Policy till 1990

After India gained independence, the main role of fiscal policy was to transfer private savings to cater to the growing consumption and investment needs of the public sector. Other goals included the reduction of income and wealth inequalities through taxes and transfers, encouraging balanced regional development, fostering small scale industries and sometimes influencing the trends in economic activities towards desired goals. In terms of tax policy, this meant that both direct and indirect taxes were focused on extracting revenues from the private sector to fund the public sector and achieve redistributive goals. The combined centre and state tax revenue to GDP ratio increased from 6.3 percent in 1950-51 to 16.1 percent in 1987-88.4 for the central government this ratio was 4.1 percent of GDP in 195051 with the larger share coming from indirect taxes at 2.3 percent of GDP and direct taxes at 1.8 percent of GDP. Given their low direct tax levers, the states had 0.6 percent of GDP as direct taxes and 1.7 percent of GDP as indirect taxes in 1950-51.

The government authorized a comprehensive review of the tax system culminating in the Taxation Enquiry Commission Report of 1953. However, the government then invited the British economist Nicholas Kaldor to examine the possibility of reforming the tax system. Kaldor found the system inefficient and inequitable given the narrow tax base and inadequate reporting of property income and taxation. He also found the maximum marginal income tax rate at 92 percent to be too high and suggested it be reduced to 45percent. In view of his recommendations, the government revived capital gains taxation, brought in a gift tax, a wealth tax and an expenditure tax (which was not continued due to administrative complexities) Despite Kaldors recommendations income and corporate taxes at the highest marginal rate continued to be extraordinarily high. In 1973-74, the maximum rate taking in to account the surcharge was 97.5 percent for personal income above Rs. 0.2 million. The system was also complex with as many as eleven tax brackets. The corporate income tax was differential for widely held and closely held companies with the tax rate varying from 45 to 65 percent for some widely held companies. Though the statutory tax rates were high, given a large number of special allowances and depreciation, effective tax rates were much lower. The Direct Taxes Enquiry Committee of 1971 found that the high tax rates encouraged tax evasion. Following its recommendations in 1974-75 the personal income tax rate was brought down to 77 percent but the wealth tax rate was increased. The next major simplification was in 1985-86 when the number of tax brackets was reduced from eight to four and the highest income tax rate was brought down to 50 percent . In indirect taxes, a major component was the central excise duty. This was initially used to tax raw materials and intermediate goods and not final consumer goods. But by 1975-76 it was extended to cover all manufactured goods. The excise duty structure at this time was complicated

and tended to distort economic decisions. Some commodities had specific duties while others had ad valorem rates.5 The tax also had a major cascading effect since it was imposed not just on final consumer goods but also on inputs and capital goods. In effect, the tax on the input was again taxed at the next point of manufacture resulting in double taxation of the input. Considering that the states were separately imposing sales tax at the post-manufacturing wholesale and retail levels, this cascading impact was considerable. The Indirect Tax Enquiry Report of 1977 recommended introduction of input tax credits to convert the cascading manufacturing tax into a manufacturing value added tax (MANVAT). Instead, the modified value added tax (MODVAT) was introduced in a phased manner from 1986 covering only selected commodities .The other main central indirect tax is the customs duty. Given that imports into India were restricted, this was not a very large source of revenue. The tariffs were high and differentiated. Items at later stages of production like finished goods were taxed at higher rates than those at earlier stages, like raw materials. Rates also differed on the basis of perceived income elasticities with necessities taxed at lower rates than luxury goods. In 1985-86 the government presented its Long-Term Fiscal Policy stressing on the need to reduce tariffs, have fewer rates and eventually remove quantitative limits on imports. Some reforms were attempted but due to revenue raising considerations the tariffs in terms of the weighted average rate increased from 38 percent in 1980-81 to 87 percent in 1989-90. By 1990-91 the tariff structure had a range of 0 to 400 percent with over 10 percent of imports subjected to tariffs of 120 percent or more. Further complications arose from exemptions granted outside the budgetary process In 1970-71, direct taxes contributed to around 16 percent of the central governments revenues, indirect taxes about 58 percent and the remaining 26 percent came from non-tax revenues (Figure 1). By 1990-91, the share of indirect taxes had increased to 65 percent, direct taxes shrank to 13 percent and non-tax revenues were at 22 percent Indias expenditure norms remained conservative till the 1980s. From 1973-74 to 1978- 79 the central government continuously ran revenue surpluses. Its gross fiscal deficit also showed a slow growth with certain episodes of downward movements (Figure 5). The state governments also ran revenue surpluses from 1974-75 to 1986-87, barring only 1984-85 (Figure 6). Thereafter, limited reforms in specific areas including trade liberalisation, export promotion and investment in modern technologies were accompanied by increased expenditures financed by domestic and foreign borrowing (Singh and Srinivasan, 2004). The central revenue deficit climbed from 1.4 percent of GDP in 1980-81 to 2.44 percent of GDP by 1989-90. Across the same period the centres gross fiscal deficit (GFD) climbed from 5.71 percent to 7.31 percent of GDP. Though the external liabilities of the centre fell from 7.16 percent of GDP in 1982-83 to 5.53 percent of GDP by 1990-91, in absolute terms the liabilities were large. Across the same period the total liabilities of the centre and the states increased from 51.43 percent of GDP to 64.75 percent of GDP. This came at the cost of social and capital expenditures. The interest component of aggregate central and state government disbursements reflects this quite clearly. The capital disbursements decreased from around 30 percent in 1980-81 to about 20 percent by 1990-91. In contrast, the

