LOVELY PROFESSIONAL UNIVERSITY

Term Paper

School of Business Department of Management

Name of the Student: Azhar Shokin Regd. No.: - 11000968

Course Code: MGT511 Course Title: Business Environment

Course Instructor: Vishwas Chakranarayan Course Tutor: Vishwas Chakranarayan

Class: MBA Semester: 1st

Section: S1001 Batch 2010-12

Student’s Signature

Azhar Shokin

Topic: - Impact of Fiscal Policy on Indian Economy

 Contents

 Introduction
 Literature Review
 Research
 Article
 Analysis
 Data and Methodology
 Main Findings
 Conclusion
 Recommendations
 References
 Impact of Fiscal Policy on Indian Economy

Introduction
In economics, fiscal policy is the use of government expenditure and revenue collection to
influence the economy.

Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary
policy, which attempts to stabilize the economy by controlling interest rates and the money
supply. The two main instruments of fiscal policy are government expenditure and taxation.
Changes in the level and composition of taxation and government spending can impact on the
following variables in the economy:

 Aggregate demand and the level of economic activity;

 The pattern of resource allocation;
 The distribution of income.

Stances of fiscal policy

The three possible stances of fiscal policy are neutral, expansionary and contractionary. The
simplest definitions of these stances are as follows:

 A neutral stance of fiscal policy implies a balanced economy. This results in large tax
revenue. Government spending is fully funded by tax revenue and overall the budget
outcome has a neutral effect on the level of economic activity.

 An expansionary stance of fiscal policy involves government spending exceeding tax

revenue.

 A contractionary fiscal policy occurs when government spending is lower than tax
revenue.

However, these definitions can be misleading because, even with no changes in spending or
tax laws at all, cyclical fluctuations of the economy cause cyclical fluctuations of tax
revenues and of some types of government spending, altering the deficit situation; these are
not considered to be policy changes. Therefore, for purposes of the above definitions,
"government spending" and "tax revenue" are normally replaced by "cyclically adjusted
government spending" and "cyclically adjusted tax revenue". Thus, for example, a
government budget that is balanced over the course of the business cycle is considered to
represent a neutral fiscal policy stance.
Methods of funding

Governments spend money on a wide variety of things, from the military and police to
services like education and healthcare, as well as transfer payments such as welfare benefits.
This expenditure can be funded in a number of different ways:

 Taxation
 Seignior age, the benefit from printing money
 Borrowing money from the population or from abroad
 Consumption of fiscal reserves.
 Sale of fixed assets (e.g., land).

All of these except taxation are forms of deficit financing.

Borrowing

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged
securities. These pay interest, either for a fixed period or indefinitely. If the interest and
capital repayments are too large, a nation may default on its debts, usually to foreign
creditors.

Consuming prior surpluses

A fiscal surplus is often saved for future use, and may be invested in local (same currency)
financial instruments, until needed. When income from taxation or other sources falls, as
during an economic slump, reserves allow spending to continue at the same rate, without
incurring additional debt.
Literature Review
Economic effects of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in
an effort to achieve economic objectives of price stability, full employment, and economic
growth. Keynesian economics suggests that increasing government spending and decreasing
tax rates are the best ways to stimulate aggregate demand. This can be used in times of
recession or low economic activity as an essential tool for building the framework for strong
economic growth and working towards full employment. In theory, the resulting deficits
would be paid for by an expanded economy during the boom that would follow; this was the
reasoning behind the New Deal.

Governments can use a budget surplus to do two things: to slow the pace of strong economic
growth and to stabilize prices when inflation is too high. Keynesian theory posits that
removing spending from the economy will reduce levels of aggregate demand and contract
the economy, thus stabilizing prices.

Economists debate the effectiveness of fiscal stimulus. The argument mostly centers on
crowding out, a phenomena where government borrowing leads to higher interest rates that
offset the simulative impact of spending. When the government runs a budget deficit, funds
will need to come from public borrowing (the issue of government bonds), overseas
borrowing, or monetizing the debt. When governments fund a deficit with the issuing of
government bonds, interest rates can increase across the market, because government
borrowing creates higher demand for credit in the financial markets. This causes a lower
aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.
Neoclassical economists generally emphasize crowding out while Keynesians argue that
fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding
out is minimal.

Some classical and neoclassical economists argue that crowding out completely negatives
any fiscal stimulus; this is known as the Treasury Vie, which Keynesian economics rejects.
The Treasury View refers to the theoretical positions of classical economists in the British
Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general
argument has been repeated by some neoclassical economists up to the present.

In the classical view, expansionary fiscal policy also decreases net exports, which has a
mitigating effect on national output and income. When government borrowing increases
interest rates it attracts foreign capital from foreign investors. This is because, all other things
being equal, the bonds issued from a country executing expansionary fiscal policy now offer
a higher rate of return. In other words, companies wanting to finance projects must compete
with their government for capital so they offer higher rates of return. To purchase bonds
originating from a certain country, foreign investors must obtain that country's currency.
Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand
for that country's currency increases. The increased demand causes that country's currency to
appreciate. Once the currency appreciates, goods originating from that country now cost more
to foreigners than they did before and foreign goods now cost less than they did before.
Consequently, exports decrease and imports increase.
Other possible problems with fiscal stimulus include the time lag between the implementation
of the policy and detectable effects in the economy, and inflationary effects driven by
increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources
that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who
otherwise would have been unemployed, there is no inflationary effect; however, if the
stimulus employs a worker who otherwise would have had a job, the stimulus is increasing
labour demand while labour supply remains fixed, leading to wage inflation and therefore
price inflation.

Fiscal Straitjacket

The concept of a fiscal straitjacket is a general economic principle that suggests strict
constraints on government spending and public sector borrowing, to limit or regulate the
budget deficit over a time period. The term probably originated from the definition of
straitjacket: anything that severely confines, constricts, or hinders. Various states in the
United States have various forms of self-imposed fiscal straitjackets.

