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Kelkar's Balancing Act

Arvind Panagariya

Thursday September 23, 2004

Dr Vijay Kelkar, one of India’s finest economists to serve the government of India, completes his two-year term as adviser to the finance minister this month.

During this brief stint, he has provided the intellectual leadership that is rare in policy making. Few observers can forget the intense debate he launched through the comprehensive draft reports on direct and indirect tax reforms soon after he took his position at the invitation of the former finance minister Jaswant Singh. That debate set a new standard for giving the common man a voice in the policymaking.

Having closely observed the deployment of the Gramm-Rudman-Hollings Act to bridge the large budget deficits in the United States in the second half of the 1980s, Kelkar had long felt that India too needed a legal instrument that would tie the government’s hands on how much budget deficit it could run. Therefore, the passage of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 was the realisation of a long-held dream for him.

In its original form, the Act requires that the revenue deficit be eliminated entirely and fiscal deficit be reduced to 3% of the GDP by 2007-08. The UPA government has amended the Act to postpone this deadline to 2008-09. The Act also requires that each year the revenue deficit be reduced by 0.5% of the GDP and fiscal deficit by 0.3% of the GDP until the final 2008-09 target is reached.

While the FRBM Act sets the targets for deficit reduction, it does not offer the roadmap of how they should be achieved. In mid-February, 2004, a task force was appointed under the chairmanship of Kelkar to answer this question. With the lightening speed that has been the hallmark of his tenure, Kelkar recently put on the table a comprehensive report on the implementation of the FRBM Act.

The first question the report asks is whether the targets set by the FRBM Act can be met by simply staying the current course.

The report answers this question in the negative arguing that even if staying the course means continued movement in policy and administration at the recent pace rather than a standstill, the targets will be missed by a wide margin.

The taskforce calculates that under this scenario, the revenue deficit will decline from 2.45% of the GDP to 1.66% and fiscal deficit from 4.43% to 3.98% between 2004-05 and 2008-09. To achieve the targets, speedier and deeper policy changes are required.

The next question the report confronts is whether the faster policy change must focus on increasing revenues or reducing expenditures and whether the change should be front-loaded or back-loaded.

The report rightly opts for a front-loaded approach that focuses on enhancing revenues. Even independently of the compulsions of the FRBM Act, India needs to speedily sort out its tax system. The piecemeal process that began two decades ago has now gone on for too long.

The resulting desperation to raise revenues has only forced the government into resorting to such instruments as the turnover tax on financial transactions that no public finance expert worth his salt would recommend.

Politically, at least, tax reform is one area in which even the Left parties do not have a good reason to block progress — on the contrary, since the reforms strengthen the government’s ability to maintain, even increase, public expenditures, they should actively support it.

As regards action on expenditures, while there is considerable scope for redirecting them to aid the poor rather than the rich or middle-income groups as currently, the case for trimming them is at best weak.

It is now fully appreciated in the policy circles that the top priority in tax reforms is the introduction of a comprehensive value-added tax on all goods and services, which the report embraces.

Constitutional hurdles in the way of such a tax have been cleared and what is required is an agreement between the Centre and states. With an integrated value-added tax system in place, companies will have to effectively pay only a single tax that can be collected at a single window. The Centre and states can then share this revenue at previously agreed terms.

In addition to the zero rate, the report recommends three tax rates called floor, standard and high to be respectively set at 6%, 12% and 20% for the Centre and 4%, 8% and 14% for the states. While the rationale for three rates can be debated (for example, why not just one), there is little scope for disagreement that with such a unified value-added tax in place, the transaction costs and inefficiencies will come tumbling down and the deficit will be tackled not just at the Centre but states as well.

On customs duties, the report recommends three rates of 5%, 8% and 10% by 2008-09. While I have advocated moving to a single tariff rate of 15% now and 5% by 2007-08, even the three rate-structure that allows no exceptions such as the automobiles that currently enjoy prohibitive custom duties on both new and used cars is a vast improvement over the current regime.

The report makes similar sensible recommendations on personal and corporate income taxes. It offers numerical calculations demonstrating that if implemented, the proposed policy changes would ensure that the targets set by the FRBM Act are more than fully met.

Few observers believe that the government will necessarily live by the dictates of the FRBM Act. Just as it has already done once, the government can amend the Act again.

The Gramm-Rudman-Hollings Act, which was introduced in the United States in 1985, achieved at best modest deficit reductions with the Congress revising it in 1990 to effectively lift the deficit targets.

Nevertheless, in the current Indian context, a government inclined to overhaul the tax system can use the cover provided by the Act to speed up the process.