payments position.

For a federal country like India, the budget of the Government of India is themost important instrument for implementing various economic and social

objectives. The budgets of State governments affect local activities. The

Government of India budget influences the whole economy. The latter tries to

bring about growth with social justice through its budget; it influencesregional, functional and overall distribution of income and wealth through itsexpenditure (transfer) payments, investments and tax policies. The provisionsof grants and loans to State governments and Union Territories and to the

private sector and various subsidies (such as for export promotion, foodgrainsdistribution, etc.) are some of the elements of Central Government budget

policy for promoting growth and income distribution. A budget in moderntimes should, therefore, not be judged sound or otherwise merely on the basis

of its deficit or surplus or balanced position. Its significance lies in its

ability to promote the various objectives of a modern state which has assumed


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the role of a welfare state and of a catalytic agent for promoting growth with

social justice.

The objectives of a budget, in modern society, cannot be promoted in

isolation. It has to be coordinated to monetary, credit and debt policies to be

effective. The questions relating to the manner of financing deficit ordisposing of surplus in a budget have close relationship with monetary andcredit policies. The emergence of deficit or surplus position in a modernbudget is the result of a deliberate policy decision.

According to the provisions of the Constitution (Article 112), the Governmentof India is required to lay an Annual Financial Statement before both thehouses of Parliament. This is known as the budget of the Central Government.Similarly, each State Government (Article 202) is required to lay an AnnualFinancial Statement before the Legislature of the State; this is called the

budget of State Government. The Annual Financial Statement or the budgetcovers all the transactions of the Central Government (or State Government)during the current and coming financial year. The financial year in India

begins on April 1 and ends on March 31. Conventionally, the budget of theRailways is separately presented to Parliament. However, the receipts andexpenditure of the Railways are considered as receipts and expenditure of theGovernment of India. Hence, the same are also included in lump in theGeneral budget.

Under the Constitution, Budget has to distinguish expenditure on revenueaccount from other expenditure. Government Budget, therefore, comprises: (i)Revenue Budget and (ii) Capital Budget.Revenue Budget consists of therevenue receipts of Government (tax revenues and other revenues) and theexpenditure met from these revenues. Tax revenues comprise proceeds oftaxes and other duties levied by the Union. Other receipts of Governmentmainly consist of interest and dividend on investments made by Government,fees, and other receipts for services rendered by Government. Revenueexpenditure is for the normal running of Government departments and variousservices, interest charges on debt incurred by Government, subsidies, etc.

Broadly speaking, expenditure which does not result in creation of assets is

treated as revenue expenditure. All grants given to State governments andother parties are also treated as revenue expenditure even though some of thegrants may be for creation of assets.

Capital Budgetconsists of capital receipts and payments. The main items ofcapital receipts are loans raised by Government from Public which are calledMarket Loans, borrowings by Government from the Reserve Bank and other

parties through sale of Treasury Bills, loans received from foreignGovernments and bodies and recoveries of loans granted by CentralGovernment to State and Union territory Governments and other parties.Capital payments consist of capital expenditure on acquisition of assets likeland, buildings, machinery, equipment, as also investments in shares, etc., andloans and advances granted by Central Government to State and Unionterritory Governments, Government companies, Corporations and other

parties.

2) Tax on Services

The service sector contributes around 54 per cent of GDP, the tax receiptsfrom this sector are mere 0.3 per cent of GDP. The contribution of service tothe Government exchequer has, however, been far from commensurate. The


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Vijay Kelkar task force on the Fiscal Responsibility and Budget Management(FRBM) Act expects the collections from service tax to grow to Rs. 80,000crore in the next four years. So the picture is clear. Broad-based levy on allservice activity with just a negative list of services exempt from tax can beexpected.

The steady deterioration in tax-GDP ratio experienced during the 1990s isclosely related to the structural change that has been taking place in theincome composition of the Indian economy. Despite the fact that the services

sectorhas shown substantial buoyancy, its contribution to the exchequer is notsignificant in relation to its sizeable share in GDP. Thus, in order to impart

buoyancy to the revenue receipts, and to provide consistency and equity in thetax structure vis--vis the composition of income, it is imperative to bring amajor part of the services sector under the tax net.

According to Amaresh Bagchi Apart from the need to get the sectorcontribute more to the exchequer, the case for bringing services under taxationrests also on considerations of efficiency and equity. Efficiency in resourceallocation suffers when certain sectors or activities remain untaxed while the

burden of taxation falls on other sectors as resources are drawn away from thetaxed sectors on tax considerations. In other words, discriminatory taxation ofgoods and services is distortionary. Equity also suffers when services gountaxed because services are consumed more by the rich. Moreover, with theadvent of modern digital technology the line between goods and services isgetting increasingly blurred as many products which were earlier transacted intangible forms are now produced and sold in forms that are intangible. This is

posing a challenge for tax authorities all over the world. The question,therefore, is not whether services should be taxed but how.

The objectives of levying a service tax are: (i) shrinking of the tax base as theshare of industry in GDP decreases while that of services expands; (ii) failureto tax services distorts consumer choices and encourages spending on servicesat the expense of goods; (iii) untaxed service traders are unable to claim VATon service inputs, which encourages businesses to develop in-house services,creating further distortions; and (iv) most of the services that are likely to

become taxable are positively correlated with expenditure of high-incomehouseholds and, therefore, service tax improves equity. In the Indian context,taxation of services assumes importance in the wake of the need for improvingthe revenue system, ensuring a measure of neutrality in taxation betweengoods and services and eventually helping to evolve an efficient system ofdomestic trade taxes, both at the Central and the State levels.

