How India can frame its fiscal architecture to realize Viksit Bharat

India must achieve and sustain a minimum of 7%+ potential real GDP growth until FY48.

In brief

• Achieving developed economy status requires 7%+ sustained GDP growth and a robust fiscal framework.
• India's primary expenditure should increase from 23.8% to 31.4% of GDP, consistent with a developed country per capita GDP threshold.
• Raising tax-GDP ratio to 25%, boosting non-tax revenues, and reducing fiscal deficit are critical to sustain India’s growth closer to its potential.

As India aims towards becoming a developed economy, that is, Viksit economy by FY48, achieving a minimum of 7%+ potential real GDP growth on a sustained basis and ensuring that India’s economic growth remains close to this potential will remain critical throughout this period. We are proposing a fiscal architecture framework that can help propel the Indian economy to achieve a developed economy (Viksit) status by FY48. 

This fiscal architecture for Viksit Bharat covers four key dimensions namely, (1) required size of government in India along with its financing, (2) recasting of GoI’s FRBM, (3) reforming fiscal transfers from GoI to states, and (4) re-strategizing government expenditure priorities as divided between GoI and states. In this month’s Economy Watch article, we are covering the first dimension, while the remaining will be covered in upcoming editions.

Primary government expenditure to GDP ratio: Now and for Viksit Bharat

The size of general government (GG) can be considered in two parts: a) general government primary expenditure (GGPE) and b) interest payments (GGIP), relative to GDP. Table 1 shows that, compared to its peers, India’s position in terms of GGPE was at the lowest in 2023 as per the IMF data. 

The required level of GGPE, with reference to a Viksit status, can be considered in relation to the relevant per capita GDP. For this purpose, we consider a cross-country framework in which per capita GDP and GGPE are plotted together (Chart 1). At a per capita GDP of US$1,994, the relevant GGPE appears to be on the trendline, that is, it is not lower than what is required for this level of per capita GDP. Here, the per capita GDP levels are considered as the averages over 2017-19.

However, the level of GGPE consistent with a developed country status defined as per capita GDP level of US$14,005¹, is estimated at 31.4%. GoI’s 2003 FRBMA had envisaged keeping its revenue account in balance or surplus. This target was abandoned in the 2018 amendment. However, in most states’ FRLs the provision for keeping the revenue account in balance has continued. The GoI may also consider re-introducing the revenue account balance target as this ensures that government dissavings are zero. It is desirable for the general government to keep the overall revenue account in balance. This would ensure that the entire fiscal deficit plus some non-debt capital receipts would be spent on government capital expenditures. Thus, the decomposition of primary expenditure between primary revenue expenditure and capital expenditure would be 25.4% and 6% (at least) respectively. This subject will be further discussed in a detailed discussion on India’s FRBM in a subsequent issue of Economy Watch. This calls for increasing India’s GGPE by more than 7% points from its FY24 level of 23.8% (as per the IMF). To this, if we add GGIP, the required size of general government total expenditure (GGTE) for India can be obtained. 

Interest payment to GDP ratio: reaching FRBM norms

Table 1 (Col 3) shows that India’s GGIP is the highest amongst the selected countries in 2023 (FY24), although its GG debt to GDP ratio is lower than most (Col 4). This can be attributed to the higher cost of borrowing in India as compared to its peers measured by the effective interest rate.

Chart 2 shows that given India’s per capita GDP level at US$1994 (average 2017-19), the trendline indicates a GGIP of 1.6% as against India’s actual level of 4.7% (average over 2017-19). For a level of per capita GDP consistent with a developed country threshold, the required GGIP is estimated at close to 2%, implying that India’s GGIP is currently unduly high. We may, however, aim to at least achieve the FRBM target of debt-GDP ratio of 60%. If the effective interest rate also goes down to 6% from its FY24 level of 6.5% (as per IMF data), the estimated level of GGIP would be 3.6%. Although this is higher than what is indicated in the cross-country perspective, at least this much should be achieved.

Adding the FRBM consistent GGIP level of 3.6% to the required level of GGPE of 31.4% gives a GGTE size of 35% consistent with a developed country per capita GDP threshold.

Financing the augmented size of government for a developed India

The increase in the GGTE from 29.1% of GDP in FY24 to a required level of about 35%, that is an increase of about 6% points, should be primarily financed by augmenting India’s general government tax revenue to GDP ratio (GGTR), besides an increase in the contribution of non-tax revenues to GDP (GGNTR) while also reducing the fiscal deficit to GDP ratio to the FRBM norm.  

India’s GGTR had languished in the range of 16% to 18% over a period of more than three decades. There are indications that India may finally be breaking out of this ceiling of 18%. Going forward, the increase in the GGTR may happen spontaneously both due to changes in the structure of the Indian economy and its increasing digitalization and formalization. It may also be driven by policy that rationalizes the direct and indirect tax structures with marginal increases in selected rates. A suitable level of tax-GDP ratio at India’s current per capita GDP as also at a developed status consistent level of per capita GDP in a cross-country framework will be examined along with its decomposition between GoI’s gross tax-GDP ratio and states’ own tax revenues to GDP ratio in a subsequent issue of EY Economy Watch. The policymakers should also take note of the recent change in terms of personal income tax revenues overtaking the corporate income tax revenues in the context of the need to increase India’s overall tax-GDP ratio.

It can be shown that a sustained nominal GDP growth of 11% and an average buoyancy of 1.125, maintained over the years, would take India’s GGTR close to 25% by FY48, amounting to an increase of 6.5% points over a period of 24 years.

India’s GGNTR has stagnated at less than 3% since FY1951 and was the lowest amongst peers in 2022 (FY23) at 2.1% as per IMF data. It is important to exploit the non-tax revenue sources better by tapping many of its government-owned untapped or under-exploited resources including land assets, assets below and above land (eg. mineral and water resources), and territorial waters.

Conclusion

Table 2 shows important milestones in this journey which requires a) increasing GGTR from its level of 18.5% in FY24 to 25% of GDP, b) increasing GGNTR from 2.3% in FY24 to 4% of GDP and c) reducing fiscal deficit and debt relative to GDP to 6% and 60% respectively. With a 6% fiscal deficit and a revenue deficit to GDP ratio of close to zero, the required decomposition of primary expenditure into primary revenue expenditure and capital expenditure would be 25.4% and 6% of GDP respectively.