25/02/2015 4:33 PM IST | Updated 15/07/2016 8:25 AM IST

Reduce Fiscal Deficit By Higher Tax Revenue, Not Lower Public Spending

The budget should put in measures to raise tax revenue to control the fiscal deficit, and not cut down on social sector spending, which is already the lowest among BRICS countries.

samer chand via Getty Images
Construction Site Being Developed in Rural India Landscape.

In the public discussion around the budget, "fiscal deficit" is quite likely the most frequently occurring term. This is fair enough, given that the budget is about balancing our expenses with income. What is disturbing, however, is that "fiscal deficit" has become a code word for, almost synonymous with, reducing expenditure. The budget and fiscal deficit are reduced to a cost-cutting exercise.

It is conveniently forgotten that the deficit is the difference between revenues and expenditures. There is much less, if any, discussion of the revenue side. For instance, a word search for "tax revenue" in the past month in India yields fewer articles than "fiscal deficit"; moreover, most of the articles on tax revenue were on the Confederation of Indian Industries suggestion to the government to raise revenues through non-tax sources.

But here's why tax revenues might be an important aspect to turn to. According to a 2009 paper by Piketty and Qian, between 1986 and 2008, the income tax paying population in China grew from 0.1% of the population to about 20% of the population. The corresponding number is 6% in Brazil and nearly 10% in South Africa. Even when tax breaks were provided in China in 2011, it brought down the income tax paying population to about 8%. The move was accompanied by raising top income tax rates. Meanwhile, throughout this 22 year period, in India the proportion of population has remained around 2-3% and top income tax rates have been around 33%.

The key reason for the income-tax paying population being stuck in India is that, afraid of antagonizing a vociferous so-called "middle class", the government has raised the tax exemption limit year after year (see Figure 3 of the paper).

When tax revenues do not grow, "fiscal space" is reduced and balancing the budget necessarily implies a reduction in expenditures. For successive governments, the most obvious candidate for any expenditure squeeze is social sector spending.

Contrary to popular perception, size of government (measured by central government expenditures as a percentage of GDP) in India is small. It is lowest among the BRICS; in fact, even in the United States of America the figure is higher than in India. Social spending also is very low (see chart).

One of the main concerns with respect to the National Rural Employment Guarantee Act (NREGA) at the time of its passage in 2004 was whether we could afford it. Ten years down the line, expenditure on NREGA has never crossed 1% of GDP, and after peaking at Rs. 40,000 crores in 2009-10, NREGA allocation has come down in absolute nominal terms to Rs. 33,000 crores in the previous financial year (approximately 0.3% of GDP). NREGA provides some economic security to 25% of the rural population.

Contrast this with Rs. 61,000 crores of tax revenues foregone in 2014-15 - twice as much as the NREGA budget - as a result of exemptions to the gold and diamond industry. The industry is, no doubt, important from the point of view of skilled employment. Just to put things in perspective it is worth recalling that, according to government estimates, the industry provides employment to approximately 1% of the labour force.

The pertinent question then, is not whether there is any fiscal space, but who has the first claim on it. If this year's budget pays attention to raising tax revenues, it will indeed be a welcome break from previous budgets.