Research
The Indian Fiscal Situation (T. N. Srinivasan Professor of Economics, Stanford
University)

Even before independence, there was a broad consensus, across the political spectrum,
that once independence was achieved, Indian economic development should be planned,
with the state playing a dominant role in the economy and achieving self-sufficiency across
the board as a major objective (Srinivasan 1996). Within three years of independence, a
National Planning Commission was established in 1950, charged with the task of drawing up
national development plans. The adoption of a federal constitution with strong unitary
features, also in 1950, facilitated planning by the central government. Several central
government-owned enterprises were established, and a plethora of administrative controls
(the so-called ‘license-quota-permit raj’) was adopted to steer the economy towards its
planned path. At the same time, fiscal and monetary policy remained quite conservative, and
inflation relatively low – the latter reflecting the sensitivity of the electorate to rising prices.
During 1950-80, India’s economic growth averaged a very modest 3.75 percent per year,
reasonable by pre-independence standards, but far short of what was needed to significantly
diminish the number of poor people. The license-permit raj not only did not deliver rapid
growth, but worse, unleashed rapacious rent-seeking and administrative as well as political
corruption (Srinivasan 1996). In the 1980s, India’s national economic policymakers began
some piecemeal reforms, introducing some liberalization in the trade and exchange rate
regime, loosening domestic industrial controls, and promoting investment in modern
technologies for areas such as telecommunications. Most significantly, they abandoned fiscal
conservatism and adopted an expansionary policy, financed by borrowing at home and
abroad at increasing cost. Growth accelerated to 5.8 percent during the 1980s, but the cost of
this debt-led growth was growing macroeconomic imbalances (fiscal and current account
deficits), which worsened at the beginning of the 1990s as a result of external shocks and led
to the macroeconomic crisis of 1991.
The crisis led to systemic reforms, going beyond the piecemeal economic reforms of the
1980s. An IMF aid package and adjustment program supported these changes. The major
reforms included trade liberalization, through large reductions in tariffs and conversion of
quantitative restrictions to tariffs, and a sweeping away of a large segment of restrictions
on domestic industrial investment. Attempts were made to control a burgeoning
domesticfiscal deficit, but these attempts were only partially successful, and came to be
reversed by the mid-1990s.

