Objectives and Orientation || Development Perspective || Macro Economic Dimensions || Policy Framework || Financing the Plan || Employment Perspective

POLICY FRAMEWORK 

Introduction

4.1.1 The Eighth Plan aims at an average annual growth rate of 5.6 percent and an average industrial growth rate of about 7.5 percent. These growth targets are planned to be achieved with relative price stability and a substantial improvement in the country's balance of payments position. It is envisaged that there will be a reasonable degree of price stability and that the ratio of current account deficit to GDP will he maintained at about 1.6 percent.

4.1.2 Performance of the economy in the base year has not been that ancouraging. Industrial growth in 1991-92 is estimated to be negligible and the overall growth of the economy is estimated to be not more than 3 percent. The annual inflation rate in 1991-92 has been about 13 percent. On the balance of payments front, although there has been some improv-;:.isent in the foreign exchange reserves (partly due to the borrowings from International Monetary Fund and partly because of enhanced foreign exchange remittances by non- residents), exports are exceptionally sluggish. Given this performance in 1991-92, a quick turn-around in the economy is required, if the major macroeconomic targets of the Eighth Plan are to be achieved.

4.1.3 One of the reasons for the sluggish export performance in 1991-92 was the collapse of our trade with the Rupee Trade Area. The dollar value of our exports to the Rupee Trade Area declined by over 40 percent in 1991-92. This adverse effect on our exports was further confounded by the recession in the major industrialised countries of the West. The poor export performance, among other factors, had its toll on industrial growth. To some extent, therefore, our economic performance during the Eighth Plan period will depend upon the external economic environment, i quick recovery in the industrialised economies of the West should give a boost to our exports and this will not only be of great help in tackling our balance of payments problems but also in giving a fillip to industrial growth.

4.1.4 While external environment is extremely important, it will be unrealistic to rely solely on favourable external conditions for a turn-around in the economy. Instead, it will be safer to take the external economic condition as it unfolds and concentrate on providing a domestic economic environment which is conducive to efficient growth of the economy. Experience shows that a set of well co-ordinated macroeconomic policies is of utmost importance in ensuring such an economic environment. In general, the following macroeconomic policies need careful consideration during the Eighth Plan period:

1. The policy regime governing trade, technology and transborder capital flows,
2. Industrial deregulation and administered price policy,
3. Financial sector reforms, and
4. The stance of demand management as reflected in monetary and fiscal policies.

4.1.5 Broadly speaking, the first three of these policies taken togelher constitute what has now come to be known as "structural" policies, i.e. policies by and large aimed at improving the supply-side of the economy. The last one corresponds to what has traditionally been covered under "stabilisation" policies, i.e., policies aimed at controlling aggregate demand in accordance with the long run growth path of an economy. Recently, Government has initiated significant policy changes on both these areas of economic policy. However, the process of reforms initiated recently represents only a beginning. We have to carry it farther if we want to reap the full benefits of these reforms. Therefore, sustaining the pace of economic reforms will be the major challenge during the Eighth Plan period. While both macroeconomic stabilisation and structural policies are important to ensure an economic environment which is conducive to efficient growth of the economy, a whole set of sector-specific policies also has an important bearing on efficiency and growth.

This chapter, however, limits its focus only on the macroeconomic policy issues. The sector-specific policy issues are discussed in volume II.

Policies on Trade, Technology and Capital Flows

4.2.1 Global development experience of the past few decades shows that a policy regime with fewer harriers to trade, both tariff and non-tar-iff.and which provides equal incentives for exports as well as production for the domestic market enables countries to achieve not only impressive export growth but also rapid and sustainable economic growth. Furthermore, experience of many countries including our own has also exposed the inherent limitations of an inward-oriented, import substituting trade regime. It is not only that such a trade regime hampers the efficiency of resource use and consequently growth but also tha" it is unsuccessful in even ensuring a viable balance of payments, A key task during the Eighth Plan, therefore, is to move our trade policy regime towards greater openness and to reap the full benefits of international trade.

4.2.2 Since June, 1991, the Government has initiated a series of trade policy changes with a view to integrating the Indian economy better with the rest of the world. The valw- of the rupee was adjusted downward by about 20 percent in July, 1991. This .'/as followed by a liberalisation of the foreign trade regime through some reduction in the quantitative restrictions. The import policy regime was revamped by shifting a significant number of items outside the purview of import licensing. Exporters were given entitlements equal to 30 to 40 percent of their export earnings in the form ofEXIM Scrips against which even restricted items were allowed to be imported. Alongwith these, the Government dispensed with a number of export- incentives including the cash compensatory support to exports. As a first step towards a gradual reduction in the tariffs, the Union Budget for 1991-92 reduced the maximum rate of import duty from more than 300 percent to 150 percent.

