Q&A: M Govinda Rao, Member, PMEAC

'Tax Incomes above Rs 15 lakh at 40%'

The fiscal deficit is under severe pressure but that just might signal the beginning of a bigger problem, given the additional demands for health, education and food security laws, M Govinda Rao, member of the Prime Minister’s Economic Advisory Council (PMEAC) and director of the National Institute of Public Finance and Policy (NIPFP), tells Santosh Tiwari. Edited excerpts:

The fiscal deficit target of 4.6 per cent of GDP this year is under tremendous stress owing to lower tax revenues and the disinvestment and spectrum auctioning programmes missing their budget targets of Rs 40,000 crore and Rs 15,000 crore respectively. How do you see the situation?
In some ways, one can see the problem in the way we have budgeted. The assumption is that expenditures will increase by only 3.5 per cent and non-interest expenditures will increase by only 1.4 per cent — that is, 1.4 per cent over the revised estimates of the previous year. Now, with the type of inflation you have and the significant amount of money that you are required to give for DA [dearness allowance] payments, obviously it will be impossible to contain non-interest expenditure at that level.

 

The second assumption in the Budget is that crude oil prices will remain around $90 per barrel. Now, even though the government has cleared a lot of backlog in the previous year’s subsidies, there is a backlog of around Rs 20,000 crore of subsidies and that too is budgeted at around Rs 23,000 crore, whatever is very unrealistic. Crude oil prices have hovered at $110 and $115 per barrel, which implies a huge amount of under-recoveries by the oil marketing companies (OMCs). Although they started increasing the prices of motor spirit, diesel, LPG and kerosene prices are heavily subsidised. With this, duties on petro products have been reduced. So the subsidy bills for fertiliser, food and oil are likely to substantially exceed the Budget estimates.

You are saying that there could have been better ways to tackle these areas in the Budget?
There is always a bit of a problem with cash budgeting which we follow and that is another reason some of us always recommend accrual budgeting, for which a lot of homework needs to be done first. But I think the government would be well advised to start the homework and get some departments to do accrual budgeting. The problem with cash budgeting is that there are two or three things that happen to keep the deficit under check — or at least show the deficits lower. One is you postpone payments to OMCs. When you do this, your cash wouldn’t go but the OMCs will borrow from the banking and financial system. So, eventually, they will have to get the money. The other thing is that you ask major taxpayers to pay advance taxes, put pressure and then get the money. And the third thing that they generally do is not to pay the contractors’ bills. If you don’t pay these bills, you will have to pay the escalation cost at some point of time. None of the three solutions is desirable.

I feel that if there is nothing very serious then the deficit is likely to show a marginal increase. There might be some drawdown from the reserves. The Finance Commission target for this year is 4.8 per cent so the government might increase it by a little bit and make it five per cent. Sticking to a 4.6 per cent fiscal deficit target is going to be extremely difficult.

Given that missing the fiscal deficit target this year is almost a certainty, what would be the impact on the government’s fiscal management plans?
The medium-term prospects are very grim. We cannot expect revenues to grow as they did from 2003-04 to 2007-08, at over 30 per cent per year. In the case of direct taxes, the tax information network has yielded a lot of money through better enforcement. Plus you had a significant expansion in the service tax base. From here, if you expand the service tax net with a negative list, there could be some expansion of the tax base. GST [Goods and Services Tax] is not likely to happen until 2013. Even if you have GST, it will increase the productivity of tax but will be revenue-neutral. I do not believe that this will be a game-changer. One of the things the government can consider is the issue of tax arrears, which run to over Rs 2,00,000 crore. A significant proportion of this is tied up in the courts. If they could clear these cases by asking the associated parties to pay half the tax involved, they would substantially reduce the tax arrears and mop up one-time revenue. The Direct Taxes Code will also help clean up the tax system but I don’t think it will spin off substantial revenue. I feel that difficult times require difficult choices.

You mean tough choices to gain more revenue?
Yes. Now you have marginal tax rate of 30 per cent for incomes above Rs 8 lakh. Even Europe is thinking of levying higher income taxes for higher-income groups. So after Rs 15 lakh of income, it may be worthwhile having a tax rate of 40 per cent. The reason I am saying this is that in the medium term, we have much more serious issues. One, we need to do the fiscal adjustments. At the central level, even if you adhere to the fiscal deficit of 4.6 per cent of GDP, then after 2014-15, you will have to reduce it by 1.6 percentage points because the central government should have a fiscal deficit of three per cent according to the Finance Commission’s plans. On top of it, there is heavy demand for increasing expenditure on health during the 12th plan. A high-level committee on the universalisation of health has made some preliminary recommendations to the government. That would require one to 1.5 percentage points of GDP. Then you have Right to Education and the Food Security Bill. I feel that you require an additional three to 3.5 percentage of GDP on account of these heads plus 1.6 to two per cent for fiscal adjustments. There is no way this additional money can be generated through higher taxes. If you carry out all the reforms, you can get an additional two to 2.5 percentage points. 2007-08 was the year when the tax-to-GDP ratio was the highest. That was close to 18 per cent of GDP, both the Centre and states taken together (the ratio for the Centre alone was close to 11.5 per cent). This has come down to 15 per cent. Even if you say that you will reach the highest level that existed in 2007, and the Centre will increase the ratio by another 2.5 percentage points and the states by one percentage point, you would be required to make a further two to 2.5 percentage point adjustment. In the meantime, if crude oil prices go up sharply, then we will certainly have a huge problem.

So expenditure control is vital.
I think it is important for the government to plan expenditure compression immediately, particularly with regard to the proliferation of subsidies. A free-for-all is not going to work; you need to really focus on targeting. It’s not really difficult to target; we need to develop political will to do it. You don’t have a choice now. If we need good universal education and healthcare, we must cut our subsidies and target them in a proper manner.