interest component increased from around 8 percent to about 15 percent across the same period (Figure 7). Within revenue expenditures, in 1970-71, defence expenditures had the highest share of 34 percent, interest component was 19 percent while subsidies were only 3 percent (Figure 3). However, by 1990-91, the largest component was the interest share of 29 percent with subsidies constituting 17 percent and defence only 15 percent .Therefore, besides the burden of servicing the public debt, the subsidy burden was also quite great.
While Indias external debt and expenditure patterns were heading for unsustainable levels, the proximate causes of the balance of payments crisis came from certain unforeseen external and domestic political events. The First Gulf War caused a spike in oil prices leading to a sharp increase in the governments fuel subsidy burden. Furthermore, the assassination of former Prime Minister Rajiv Gandhi increased political uncertainties leading to the withdrawal of some foreign funds. The subsequent economic reforms changed the Indian economy forever.

Scenario after 1991

The 1991 Balance of Payments [BOP] crisis forced India to procure a $1.8 billion IMF loan and acted as a tipping point in Indias economic history. The IMF bailout wounded the pride of a country that had strove above all for self-sufficiency through its post-independence socialist policies. The bailout announced to Indian policymakers and the world the countrys policy failures. The BOP crisis immediately confronted P.V. Narasimha Raos newly elected Congress government, which had been swept into power in mid-1991 in the aftermath of Rajiv Gandhis assassination. Rao had already appointed a non-political figure, economist Manmohan Singh, as finance minister in a gesture that symbolized Raos desire to charge forward with economic reform. In response to the crisis, the government immediately introduced stabilization measures to reduce the fiscal deficit. The fiscal tightening and devaluation of the rupee by approximately 25% adequately reduced the current account deficit. Yet, the crisis itself did not spur the significant changes India needed. FISCAL AND ADMINISTRATIVE REFORMS Initial fiscal reform focused on politically feasible revenue-related issues like rationalizing the tax structure and increasing compliance. Rao and Singh had to abandon their initial attempts to curb the deficit through spending cuts, and by 1996, the annual deficit had climbed back to 1991 levels 10.5% of [Link] to public opinion, reformers could not break the vicious cycle of over expenditure and poorly targeted spending. The center government drove an initiative to move the country toward a Value-Added Tax system, and by 2005, most state governments had adopted it. According to Delhis Secretary of Finance Sanjeev Khairnar, the VAT contributed 70% of Delhis total revenue collection, but many others questioned the extent of its implementation nationally. States choose their tax levels, and the long lines of trucks at state borders illustrate the inefficient competition that results. The distribution of responsibilities between state and central governments in tax collection and public good provision has created perverse incentives, with states and municipalities poorly utilizing resources and failing to deliver. Local governments also suffer from even greater fiscal problems. Tax evasion is rampant, with some business and public leaders estimating that a mere 20% of taxable revenue is actually collected. The poor performance of the government only exacerbates the taxevasion problem. Ultimately, greater cooperation among the different levels of government is needed to coordinate decision making, expenditure targeting, and tax collection procedures

FINANCIAL SECTOR REFORMS In order to liberalize the financial sector, Rao established committees to research and make recommendations regarding financial system modernization, deregulation, and lending improvements. The committee-based approach reflected Raos strategy of building consensus through Indian-led and designed plans. Before the 1990s, regulations limited the ability of the Indian financial sector to efficiently allocate resources. Regulations required heavy investment in government debt, while lending was restricted to specific sectors. Bank nationalization left management of most financial institutions to political forces. Efforts to privatize and introduce competition were approached cautiously, due to the Political sensitivity of these reforms and resulted in more limited change than did deregulation. Changes did not impact the banking workforce or management structure; banks remain overstaffed and poorly managed. Trade unions persist as a formidable enemy of future reforms aimed at reducing operating expenses. The large and mobilized workforce, associated with the Communist parties, has gone on strike in the past, holding the entire banking system hostage. Indias fiscal reforms focused on generating revenue through rationalizing the tax structure and increasing compliance. Specifically, the reforms: Lowered taxes (individual, corporate, excise and custom) Broadened the tax base; Removed exemptions and concessions to reduce distortions; Simplified laws and procedures to close loopholes and increase compliance, including using technology to better track tax payments.