Gross tax-to-GDP ratio of the Central Government increased to 11.5 per cent of GDP, marking its second-highest level in the past half a century. The only time when it was higher was in FY08, at 12 per cent of GDP. States also experienced tax buoyancy. India’s total taxes (Centre + States) stood at its new high of 18 per cent of GDP in FY23, marginally better than 17.9 per cent in FY22 and 17.6 per cent in FY08.
An obvious implication of that is more government spending. Right? Highly unlikely, for three reasons.
First, the Union Government has targeted to reduce its fiscal deficit from a reported 6.4 per cent of GDP to around 4.5 per cent by FY26. It is very likely that the pre-Covid deficit level of 3.5 per cent of GDP will not be reached before the end of this decade. Assuming States’ fiscal deficit at 2.5 per cent of GDP (same as in the pre-Covid period) by FY30, the aggregate fiscal deficit is assumed at 6 per cent of GDP by the end of this decade. Keeping these fiscal deficit assumptions sacrosanct, we can find the maximum possible growth in fiscal spending during the remainder of this decade, using different assumptions for nominal GDP growth and tax buoyancy.
Average growth
During the pre-pandemic period, the average nominal GDP growth was 11 per cent with tax buoyancy of about 1.1x. The average fiscal spending growth during that period was 12.5 per cent, incorporating the off-budget spending (largely food subsidies). Assuming similar nominal GDP growth and tax buoyancy during the next many years, the maximum possible average fiscal spending growth could be 10.1 per cent, much lower than the average growth in the pre-pandemic period (Exhibit 1).
However, with a more realistic nominal GDP growth of 10 per cent per annum and tax buoyancy of 1.3x, the maximum average growth in fiscal spending could be 10.5 per cent during the remainder of this decade, lower than 12.5 per cent average growth in the pre-Covid level. Any further increases in fiscal spending will require higher than targeted fiscal deficit, higher tax buoyancy, higher GDP growth and/or high inflation.
Second, a lot of discussion is happening around the quality of government spending. The Union Government’s capital spending has increased 2.5 times in the past three years and budgeted at ₹10 trillion in FY24. It is, thus, budgeted at 3.3 per cent of GDP in FY24, double of just 1.7 per cent of GDP in FY20 before the pandemic. This appears exceptional. Unfortunately, this on-budget increase has only compensated for a decline in investment spending of CPSEs (central public sector enterprises) which has declined to just 1.3 per cent of GDP in FY23RE and budgeted at 1.1 per cent of GDP in FY24, from 2.3 per cent of GDP before the pandemic. Adding net investments by States (and thus, excluding loans by the Centre to States from its total capex), combined investments of the public sector fell to 6 per cent of GDP in FY22 and further to an eight-year low of 5.7 per cent of GDP in FY23RE, from about 6.3 per cent of GDP in the pre-pandemic period (Exhibit 2). We can at best hope for public investment to recover to pre-pandemic levels, no more.
Trend may not continue
Third, there is a very high likelihood that while the Union Government has increased its investment spending rapidly over the past few years, this trend may not continue for long. There are only three ways in which the capex can increase: higher tax buoyancy, substitution from revenue spending, and/or higher borrowings.
As mentioned earlier, even with higher tax buoyancy, the average growth in fiscal spending over the next few years will be lower than the pre-Covid levels, if the fiscal deficit targets are to be met. Thus, so far, the government has been able to increase total spending, and thus, capital spending, only because of its ability to run a higher fiscal deficit. If consolidation happens, then the recent improvements in tax performance will have to be entirely deployed for that purpose.
If rising revenues offer little cheer, how much room is there for growth focused expenditure switching? Although the share of capital spending is budgeted to increase to 22.2 per cent of total spending of the Central Government in FY24 from 13.5 per cent in the pre-Covid period (and 17.4 per cent in FY23P), the share of investments (excluding loans and advances) is estimated to have increased modestly to 15.4 per cent in FY23 of total spending on a combined general government basis, from 14 per cent in the pre-Covid years. It means that the share of States in combined capex has declined from around 60 per cent in the pre-Covid years to less than 50 per cent in FY23.
Discretionary spending
Further, we classify Central Government spending into mandatory (including salary and wages, interest payments and pensions [SIP]), semi-mandatory (defence and grants to States/UTs) and discretionary spending (including all other expenditure). The share of mandatory spending has fallen to 35-40 per cent of total spending in the post-Covid period, while the share of discretionary spending has risen to 40-42 per cent. Investment spending, which is included in the latter, is budgeted to make up for about 55 per cent of total discretionary spending of the Union government in FY24, compared to 45 per cent in the pre-Covid years. Discretionary spending is maxed out and any shocks or revenue reversals will put downward pressure on Government discretionary, especially investment spending, if the fiscal deficit targets are to be met. Similarly, if the Government chooses to announce new spending to entice voters before elections, it is highly likely that discretionary spending, including investments, will take a bigger hit.
Overall, the Government has limited ability to support economic growth. Yet again it has to be recognised that only the private sector can do the necessary heavy lifting sustainably, else India’s growth story will stick at or below 6 per cent for the foreseeable future.
Rathin is a macro-fiscal economist and a former member of EAC-PM, and Nikhil is chief economist, Motilal Oswal