The Government's Fiscal Dilemma: Balancing Spending, Taxation, and Deficits

Governments across the world grapple with the fundamental challenge of balancing public spending, taxation, and deficits. This debate is particularly intense in India, where citizens demand more spending on essential sectors like education, healthcare, and infrastructure while simultaneously advocating for lower taxes and reduced borrowing. However, these demands are inherently contradictory, making fiscal policy a complex balancing act. This blog explores the intricate relationship between government spending, taxation, and fiscal deficits in India, evaluating the legitimacy of various perspectives and proposing a way forward.

The Spending Paradox: Do We Spend Too Much or Too Little?

One common argument is that India spends too much. However, a closer look at expenditure patterns suggests otherwise. For instance:

Education: The National Education Policy (NEP) recommends that India allocate 6% of its GDP to education, but actual spending has hovered around 3-4%.

Healthcare: The recommended spending on healthcare is 2.5% of GDP, yet India currently spends only about 1.5%.

Infrastructure: India has ramped up infrastructure investments, yet per capita spending remains lower than in developed nations.

Law and Order: Public safety and judiciary reforms require higher allocations to enhance governance efficiency.

Clearly, India’s fiscal commitments remain constrained by limited revenue generation, raising the question: if we must spend, where should the money come from?

The Taxation Puzzle: Who Should Pay?

A universal sentiment is that taxation is burdensome. Whether rich or middle-class, most individuals feel overtaxed. Yet, the reality is that India’s tax-to-GDP ratio is among the lowest globally, at around 10-11%, compared to over 30% in many developed economies.

One crucial factor is the income tax exemption limit, which determines who contributes to direct taxes. Ideally, the exemption level should align with per capita income and poverty benchmarks. However, India's exemption levels are relatively high compared to its GDP per capita, reducing the tax base.

Historically, attempts to shift the tax burden solely onto the wealthy have not yielded substantial revenue gains. In the 1970s, India experimented with a maximum marginal tax rate of 97.75%, but this led to widespread tax evasion and black money proliferation rather than increased revenue collection. Consequently, tax rates were rationalized in subsequent decades, leading to improved compliance and economic expansion.

The Deficit Dilemma: Can We Spend Without Borrowing?

A large section of the public believes India’s fiscal deficit is excessive. As of recent estimates, the central government's fiscal deficit hovers around 5 to 6% of GDP, with combined state and central deficits exceeding 9%. High deficits can lead to inflation, crowding out of private investment, and increased interest burdens. Yet, under-spending can stunt economic growth and social development.

A key challenge is how to finance spending without excessive borrowing. Options include:

1. Broadening the tax base: Ensuring more individuals and businesses contribute.

2. Reducing tax exemptions: Aligning exemption levels with per capita income.

3. Enhancing tax compliance: Strengthening enforcement to curb evasion.

4. Public-private partnerships (PPP): Leveraging private investment for infrastructure.

5. Strategic borrowing: Prioritizing debt for productive capital expenditure.

India's fiscal policy must strike a balance between spending, taxation, and deficits. The country spends relatively less on critical sectors, yet its tax base remains narrow. Sustainable fiscal policy requires broadening the tax net while ensuring efficient utilization of public funds. The focus should be on targeted spending that drives economic growth and enhances social welfare while maintaining fiscal discipline. Ultimately, a well-calibrated approach is key to India's long-term economic stability and development.