Creating Fiscal Space In Today's India
In this special column, Prof Mukul Asher explains what fiscal space has come to mean in modern economics, why creating it is more complex than it seems at first, and how it can be done in India.
This article presents and explains a possible framework for generating fiscal space. It can be adapted for a specific context by a city, a state, a region, or a country to enhance fiscal sustainability and to address present and future fiscal risks. It is thus intended to facilitate a systemic and integrated approach for addressing fiscal challenges.
Such a framework is particularly relevant for India due to the evolving dynamics of Union- State fiscal relations which portends availability of larger unconditional resource transfers and responsibilities for the provision of public amenities from the Union government towards the States.
Increased resources and responsibilities however must be matched by significantly improved institutional and technical capabilities in public financial management by the States if the cooperative federalism paradigm being pursued is to improve governance, and make India’s development process more broad-based and resilient. State-level leadership and willingness to organize needed skill-sets will be key aspects in managing fiscal risks, and therefore affect the extent to which a state addresses its development challenges. This is a medium duration process, but its beginning must be made urgently.
There has been several developments globally (these also apply to India) which have contributed to heightened anxiety about ensuring fiscal sustainability and managing fiscal risks.
Fragile macroeconomic environment: First, the 2008 global crisis and its aftermath, being manifested in the ongoing crisis centering on tough conditions imposed by the Euro Zone countries on highly indebted Greece, has sharply underscored the consequences of unsustainable fiscal and public debt policies. The Greek Parliament has had to approve these conditions in return for assistance in debt management and in maintaining economic linkages with the outside world.
Fragility of international macroeconomic environment is reflected in subdued growth projections. Thus, OECD’s June 2015 projections are, that as compared to the annual average of 3.9 percent for the 2002-2011 period, global GDP is projected to grow at 3.2 percent during the 2012-2015 period. A similar subdued trend in the world real trade growth is also projected, suggesting challenging trading environment for using external trade as an engine of growth.
Constrained Autonomy of Tax Policy: Second, constraints on tax policy autonomy, including limited results from measures designed to moderate shifting of tax bases to countries with greater ability and willingness to practice “fiscal dumping” (i.e. luring of tax bases by certain tax jurisdictions without underlying commensurate real economic activities in that jurisdiction); due to globalization and associated technological changes; and the proliferation of preferential trade agreements (PTAs), have made raising revenues from conventional income, sales, excise, and customs taxes much more difficult for any single country. A review of entering into PTAs without adequate preparations and strategic considerations therefore merits considerations, including by the Indian policymakers.
Funding good governance: Third, several factors, including rising incomes and expectations of the populations concerning public amenities; growing aspirations for better quality of living and quality of life, growing urbanization, demographic trends portending ageing populations, and changing patterns increasing the share of GDP devoted to health care, are likely to lead to higher level of government expenditure in this area. This expenditure will need to be funded, i.e. greater proportion of nation’s GDP will need to be devoted to them. Both public and private sectors will need to contribute to funding. The issue of funding is separate from the financing mix used, such as taxes, insurance premiums, mandatory and voluntary saving and others.
The above three broad developments have hastened the urgency of understanding how to generate fiscal space in a manner which improves public financial management practices, preserves fiscal sustainability, and enables addressing the current and future fiscal risks.
Before analyzing the suggested framework, it may be useful to briefly review the manner in which fiscal space has been defined in the literature.
The Concept of Fiscal Space: A Brief Overview
Heller (2005) has defined fiscal space as ‘the availability of budgetary room that allows government to provide resources for a desired purpose without any prejudice to the sustainability of government’s financial position.’ This is a broad and rather vague definition, with varying interpretations possible.
