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Budget 2006: Outlays, Inequality and Growth

Budget 2006: Outlays, Inequality and Growth

The fiscal deficit is being contained by a decrease in interest payments and capital expenditures, along with a secular rise in direct taxes. However, the reduction in capital expenditures, mainly in infrastructure, is growth constraining. This article argues that infrastructure expenditures have a propensity to increase inequality and this turns the attention of government towards redistribution, which, in turn, increases transfer payments and squeezes out capital expenditures. Sorting out governance issues associated with infrastructure spending is essential to making budgetary finances more growth-oriented.

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BUDGET 2006

Outlays, Inequalityand Growth

The fiscal deficit is being contained by a decrease in interest payments and capital expenditures, along with a secular rise in direct taxes. However, the reduction in capital expenditures, mainly in infrastructure, is growth constraining. This article argues that infrastructure expenditures have a propensity to increase inequality and this turns the attention of government towards redistribution, which, in turn, increases transfer payments and squeezes out capital expenditures. Sorting out governance issues associated with infrastructure spending is essential to making budgetary finances more growth-oriented.

ERROL D’SOUZA

“I believe that growth is the best

antidote to poverty… Growth will be

our mount; equity will be our companion; and social justice will be our destination.” That is the stated strategy of union finance minister, P Chidambaram

– growth, tempered, of course, by policy to keep inequality tolerable, will lead to equity.

The growth taking place is attributed to an investment boom and “it appears that India is catching up with the high investment rates of east Asia and China” (budget speech). The Economic Survey had noted that investment increased steadily from 23 per cent of GDP in 2001-02 to 30.1 per cent in 2004-05. It attributed this to a virtuous cycle of growth and savings. With a “homebias”, the domestic savings finances the bulk of domestic investment and as savings will increase with accelerating income growth, the Survey argued that the investment rate was likely to rise.

The increased savings in the economy are not, however, due to the benign demographic dynamics associated with a decline in the dependency ratio that the Survey attributes it to but rather due to the rapid increase in public savings. Public savings had remained negative from 1998-99 to 2002-03. In 2002-03 it turned positive at 1 per cent of GDP and by 2003-04 it rose even further to 2.2 percentage of GDP. This increase in public savings arose from progress in the implementation of the Fiscal Responsibility and Budget Management Act and higher savings from non-departmental enterprises.

On the fiscal front, how did this savings take place? Chart 1 depicts the expenditures and current revenues of the central government. From 2002-03 the expenditures of the government have been declining and the current revenues have been rising. Declining expenditures from 16.0 per cent of GDP in 2002-03 to a budgeted

14.4 per cent during 2006-07 and an increase in current revenues from 9.4 per cent of GDP to 10.3 per cent in 2006-07 have resulted in the decline in the fiscal deficit.

So from the point of view of the centre’s budget, it is reducing dissaving by reducing expenditure and some increase in current revenues. How did the centre manage to reduce expenditure? Chart 2 reveals that transfer payments have beenreduced from

7.2 per cent of GDP in 2002-03 to a budgeted 5.7 per cent in the current year. The decline in transfer payments is mirrored in the decline in a major component of transfer payments, i e, interest payments, that declined from 4.8 per cent of GDP in 2002-03 to a budgeted 3.6 per cent of GDP this year. In contrast, interest payments from 1997-98 till 2001-02 increased from

4.2 per cent of GDP to 4.7 per cent of GDP and grew at a trend rate of 12.3 per cent during the period. Interest payments grew at a smaller trend rate of 3.9 per cent during 2002-03 to 2006-07, a reflection of the benign interest rate regime during this period. However, as current expenditures have increased from 6.6 per cent to

6.8 per cent in the same period, the decline in transfer payments had to be accompanied by a decline in capital expenditures from