Of the conference papers, Kochhar (2004), Rajaraman (2004), Roubini and Hemming (2004);
Hausmann and Purfield (2004); and Heller (2004) all provide qualitative and empirical
summaries of India’s fiscal situation. Several of these papers also put India in an international
perspective. Other recent empirical evaluations include Mohan (2000), Lahiri and Kannan
(2002), Rangarajan and Srivastava (2003), World Bank (2003) and IMF (2003). All present
similar numbers, though with some minor differences. Table 1 summarizes the trends in
Central and State fiscal deficits since 1990. It shows that fiscal deficits began to rise in 1997-
98 at both levels of government, though the rise was much greater at the State government
level. In fact, fiscal balances at both levels were severely affected by the large pay increases
granted to Central government employees in 1997-98, followed by similar increases at the
state level the following year. Interestingly, the Center’s balance has continued to deteriorate
slowly after 1997-98, while the States’ aggregate position appears to have stabilized after the
one-time shock. Table 1 also shows that two other fiscal indicators have deteriorated since
1997-98. First, the revenue deficit (i.e., balance between current receipts and expenditures)
has grown as a percentage of GDP: current expenditures have not been controlled well –
reflecting budgetary pressures such as subsidies, as well as the government pay hike.
However, an excessive emphasis on the revenue deficit is misplaced: current expenditures
include spending on health and education, which, if effective, is investment in human capital,
with significant social returns. Analogously, some capital expenditures include items that
should be deemed as current, because they are essentially maintenance expenditures, and
others that have negligible social returns. Second, the primary deficit (after taking out net
interest payments from expenditures) has grown, after the initial reduction in the early 1990s,
indicating that the problem is not simply growing interest payments, though these have also
gone up as a percentage of GDP. Clearly, Table 1 throws doubts on the future sustainability
of the current trajectory.
Fiscal deficits financed by borrowing add to the government debt. Table 2 summarizes recent
trends in the general government debt. After some decline in the early 1990s, the stock of
government debt rose steadily after 1997-98, as a percentage of GDP. In fact, Buiter and
Patel (1992) had pointed out the unsustainability of India’s government debt in the sense that
the expected present value of future surpluses was inadequate to pay off the debt as of 1990.
In 1995 (Buiter and Patel, 1997) they updated their analysis and found that the problem
remained. The methodology in such analyses involves discounting and controlling for future
stochastic shocks: therefore the conclusions are dependent on specific assumptions about
which there could be differences among analysts. Nevertheless, several authors, using
different data sets and varying detailed assumptions, have reached similar conclusions.
Furthermore, as Lahiri and Kannan (2002) note, sustainability in a formal sense is not
enough: illustrative (non-stochastic) calculations – assuming an interest rate of 5 percent,
growth rate of 6 per cent, and primary deficit of 5 percent of GDP – imply that debt stabilizes
at 500 % of GDP.11 Clearly such a trajectory would collapse well ahead of reaching this
notional limit, as the implied interest payments and required taxes are noncredible. A related
distinction Roubini and Hemming, 2004) is between sustainability and ‘financeability’: the
latter captures investors’ willingness to finance debt. It is conceivable that investors finance
debt that is unsustainable given publicly available information, either because their private
information about the future makes them believe it is sustainable, or because they are
irrational. It is also conceivable that investors refuse to finance what appears to be sustainable
debt. As Roubini and Hemming (2004) point out, currently investors seem to be willing to
finance a debt that appears unsustainable in the long run. If we rule out differential and
correct private information, this situation, by construction, cannot continue forever, in the
absence of fiscal adjustment. Roubini and Hemming note, based on Early Warning System
(EWS) models that attempt to quantify such risks of crisis, that the estimated probability of a
sovereign debt crisis for India in the next 12 months is only 2%, but this could increase very
quickly with any rise in interest rates. We return to these issues of risk and possible response
in later sections.
There are two additional arguments going in opposite directions. The first, pointing to the
existence of substantial off-budget items and contingent liabilities, says that the situation is
even more unsustainable than that implied by conventionally measured fiscal deficits. The
second argues that India’s fiscal situation is in fact sound, and many analysts (including us
and the authors of conference papers), have exaggerated the problems. The first argument is
straightforward. There are indeed large and growing off-budget items that represent current
or future claims on the government’s revenues, and these make the fiscal situation even more
unsustainable. The World Bank (2003, Chapter 2), estimates the general government debt at
85% of GDP, with the debt of public sector enterprises adding another 10% of GDP, and
contingent liabilities from guarantees in support of loss-making public enterprises at a further
12% of GDP. All three components – as well as the total, at 107% of GDP – are significantly
greater in magnitude relative to GDP than they were in 1991. While losses of public sector
enterprises raise somewhat different policy issues than government budget deficits, they are
clearly part of the government’s immediate problem. EWS models, and even credit rating
agencies, may not be fully informed of these non-budget liabilities and hence may
underestimate crisis probabilities. Another significant problem in the medium and long run
arises from the government’s pension schemes, some of which are defined benefit schemes
with fundamental structural imbalances (Gillingham and Kanda, 2001; World Bank, 2001;
Heller, 2004; Howes and Murgai, 2004; Kochhar, 2004;13 Roubini and Hemming, 2004).
Heller identifies several other sources of major long-run challenges to India’s fiscal policy,
which involve a great deal of uncertainty, but the contingent liabilities associated with the
current pension systems are predictable as well as worrisome.
The second view, if correct, would call for different policy responses. One strand of this
view, echoed by India’s Finance Minister (Business Standard, 2004), is that sustained high
growth and low interest rates will take care of any future problem. It is certainly true that
India has so far managed to avoid any fiscal crisis that growth rates have exceeded interest
rates despite the deterioration in the fisc, and also that interest rates have recently been quite
low by historical standards. We, and many other analysts, would argue that the cost of India’s
high fiscal deficit has been growth that is below potential. A full justification of this argument
would require a well-specified growth model, which is beyond the scope of the paper, though
we provide some pointers in Section 5. A second strand, which we discuss in Section 4, is
that the fiscal deficit is not of great concern since India’s current external situation is
comfortable: unlike in 1991, foreign exchange reserves are ample, the size and composition
of external debt are more favorable, and foreign trade appears to be more robust.
A third strand is that India’s government debt to GDP ratio is not high by international
standards (Rakshit, 2000, p. 35), and thus is not indicative of a potential crisis. However,
India’s ratio is low only in comparison to the upper tail of the distribution of the ratio across
countries, including those that have not had a fiscal crisis. In comparison to similar emerging
market economies, India’s debt ratio is relatively high (e.g., Roubini and Hemming, 2004,
Figure 1, and Hausmann and Purfield, 2004, Table 1). Furthermore, even if the level of debt
is not high (however measured), the potential debt dynamics are still cause for concern in the
short run. Finally, even if a crisis is many years away – indeed, even if it never occurs – the
costs of the current fiscal stance, in terms of forgone growth, may well be substantial.
Rakshit (2000, pp. 43-44), however, argues that low private savings (household and
corporate) rather than high and growing public consumption has constrained growth in India.
Related arguments from Rakshit and others against crowding out, inflationary impacts of
monetizing the government deficit, and negative impacts of financial repression are all rooted
in what we may term a ‘structuralist/Keynesian’ view of India’s economy (that it is an
economy constrained by deficient aggregate demand rather than by capacity resources and by
market imperfections). We will address these in subsequent sections.
One point that does emerge from this debate is the importance of levels of, and trends in, tax
revenues in affecting the course of fiscal deficits, but these trends have been highlighted by
many economists, independently of any structuralist assumptions (e.g., Rao, 2000; Singh and
Srinivasan, 2002; World Bank, 2003; Rajaraman, 2004; Hausmann and Purfield, 2004). Be
that as it may, there are enough indicators, in our view, of the unsustainability in India’s
public finances, and we focus in the rest of the paper on policies (particularly those relating to
financial and external sectors) that lead away fromslow growth and risks of crisis, while
respecting legitimate distributional concerns and political constraints.
Article
Sustainable Fiscal Policy for India (Peter S. Heller and M. Govinda Rao 2007)