The World Bank Group (2015, Chapter 3), in discussing how to generate fiscal space and use it in the developing countries, adopts the definition of fiscal space as the “…availability of budgetary resources for a specific purpose…without jeopardizing the sustainability of the government’s financial position or sustainability of the economy”. The focus of the World Bank Group (2015, Chapter 3) study is on fiscal space generation and use among a cross-section of countries for short-term counter cyclical fiscal policy to cope with macro-economic shocks, such as those generated by the 1997-98 East Asian financial crisis, and by the 2008 global crisis.
The above study identifies fiscal rules imposing specified numerical targets on budgetary aggregates; stabilization and reserve funds which involve setting aside revenue from commodity booms or fiscal and balance of payments surpluses; and medium term expenditure frameworks (MTEFs) designed to link budgetary plans and allocations on the one hand and growth and other strategic objectives on the other in a multi-year flexible framework.
Some studies (e.g. Ortiz et al 2015) approach the concept of fiscal space from the advocacy perspective for significantly expanding social sector programs, without considering design, implementation, and actual outcomes of the ongoing social sector programs. Such studies simply enumerate various sources from which government can obtain higher revenue, and assert that government expenditure be re-allocated, usually from defense sector, expenditure on which is inappropriately asserted to be without merit, towards social sector, inappropriately asserted to be of “investment nature”.
There are three important questions missing from such studies, which is not surprising as their intention is advocacy not analysis.
The first missing question is that whether society’s resources devoted to current social sector (and other) programs bring commensurate benefits to the society. The success of a typical subsidy program is when conditions giving rise to its need are substantially mitigated, and therefore over time subsidy expenditure and beneficiaries exhibit downward trend. Instead, the usual assumption is that more expenditure on areas of advocacy and more beneficiaries are by definition desirable. Thus, requisite rigorous analysis of the current social sector programs and current social sector organizations is usually precluded. In many subsidy programs, entry is encouraged by the beneficiaries, but exit often necessitates difficult political choices.
The second missing question is the need for trade- offs among different sources of government revenue generation. Thus, foreign assistance, which is not sustainable or desirable in the long run, is advocated in such studies as one of the options for generating fiscal space.
The third is the neglect of context- specific factors, including political economy of reform in particular countries, as well as globally. This is illustrated by advocacy of shifting defense expenditure to social sector programs; significantly reducing fiscal incentives, and proposals for eliminating shifting of tax bases to low tax jurisdictions.
Analysts concerned with broader development issues focus on how additional fiscal revenue and expenditure can be generated from such avenues as reprioritization and efficiency enhancing of expenditures, domestic revenue mobilization, budgetary deficits, and in selected countries, in the short-run from development assistance.
These analysts also emphasize on how these additional resources are used for obtaining better societal outcomes from specific government spending such as on education or health; and how government spending can help in enhancing broad-based economic growth. This suggests that developmental aspects rather than short term stabilization aspects are emphasized in such definitions of fiscal space.
Thus, Roy, Heauty, and Letouze (2007) adopt the following definition of fiscal space: “Fiscal space is the financing that is available to the government as a result of concrete policy actions for enhancing resource mobilization, and the reforms necessary to secure the enabling governance, institutional and economic environments for these policy actions to be effective, for a specified set of development objectives.”
Some analysts such as Asher (2005) have argued that greater competence and willingness in generating non-conventional revenue resources can help generate fiscal space. Such sources include using state assets, both physical and financial, more productively; revenue from state-created property rights in a transparent and economically desirable manner; and willingness to use non-tax revenue, including appropriate cost recovery and user charges, and surpluses of regulatory bodies. State assets involve such areas as land owned by the state, mining, telecommunication spectrum, and other rights, air-space above and area within and below public sector properties, including railways and bus stations, and accumulated balances in various funds, including pension funds.
Willingness to charge for publicly organized (not necessarily produced) goods and services (such as water and electricity) also involves taking responsibility for effectiveness in delivering these goods and services, increasing accountability of the government. This is perhaps one of the factors constraining many authorities to use cost recovery and user charges more expensively. For those who may require assistance, use of utility vouchers, combined with block pricing, where per unit pricing increases with usage, merits serious considerations. Progress on pre-conditions necessary for using such methods, including installing of effective metering systems,is essential if fiscal costs are to be managed.