3.2 per cent to 1.9 per cent. It is apparent that there is a squeeze applied on investment expenditure that has contracted the expenditure of the government. In fact, capital expenditure (Plan and non-Plan) during the period has grown at a trend rate of -17.5 per cent, which is a significant rate of deceleration. A perception about capital expenditures has been that the reduction is due to a reduction in loans to states. In fact, loans to states and union territories reduced from 1.36 per cent of GDP in 1998-99 to 0.14 per cent in 19992000, contributing to the steep decline in loans to the rest of the economy as depicted in Chart 3. After that non-Plan capital expenditure increased rapidly and by 2003-04 it contributed to the marginal increase in capital expenditures to 4.1 per cent of GDP, up by 0.5 per cent of GDP since 1998-99. Thereafter non-Plan and Plan capital expenditures have been decelerating. That the deceleration in capital expenditures is not related to the decline in loans to states or capital transfers to states is evident from Chart 4 which is based on the economic and functional classification of the budget as done by the ministry of finance (MoF). This graph depicts a deceleration in capital expenditures from 1999-2000 right up till 2005-06.

Decline in Capital Expenditure

As GDP grew at a faster rate than the growth in interest payments, the transfer payments/GDP ratio declined. In contrast, interest payments from 1997-98 till 2001-02 grew at 12.3 per cent a year. Thus, a negative growth in capital expenditures combined with a period of high growth in GDP resulted in a steep decline in the expenditures of government as a proportion of GDP. Public capital

Economic and Political Weekly March 11, 2006

Chart 1: Trends in Expenditure and Revenues

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16.00

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10.00

8.00

6.00

4.00

2.00

0.00

Per cent of GDP Per cent of GDP Per cent of GDP

1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Year

Centre’s revenues

Fiscal deficit Central government expenditure

Chart 2: Components of Central Expenditures

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

0.00

1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

Year Current transfers

Interest payments

Capital expenditures Consumption expenditures

Chart 3: Components of Capital Expenditures

2.50

2.00

1.50

1.00

0.50

0.00

Year

Non-plan capital expenditure

Loans to rest of economy

Plan capital expenditure

expenditures in India are known to crowd On the revenues side of the budget Chart 5 in private capital formation and to the depicts that tax revenues (net to the centre) extent this is true, the decline in this increased from 6.5 per cent of GDP in component of expenditures is antithetical 2002-03 to a budgeted 8.4 per cent in 2006to the attainment of the objective of getting 07. At the same time non-tax revenues to a 10 per cent growth rate. declined from 3 per cent of GDP to 2 per cent of GDP during the same period. Nontax revenues are scheduled to decline over time as profitable government enterprises would be required to plough back their profits into investments rather than make dividend payments to the centre. Thus, from the revenue side, the fiscal deficit can be reined in only if tax revenues are buoyant. Chart 6 depicts that a major component of revenues – customs – has been declining ever since 1997-98 as India integrates with the world economy. Union excise duties have remained roughly the same fraction of GDP right through the period. Hence, the increased tax revenues have been coming from direct taxes. Corporation tax has increased from 1.8 per cent of GDP to a budgeted 3.4 per cent in 2006-07. That represents an almost doubling of the share of GDP. The other buoyant component of revenues is income taxes that have risen from 1.5 per cent of GDP in 2002-03 to a budgeted 2 per cent of GDP next fiscal year. The much talked about service tax has, in contrast, risen sharply in the last few years as a source of revenue as coverage has been improved and rates raised from 0.2 per cent of GDP in 2002-03 to a budgeted 0.9 per cent of GDP currently.

1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

Increased direct taxes are a direct function of compliance (a more efficient tax administration) and expansion of the tax base given that rates are more or less stable. Hence, tax buoyancy can only be ensured when the economy experiences a stable and high growth of GDP. This requires the facilitation of a climate of investment. Here, reduced public investment from the budget is growth constraining. The Economic Survey rightly notes that “India’s growth prospects are intricately intertwined with the rapid development of physical infrastructure such as power, roads, ports, and airports, and efficient delivery of such services”. It is well known by policy-makers that the provision of public capital is an effective way of promotion of economic growth. So why did the reduction in capital formation by the government over time occur?