4.2.3 Within eight months of introducing these trade policy changes, the Government initiated another set of policy changes in the areas of trade and transborder capital flows coinciding with the Union Budget for 1992-93, these changes being more far reaching than the ones initiated in July 1991. The EXIM scrip scheme was replaced by a system of partial convertibility of the rupee on the current account of the balance of payments, Under the new system, all foreign exchange remittances, whether earned through exports of goods and services or remittances, can be converted into rupees in the following manner: 40% of the foreign exchange remitted can be converted at the official exchange rate while the remaining 60% at a market determined rate. The foreign exchange surrendered at the official exchange rate will be available to meet the foreign exchange requirements of essential imports such as petroleum and oil products, fertilisers, defence and life saving drugs. All other imports, except for a "negative" list are freely importable provided the foreign exchange for these imports are obtained from the market. Similarly, the foreign exchange required for other payments on private account including travel, debt service payments, dividends, royalties and other remittances will have to be obtained at the market rate. In another significant step, to arrest the diversion of foreign exchange to illegal channels, the Government has legalised the import of gold. Returning Indians and NRIs ara now allowed to import 5 kilograms of gold per passenger with a modest import duty. Along with this, the Government has introduced a Gold Bond Scheme, with a view to help mobilise the idle Private gold reserves of the country to supplement official reserves.

4.2.4 The Export-Import Policy (EXIM policy) for the Eighth Plan period announced subsequent to the Union budget has operationalised many of the trade policy changes announced in the Budget. The new EXIM policy has now specified the "negative" list of imports, the import of which is either banned, canalised or subject to import licence. Similarly, the EXIM policy has specified a "negative" list of exports, the exports of which is either banned, canalised or subject to export licence. In addition to specifying the negative lists of imports and exports, the EXIM policy has announced a set of incentives for exports and deemed exports.

4.2.5 The process of lowering the customs tariff rates, which was initiated in the 1991-92 Union budget was carried further in the 1992-93 budget. The maximum tariff rate was further lowered to 110 percent in the 1992-93 Budget.The items on which tariffs have been lowered comprise capital goods, petro-chemicals, newsprint, asbestos, and pesticides used in agriculture.

Further Trade Policy Reforms:

4.2.6 During the Eighth Plan period, further trade policy reforms are needed to be carried out so that the economy is better integrated with the rest of the world. The key objectives of these reforms should be two-fold: (i) a further pruning of the "negative" lists of imports and exports, and (ii) a gradual reduction in both the level and dispersion of tariff rates. At this stage, it is difficult to pinpoint the specific items which need to be taken out of the negative lists. As a broad guideline, as the foreign exchange situation improves and the economy becomes more resilient, our objective should be to remove most raw- materials and components from the negative list of imports. In later phases of reforms, the manufactured items should also be removed from the "negative" list and by the end of the Eighth Plan the negative list of imports should contain only items which would be banned for reasons such as environment and safety. Any protection deemed necessary for domestic industry should basically be given through the exchange rate and the tariffs. Introduction of the partial convertibility on the current account is a highly desirable move. However, as the domestic economy gets more stabilised and as the external environment improves, we should move away from the dual exchange market system, unify the exchange rates and make rupee fully convertible on the current account. It should be possible to achieve the objective in stages before the end of the Plan period.

4.2.7 Along with the reforms of the import policy and the exchange rate regime, the structure of our tariffs requires substantial rationalisation. Broadly, our objective should be to eliminate the existing distortions in the tariff structure and effect a substantial reduction in the tariffs by the end of the Eighth Plan. The recent tariff reductions, though substantial, still leave us with tariff levels on manufactured items which are far too high. It should be the objective of policy to move to a trade regime in which the average tariff level comes down to about 25% within a period of three to four years. As a first step towards this, our efforts should be to eliminate the most serious distortions first. One of the most serious distortions of our tariff structure has been the unusually high tariff rates on intermediate and capital goods. The Union Budget for 1992-93 has reduced these rates marginally. We need to reduce these rates further. Subsequently, as the domestic industry becomes more resilient, we may liberalise import of certain consumer goods and lower their tariffs.

Policies on Capital Flows:

4.2.8 As part of the package of recent trade policy reforms, the Government has liberalised capital flows in the form of foreign direct investment. Specific measures in this direction are (i) automatic approval of foreign technology collaboration as well as foreign equity participation upto 51 percent in about 31 areas; (ii) delinking technology transfer from equity investment to impart flexibility in sourcing of technology imports ; (iii) automatic clearance for import of capital goods in cases where foreign exchange flows through foreign equity. More recently, the Foreign Exchange and Regulations Act (FERA) has been amended to place FERA companies on par with Indian companies for all operational purposes. Foreign companies are now permitted to use their trade marks, accept appointment as agents or technical or management advisors. They are also allowed to borrow and accept deposits from the public and acquire and sell immovable property.