In analyzing fiscal space generated for use in any one area, such as age-related expenditure, the opportunities foregone for using the space for other purposes should also be considered in public policy discussions. Some analysts have argued that addressing curbing of activities resulting in collection of benefits of government programs by those not targeted by such programs, essentially curbing benefit cheating, could also help improve fiscal space.
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Thus, the specific instruments and avenues for generating and for using fiscal space will vary among countries, and among regions within the same country.
Fiscal Space Framework
A Suggested Framework in Figure 1 has three distinct yet interrelated components. Strategies for generating fiscal space should view them in a systemic manner, with context specific initiatives, appropriate for eliciting desired responses from all relevant stakeholders
Three main components are enhancing rate of growth and broadening its base; improving revenue generation from conventional and unconventional sources; and better expenditure management for obtaining value for money.
A detailed analysis of each is not attempted here. But illustrative examples are given which would strongly suggest that generation of fiscal space is not a mechanical exercise of simply raising taxes (or ceases), or reducing expenditure, but requires understanding of linkages between a variety of economic and social policies, bureaucratic incentive structures, and social and political norms.
Using insights the literature on behavioral studies to nudge social and political norms and behavior in the desired direction is the main theme of the World Bank’s 2015 World Development Report.
Analysis of mind, society and behavior in the above Report is relevant as several initiatives of the current government, such as Swacch Bharat, Smart Cities, Beti Bachao Beti Padhao ( save and educate girl children) involve altering social norms, while others such as insistence on accountability of government employees and organizations involve bureaucratic behavior.
At a broader level, shifting public discussion and debates from “Poverty and Personality-centered” politics to Development and Policy oriented” politics also involves altering Social and Political norms in India.
Enhancing Growth Rate
In the Indian context, improving current low rate of participation of women in labour force has the potential to enhance growth rate, broaden economic opportunities, and generate fiscal space. Thus, according to the ILO’s Global Employment Trends 2013 Report, India’s labour force participation rate for women fell from just over 37 per cent in 2004-05 to 29 per cent in 2009-10. It is in this context that such initiatives such as Beti Bachao Beti Padhao (Save and educate girl child) could not only improve gender equality, but also enhance growth rate and generate fiscal space.
Another recent initiative of setting up an online national agriculture market to improve efficiency of logistics and supply chains for farmers and other stakeholders could also serve as an illustration in helping to enhance growth broaden economic and fiscal base, and help generate fiscal space. Some estimates suggest that improved agricultural logistics and supply chains could raise India’s GDP growth rate by around 0.5 percentage points annually.
Improving Revenue Performance
There are opportunities for generating fiscal space from conventional and non-conventional sources at Union State and local government levels. The key challenge is to create proficiencies and capabilities in generating such revenue.
In taxes, “broadening base-lowering nominal rate” strategy has much to commend it from theoretical and policy perspectives. As an example, tendency to raise income tax limits below which the tax is not applied, and to also add to number and amount of exemptions for specific purposes has led to significant erosion of the individual income tax base. The number of individual income taxpayers in India is only around 35 million. This is widely regarded as much below the number (estimate range from 70 to 100 million) which should be in the income tax registry under current laws.
It is reported that the Income Tax Department (ITD) is to initiate measures to add 10 million persons to the individual income tax registry by 2016. There are also significant numbers of current income tax payers who are reporting incomes significantly below their legally required income, thereby resulting in revenue erosion.
Similar conditions are also prevalent concerning corporate income tax. Thus, ‘broadening- the- base-lowering nominal rate’ strategy, effectively implemented, could generate fiscal space, while preserving fairness and not adversely impacting economic growth. It is on these criteria that the income tax administration should be evaluated.