The standard take on this is that the fiscal retrenchment programme, which put constraints on debt and expenditure policies, reduced the public sector’s contribution to capital accumulation. Our take on the deceleration in public infrastructure is that though hard budget constraints may have decreased this type of public spending, it is related to the distributional consequences that

Economic and Political Weekly March 11, 2006

Chart 4: Economic Classification of Expenditures (MoF)

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6.00

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1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 Year

Per cent of GDP Per cent of GDP Per cent of GDP

Consumption

Capital formation + investments and loans to rest of economy

Transfer payments

Total expenditure

Chart 5: Financing Sources of Central Expenditures

9.00

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

0.00

1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Year

Net centre’s tax Non-tax revenues Fiscal deficit

Chart 6: Sources of Central Tax Revenues

4.00

3.50

3.00

2.50

2.00

1.50

1.00

0.50

0.00 1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

Year

Corporation tax

Income tax

Customs

Union excise duties

have arisen from the nexus between cor-to act to some extent independently of ruption and investment expenditures voters and interest groups. Rent seeking [D’Souza 2006]. Infrastructure services is promoted by this and it causes cost and are often associated with a monopoly on time overruns in infrastructure projects, as delivery and substantial discretion in well as state functionaries extracting bribes the hands of bureaucrats. This provides and a reduced effectiveness of the infrathe space for the state and its apparatus structure, due to the poor quality in terms of, say, energy losses in power generation or telephone line faults.

Deficits and Transfer Payments

However, higher public investment disproportionately benefits larger firms and inequality increases. Infrastructure raises the productivity of all firms, but those with higher factor endowments benefit more from an increase in effective infrastructure compared to firms with lower endowments. In addition, the corruption accompanying public investment increases inequality.1 Increased inequality results in an increase in the skewness of the distribution of income. The increased concentration of income at the top makes redistribution more attractive for the median voter and electoral competition makes the government attentive to this preference. Governments reallocate expenditures towards transfers and away from public investment. By subsidising infrastructure such as electricity and water, etc, there was an attempt to target service delivery and redress inequality. This further diminished the effectiveness of infrastructure. However, the state increasingly financed this not via higher taxation, but via borrowings. The lack of complementary public investment in infrastructure made firms invest less themselves and these savings was borrowed by the government to finance consumption expenditures and transfer payments. At the same time another nexus between government and industry developed. Still in pursuit of graft revenues2 but unable to provide a return in terms of cost reducing infrastructure, the state began to relax its power to tax and allowed tax evasion to grow. This resulted in a requirement for even more borrowings by the state [Kumar 2002]. The rise in fiscal deficits and transfer payments were thus contemporaneous.

This is in contrast to the situation in the four high performing Asian economies – Japan, South Korea, Singapore and Taiwan. Here, public expenditure policy complemented the export-led strategy by providing quality infrastructure and by emphasising fiscal discipline so as to promote price stability. The levels of public expenditure in these economies were comparable to the level prevailing in east Asia and south Asia of around 21 per cent of GDP. Yet the functional composition of expenditures was different [Rao 1998]. In all these economies there was a distinctly larger share of public resources devoted

Economic and Political Weekly March 11, 2006 to the provision of infrastructure. In India, the increased allocation to transfers, subsidies, and public sector wages reduced the allocation to public investment. At the same time, continued corruption reduced the effectiveness and productivity of public spending. The decline in factor productivity eventually reduces the gains from corruption to beneficiaries in the private sector who seek a reduction in the fiscal and regulatory space of the state.

In the Indian context, it is now well established that additional investments in rural roads, agricultural research, education and health, result in higher productivity growth and have a larger impact on poverty reduction than do subsidies such as fertiliser subsidies [Fan, Hazell and Thorat 2000; Zhang and Fan 2004]. Good roads, for instance, lower transport costs and result in farmers saving on input purchase and bringing their agricultural produce to the market. Savings in input costs not only enable farmers to buy more fertiliser that increases yields, but also the better access to transportation shifts cropping patterns toward high value added fruit and vegetable production, owing to the reduction in perishability risks. This diversification of agriculture is an objective the finance minister has set and yet over time the government has increased subsidies on fertiliser and electricity at the expense of productivity increasing investments.

