India—East Asian Growth, Latin American Deficits

Over the past 25 years, India’s economy grew at an average real rate of close to 6 percent, yet by the end of this period, the general government debt-to-GDP ratio was 34 percentage points higher. We examine the links between the public finances and growth in the post-1991 period. The persistent combination of high growth and high fiscal deficits appears less schizophrenic once macro-micro linkages and lags are taken into account. We argue that the main factor in the deterioration of government debt dynamics after the mid-1990s was not fiscal profligacy but a reform-induced loss in trade, customs and financial repression taxes; these very factors plus lower entry barriers have over time contributed to stronger microfoundations for growth by increasing competition and hardening budget constraints for firms and financial sector institutions. We attribute the unexpected growth resurgence of the past few years to the lagged effects of these factors, which have taken time to attain a critical mass in view of India’s gradual reforms. Similarly, the worsening of the public finances after the mid-1990s can be attributed to the cumulative effects of the tax losses, the negative growth effects of cuts in capital expenditure that were made to offset the tax losses and a pullback in private investment (hence growth and taxes) after what increasingly appears to have been a low-quality investment boom during the first few years of the reforms. Capital expenditure cuts have contributed to the infrastructure gap which is now the biggest constraint on private investment and continued rapid growth. We discuss the on-going reforms in revenue mobilization and fiscal adjustment at the states’ level, which if successfully implemented, will better align the public finances with growth and contribute fiscal space for infrastructure