Sustaining India’s long-term growth: role of government finances

Strong prospects for progressively augmenting tax and government expenditure to GDP ratios 

In brief

• The combined tax-GDP ratio is estimated to cross the threshold of 18% in FY24 and FY25.
• A sustained combined tax buoyancy of more than 1 would provide additional fiscal space for supporting vital expenditures in sectors including education and health.
• Apart from ensuring a sustained fall in GoI’s debt-GDP ratio, there is also a need to sustain the combined fiscal deficit at 6% of GDP to enable private investment growth.

Evaluating the state of government finances in India, including both central and state governments, is crucial for managing finances to support sustained economic growth. Since the global demand is expected to remain sluggish, the Indian government’s intervention and its contribution to the long-term economic growth process will remain critical in the medium-term. 

An analysis of the central and all-state fiscal aggregates is provided with an emphasis on post fiscal transfer profiles, which may be of relevance to the deliberations of the Sixteenth Finance Commission (FC16).

Evolution of India’s combined tax-GDP ratio

Chart 1 shows the evolution of the combined tax to GDP ratio in India and its decomposition into GoI’s gross tax revenues (GTR) and states’ own tax revenues (OTR). After increasing on trend basis throughout the period from the early 1950s to the late 1980s, the combined tax-GDP ratio fell from a peak of close to 16% in FY1988 to a trough of 13.1% in FY1999. Since then, it has recovered but remained volatile within the narrow range of 16-18% of GDP. There are signs that this ratio, which has just crossed the threshold of 18% in FY2024, may remain above this level in the near future. In FY2024 when the combined tax-GDP ratio increased to 18.5%, the GoI’s contribution was 11.7% which was still lower than the previous peak of 12.1% in FY2008. State governments have also contributed to the extent of 6.8% which is equal to their previous peak achieved in FY2013.

If a tax buoyancy of higher than 1 can be maintained over the medium-term, the much-needed expansion in the education and health sectors can be supported by the expanded fiscal space financed by the progressively increasing combined tax-GDP ratio with a view to sustain India’s GDP growth in the medium to long term.

Trends in combined revenue receipts and expenditures

Revenue receipts comprise both tax and non-tax revenues. The post transfer (tax devolution and grants by the GoI to states) share of the GoI and the states in the combined revenue receipts is of considerable importance in determining their relative intervention in the economy. As shown in Chart 2, we can divide the long-term history of the evolution of the relative shares into three phases. In Phase 1, the share of the states averaged 55.1%. In phase 2, this increased to 61.4%. In phase 3, this increased further, averaging close to 66%. We may attribute this sharp increase in phase 3 to the recommendation of FC14 pertaining to an increase in the share of states in central taxes to 42% from 32%.

The size of the government, as measured by the combined government spending, averaged 27.4% of GDP, divided between GoI and states at 11.8% and 15.6% respectively during FY2012 to FY2024. In terms of the relative shares of GoI and states in the combined total expenditures, there has been a near-equality up to FY2012 after which a noticeable departure in favor of the states started showing up.

The effective expenditure by the GoI and the state governments is not total expenditure. Rather, it is primary expenditure which is total expenditure minus interest payments. Interest payments constitute transfers to the rest of the economy and do not indicate purchases of goods and services by the government. Primary expenditure, thus, reflects the available fiscal space for undertaking expenditures by the center and the states.

The shares of the GoI and the states in the combined primary expenditure remained close to each other during FY1951 to FY2011, with GoI’ share averaging 47.2% (Chart 3). This share fell to an average of 38.1% during FY2012 to FY2024. For minimizing the fall in its share in combined primary expenditure, the GoI has attempted to borrow relatively more. It has also tried to increase the non-sharable cesses and surcharges. That is why, the two shares have come relatively closer in the more recent years.

India’s fiscal responsibility status

A long-term analysis of the division of borrowing space between GoI and the states shows that the share of GoI in combined fiscal deficit has remained higher than that of states in most of the years since FY1991, with few exceptions (Chart 4).