The fiscal policy assumes centre stage in policy deliberations as the continuous fiscal
imbalances and rising levels of public debt pose risks to the prospects for macroeconomic
stability, and accelerating and sustaining growth. Appropriate and timely fiscal policy
measures can promote growth by setting efficient and effective use of scarce resources and by
creating the right incentive signals. The well designed fiscal strategy would help to move an
economy like India towards a higher growth path without high inflation or intergenerational
transfers of the burden of public debt. India’s democratic system and federal structure present
challenges to fiscal policy that are also common across all federal democracies and are well
recognised in theoretical terms. The fiscal experts in India and outside contributed from time
to time in revealing the strengths and weaknesses of the India’s fiscal policy and suggested
future course of action. Set against the above backdrop, the book under review, which is a
selection of 10 papers presented in a conference jointly organised by the International
Monetary Fund and the National Institute of Public Finance and Policy highlights various
aspects of India’s fiscal policy, its sustainability and its impact on the other sectors of the
economy and draws lessons and priorities taking into account the international experiences.
The book examines how India’s fiscal situation evolved over the years, the role played by
reforms, Central-State fiscal relations, risks of high public debt and the critical areas for
reforms. It explores ways of meeting challenges including reduction of public debt and
adoption of sound fiscal policies which assumes critical role in realising the economic
ambitions. Interestingly, India’s economy has grown rapidly since the beginning of the 1990s
despite a large and growing fiscal imbalances and debt levels and it would be of great interest
to examine whether India has found a way to reconcile sustained expansionary fiscal policies
with relative macroeconomic stability. The analysis indicates that the India’s fiscal policy
requires immediate attention in order to have sound and sustainable fiscal situation in the
long run as high growth and low interest rate may not be able to take care of the problem of
long term debt sustainability nor risks of a crisis in the short and medium term. The focus on
the budget deficit alone may be misleading as the problem of off-budget and contingent
liabilities is serious and needs to be addressed. Keeping in view the growth implications in
long run, there is a need to examine public consumption, investment, taxation and deficits in
a framework that recognises that these are all endogenously determined, along with the
growth rate. As the fiscal imbalances continue to exist and debt level is rising, the reforms
mainly aimed to enhance government revenues are critical. While there is ample room for
improving the structure of indirect taxes, in particular, improved tax administration and
enforcement remains one of the most critical areas for reform. Tax reform is an essential step
towards increasing government revenue, as well as reducing microeconomic distortions. On
the expenditure side, the quality of expenditure at both Centre and State level has
deteriorated, and the same needs to be addressed on priority basis. Institutional reforms such
as improvements in the intergovernmental transfer system, borrowing mechanisms for State
governments, and budgeting practices and norms are all technically possible and may well be
politically feasible.
Fiscal Developments and Outlook in India, by Indira Rajaraman focuses on the factors
underlying the continued weak fiscal position during the previous one and half decades as
well as the prospects of recent fiscal reforms. The author identifies that the impact of trade
liberalisation measures and their associated loss of tariff revenue remained the major factor
underlying the weakened fiscal position since the early 1990s. Unlike other countries which
undertook tariff rate reductions, India did not compensate the loss of revenue by a
commensurate increase in domestic taxes. The author is of the view that buoyant growth in
India is essential for fiscal reforms to be possible and this requires that the kinds of physical
and social infrastructure should go up in both quality and quantity. The author finds two
strands to the fiscal imbalance path in India. First, high interest rates on public debt which
started rising sharply in the 1980s and details the political economy pressure that fuelled this
rise. Second, non-interest fiscal indicators which worsened sharply in 1998 with the real
wage hike introduced that year for government employees and pensioners raising the
consolidated salary bill substantially. An econometric exercise investigates whether this event
was endogenous to the political economy. The regression equations show an election year
response, which has become more marked in the last 30 years. The author recognises the
importance of two major reforms, i.e., the reforms of the interest rates guaranteed under the
NSSF and passage of the Fiscal Responsibility Legislation. The issues relating to the scope,
nature and conduct of fiscal policy, particularly in the context of maintaining macroeconomic
stability and enhancing growth, assume importance. The paper, ‘India: Macroeconomic
Implications of the Fiscal Imbalances’, by Kalpana Kochhar examines both the evolutions of
fiscal imbalances and key developments in major macroeconomic variables in order to assess
the macroeconomic impact of the growing fiscal imbalances. Keeping in view the persistent
fiscal imbalance and indebtedness, arguably, the fiscal situation is the single biggest threat to
macroeconomic stability. The rising fiscal imbalances and debt reflects a weakening in
revenue mobilisation, persistent deficit at Centre and State level and narrowing of the gap
between real interest rate and growth rate. The author interestingly finds that on account of
high fiscal imbalance there were hidden costs on the economy in terms of the foregone
potential for even higher economic growth than that has recently been experienced. The large
and increasing fiscal deficit led to a crowding out of productive public expenditure and
constrained the scope for further structural reforms and liberalisation and rooms for
macroeconomic policy manoeuvre – adversely impacting the growth prospects. In order to
avoid the crisis, the author feels that there is strong need of revenue mobilisation efforts and
reorientation of expenditure away from subsidies and towards physical and social
infrastructure projects. India’s medium term economic prospects, among others depend
critically on progress with the closely intertwined tasks of fiscal consolidation and structural
reforms. The rising level of fiscal imbalances and resultant high level of debt may create a
vicious circle inducing a fall in the ratio of private to total credit, rising inflation and falling
economic growth. In this regard, William Easterly in his paper, ‘The Widening Gyre: The
Dynamics of Rising Public Debt and Falling Growth’, examines that fiscal policy variables
affect growth and finds suggestive evidence, in line with the previous literature, that fiscal
policy variables – or variables affected by the fiscal policy such as budget deficit, inflation
and the share of private in total credit do affect growth. Sustainability of public debt has
emerged as an important issue in public policy discussions and academic debates among
policy makers, economists, credit rating agencies and multi-lateral institutions. It has been
widely recognised that unsustainable debt often tends to impact on Governments’ ability to
undertake developmental activities and also may crowd out the private investment. Richard
Hemming and Nouriel Roubini in their paper, ‘A Balance Sheet Crisis in India?’, use a
balance sheet approach to assess India’s vulnerability to a crisis as a result of its high fiscal
imbalances. The authors explore the question of the financeability of a country debt position,
the vulnerabilities associated with the way in which India’s public debt is financed and the
experience from other emerging market economies which face high debt ratios in recent
years. The authors find that India’s debt is clearly financeable over the short term, reflecting
such important strengths as modest rollover/liquidity risk, lack of currency mismatches and
limited liability dollarization, small current account imbalances and low external debt,
financial repression and capital controls. In principle, these are insulating factors to the large
deficit and high share of debt to GDP. The paper concludes that a failure to tackle fiscal
consolidation in the near term will only increase India’s vulnerability in the future.
Peter S. Heller in his paper, ‘India: Today’s Fiscal Policy Imperatives Seen in the Context of
Long-Term Challenges and Risks’, provides an alternative perspective on why India needs to
move soon to address the fiscal imbalances. A continuation of current fiscal policies, the level
of fiscal deficits and character of government expenditure, would put India on an
unsustainable course in terms of the constraints that it would impose, in the future, on the role
that public sector would be able to play in effectively addressing these longer term
challenges. The author emphasises on undertaking the appropriate reforms in order to placing
fiscal house in order today so that India have sufficient fiscal leeway in the future to address
the long term fiscal challenges including those of demographic developments in the
population at large, the demographics of civil service and military pensions, the imperatives
of social insurance reforms and urbanization patterns and the effects of the globalization.
The paper states that India now has a fiscal policy framework that neither offers that futures
fiscal leeway, nor provides an appropriate expenditure programme that is responsive to the
obvious and immediate needs of the economy of the coming decades. Current fiscal policy is
recognised by most analyses as unsustainable. An important policy message may be drawn
from the paper is that India should be cautious about how it formulates new policy
commitments so as to avoid excessive preemption of future budgetary resources and thereby
avoiding the mistakes of industrial economies. In order to enhance the revenue performance,
the strategies focusing on rationalisation of tax rates, better tax compliance, improved
efficiency in tax administration and review of tax exemptions/incentives would be helpful.
Over the last decade, income tax rate at the Central Government level has undoubtedly been
made internationally comparable, central excise duties have been converted to a truncated
VAT (CENVAT) up to the manufacturing stage and custom tariffs on imports have been
sequentially scaled back to approach comparable international level. The various exemptions,
