We need tax reforms to support India’s expenditure path

A lot of attention is lavished on the bottom-line of annual government budgets, aka the fiscal deficit. That is understandable. The fiscal deficit influences a range of current economic variables, from aggregate demand to interest rates, which in turn has important implications for companies, home buyers, job seekers, bond traders and many other economic agents.

However, the overarching goal of fiscal policy over the medium term is to stabilize the ratio of public debt to gross domestic product (GDP), to help achieve rapid economic expansion with macroeconomic stability.

The pandemic shock led to a massive increase in public debt in all major economies, as tax collections fell sharply even as governments spent money to prevent a total economic collapse. India was no exception. The ratio of public debt to GDP shot up by more than 13 percentage points in one year, which itself came on the heels of a gradual increase over the second decade of this century.

Also read: Focus on tax and spending reforms in FY25 budget: Bibek Debroy

Since then, this key fiscal ratio has come down gradually from 88.4% in fiscal year 2020-21 to 82.2% in 2023-24. The International Monetary Fund expects the public debt ratio to fall to 77.5% in 2029, very near its pre-pandemic level, but still higher than what fiscal economists believe is ideal for India.

The fall in the public debt ratio was because of underlying debt dynamics. First, nominal GDP growth was well above the rate of interest that the government pays on its borrowing. Second, the primary fiscal deficit was also brought down once the worst economic effects of the pandemic dissipated. These two main drivers of public debt over long periods of time worked in our favour, thanks to effective macroeconomic management in New Delhi and Mumbai.

In the next five years, India will be under pressure to increase its military spending, given the darkening geopolitical clouds; it has to invest in a green transition that is necessary not just to meet international commitments, but to protect citizens from the erratic waves of excess heat and rain; it needs to increase spending on a range of public goods and essential services.

One option is to create space in the budget by reducing unnecessary spending. However, that is easier said that done. The results of the 2024 national elections could lead to more pressure on the government to open spending taps to placate an electorate with several economic pain points, especially the lack of quality jobs. The task of further bringing down the fiscal deficit as well as the public debt ratio needs to be framed against this backdrop.

Also read: India needs a fairer and simpler income tax system

How can a country meet its growing spending requirements while staying true to a chosen fiscal path? The answer lies on the revenue side of the government budget. The ratio of total government revenue to GDP has stayed within a tight range in India over the past three decades, despite profound changes in the underlying economy.

So much of fiscal policy—including the very important component of fiscal federalism—has become a zero-sum bargaining game between various interest groups, ministries and levels of government.

The upshot: tax reforms should be one of the key policy concerns of the third Narendra Modi administration. India needs to increase the amount of tax collected for every unit of economic output, otherwise it will have to compromise on either its spending requirements or its fiscal fitness.

There is reason for hope, thanks to the fact that India is likely to cross an important development milestone by the end of this decade—the transition from being a lower-middle income country to becoming an upper-middle income country, which the World Bank currently defines as a country with a per capita income of between $4,466 and $13,845 a year.

The chart here shows that the average upper-middle income economy generates more tax revenue per unit of output than the average lower-middle income economy. A few years ago, there was a spirited debate in India whether the government collects enough tax, given the level of income. Data showed that our ratio of tax collections to GDP can broadly be predicted by the level of average income.

India is not an outlier. The challenge will be to ensure that tax collections continue to rise in tandem with incomes in the underlying economy, hopefully leading to the sort of fiscal turning point that this column had written about a few years ago (bit.ly/3VsJ5YF).

Recent data on the number of individuals filing income tax returns as well as the number of firms covered by the goods and services tax (GST) points to a widening tax base, even though most individuals who file income tax returns still report zero tax liabilities. The widening tax base needs to be supplemented with a reformed tax policy.

Also read: Budget 2024: Setting the tone for the future course of tax reforms

Direct tax rates need to be low, stable and predictable. The average GST rate is now below what most studies show is the revenue-neutral rate. That needs to be fixed, even as the overall GST structure is simplified. A higher tax-to-GDP ratio will not only allow for more budgetary freedom but also hopefully strengthen the fiscal base of the Indian state in the years ahead.