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Nuts and bolts of fiscal reforms

August 02, 2004 14:58 IST

The Task Force on the Implementation of the Fiscal Responsibility and Budget Management Act, 2003, chaired by Dr Vijay Kelkar, submitted its report on July 16.

It is, in a substantial sense, an extension of the two Task Forces, one each on direct and indirect taxes that had been chaired by Dr Kelkar and which released their reports in 2002.

The FRBM Act required that the revenue deficit be eliminated by 2007-08, a deadline that has been extended by one year via the recent Finance Bill.

It also requires that the annual Budget exercise be carried out in the context of a medium-term fiscal framework, so that there is some consistency and continuity to the assumptions that underlie the Budget each year. These requirements motivate the latest Task Force report.

While the FRBM Act itself imposes only the deadline for the elimination of the revenue deficit, the rules notified under it actually require an annual reduction within this parameter. The government, therefore, has no option but to deal with the problem from the first year itself.

Business-as-usual simulations (which do assume that reforms and other good things will happen) carried out by the Task Force suggest that the revenue deficit will still be at 1.66 per cent of GDP in 2008-09.

In addition, the overall fiscal deficit will be close to 4 per cent of GDP, also a violation of the notified limit of 3 per cent. Both revenue and expenditure measures can be implemented to close the gap, but the Task Force puts the greater burden of adjustment on revenues, and rightly so. The simple reason for this is the perception that revenue collection is far below what it reasonably should be.

The macroeconomic context in which the Task Force has placed its analysis and recommendations is itself a subject of debate. Space, however, constrains me to restrict this column to a discussion of the tax recommendations.

On corporate taxes, the Task Force reinforces the recommendations of its predecessor by seeking to eliminate the various exemptions currently available to companies and which bring the effective rate of taxation far below the notional 35.875 per cent.

The economic rationale for doing away with exemptions based on a range of factors including location and technology is that such exemptions are always biased towards capital intensity, while there is little evidence to suggest that they have contributed significantly to competitiveness and efficiency. All this is in exchange for a reduction of the marginal tax rate to 30 per cent.

The first Task Force offered two options for implementation -- a one-shot approach or a three-year phasing in. This version introduces a "grandfathering" option. Firms that have made investments taking into account the tax exemptions will be allowed to take advantage of them.

Only new firms will be subject to the new rules. Despite many problems with grandfathering, I think it is a practical and, most importantly, a politically more saleable approach. This alternative, to my mind, is a significant improvement over the more restrictive approach of the first Task Force.

However, this Task Force also recommends a reduction of depreciation allowance from the current 25 per cent to 15 per cent. The rationale provided is that the new rate is more in keeping with the current inflation and interest rate scenario. It is not entirely clear what the rate of obsolescence has to do with these two variables.

The merits of accelerated depreciation are based on the notion that rapid technological change requires a quick replacement of capital equipment in order to translate into efficiency and productivity gains. The economic life of capital assets is measured not by how long they are productive but by how long it takes the next generation to come into the market.

Reducing the allowable depreciation rate may be consistent with the objective of reducing the capital intensity bias of the regime, but it is inconsistent with the encouragement of firms to assimilate new technology as quickly as possible.

On personal taxes, the raising of the threshold and the compression of rates also follow the earlier blueprint and are welcome. Tax exemptions for savings are also being grandfathered, but the new emphasis is on channeling savings into long-term instruments that will be intermediated into good things like infrastructure.

This is a very important re-orientation. The problem, if any, is likely to be seen in the relatively high threshold levels for entry into the new pension and insurance schemes.

People entering the tax net may simply not have the liquidity to take advantage of these schemes. There may be a need to revisit the issue of the threshold income at which the existing exemptions will be no longer available.

On indirect taxes, the recommendations are far-reaching. The Task Force argues for not only an integration of goods and services taxes at the central level (as was attempted in the recent Budget) but also integration between central and state taxes.

It suggests a "grand bargain" between the Centre and the states involving agreement on the set of goods and services to be taxed at different rates and, eventually, a sharing of revenues between the two levels of government.

The Task Force recognises the huge infrastructure and co-ordination requirements of this programme but argues that it is imperative that the governments get started on it as soon as possible.

Being in a situation in which two wings of the same government department often cannot communicate with each other, it is rather difficult to visualise the degree of co-ordination that the grand bargain would require being realised in five years.

On the other hand, it is really a matter of national shame that we consider ourselves a global IT superpower and yet have among the most IT-challenged governments in the world. The realisation of the goals of the grand bargain is a challenge not just for tax administration, but for our IT capabilities as well.

Finally, on customs duties, this Task Force retains a preference for differential rates for capital, intermediate, and final goods, but lowers the rates from those recommended by the previous report.

I believe that a uniform tariff is more consistent with India's economic structure, but at rates that are so low, the losses due to differentiation are not likely to be very significant.

To conclude, one of the major contributions of the FRBM Act was to force any consideration of fiscal policy to be done in an explicit macroeconomic framework.

By bringing together macro and micro considerations in laying out its recommendations, the Task Force provides a strong basis for implementation. The compulsion is pretty clear and so is the need for radical measures, whatever they may be.

The writer is chief economist, Crisil. The views expressed are personal

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