Fiscal Policy, Devolution and Indian Economy

In this paper, an attempt has been made to look at four empirical issues that may be of interest to the fiscal policy in India and especially to the 15th Finance Commission: what has been the impact of higher devolution of Central taxes to the States on overall economic growth, fiscal balance and other indicators? What could be the impact of changes in external conditions on the macroeconomic prospects? What mix of expenditure policies would allow the Indian economy to achieve higher growth and fiscal consolidation? And finally, can India achieve the medium term target of US$ 5 Trillion by 2024-25? To address these issues, this paper uses a modified NIPFP-macroeconomic policy simulation model for the Indian economy. Higher devolution share to the States, vis-à-vis the baseline scenario, causes economic growth to be marginally lower by 0.4% for the period 2015-20 (14th Finance Commission period) on an average and by 0.3% over the projection period 2020-2025 (15th Finance Commission period). It is also found that an expenditure switching strategy in favour of capital expenditure (by more than 1% of GDP) with the centre assuming the greater share of the increase, and reduction in revenue deficit to GDP makes it possible to combine high growth (8%) with fiscal consolidation that brings down the general Government’s liability to GDP ratio to 60 per cent by the end of 2024-25. With greater public investments and its complementarity with private investment, the target of $5 trillion economy by 2024-25 may be achievable. The analysis also suggests that distribution of debt targets between Centre and States in the proposed FRBM roadmap may need to be revised.