however, have affected the quality of tax administration and revenue performance. For a
couple of decades, services sector has grown rapidly and now represent more than half of the
GDP. In view of its increasing role in GDP, the taxation of service sector assumes
importance. It is imperative to introduce comprehensive taxation of services at the Central
level and the selected services should also be seriously considered for appropriate assignment
for taxation to the States and local bodies. On taxation of services, India can draw important
lessons from Brazil, which was one of the first countries to introduce a comprehensive Value
added tax (VAT) on both goods and services in the mid-1960s. Parthasarathi Shome in his
paper ‘India: Resource Mobilization through Taxation’ finds that though there have been
significant changes in the tax structures in the 1990s, however, the insufficiency in
streamlining the wide prevalent incentives and exemptions has adversely affected the full
potential of revenue productivity in both individual and corporate income tax.
It was recognised that competitive sales tax reductions by States aimed at attracting
investments had led to revenue losses without commensurate gains. The author emphasises
on the reforms on both tax policies and revenue administrations. In their paper, ‘Subsidies
and Salaries: Issues in the Restructuring of Government Expenditure in India’, Stephen
Howes and Rinku Murgai found that while there are ways to reduce subsidies through a
combination of efficiency improvements and tough decisions, however, attempts so far to
reduce subsidies have met with little success. The paper examines the agricultural power
subsidy as a case study and situates India’s growing subsidy bill within the context of a trend
towards agricultural protectionism. There is no assured path forward and sustained reduction
in the expenses towards subsidy will require institutional experimentation. The authors
suggest that there is potential of decline of salary bill of Government sector (Centre and State
Governments) by 2 per cent of GDP over the next decades – via both wage and hiring
restraint without sacrificing expenditure quality. There is also a need to address the growing
pension’s outlays. The usual emphasis on expenditure restructuring through subsidy
reduction is complemented in the paper by an equal emphasis on salary bill reduction. The
authors are of the view that a reduction in the salary bill is not likely to come about by active
downsizing but by a combination of hiring and wage restraint. With regard to the power
sector, the authors stress the importance of privatization as perhaps the only way to bring
commercial discipline into the rural segment of the power sector, however, at the same time
acknowledge the associated risks and difficulties.
Ricardo Hausmann and Catriona Purfield in their paper, ‘The Challenges of Fiscal
Adjustment in a Democracy: The Case of India’, provide thought provoking views and find
that India’s tendency to run large deficit and accumulate debt has deep institutional roots
embedded in its highly decentralized democratic system. The paper mainly studies three
aspects of fiscal consolidation. First, it accounts for the lack of symptoms of an impending
crisis by pointing to some aspects. However, the lack of symptoms is double-edged sword: it
makes crisis less likely for any level of debt, but society is less responsive to fiscal
imbalances, thus making the eventual problems much larger. Second, it analyses possible
implications of the fiscal responsibility legislation on India’s imbalances. Third, it studies
India’s federal system and the role of States in the fiscal adjustment effort. The authors find
that India’s ability to tolerate high deficit and debt without encountering the types of crises
experienced by many other emerging economies is a mixed blessing. It reflects the
comparatively large and closed nature of its economy as well as its deep domestic capital
market and large, albeit captive, pool of domestic savings. The last has allowed the
Government to finance deficits with long term fixed rate debt instruments. The authors
recognise the recent institutional reforms based on legal backing.
The authors suggest a State level fiscal consolidation plan including those of imposition of
borrowing ceiling on States to constrain their deficits and reforms to the system of
intergovernmental transfers to give a more stable and reliable source of revenue. In a federal
set up, stable and reliable sources of flow of funds helps in formulating the future strategies at
sub national levels governments. For sound fiscal management, however, the efforts should
be undertaken by both the Central and State Governments.
The federal budgetary systems bring especially difficult challenges. For example, the
Argentina made significant economic progress on a wide range of issues in the 1990s.
However, the complicated financial relations between the federal Government and provinces
crucially undermined attempts at fiscal control as the provinces had little incentives to control
their spending. Eduardo Refineppi Guardia and Daniel Sonder in their paper, ‘Fiscal
Adjustment and Federalism in Brazil’, draws the lessons from the another large federal
Brazil. The authors emphasise that during the time of fiscal adjustment the fiscal-federal
system needs to be respected as an integral element of policy design, though the system itself
may need to be adapted if situation requires to maintain macroeconomic stability and to
achieve the objectives of fiscal adjustment. The authors emphasise on major elements of a
fiscal-federal system and the ways in which these were adapted in the context of Brazil’ fiscal
adjustment experience during the late 1990s. Among others, these include assignment of
revenue and expenditure responsibilities between the Centre and the States and the rules
determining the control of sub-national debt. The paper assumes importance in the sense that
it sets priority for Indian policy makers to reconsider the scope for adapting their own system.
In the concluding chapter, ‘Fiscal Policy in India: Lessons and Priorities’, Nirvikar Singh and
T.N. Srinivasan assesses India’s current fiscal situation, it’s likely future evolution and
impacts on the economy. The authors examine possible reforms of macroeconomic policy
and broader institutional reforms that will bear on the macroeconomic situation. The authors
also take into account the factors such as political feasibility of possible reforms. They also
examine both medium and longer run scenarios, fiscal sustainability and adjustment going
beyond conventional government budget deficits, to include off-budget liabilities, both actual
and contingent. The chapter concludes that some short run fiscal adjustments are clearly
necessary to avoid any possibility of a crisis, but at the same time more fundamental
adjustments- in the tax system, the structure of the expenditure and the financial sector must
be on the agenda for reforms. The book, a major contribution to the fiscal literature, is
thought provoking, timely and pertinent to India’s fiscal affairs. The various aspects of
India’s fiscal policy, related issues, implications on growth, feasibility of implementations of
reforms in the existing democratic and federal set up are well recognised and addressed. It
provides adequate insights and suggests a road map, taking into fiscal policy and its linkages
with other macroeconomic policies, for a sound and sustainable fiscal policy for India. The
reforms in tax administration, expansion of tax base through more services in tax net,
introduction of transparency in fiscal matters and channelization of expenditure along
productive lines among others reforms are suggested to be initiated on priority basis. Several
fiscal policy measures have already been initiated in India during 1990s covering most of
these areas. Furthermore, the book provides very useful insights on the optimal level of fiscal
decentralisation for India. The discussion on linkages of fiscal policy with other sectors and
its implications including on growth is very relevant and will provide valuable inputs to the
policy makers in India to further facilitate the fiscal reforms process with a view to
strengthening fiscal situation. Growth implications of the fiscal policy could have been
addressed more adequately taking into account the more disaggregated information and also
simultaneously the impact of taxation, expenditure and budget deficits components on the
growth.
The analysis on India’s fiscal situation with an international perspective and its linkages with
other sectors provides adequate insights to policy makers and provokes researchers to take
further work in this area. In this regard, a phase-wise analysis of various aspects of fiscal
policy could have been more useful to understand the strengths and weaknesses of policies in
different phases. The issues like rigidities in bringing expenditure to a lower level or in
channelizing it towards productive lines apart from sustainability of public debt, which
continue to pose problems for the on-going process of fiscal consolidation could have been
addressed adequately. Keeping in view the problems as highlighted in number of papers,
there needs to be some short run fiscal adjustment to avoid any probability of a crisis. In this
context, the future course of action meant for short run and long run could have been
provided adequately keeping in view India’s democratic and federal set up. Nevertheless, the
book remains an important contribution to the India’s fiscal literature. It may be concluded
that the book provides very useful insights for policy makers to undertake appropriate and
timely policy measures in order to strengthen fiscal position and avoid any crisis in the short
and medium term and for sustainable fiscal situation in the long run.
Analysis
In response to the largest economic downturn since the 1930s, several countries around the
world implemented large fiscal stimulus to cushion the blow from the financial crisis and
jump start the economic recovery. During the initial phases of the crisis, policy makers
concerns about the effectiveness of monetary policy, stemming from very low interest rates
to weak transmission mechanism, led to embark in sizable fiscal stimuli packages to offset
falling private sector demand. India was no exception to this. Despite the much shallower
slowdown in overall economic activity, industrial production growth fell markedly and
overall financing conditions tightened significantly during the acute phase of the crisis. The
Indian authorities undertook several measures to address the economic fallout from the crisis.
On the fiscal front, the Indian government implemented large expansionary measures in
208/09 and 2009/10. As a result of the fiscal expansion, the deficit increased sharply and the
contribution of government consumption to GDP growth in the last two quarters of 2008/09
was sizable. This paper assesses the effectiveness of fiscal policy in India.

