The Union Budget for 2020-21 was passed on March 23, 2020. The assumptions behind that last budget were rendered meaningless almost immediately.
On March 24, India started locking down, which lasted for ten weeks, and was followed by several stages of gradual unlocking, which is still going on.
The unusual circumstances of FY’21 affected many avenues of policymaking, and budget management was no exception. However, it would be a mistake to consider this year’s circumstances in isolation, as doing so would deny us a proper understanding of the churn in the Indian economy. It also makes it easy to blame all the problems on the pandemic, but the truth is that Indian economy was not doing fine even before that.
Before the pandemic
The COVID-19 crisis affected the last quarter (January-March) of 2019-20. But economic growth in the three quarters between April and December in 2019 was the lowest for those quarters since 2002-03. Even in the crisis year of 2008-09, those three quarters had registered higher growth. India was going through a sharp slowdown, especially in the investment component of the GDP.
During the three quarters between April and December in 2019, ‘Gross Fixed Capital Formation’ shrunk by 1.6% over the corresponding period of the previous year.
India’s public finances have also been in a crisis, with the government struggling to achieve the budgeted revenues.
In 2017-18, due to low dividends from the Reserve Bank of India (RBI) and public sector firms and disappointing fees from the telecom sectors, non-tax revenues fell short of budget estimates by about Rs 1 lakh crore.
In 2018-19, tax revenues fell short of budget estimates by about Rs 1.6 lakh crore, mainly because GST collections were well below expectations.
In 2019-20, the tax revenues fell short of budget estimates by about Rs. 3 lakh crore (budget estimate was Rs. 16.5 lakh crore but the provisional actual was Rs. 13.6 lakh crore). Even though the RBI gave a much larger dividend to the government than initially budgeted, because of a shortfall in tax revenues and other sources of receipts, the overall shortfall in receipts in 2019-20 was still more than Rs. 3.3 lakh crore.
Since 2016-17, there has been a considerable decline in the Centre’s tax to GDP ratio. If we deduct the GST compensation cess, which is collected in lieu of states’ tax revenues, the Centre’s net tax receipts have dwindled from 7.16% of GDP in 2016-17 to 6.18% of GDP in 2019-20. Since taxation is on incomes and economic activities, a slowing economy has obviously not yielded robust tax collections.
It is worth noting here that the Centre’s struggles with tax revenues have continued even though it has tried to lower the share of states in the Centre’s tax collection. Following the 14th Finance Commission’s recommendations, the Central government had to share more of its collected taxes with the states. States’ share in the divisible pool of taxes was raised from 32% to 42%. But the divisible pool of taxes that is shared with the states does not include cesses and surcharges. To reduce the size of the divisible pool of tax resources, the Central Government has raised the cesses and surcharges, especially on diesel and petrol. Cesses used to be around 10-15% of total collection of union excise duty even until 2017-18, but are now more than 50% of the collection.
Another unusual step to boost the receipts in recent years is divestment of shares of one public sector enterprise by selling them to another public sector enterprise. This method has earned the government about Rs. 70,000 crore since 2017-18. This includes two major transactions – the sale of HPCL to ONGC and the sale of REC to PFC. Such sales have been called “strategic disinvestment”, but they are not consistent with the intent behind strategic disinvestment, which is to privatise public sector firms that the government does not want to run.
In spite of such steps, there have been large shortfalls years after year. The government met the shortfalls partly by raising its own borrowings, but mostly by borrowing through public enterprises. In 2017-18, the expenditure met from the resources of public sector enterprises increased by more than 80% over the previous year (from Rs 3.38 lakh crore to Rs 6.1 lakh crore), while its compounded average growth in the preceding three years was only 8.7%.
Much of this growth in expenditure from resources of public sector enterprises happened because they had to borrow to meet expenditure that was previously met by the government. Even for food subsidy, Pradhan Mantri Awas Yojana, Saubhagya Yojana, Swachh Bharat Abhiyan, Pradhan Mantri Krishi Sinchayee Yojana and other schemes, a significant part of expenditure was met by off-budget borrowing through public sector enterprises.
For instance, Food Corporation of India (FCI) borrowed to meet the shortfall in the government’s food subsidy transfers, as the government did not acknowledge the full subsidy incurred during the year and delayed the transfer to the FCI. Since 2017-18, the government’s transfer to FCI has been only 50-60% of the subsidy incurred during the year, and even this transfer has also been towards the previous years’ dues. So, FCI has been building up debt to cover the expenses.
It is also worth noting that since 2017, the National Small Savings Fund (NSSF), which earlier used to lend only to Central and State governments, was allowed to lend to public enterprises like FCI. Since NSSF is effectively in government’s control, this facility gives these enterprises access to borrowing without going to the market.
