6 minute read 22 Jul 2022
Fiscal strategies for India

Why India needs to re-strategize its government finances

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

6 minute read 22 Jul 2022
Related topics Tax COVID-19

Going forward, India’s policy focus should be on making it the largest GDP economy.

In brief

  • As per the UN World Population Prospects 2022[1], India is forecasted to emerge as the largest economy in terms of size of total population in 2023.
  • We examine the need to re-strategize India’s policies to ensure that it becomes the largest output economy, at least in purchasing power parity (PPP) terms.
  • A pre-requisite for this is to re-structure the management of government finances.

Population projections for India: new markers

In terms of India’s evolving demographic profile, several important time markers in the 21st century can be highlighted. First, India’s total population is projected to be the largest, overtaking that of China by 2023, i.e., within a year. Second, the share of working age population to total population would overtake that of China, reaching its highest level at 68.9% by 2030, i.e., in another eight years. In absolute numbers, India will provide 104.3 crores working age persons in 2030. Third, correspondingly, India’s overall dependency ratio would be the lowest in its history by 2030 at 31.2%. Fourth, the excess of India’s working age population over that of China would be at a maximum by 2056. Fifth, India’s young dependency ratio is expected to overtake the old dependency ratio by 2056. Thus, India would remain the largest provider of human resources in the world, well ahead of China throughout the seven decades of this century, precisely when populations in many advanced countries would be aging fast. With the burgeoning working age population significant risk factors are also associated, particularly if these working age persons are not productively employed. In this context, it is critical to ensure that this population is suitably educated, trained and skilled, which requires an extensive re-look at management of India’s government finances and its fiscal strategies.

Stagnating size of the government

Size of the government in India, as measured by the combined expenditure of central and state governments relative to GDP, has been stagnating in the range of 26-27% since the mid-1980s (Chart 1). This does not compare well with corresponding global trends. India should endeavor to raise the size of the government at least up to the level of the US which has been in excess of 35% of GDP in recent years[2].

Chart 1: India’s total expenditure to GDP ratio (%)

India’s languishing revenue-GDP ratio

The primary reason for a low size of the government is India’s relatively low and stagnating tax-GDP ratio, which has languished in the range of 16-18% since the late 1980s (Chart 2). In this case also, we may benchmark a target tax-GDP ratio of 25% which is closer to where the US presently is. This would require maintaining a tax buoyancy with respect to GDP of higher than 1 for a number of years.

Chart 2: India’s combined tax-GDP ratio (%)

The stagnation in India’s non-tax to GDP ratio at less than 3% has prevailed since the early 1950s. The main reasons for this relate to India’s loss-making or low dividend yielding public sector enterprises, and non-recovery of costs of publicly provided services, including health and education. User fees and charges, that refer to the charges for the public provision of goods and services, have remained administered or regulated. These charges remain delinked from the unit cost of service provision, which has been increasing along with the overall inflation. Periodic revision of user fees and charges and realization of much higher values of property owned by the government and the public sector, including land, are clear ways of improving the performance of non-tax revenues. Further, assets owned by the government in the skies and under water and land should also be exploited to generate additional non-tax revenues.

Re-visiting government’s sectoral priorities

If, over time, India is able to raise its tax-GDP ratio closer to the target of 25% and the non-tax to GDP ratio closer to about 5%, it can sustain a size of government in the range of 35-37% of GDP by adhering to a sustainable fiscal deficit level of about 6-7% of GDP, excluding a small component of non-debt capital receipts. As the revenue-GDP ratio increases, the government must ensure that the allocation of expenditures towards three priority sectors namely, education, health and physical infrastructure is progressively increased. Since the young dependency ratio is forecasted to remain higher than the old dependency ratio until 2056, it would be prudent to prioritize education ahead of health. At present, India’s government expenditure on education relative to GDP is at 4.4% (2018). This should be raised to 6%. Government expenditure on health has languished at about 1% of GDP (2019), which is much below the corresponding global average. This should be raised to at least 3%, closer to the corresponding average of middle-income countries at 2.8% (2019). Expenditure on physical infrastructure, including defence capital expenditure, may be raised to 6-7% of GDP, which would imply keeping combined revenue account of the government at least in balance if not in surplus. This would ensure adherence to the so-called ‘Golden Rule’, where government borrowing is matched by creation of corresponding assets. This requires maintaining strict fiscal discipline over economic cycles. For this purpose, both the central and state governments have enacted their respective fiscal responsibility legislations (FRLs).

Sustainable fiscal imbalance

Center’s recently amended fiscal responsibility and budget management act (FRBMA) in 2018 provided targets for the combined management of the central and state finances in terms of debt and fiscal deficit relative to GDP. It specified a combined debt-GDP ratio of 60% and a combined fiscal deficit to GDP ratio of 6%. The debt-GDP target for the Center and states was kept at 40% and 20% respectively, while the fiscal deficit to GDP target was at 3% each. Due to the deleterious impact of COVID-19, the combined debt-GDP ratio rose to an estimated level of 88.4% in FY21, exceeding the FRBM threshold by 28.4% points. Government finances need to be nursed back to sustainable levels in the medium term. In view of trends characterizing nominal growth and effective interest rate, there may also be a need to re-examine Center’s FRBMA with a view to re-fixing the debt and fiscal deficit targets. For a detailed discussion, see Srivastava et al. (2021)[3].

Conclusion

There is a strong likelihood that India may emerge as the largest economy in the world in terms of size of GDP in PPP terms within the next few decades after having emerged as the largest economy in terms of total population in a year’s time. One pre-requisite for achieving this target is re-strategizing government intervention in the economy to accord higher priorities to education, health, and physical infrastructure. For this, restoration of FRBM targets of fiscal deficit and government debt relative to GDP and achieving balance on the revenue account are critical so that adequate fiscal space can be created.

(Contributors: Muralikrishna Bharadwaj, Senior Manager, EY India; Tarrung Kapur, Manager, EY India; Ragini Trehan, Manager, EY India)

Summary

If India’s emergent working age population is productively employed, a virtuous cycle of lower dependency, higher savings and investment, and higher growth can be created.

About this article

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

Related topics Tax COVID-19