Even as large fiscal stimuli packages are being implemented around the world, the
effectiveness of fiscal policy to counter falling aggregate demand has been called
increasingly into question. In particular, the evidence on the magnitude of fiscal multipliers
has become a hotly debated issue in academic as well as policy circles. Unfortunately,
theoretical models yield wide ranges of fiscal multipliers depending on assumptions about
the functioning of the economy (e.g., degree of price rigidity) and structural parameters
(labour supply elasticity), and to complicate matters further, empirical estimates of the
impacts of fiscal policy also vary significantly and are highly dependent on the methodology
employed (Perotti, 2009). Nonetheless, as the Indian authorities have started to exit from
accommodative stance in a calibrated way, having estimates of fiscal multipliers is likely to
be useful. In addition, shedding light on the size of fiscal multipliers could also enhance our
understanding of other features of the economy and help assess the extent of crowding-out
going forward.
This paper analyses empirically the effectiveness of fiscal policy in India. We apply simple
structural and recursive vector auto regression (VAR) to gauge the effects of fiscal policy on
GDP and other macroeconomic variables. The data used span the period 1996-2009, covering
a period of mild deficits and the fiscal consolidation phase during 2003-2007. Two VARs are
estimated: a small VAR with spending, tax revenue, and GDP and a larger VAR which
includes inflation and short term interest rate (to control for monetary conditions).
Our major findings can be summarized as follows:
 Preliminary findings for India show that discretionary fiscal policy shocks have
economically significant effects on activity, with current government spending multiplier
estimated at one (on impact), declining to around 0.5 after four to five quarters, suggesting
partial crowding out of some private demand component.
 Consistent with evidence for other countries, the development spending multiplier is
greater than 1, suggesting that composition of spending matters, with a persistent effect even
at 16 quarters.
 Tax revenue multiplier is about twice as large as current spending (same order of
magnitude of development spending), and remains significant after 8 quarters. This is also
consistent with the cross-country evidence, which shows large tax multipliers, especially at
longer horizons.
The remained of this paper is organized as follows. Section II reviews the literature on fiscal
multipliers and the cross-country evidence on the impact of fiscal policy on economic
activity. In this section, we also motivate the need to uncover empirical evidence on fiscal
multipliers, since theoretical predictions from simple models are very sensitive to hard-to-
estimate (unobserved) parameters. In other words, the quest for reliable evidence on fiscal
multipliers lies in the data.