Off-budget borrowing does not reflect in the fiscal deficit numbers. Such practices weaken the sense of budget constraint that disciplines the government. If the government can choose to move part of its own borrowing to some public sector enterprises, there is really no hard constraint on how much deficit it can have. Instead, it can simply choose to show whatever deficit it wants to. These practices are in violation of the spirit of the Fiscal Responsibility and Budget Management (FRBM) law, which is the statute to maintain discipline in government’s budget management. Unfortunately, the Parliament did not hold the government accountable for these practices.
This practice continued in 2018-19 and 2019-20. The expenditure met through public enterprises remained elevated and grew further. Given the fiscal constraints, chances are that this trend has continued in 2020-21 as well.
So, the real fiscal deficit was much larger than reported. Even without adding the off-budget borrowing, the provisional numbers show that the fiscal deficit in 2019-20 was 4.6% of GDP, much higher than the budgeted 3.3% and the revised estimate of 3.8% presented to the Parliament. Adding the off-budget expenditure, the Centre’s fiscal deficit would have been close to 6% of GDP.
As the government decided to move a significant part of its revenue expenditure (the ongoing operating expenses of running the government and its schemes) to public enterprises, the quality of on-budget expenditure should have improved, especially given the need to respond to the growth slowdown. Capital expenditure by the government is known to have a large multiplier effect on the economy – over time, boosting the GDP by several times the expenditure amount. Revenue expenditure and tax cuts usually do not have such large multipliers.
But in recent years, capital expenditure has fallen as a percentage of the government’s budget.. As the economy slowed down after 2016-17, the government has reduced the share of capital expenditure. Perhaps, this expenditure composition has contributed to the slowdown to some extent. Since investments by the private sector have also been falling for a decade, the overall investments in the economy have come down substantially. In 2019-20, the share of Gross Fixed Capital Formation in the GDP was 29.75% – the lowest since 2006-07.
Some of the reasons for a bias against capital expenditure lies in the choices that the government has made over the years. Consider, for example, the pension bill. Pensions are committed expenditure, and the government has no flexibility with regard to such expenditure. Since 2014-15, when the one rank one pension scheme was implemented, defence pensions have grown at a compounded annual growth rate of 17.2%, while the capital expenditure for defence has grown at 7% per annum. The growth in defence pensions has accelerated considerably since OROP was implemented. Defence pensions were growing at less than 7% per annum in the three years before the decision was implemented. The share of defence pensions has increased from 17.8% of defence expenditure in 2013-14 to 26% of defence expenditure in 2019-20. This and other decisions around subsidies, cash transfers and welfare schemes have made it difficult to achieve any major increase in growth-enhancing capital expenditure by the Central Government.
All this means that India entered the COVID-19 crisis with weak public finances and a mess in budget management.
Adjustments in response to the pandemic
The pandemic exacerbated the economic crisis. But the pandemic’s consequence was not just a sharper slowdown. The pandemic also added radical uncertainty to the situation. It became very difficult to figure out what was going on, what would be the consequences, and what needed to be done to protect the national interest in the long run.
The year is likely to register the sharpest contraction in the economy since independence. Public finance could not have remained untouched by these disruptions. Budget management during a crisis differs in important ways from that during other times. Receipts and expenditures need large adjustments at frequent intervals. Estimates do not hold for long, and need to be revised frequently, as the reality changes.
As the growth estimates changed drastically due to the pandemic, the receipts budget seemed quite unrealistic. Although the government has not published any revised estimates in the interim (the estimates will be presented on budget day), the non-debt receipts is surely falling short by a huge margin. During the previous three years, on an average, about 50% of non-debt receipts were collected between April and November, but only 37% were collected in this period this year.
To partly make up for the shortfall, the government turned to its favorite source of tax – excise duties on petroleum products. The excise duties were raised. Overall, 42.1% of budgeted tax revenues were collected between April and November 2020, while 50.6% of the budgeted revenues were collected during the corresponding period of the previous three years. The shortfall in non-tax revenues – mainly dividends and profits and telecom sector license fees – and disinvestment proceeds has been much larger.
Much of the rise in union excise duties was through a cess. Since cesses are not shared with states, the Centre’s transfer to states comprised only 32.6% of the gross tax revenues collected between April and November, while the states had received 36.2% of the centre’s gross tax revenues during the corresponding period of the previous three years. If the ratio had remained the same, the states would have received about Rs 37,000 crore as share of Centre’s tax revenues by November in this financial year. So, the revenue adjustment was made in a way that did not benefit the states. In the crisis, the Centre doubled down on its strategy of reducing the size of the divisible pool of tax resources.
