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Major challenges that India face in key areas of fiscal policy


Fiscal policy plays an increasingly important role in India. Decisions on fiscal policy, especially if properly synchronized with monetary policy, can help smoothen business cycles, ensure adequate public investment and redistribute incomes.

The four main components of fiscal policy are (i) expenditure, budget reform (ii) revenue (particularly tax revenue) mobilization, (iii) deficit containment/ financing and (iv) determining fiscal transfers from higher to lower levels of government. Fiscal policy works through both aggregate demand and aggregate supply channels. Changes in total taxes and public expenditure affect the level of aggregate demand in the economy, whereas, the structure of taxation and public expenditure affect, among others, the incentives to save and invest (at home and abroad), take risks, and export and import goods and services.

Tax and Expenditure Profiles of India

The pressures for high and growing government expenditure in India are manifold. Because of their low per-capita incomes and high incidence of poverty, India faces an urgency to have high rates of economic growth. This places a strong burden on policy to ensure rapid economic growth whereas, at the same time, the limited efficacy of policy instruments and governance inadequacies imply that the effective scope for policy is constrained. This mismatch between expectations from and actual effectiveness of policy is particularly acute in India, as compared to developed countries. In the former with the perpetual weakness of institutions to mobilize and direct savings, the role of the state is crucial in harnessing resources for development. With weak regulatory apparatus and imperfect market signals, the state plays an important, even dominant, role in allocating investment funds and in anti-poverty programs as well as in their design. Pressures for populism through price controls and the like are considerable.

Fiscal Deficit Issues in India

The exercise of fiscal policy in India has its limits. The combination of low revenues and inelastic expenditures means that expenditures routinely, and even increasingly, outpace revenues. With poor credit and bond markets and downwardly inflexible fiscal expenditures, some of the financing of the resultant deficit spills over onto the external sector and the central bank.

Given financing constraints many developing countries like India have to opt, to a considerable extent, on non-bond (monetary) financing of the deficit. This then establishes a direct links between fiscal policy and the monetary base of the central bank blurs the distinction between fiscal and monetary policy and compromises central bank independence. If high public expenditure is financed by issuing government bonds there is a possibility of crowding out of private investment. By contrast, low and stable levels of the fiscal deficit by sending a positive message on a government’s ability to service its debt, may attract private investors and reduce the risk of economic crises. This, in turn, yields further benefits in terms of higher rates of investment, growth, educational attainment, increased distributional equity and reduced poverty.

If the link between fiscal deficits and monetary expansion were quantitatively strong, there would be a link between the fiscal deficit and inflation — particularly if seigniorage revenues were used to close the budgetary gap. However, in India this association is weak. Some Experts find a positive correlation between inflation and the fiscal deficit only when the inflation rate is high and there is a clear seigniorage motive to get additional revenue from money creation

Even if fiscal deficits are sustainable these could impact on economies. Of particular interest to economists is the impact of fiscal deficits on the prospects for economic growth. The financing of fiscal deficits by reducing the amount of funds available for private investment, commonly known as ‘crowding out’ could, it is argued, hurt the prospects for economic growth. A contrary view argues that public investment, irrespective of how it is financed, by building infrastructure and providing support services creates a more conducive climate for private investment and, hence, improves the prospects for economic growth. Ultimately, thus, whether public deficits impede or spur economic growth becomes an empirical question. Public expenditure is permitted to be both growth enhancing as well as growth inhibiting and there are distortionary taxes in place. The government budget is not required to be balanced and fiscal deficits are permitted. It is shown that the impact of the deficit depends upon the mode of financing it. Deficits can be growth enhancing if financed by limited seigniorage but it is likely to be growth inhibiting if financed by domestic debt; and to have opposite flow and stock effects if financed by external loans at market rates. These opposite effects, in turn, define a threshold effect before attaining which fiscal deficit has growth enhancing effects and after which the effects of fiscal deficits are growth inhibiting.

Norms for Tax and Expenditure Reforms in India

One of the principal aims of a meaningful tax/expenditure reforms policy would be to bolster the savings and investment rates in the economy in order to raise growth rates. A higher growth rate, it is widely accepted, is the best way to lower poverty over the medium term. Raising the rate of savings and the rate of growth of the economy becomes a circular issue — the higher the rate of savings the higher the rate of growth of the economy and the higher the rate of growth the higher the rate of savings at least at low absolute levels of per capita income. Their results also point to the possibility of incomplete. In other words, a given rise in public savings is accompanied by a less than commensurate drop in private savings. Consumers would realize that any increase in public expenditure would be paid for by taxes and adjust private saving commensurately.

Since the prime determinant of the saving rate appears to be the level and rate of growth of per capita income, all tax-induced distortions that create inefficiencies and lower the potential rate of economic growth should be eliminated. Thus there is urgent need for tax reforms. The basic tenets of tax reform are well known and far too elaborate for a complete analysis to be attempted here.

An important canon of tax reform is that as an economy develops reliance on indirect taxation, as a source of revenue should decline. This is because indirect taxes typically have an excess burden (or deadweight losses) associated with them. Furthermore efficient indirect taxation (one that minimizes excess burden to the representative consumer, for example) can be quite regressive. One can make indirect taxes more progressive by sacrificing some amount of efficiency but the extent of the redistribution possible through such means is quite limited.

This principle applies to indirect taxes that are differentiated and distortionary. If, however, indirect taxes can be levied on final consumption alone it would be possible to avoid the tax-induced changes in relative prices that characterize production taxes such as excise duties.

Expenditure Reform

Tax reforms should be complemented with appropriate adjustment of government expenditures. Typically this calls for reduction of current subsidies and augmentation of subsidies for well-defined capital projects. The impact of public expenditure is usually ascertained through an ex-post incidence analysis. The question typically asked, is given some tax or public expenditure: i) who pays or receives the benefits of public spending; ii) how much does everyone receive in accounting terms; iii) how much does everyone receive when taking into account behavioral responses to taxes or the free delivery of public services; iv) what are the indirect effects of the program. Such analyses enable the researcher to ascertain the actual distribution of the amount budgeted as a tax receipt or a public expenditure and helps decide whether public expenditures are worth their cost.

A problem with this methodology is that only existing taxes or public programs may be analyzed. We must evaluate not what does exist but what might exist. This is the theme of benefit incidence analysis. Such analysis is marginal (because it should capture differences from the status quo) and behavioral (because of the need to generate counterfactuals).


The role of fiscal policy in India is as important as it is complex. India faces the unenviable task of accelerating their rates of economic growth to reduce poverty is a short span of time even as they face greater uncertainty, in the face of globalization, about key elements of their fiscal policy such as the tax base. Furthermore, the exercise of fiscal policy is often circumscribed by increasing pressures from the regulatory and exchange rate regimes in place and subject to considerable pressure from external parameters such as competing countries’ tax rates. It would be difficult, for example, for a given developing country to have corporate tax rates very different from its competitors or burden monetary policy with high fiscal deficits which could lead to sharp depreciation of the exchange rate.

Nevertheless, the onus on fiscal policy remains substantial. This article has outlined some of the major challenges that India face in some key areas of fiscal policy: their tax, expenditure and intergovernmental transfer policies. Even here the treatment has been selective, (e.g., there has been little discussion of corporate taxation and indirect tax harmonisation) in order to provide an overview of the issues involved and an introduction to the literature on these topics.

Thanks and Regards

CA Pankaj Galhotra

A-203, Mahaveer Universe,

Near Bhandup Police Station, Bhandup (w)

Mumbai- 400078


Published by

CA Pankaj Galhotra
(CA (Tax advisory))
Category Others   Report

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