One would expect public investment in agriculture to be acceptable to farmers as it increases output and hence incomes at given prices. However, it also causes the terms of trade to change against agriculture. Farm and rural lobbies seeking to avoid the cheapening of agricultural prices would rather extract the marginal rupee of government spending as a subsidy to themselves than have government spend it on investments that benefit others, especially the unorganised, due to the lowered prices for agricultural goods. A government that is serious about the ‘aam admi’ should opt for higher public investment in roads, electrification, agricultural extension and research. But, as we argued above, the median voter keeps it transfixed to transfer payments and subsidies. Structurally, then, there is no simple budgetary way of addressing the issue and getting more resources diverted to capital formation. It is simply not in the interests of any political party that is sensitive to its votes.

It is not just physical capital but also human capital that have a beneficial impact on growth. In this case there has been a rise in the expenditure on the component “education”, art and culture in the budget from 0.40 per cent of GDP in 2002-03 to

0.60 per cent in 2006-07. Similarly, the expenditure on health and family welfare has increased from 0.28 per cent of GDP in 2002-03 to 0.51 per cent of GDP budgeted for next year. Does this type of policy reduce inequality? In more unequal societies the median voter will elect a higher rate of taxation to finance public education which increases aggregate human capital and economic growth ceteris paribus. This, however, has dynamic effects. The direct effect of greater human capital is to lower the relative wage between unskilled and skilled workers and there is a reduction in inequality. At the same time human capital generates more innovations and enhances efficiency which in turn increases the demand for skilled workers to absorb new technologies and increases inequality. There is a non-monotonic relation between inequality and growth [D’Souza 2004].

Economic and Political Weekly March 11, 2006

It also means that we cannot know ex ante as to what is happening to inequality and ex post we face stark trade-offs. Inequality may not be easy for policy to target. However, the east Asian success did depend on higher levels of initial equality and distribution of assets, egalitarian high quality education systems, and a labour intensive growth strategy that led to employment creation and that lesson is useful especially as Brazil and Mexico have seen substantial growth but far less equity.

Growth, or more accurately, the quality of growth is intricately linked to inequality and so the finance minister and the government need to do more by addressing problems of governance as well, since poor governance reduces the effectiveness of public spending and this, due to the redistributive implications referred to above, makes it more difficult to redirect expenditures away from transfer payments and towards infrastructure spending. This is a larger issue and there will be other occasions to visit the issue.

m

Email: errol@iimahd.ernet.in

Notes

1 Davoodi, Gupta and Alonso-Terme (2002) show for a large sample of countries that a worsening in the corruption index of a country by one standard deviation is associated with the same increase in the Gini coefficient.

2 We may surmise that graft was an off budget source of revenues used for influencing votes during an election whereas transfers were a budgetary source of influencing the median votes.

References

D’Souza, E (2004): ‘Wage Disparity and Human Capital Accumulation’, Indian Journal of Labour Economics, Vol 47, No 4.

– (2006): ‘Public Investment and Infrastructure: A Political Economy Tale’, Centre for Economic and Social Studies, Hyderabad, mimeo.

Fan, S, P Hazell and S Thorat (2000): ‘Government Spending, Growth and Poverty in Rural India’, American Journal of Agricultural Economics, 82(4), November, 1038-51.

Gupta, S, H Davoodi and R Alonso-Terme (2002): ‘Does Corruption Affect Income Inequality and Poverty?’ Economics of Governance, 3, 23-45.

Kumar, A (2002): The Black Economy in India, Penguin Books India, New Delhi.

Rao, M G (1998): ‘Accommodating Public Expenditure Policies: The Case of Fast Growing Asian Economies’, World Development, 26(4), 673-94.

Zhang, X and S Fan (2004): ‘How Productive Is Infrastructure? A New Approach and Evidence from Rural India’, American Journal of Agricultural Economics, 86(2), May, 492-501.

Economic and Political Weekly March 11, 2006

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