The controversy around GST compensation further muddied the waters of Centre-state fiscal relations. There was a backlog from the compensation to be paid in 2019-20. Further, the fall in tax collection increased the gap in projected revenue growth and actual revenue growth. The overall decline in tax collection affected the compensation fund as well. After much pushback, Centre agreed to borrow on its own account to bridge part of the shortfall (to the tune of Rs. 1.1 lakh crore), but the remaining shortfall was to be met by the states’ borrowing on their own account. Although states were allowed to expand their borrowing by 2% of GSDP, the Centre imposed certain conditions for enhanced borrowing. Additional borrowing up to 0.5% of GSDP was allowed unconditionally, but borrowing beyond that was made contingent upon certain reforms relating to universalisation of ‘One Nation One Ration card’, Ease of Doing Business, power distribution and Urban Local Body revenues.
This process of negotiations and adjustment is still ongoing, as some of the states are asking the Centre to borrow more on its own account to compensate for the tax shortfall, and to ease or remove conditions for additional borrowing. The stakes are quite high, as much of the expenditure responsibility is with the states, and since the states are not free to borrow additional money without the Centre’s approval and it would not be easy to raise revenues, a shortall would only be met by cutting expenditure.
To some extent, Centre’s argument about this being a case of force majeure is right. The shortfall for the year is unprecedented, and could not have been foreseen. Therefore, if full compensation is to be given, it would have to be collected and given over an extended period of time. However, the states are also in a tough spot, as their hands are tied. They are also facing abysmal revenues, constraints on additional borrowing, and rising demand on expenditure.
The GST is built on pooling sovereignty of the Union and the states, and therefore requires trust and cooperation between the two levels of the Indian state. The low level trust between Centre and some of the states ensured that no good faith agreement was possible, and these controversies are likely to continue. These are not the right conditions for an ambitious reform like GST to stabilise.
On expenditure side, crisis forces the government to consider two additional objectives: stimulating the economy, and helping businesses and persons who have suffered from the crisis. The Central government took a very restrained approach towards making new expenditure commitments. The view that the government seems to have taken is that it was not wise to stimulate demand in the economy while the many supply side restrictions of lockdown were in place.
The inflation numbers seem to back this argument to some extent. Only in December consumer price inflation eased enough to get within the target range of 2 to 6%. From April to November inflation remained above 6%. This was not surprising as the demand that was there was also not being met due to the supply side constraints created due to the pandemic. Boosting demand at such a time may have led to higher inflation, possibly having destabilising consequences for the economy. Now that inflation seems to be easing, the government can consider stimulating demand through fiscal measures.
For much of the year, the government’s expenditure adjustments have focused on relief measures – food supply, employment guarantee, additional loans for businesses, etc. However, only a small part of the relief was given in the form of on-budget expenditure, and the remaining was through contingent liabilities such as guarantees on loans and through policy measures such as expediting payments to MSMEs. So, this year’s on-budget expenditure adjustments on account of these measures are likely to be quite small, albeit some of the contingent liabilities will become on-budget expenditures in the years to come.
Overall, between April and November, the government spent about 62.7% of the budgeted expenditure, while during the corresponding period in the previous three years, it had spent 66.8% of budgeted expenditure. As discussed earlier, the shortfall in non-debt receipts has been much larger than the shortfall in expenditure, and therefore the deficit is likely to be much higher than budgeted even if the government spends less than what it had budgeted.
Government has rightly kept up a reasonable pace of expenditure even though the receipts have fallen way behind. In a year like this, cutting government expenditure unnecessarily could have increased the hardship. While the overall expenditure until November had not been cut by much, and is only a little less than what it was during the corresponding period of previous years, adjustments have been made across expenditure areas. Data on expenditure is available for the April to November period. If we consider how expenditure until November this year compares with expenditure during the same period of the previous year, we can see that many adjustments have been made.
The government has spent a lot more than it did in this period last year on health, food subsidy, rural employment, etc. It has spent along the pattern of previous year on agriculture and farmers’ welfare, fertiliser subsidy, railways, road transport and highways, etc. Expenditure in this period has been much less than the corresponding period of previous year for telecommunications, defence, home affairs, housing and urban affairs, human resource development, petroleum subsidy, power, women and child development, etc.