4.2.9 These relaxations of foreign investment policy are in the right direction. Yet, if India were to attract significant flows of foreign investment and technology in an increasingly interdependent world, the Government should continuously monitor the progress on this front, compare our policies on foreign investment with those of the other developing countries and make swift changes in them if required. Afterall, our share cf world capital flows will depend not just on our set of policies, but on our policies vis-a-vis those of other developing countries. Overall, our strategy during the Eighth Plan should be one of relying less on external commercial borrowings and more on foreign direct investment for financing the current account deficit. It .should be possible to increase the flow of direct foreign investment to about $ 1 billion per year by the end of the Plan period. This would still be a modest amount given the size of the econ, omy. This would require a continuous watch on our foreign investment policy and strong initiatives from our side.

Industrial Deregulation and Administered Price Policy

4.3.1 Historically, like our trade policy regime, our domestic economic policies, be it in the product or the factor markets, have been highly restrictive. Domestic economic activities have been subject to a wide array of detailed and discretionary Government controls. In the industrial sector, such controls took various forms: barrier to entry and expansion implemented through industrial licensing; reservation of a large number of industries for the public sector as well as the small scale sector; highly time-consuming procedures required for the exit of firms from an industry; and price and distribution controls on various industrial products. In recent years, it has been increasingly realised that this regulatory apparatus on domestic enterprises has led to wide-spread inefficiency in the economy in general and the industrial sector in particular. The Government has, therefore, been relaxing some of these controls in recen) years and especially during the last few months,

4.3.2 The thrust of the new industrial policy announced in July, 1991 is on removing bureaucratic controls that thwart industrial development and opening up a large number of industries to the private sector. The requirement of industrial licensing has been abolished for all but 18 product categories such as defence equipments, industrial explosives, electronic aero-space, coal, petroleum, alcohol, hazardous chemicals, pharmaceuticals and drugs, and certain consumer goods such as sugar, edible oils, refrigerators, motorcars and consumer electronics. The maximum asset limit on the size of the companies which has hitherto been enforced under the Monopolies and Restrictive Trade Practices Act has been scrapped. As a result, firms will be able to grow to optimum size and reap the benefits of economies of scale - a process which was until now hindered by the anti-monopoly legislation. The location policy for industries has been substantially simplified and liberalised. The Government has also abolished the phased manufacturing programme, under which domestic manufacturers were hitherto required to increase the domestic input-content of their products in a specified time period. In another significant step, the number of industries reserved for the public sector has been drastically reduced, thus opening a large number of industries for the private sector.

4.3.3 These relaxations of the regulatory apparatus governing domestic economic activity have certainly eased the barriers to entry in the industrial sector. It should help to make the industrial sector more competetive both domestically and internationally. The thrust of the industrial policy during the Eighth Plan period should be to sustain the pace of these deregulatory measures. In this context, two areas appear to need attention (i) industrial deregulation and ii) administered price policy.

Further Delicensing of Industries:

4.3.4 With the recent policy changes, industrial production subject to licensing control has been reduced to about 20 per cent. However, some aspects of the new industrial policy seem to be somewhat restrictive. For example, the continuation of the licensing requirements for industries such as sugar and edible oils has no clear justification. Equally important, there are no strong reasons as to why the production of consumer durables such as motor cars, refrigerators and consumer electronics should be subject to industrial licensing. During the Eighth Plan, therefore, there is a need to further shortern the list of industries requiring industrial licensing. Most of the consumer goods industries which now require industrial licensing should be delicensed. Only industries related to defence, explosives and hazardous chemicals should be in the restricted list of industries requiring industrial licensing.

Policy Towards Unviable Units:

4.3.5 A liberal policy towards the entry and expansion of firms is a necessary condition for inducing competition and enhancing the efficiency of resource use. However, the benefits of such a policy will be greatly reduced if we do not have a rational policy towards unviable firms. For maximum gain in efficiency, removal of entry barriers should also be accompanied by freedom to exit. Our industrial exit policy is highly restrictive and time-consuming. This is one of the major factors behind the wide-spread sickness in the industrial sector, both in the public and the private sectors. Rules and procedures regarding the exit policy for industry, therefore, need a thorough review with the aim of making it much easier for any economically unviable firm to close down.

