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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
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  Policy till 1990 After India gained independence, the main role of fiscal policy was to transfer private savings tocater to the growing consumption and investment needs of the public sector. Other goalsincluded the reduction of income and wealth inequalities through taxes and transfers,encouraging balanced regional development, fostering small scale industries and sometimesinfluencing the trends in economic activities towards desired goals.In terms of tax policy, this meant that both direct and indirect taxes were focused on extractingrevenues from the private sector to fund the public sector and achieve redistributive goals. Thecombined centre and state tax revenue to GDP ratio increased from 6.3 percent in 1950-51 to16.1 percent in 1987-88.4 for the central government this ratio was 4.1 percent of GDP in 1950-51 with the larger share coming from indirect taxes at 2.3 percent of GDP and direct taxes at 1.8percent of GDP. Given their low direct tax levers, the states had 0.6 percent of GDP as directtaxes and 1.7 percent of GDP as indirect taxes in 1950-51.The government authorized a comprehensive review of the tax system culminating in theTaxation Enquiry Commission Report of 1953. However, the government then invited the Britisheconomist Nicholas Kaldor to examine the possibility of reforming the tax system. Kaldor foundthe 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 92percent 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 anexpenditure tax (which was not continued due to administrative complexities)Despite Kaldor’s recommendations income and corporate taxes at the highest marginal ratecontinued to be extraordinarily high. In 1973-74, the maximum rate taking in to account thesurcharge was 97.5 percent for personal income above Rs. 0.2 million. The system was alsocomplex with as many as eleven tax brackets. The corporate income tax was differential forwidely held and closely held companies with the tax rate varying from 45 to 65 percent for somewidely held companies. Though the statutory tax rates were high, given a large number of specialallowances and depreciation, effective tax rates were much lower. The Direct Taxes EnquiryCommittee of 1971 found that the high tax rates encouraged tax evasion. Following itsrecommendations in 1974-75 the personal income tax rate was brought down to 77 percent butthe wealth tax rate was increased. The next major simplification was in 1985-86 when thenumber of tax brackets was reduced from eight to four and the highest income tax rate wasbrought down to 50 percent .In indirect taxes, a major component was the central excise duty. This was initially used to taxraw materials and intermediate goods and not final consumer goods. But by 1975-76 it wasextended 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 wasagain 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-manufacturingwholesale and retail levels, this cascading impact was considerable. The Indirect Tax EnquiryReport of 1977 recommended introduction of input tax credits to convert the cascadingmanufacturing tax into a manufacturing value added tax (MANVAT). Instead, the modifiedvalue added tax (MODVAT) was introduced in a phased manner from 1986 covering onlyselected commodities .The other main central indirect tax is the customs duty. Given that importsinto India were restricted, this was not a very large source of revenue. The tariffs were high anddifferentiated. Items at later stages of production like finished goods were taxed at higher rates thanthose at earlier stages, like raw materials. Rates also differed on the basis of perceived incomeelasticities with necessities taxed at lower rates than luxury goods. In 1985-86 the governmentpresented its Long-Term Fiscal Policy stressing on the need to reduce tariffs, have fewer rates andeventually remove quantitative limits on imports. Some reforms were attempted but due to revenueraising considerations the tariffs in terms of the weighted average rate increased from 38 percent in1980-81 to 87 percent in 1989-90. By 1990-91 the tariff structure had a range of 0 to 400 percentwith over 10 percent of imports subjected to tariffs of 120 percent or more. Further complicationsarose from exemptions granted outside the budgetary processIn 1970-71, direct taxes contributed to around 16 percent of the central government ’ s 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 percentand non-tax revenues were at 22 percent India ’ s expenditure norms remained conservative till the 1980s. From 1973-74 to 1978- 79 thecentral government continuously ran revenue surpluses. Its gross fiscal deficit also showed aslow growth with certain episodes of downward movements (Figure 5). The state governmentsalso 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 andinvestment in modern technologies were accompanied by increased expenditures financed bydomestic and foreign borrowing (Singh and Srinivasan, 2004). The central revenue deficitclimbed from 1.4 percent of GDP in 1980-81 to 2.44 percent of GDP by 1989-90. Across the same period the centre‟s 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 to5.53 percent of GDP by 1990-91, in absolute terms the liabilities were large. Across the sameperiod the total liabilities of the centre and the states increased from 51.43 percent of GDP to64.75 percent of GDP.This came at the cost of social and capital expenditures. The interest component of aggregatecentral and state government disbursements reflects this quite clearly. The capital disbursementsdecreased 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 shareof 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 subsidiesconstituting 17 percent and defence only 15 percent .Therefore, besides the burden of servicing thepublic debt, the subsidy burden was also quite great. While India‟s external debt and expenditure patterns were heading for unsustainable levels, the proximate causes of the balance of payments crisis came from certain unforeseen external anddomestic political events. The First Gulf War caused a spike in oil prices leading to a sharp increase in the government‟s fuel subsidy burden. Furthermore, the assassination of former Prime Minister  Rajiv Gandhi increased political uncertainties leading to the withdrawal of some foreign funds. Thesubsequent 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 India’s 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 pol icymakers and the world the country’s policy failures.   The BOP crisis immediately confronted P.V. Narasimha Rao’ s newly elected Congress government,which had been swept into power in mid-1991 in the aftermath of Rajiv Gandhi’s assassination. Rao had already appointed a non-political figure, economist Manmohan Singh, as finance minister in a gesture that symbolized Rao’s desire to charge forward with economic reform. In response to the crisis, the government immediately introduced stabilization measures to reduce the fiscal deficit. Thefiscal tightening and devaluation of the rupee by approximately 25% adequately reduced the currentaccount 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 taxstructure and increasing compliance. Rao and Singh had to abandon their initial attempts to curb thedeficit through spending cuts, and by 1996, the annual deficit had climbed back to 1991 levels  –   10.5% of GDP.Sensitive to public opinion, reformers could not break the vicious cycle of overexpenditure 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 Delhi’s   Secretary of Finance Sanjeev Khairnar, the VAT contributed 70% of Delhi’s 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 publicgood provision has created perverse incentives, with states and municipalities poorly utilizingresources 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 taxablerevenue is actually collected. The poor performance of the government only exacerbates the tax-evasion problem. Ultimately, greater cooperation among the different levels of government is neededto 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 makerecommendations regarding financial system modernization, deregulation, and lendingimprovements. The committee-  based approach reflected Rao’s strategy of building consensus through Indian-led and designed plans. Before the 1990’s, regulations limited the ability of the Indian financial sector to efficiently allocateresources. Regulations required heavy investment in government debt, while lending was restrictedto specific sectors. Bank nationalization left management of most financial institutions to politicalforces.Efforts to privatize and introduce competition were approached cautiously, due to thePolitical sensitivity of these reforms and resulted in more limited change than didderegulation. Changes did not impact the banking workforce or management structure;banks remain overstaffed and poorly managed. Trade unions persist as a formidable enemy of futurereforms aimed at reducing operating expenses. The large and mobilized workforce, associated withthe Communist parties, has gone on strike in the past, holding the entire banking system hostage. India’s 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 usingtechnology to better track tax payments.
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