Some of the automatic stabilisers worked. As many workers went back to their villages, it seems some sought work under MGNREGS. By January 25th, the scheme had already generated 312 crore person-days of work, while it had generated 265 crore person-days during all of 2019-20. This year, 10.17 crore persons have already worked in this program, while 7.89 crore persons had worked in 2019-20. On the other hand, an unacceptably high rate of failure has been seen in last mile withdrawal of payments. It seems the payment infrastructure could not deal with the high transaction volumes. The plumbing of public finance is still a work in progress.
If the pace of expenditure continues, the fiscal deficit is likely to exceed 7.5% of GDP, the highest since 1990-91. A statistical quirk that will make the deficit look larger is the shrinkage in GDP, which is the denominator for deficit ratios.
Looking at the budget for 2021-22
The budget for 2021-22 should be considered against the backdrop of longstanding fiscal problems, and the responses to the crisis of 2020-21. What are the key things to watch out for?
First, will the government bite the bullet and restore integrity to budget management? For four years, the problem of off-budget expenditure has been allowed to fester. It has worked for the government politically, as it has been able to achieve the level of expenditure it wanted without acknowledging the real level of deficit. However, continued lack of integrity in the budget management process will make it difficult for the political leadership of the government to hold the bureaucracy accountable. In any case, the off-budget expenditure will have to be brought on the budget at some point. The pandemic presents an opportunity to wash these sins away, and bring all such expenditure on budget. Since the parliament has shown little ability or willingness to enforce accountability for such matters, one can hope that the government will at least see its own long-term interest in having a more robust budget management process. If a party plans to stay in power for long, it needs to worry more about the long run.
Second, will the government do its part in boosting economic growth? Now that the supply side constraints have eased to a large extent, the government could look to boost demand. It is well-known that well-selected and properly executed capital expenditure projects, especially in infrastructure sectors, can boost the economy, and eventually pay for themselves by generating economic growth. Further, the government may also need to recapitalise public sector banks, because once the moratorium will end, bad loans will start surfacing again. The liquidity conditions will not always remain favourable. The pace and quality of economic recovery will be significantly determined by what the government does.
Third, will the government use this crisis to take bold decisions to change the profile of its expenditure and asset ownership? Unlike other times, public finance decisions in a crisis need not be incremental – the previous year’s expenditure does not serve as a benchmark for the crisis period. To be able to boost growth, the government needs to focus more on capital expenditure. This reversing of the trend of recent years necessitates serious expenditure management reforms to cut down on inefficient revenue expenditure such as subsidies for the well-off. Further, the government may also need to change the profile of its asset ownership, by moving many operational assets to the private sector and focusing itself on creating more greenfield projects. The crisis presents the opportunity to take such decisions.
Fourth, will the government present a detailed medium term fiscal perspective beyond the statements mandated by the fiscal responsibility law? Because of the crisis, massive adjustments are being made in both receipts and expenditure. The debt burden is rising. Decisions taken during a crisis can have huge consequences for a long time. In a crisis, wasteful decisions can be taken because of haste and uncertainty. Although the government has been quite restrained in its decisions, it is too early to say whether the adjustments made during the year have been the right ones. For instance, this year, a number of areas have seen much lower expenditure than budgeted, and we do not know the consequences of these adjustments. In India, the absence of a comprehensive medium term fiscal management framework makes most of budgeting an exercise of annual incrementalism. Since the crisis has forced larger adjustments in the budget, the government needs to anchor its decisions in a medium term perspective on expenditure, receipts and deficits. While the FRBM law mandates certain medium term statements, those are lacking in details. It is important that the government lays down a more detailed medium term fiscal statement to explain the rationale for the adjustments being made.
Fifth, what will become of the FRBM Act? Back in 2008-2009, in response to the global financial crisis, the government gave a large stimulus to the economy, and decided to suspend the FRBM law to create the legal space for itself. This time as well, there is a temptation to suspend the law altogether, as the escape clause in the law seems inadequate in dealing with the present crisis. Perhaps, instead of suspending the law altogether, it would be better to present amendments to the law, which provides a medium term restatement of the government’s intent with regard to fiscal responsibility.
Sixth, will the government reach out in good faith for a reset in its fiscal relations with the states? Tensions brewing between Centre and states on fiscal issues in the last few years seem to have come to a head this year. The shrinking divisible pool and the delays in GST compensation are serious issues for the states, which are facing an unprecedented fiscal crisis. A key aspect of India’s success as a federal polity is the management of Centre-state fiscal relations. Although the Central government relented to some extent on GST compensation, there is a need for more comprehensive thinking and discussion on Centre-state fiscal relations. This thinking and discussion can only happen on the foundation of trust.
Some of the answers to these and other such questions will be available soon, on February 1, to be precise.
Suyash Rai is a Fellow at Carnegie India. Views are personal.