The service tax was levied in India on the basis of the recommendations madeby the Tax Reforms Committee (Chairman: Dr. Raja Chelliah), the provisionsof which were brought into force with effect from July 1, 1994. The coveragehas progressively widened over the years. The service tax is applicable to all

parts of India except the State of Jammu and Kashmir and is leviable on thegross amount charged by the service provider from the client. The rate ofservice tax has been increased from 5 per cent to 8 per cent on all the taxableservices and finally to 10 per cent. Collections from the service tax haveshown a steady rise from Rs. 410 crore in 1994-95 to Rs. 14,134 crore in2004-05; however, they accounted for only 4.4 per cent of the total taxreceipts of the Centre (0.3 per cent of GDP) in 2004-05. The service tax isenvisaged as the tax of the future. The inclusion of all value added services inthe tax net would yield a larger amount of revenue and make the existing tax


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structure more elastic. The increase in the share of the services sector in GDPholds the key to larger revenue generation.

3) Value Added Tax (VAT)

As the term indicates, VAT is a tax on value added to the price of acommodity at each stage. It may be due to passing of the product throughvarious hands in a channel of distribution, or the value added in its price dueto some activity of production or manufacture or processes undertaken on the

commodity.It is a tax at the final or retail point of sale, which is collected ateach stage of sale when there is a value addition to the goods . In other words,the total amount of tax which is to be collected at the final stage or retail pointis collected in installments. VAT is a form of indirect sales tax paid on

products and services at each stage of production or distribution, based on thevalue added at that stage and included in the cost to the ultimate customer.

Unlike sales tax, in VAT, business gets reimbursement on their purchase ofraw material used in their manufacture. Example CASE I (without VAT)suppose an air-conditioner producer spends Rs. 100 in making an air-conditioner. He sells it to a wholesaler for Rs. 120 and makes a profit of Rs.20. Retailer sells it to final consumer for Rs. 150 and makes a profit of Rs. 30.

CASE II (with VAT of 10 per cent). AC manufacturer pays Rs. 110 for rawmaterial. Raw material supplier pays Government Rs. 10 as tax. Nowmanufacturer sells the AC to wholesaler for Rs. 132. His profit is 22 but

because he pays a VAT of Rs. 2, his profit remains same as in case I. This isbecause value of the good has increased by Rs. 22. Now retailer sells AC forRs. 165 and pays Government a VAT of Rs. 3. The value or price of good inthis stage has increased by Rs. 33. Retailer earns, same profit after tax of Rs.30. In VAT, it is presumed that businesses do not lose anything directly to tax

but they have lot of paperwork and proper accounting to do to getreimbursement.

What needs to be realised is that one major merit of the VAT system is its

neutrality. This signifies that by installing a single tax rate on inputs andrefunding taxes paid on inputs, VAT will encourage manufacturers to choose

products and processes on the basis solely of techno-economic considerations,while in contrast, under a regime of differential rates and without setoff oftaxes paid on inputs, such decisions would be influenced extraneously by thedifference in the tax rates on the inputs. This aspect, apart from prevention ofthe cascading effect (of tax on tax) and the in-built safeguards againstcorruption and evasion, should vindicate the decision to impose VAT.

Since VAT is calculated at each stage of production, VAT liability is, thus,calculated by deducting input tax credit from tax collected by the producerduring the time when he paid the tax. Actually, it is a multi-point sales tax and

is collected on value addition only at each stage. The benefit to the trader in aVAT system is that he can claim the tax paid on purchases (as input credit)and adjust it against the VAT collected on sales.

VAT is called a transparent tax because in the VAT system, though tax islevied at every stage from manufacturer to the end consumer it is leviedonly on the basic cost + value add/margin and not on the VAT component, atevery stage. The complete transparency of the system will ensure that at any

point in the transaction chain, you will be able to determine how much VAThas been paid for the goods. Also, since there is total transparency of VAT

paid and received, at each stage of a transaction, it may seem that the tax


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outlay across the transaction chain has increased. But, in effect, the total taxoutlay actually reduces in the VAT system due to input credit. It is atransaction tax levied at multi-points with a benefit of set-off at each stage.

Where Did This System Originate?

VAT was first introduced in France in 1885. It was known as Taxe Sur LaValeur Adjoutee. Thereafter, it spread to other countries. By the end of the1980s, as many as 60 countries adopted VAT. The number now swelled to

more than 130. Almost all the developed countries and many of thedeveloping countries have adopted VAT in some form or the other. In theEuropean Union (EU), adoption of VAT is compulsory for all its members.The trend of adoption of VAT has, thus, been the most remarkable andimportant even in the evolution of commodity taxation in the present times.As far as Asia is concerned, South Korea was the first country to adopt VATin 1997.Japan introduced it in 1989, Pakistan in 1990,Bangladesh in 1991,China in 1994 and Sri Lanka in 1995. At present, VAT is operational in

Indonesia, Mongolia, the Philippines, Si

government finance-union and states

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