Cross-Country Evidence on Fiscal Multipliers

As we show below, tightly parameterized economic models offer limited guidance to gauge
the magnitude of fiscal multipliers.2 For example, in a simple flexible-price DSGE model the
effect of a government spending shock on GDP depends on the elasticity of labour supply,
the coefficient of relative risk aversion of the representative agent, and the share of
government spending in GDP (Box 1). In a slightly more complicated model with money and
price rigidity, the effect of the spending shock depends on several additional parameters,
including the persistence of spending shocks.
Evidence on the effects of fiscal policy on the economy is mostly based on three approaches:
 The narrative approach, pioneered by Ramey and Shapiro (1998) involves isolating the
exogenous unanticipated component of fiscal policy changes and estimating reduced form
regressions of GDP on dummy variables corresponding to episodes of exogenous fiscal
policy changes.4 The event study may also focus on consumer or investment behaviour, as in
Shapiro and Slemrod (2003, 2009) and Barro and Redlick (2009). Evidence from such event
studies is consistent with some effectiveness of fiscal policy. For instance, the 2001 income
tax rebates in the United States were found to be effective in boosting consumption, but the
multiplier was estimated at less than one. In the IMF’s World Economic Outlook (October
2008) the results from the event studies show that the levels of public debt and composition
of fiscal measures are important determinants of the effectiveness of fiscal policy; high debt
levels lower the multiplier because of fiscal expansions are associated with rising interest
rates and spreads.
 The second approach is based on full-fledged structural models. The class of models used
range from the more traditional simultaneous equations models such as the one used by
Macroeconomic Advisers5 to fully-optimizing DSGE models with price rigidities as in
Taylor et.al. (2009). Not surprisingly, the authors find that the size of estimated multipliers is
not robust. They estimate a benchmark New Keynesian DSGE models and find that
multipliers are about 1/6 of the ones reported in the Romer and Bernstein (2009). Taylor et.al.
(2009) also show their results are robust to the inclusion of hand-to-mouth consumers in their
model, a feature that many believe is critical to generating sizable multipliers. Results based
on other models in the DSGE tradition show that fiscal policy remains effective when
monetary policy remains accommodative, as can be seen in the IMF analyses in Box 2.1 in
the April 2008 World Economic Outlook and Freedman et.al. (2009). This point is
emphasized by Christiano et.al. (2009); they find that the fiscal multiplier is large (greater
than one for government spending) when the nominal interest is constant.
 The third approach has been pioneered by Blanchard and Perotti (2002). It involves
identifying fiscal policy “shocks” using VARs and simulating the dynamic impact of these
shocks on GDP and other variables of interest. Identification of the fiscal shocks is typically
achieved by assuming that government spending is predetermined within a quarter (such
assumption would not be reasonable with annual data). The VAR studies typically find a
larger effect of government spending on GDP and in some cases crowding-in of consumption
(e.g. Blanchard and Perotti, 2002, and Gali et.al., 2007). Other VAR studies find crowding-
out of consumption and a smaller but positive effect on GDP (see Perotti, 2009). Uhlig and
Mountford (2008) use less restrictive sign-restrictions to identify fiscal shocks and find much
smaller deficit-spending multipliers.6 Interestingly, several VAR studies tend to find very
large tax multipliers. This evidence is also consistent with the regression approaches of
Romer and Romer (2008) and Barro and Redlick (2009), particularly at longer horizons.

In the case of emerging markets, the evidence is relatively limited. Ilzetzki, Vegh and
Mendoza (2009) estimate fiscal multipliers for 45 countries based on the BP approach. They
find that multipliers that to be larger in high income countries, in countries with
predetermined exchange rates, in more closed economies, and in economies with lower
debt levels. The IMF October 2008 WEO also has a detailed analysis of fiscal multipliers
based on panel regressions. The results generally indicate small multipliers for both taxes
and spending. The analysis in the WEO also shows that credibility of policy framework and
degree of monetary accommodation is critical to the overall effectiveness of fiscal policy.
Data and Methodology

Data
The data are quarterly and span the period 1996Q2-2009Q3. The variables included in the
estimation are the wholesale price index (WPI), real GDP at market prices, the NEER, the 3-
month nominal interbank interest rate, and foreign variables. The latter includes the “world”
oil price (average from the IMF’s WEO) and the 3-month LIBOR. The GDP and WPI and
fiscal variables are seasonally adjusted. The fiscal variables used are based on the national
accounts (in the case of government consumption) or the CGA (both current and capital
spending).

Baseline VAR Identification Schemes

As note in the previous section, the VAR methodology, which has been successfully applied
to identify monetary policy shocks, has been adapted by BP to simulate the effects of fiscal
policy on the economy. The baseline identification assumption followed here is adapted from
BP.

In the small recursive VAR, variables are ordered from the most exogenous to the most
endogenous. In our case, this corresponds to the following posited ordering: G, Y, and T. In
this case: (i) government spending does not react (within a quarter) to shocks to GDP and
revenues, consistent with some stickiness in spending decisions but still allows for relatively
short “inside” lags; (ii) GDP reacts contemporaneously to spending shocks (but not to tax
shocks); and (iii) tax revenues react to both spending and GDP shocks since revenues are
assumed to be the most endogenous of the three variables included in the small VAR. In the
case of the augmented VAR, the WPI is included right after GDP (but results are unchanged
if the ordering with GDP is reversed) and the interest rate is ordered last. In the augmented
(seven-variable) VAR with foreign variables, oil prices and the LIBOR are block exogenous.
In the indentified VAR timing remains critical for the identification strategy: it is assumed
that it takes longer than a quarter for discretionary fiscal policy to respond to a shock to GDP.
This is equivalent to saying that the systematic discretionary response of fiscal policy is
absent in quarterly data. Such an assumption is much harder to justify with annual data, but
given the lags in policy implementation and budget cycles, this seems a reasonable
assumption in our context. More generally, this type of timing assumption has been
extensively used in the VAR literature (including on monetary policy) since it is easy to
implement and it is consistent with different classes of models
 As in the recursive VAR, government spending does not react contemporaneously to
structural shocks to taxes and GDP (note the restrictions on 𝛼𝑌𝐺and 𝛽𝑇𝐺); in the augmented
VAR, spending responds contemporaneously to the WPI (it is imposed that government
spending declines in real terms with an unanticipated increase in the WPI);
 GDP responds contemporaneously to shocks to both fiscal variables; in the augmented
VAR GDP does not react to price or interest rate shocks within the same quarter due to
stickiness in production plans;
 Tax revenues react contemporaneously to both GDP and spending shocks (they are
endogenous in part because they react to aggregate spending and because of the systematic
discretionary component of fiscal policy discussed above); moreover, the parameter 𝛽𝐺𝑇 is
estimated from the data, allowing shocks to spending to affect revenue shocks—consistent
with the view that revenues are determined after spending.
 The foreign interest rate and domestic output responds contemporaneously to the oil price
(or commodity prices) within a quarter, but the latter is not affected by the former
contemporaneously (zero restriction);
 Domestic prices respond contemporaneously to oil price shocks (in the augmented VAR)
and to output (the second restriction can be relaxed without affecting the results); also, in the
augmented model, the interest rate elasticity of tax revenue and government spending is set to
zero, and the interest rate responds to all variables in the system.