The above analysis applies to other taxes as well at all levels of government. The strategy suggested requires willingness on the part of the policymakers and the executive to acquire capacities to broaden tax base. This will be also relevant for the GST (goods and services tax) when it is implemented.
There are several opportunities for revenue generation from non-conventional sources. The Union Government has already raised equivalent of 2.5 percent of 2013 GDP from coal, spectrum and related auctions, with most of the revenue from coal auctions accruing to the States where such mines are located. More such revenue is likely to accrue as additional coal mines are auctioned.
THE MINES AND MINERALS (DEVELOPMENT AND REGULATION, AMENDMENT ACT, 2015 under which States can generate revenue from their own mining resources would require proficiency in organizing transparent, accountable, and effective auctions (and other appropriate instruments) to generate fiscal space. Such proficiency should also be consistently exhibited by the Union government as role of auctions in allocating state assets increases.
Better Expenditure Management
One of areas of better expenditure management worth noting is the potentially large savings from better procurement practices. Thus, in India, in 2013-14, combined government expenditure of The Union and the State governments was nearly 30 percent of GDP, of which between 12 and 15 percent comprised procurement of current and capital goods and services. Even a saving of 10 percent as compared to current procurement practices could potentially generate fiscal space of between 1.2 and 1.5 percent of GDP. This is non-trivial.
It is no coincidence that the Ministries of the Union government with large spending and procurement such as Railways and Defense has been focusing on procurement reforms to generate resources for their modernization programs. There is however substantial scope in improving procurement practices, particularly in the States, and in the Urban and local bodies.
India’s recent initiatives towards direct benefit transfers (DTBs) in bank accounts, combined with Aadhar card or similar instruments for identification, and better design of benefit programs could create fiscal space. Thus, official estimates of savings from DTBs for LPG subsidy are around INR 120 Billion, a non-trivial amount. The DTBs however should be used only where pre-conditions for its effectiveness are present.
Speeding up project implementation, such as for road construction, could also generate fiscal space by lowering effective project costs.
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Many of India’s current arrangements, such as indexing civil service wages and pensions to not only prices but also to wages through establishing Pay Commission at regular intervals also need to be reviewed if generating fiscal space is to be consistent with fairness and with broad-based growth requiring business competitiveness.
The above analysis strongly suggests that generating fiscal space in a systemic and integrated manner is a complex exercise. It involves not only flows of receipts and expenditure, but also balance sheet items. Thus, preparing asset registry, and accounting for accrued and contingent liabilities have become essential.
Setting up fiscal risk management office in the Union Government, and in each of the States merits serious consideration. Such office should have the requisite authority, access to technical and professional expertise. There is potential for sharing such expertise between the Union and the State governments, for example with revenue forecasting and estimation of contingent liabilities provided by the designated agency of the Union government.
It is evident that current practices and organizational structures at the Union, the States and in the Urban and Local bodies are inadequate to undertake the exercise involving such complexity. A shift towards much greater professionalism, accountability, and organizational effectiveness in public financial management are needed.
Asher, Mukul G. (2005), Mobilizing non-conventional budgetary resources in Asia in the 21st century, Journal of Asian Economics, 16,6, pp.947-955.
Heller, P (2005), “Back to Basics – Fiscal Space: What is it and How to Get it”. Finance and Development. 42(2),p.3.
Ortiz, I., M.Cummins, and K., K karunanethy (2015), “ Fiscal Space for Social Protection: Options to Expend Social Investments in 187 countries”, Geneva: International Labor Office, Extension of Social Security Series No.48,
Roy, R., A. Heuty, and E. Letouze (2007). Fiscal Space for What? Analytical Issues from aHuman Development Perspective. UNDP Paper for the G-20 Workshop on Fiscal Policy. Istanbul, 30 June – 2 July. Available at:
World Bank, (2015). Global Economic Prospects: Having Fiscal Space and Using It, The World Bank, Washington D. C.
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