Main Findings
The main results from the BP and the recursive VAR are broadly consistent with a reasonably
strong effect of fiscal policy shocks on GDP. The main results from the scaled impulse
response functions (IRFs) based on BP approach along with the IRF’s 68 percent probability
bands can be summarized as follows:

 Current Spending multiplier is slightly above one on impact, and declines to around 0.5
after 5 quarters, suggesting a rapid crowding out of some private demand component after a
couple of quarters. As in Uhlig and Mountford (2008), the deterministic component of the
VAR does not include a time trend. When a time trend is included the IRF shifts downwards
and becomes insignificant after 5 quarters. Another important result, consistent with some of
the findings in Perotti (2009), is that the identified government spending shocks are fairly
similar for the recursive and BP approaches.
In both approaches, tax revenues increase on impact by less than the increase in spending,
suggesting that the “pure” can be identified as a deficit-financed spending shock. In the case
of the sign-restriction approach, tax revenue does not increase at all in the first 4 quarters.
Inflation increases gradually with the spending shock, with the effect peaking after 6 quarters.
Interest rates also go up, but the effect is not significant, suggesting that crowding out
operates through some other channel.
 Development spending multiplier is greater than 1, suggesting that composition of
spending matters (consistent with cross-country evidence discussed above). The uncertainty
surrounding this multiplier is also large, probably reflecting the volatility of development
spending. Interestingly, the effect persists even after 16 quarters, suggesting some crowding
in effects of that type of spending.
 Tax revenue multiplier is about twice as large as current spending (same order of
magnitude of development spending), and remains significant after 8 quarters. Given that
spending does not react to the tax shock, the experiment can be interpreted as a
deficitreducing tax increase. The result is broadly in line with Uhlig and Mountford (2008)
and Romer and Romer (2008), which report very large tax multipliers. The former argue that
the distortionary effect of taxes shows up at longer horizons, underscoring the need for proper
dynamic scoring of tax cuts. Another interesting result concerning the tax shock is that the
immediate effect of the tax increase on GDP is the same as in recursive approach (when it is
restricted to zero). In the sign-restriction approach tax increases lower GDP on impact.

Remarks on Crowding Out

The results above suggest that crowding out might dull the effects of fiscal policy. First, the
current spending multiplier is well below one after a few quarters, suggesting that the
increased spending reduces the availability of resources for the private sector, leading to
crowding out. The effect on growth over the longer term depends on which component of
demand declines, but given the relatively small size of the multiplier and the evidence (in
other countries) that consumption of credit-constrained households is not very sensitive to
interest rates, it is likely that private investment declines following a deficit-financed increase
in government spending. Moreover, in India as in other developed and emerging economies,
higher deficits are not always accompanied by higher interest rates. In the case of our model,
the estimations were conducted with short term interest rates. But as seen recently, long term
interest rates (which are more relevant for investment decisions) have displayed sensitivity to
budget announcements. Thus the existence of a traditional crowding out effect with higher
long term interest rates causing a decline in private investment cannot be ruled out.
The credibility of the fiscal policy and the fiscal framework more generally are also important
determinants of the effectiveness of fiscal policy. While interest rates on government bonds
may not respond to bad news about the fiscal position, credit spreads may do the job, raising
the cost of financing for corporates and households. Agca and Celasun (2009) find that public
external debt has a sizable positive impact on corporate syndicated loan spreads. Their
findings are consistent with the view that fiscal expansions and the associated debt buildup
may crowd out private access to external markets by increasing spreads. In the case of India
since they also show that while increases in overall public debt raises private borrowing costs
in external markets, but the main driver of this relationship is external public debt.
Additional Evidence from Indian States
Data for the states can also be used to estimate fiscal expenditure multipliers. The evidence
above suggests that spending multiplier is around one, broadly consistent with the finding
above. The estimation of the states’ spending multiplier follows the cross-country empirical
literature (WEO, 2008 and Gupta et al. (2004). While it is hard to find credible instruments
for government spending (such as election cycles), GMM dynamic panel estimation is
applied to identify the causal impact of spending on economic activity. The results are
presented in the table below. As can be seen from the table, the estimated multipliers range
from 0.9 to 1.3, suggesting some crowding-out of private demand.

Concluding Remarks

This paper assesses the effects of fiscal policy on economic activity in India over the
last decade and half and finds that fiscal policy can play an effective countercyclical role. The
results also have implications for the design of fiscal consolidation plans going forward. In
particular, our finding suggest that expenditure reform aimed at curtailing the growth of
spending may be preferable to tax increases because the latter may have larger (negative)
effects on growth over the longer term.
The findings also shed light on the nature of crowding out and the need for careful dynamic
scoring of fiscal plans. The inclusion of debt in the empirical models and further analysis of
the effects on fiscal shocks and announced fiscal measures on aggregate demand components
are important issues for future research.
Recommendations
1. Appropriate and timely fiscal policy measures can promote growth by setting
efficient and effective use of scarce resources and by creating the right
incentive signals.

2. The well designed fiscal strategy would help to move an economy like India
towards a higher growth path without high inflation or intergenerational
transfers of the burden of public debt.

3. India is essential for fiscal reforms to be possible and this requires that the
kinds of physical and social infrastructure should go up in both quality and
quantity.

4. Keeping in view the growth implications in long run, there is a need to

examine public consumption, investment, taxation and deficits in a framework
that recognises that these are all endogenously determined, along with the
growth rate.
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www.econlib.org/library/Enc/FiscalPolicy.html

rbidocs.rbi.org.in/rdocs/Publications/PDFs/82936.pdf

tutor2u.net/economics/.../a2-macro-fiscal-policy-effects.html