4.3.6 A key consideration in evolving a practical industrial exit policy should be that it should protect the legitimate interests of labour, whether in the public or the private sector. In the case of units which can be made economically viable by restructuring the unit and retraining/redeploying the labour, no effort should be spared to do this. Only in the case of units where even restructuring would not render it economically viable should the option of closure of the unit be allowed. Even here, to minimise the adverse effects of closure of a unit on labour, several options like the introduction of compulsory insurance or the creation of a fund to pay retrenchment benefits to employees should be tried. The Government has already set up the National Renewal Fund with a view to providing assistance to cover the cost of retraining and redeployment of labour affected by the restructuring of an industrial unit. It is expected that the National Renewal Fund will help in the restructuring of about 30 to 40 public sector units within the next two to three years involving effective rehabilitation of many of these units. Where this is not possible, it will help to compensate labour or assist in their rehabilitation. Similar other options need to be explored.

Small Scale Industries:

4.3.7 Another area which needs a thorough examination relates to small scale industries. The small scale sector has a unique place in a strategy of labour-intensive industrial growth. Due to several policy initiatives taken by the Government, this sector has helped to achieve a reasonable growth in industrial employment, especially at a time when employment in the organised industrial sector has stagnated. Yet, one of the major problems with this sector has been the lack of adequate modernisation and technological upgradation. To take advantage of the technological changes which are taking place in the present day world, it would be necessary for the small scale units to modernise and upgrade their technology. This would help them to compete effectively with the larger industrial units.

Administered Prices:

4.3.8 The proposed rationalisation/relaxation of entry and exit policy should enhance the competitiveness of the industrial sector. These benefits will be somewhat reduced if the Government continues to administer prices and the distribution of various industrial products. At present, the prices of industrial products such as natural gas, petroleum, petroleum products, coal, electricity, fertilizer, sugar and various non-ferrous metals are being administered by the Government. A thorough review of the usefulness of these price controls needs to be carried out. Wherever the product concerned is internationally tradable, the Government should decontrol the prices. In order to ensure that such price decontrols do not allow the existing producers to hike prices and hence enjoy "rents", the tariff rates on the import of these products should be suitably adjusted downwards, as had recently been done in the case of steel. Without such a supportive tariff adjustment, decontrol of hitherto administered prices may lead to unreasonable increase in the prices, thereby hurting the consumers.

4.3.9 Unlike in the case of tradable goods, it is difficult to deal with administered prices of non-tradable goods, such as, say, electricity and public transportation in which the Government sector has a near monopoly. In these cases, the best that can be done is to ensure that the enterprises producing/providing these goods and services cover the Long Run Marginal Cost of Production (LRMC). The basic idea is that prices should cover capital and current costs of efficient production. While the determination of the LRMC of production is sometimes difficult, the Bureau of Industrial Costs and Prices (BICP) has successfully demonstrated that in the majority of industries the computation of LRMC is practicable. Therefore, for effective implementation of such a normative approach to administered prices of non-tradable goods, an organisation such as the BICP may be charged with the responsibility of undertaking comprehensive studies of cost-price structures of such products every three to five years. It is, however, important to distinguish between fixing the normative prices based on LRMC for an industry at a point of time and providing for justifiable changes in costs over time. In this context, a two-step approach which has been suggested by the Ministry of Finance in its paper on  Administered Price Policy in 1986 may be followed. First, the base level of prices should be fixed after carrying out detailed studies of costs on a normative level of efficiency. Once this has been done, changes arising from increases in input costs should thereafter be made automatic.

Financial Sector Reforms

4.4.1 A vibrant and competitive financial system is necessary to support the proposed reforms in the structural aspects of the real economy. Over the years, the Indian banking and the financial system has made impressive progress in extending its geographical spread and functional reach. The widening and deepening of the banking system has been a major factor in promoting financial intermediation in the economy and in the growth of financial savings. The credit reach also has been extensive and the banking system now caters to the needs of several million borrowers especially in agriculture and small industry. Besides the banking system, the Development Financial Institutions (DFIs) have also provided the much-needed institutional support for investment in the private sector. The last decade has also witnessed considerable diversification of the money and the capital market. Despite this commendable progress, there has been a steady erosion of the operational efficiency of the banking system. The balance sheet of the performance of the financial sector is thus mixed, strong in achieving certain socio-economic goals and in general widening the credit coverage but weak in viability.

4.4.2 The Committee on the Financial System which has recently submitted its report to the Government of India, has identified the major factors responsible for the decline in the efficiency and the profitability of the banking sector. These are: (a) directed investment; (b) directed credit programmes; (c) massive and somewhat uneconomic expansion of bank branches and (d) inadequate attention to portfolio quality. There have also been weaknesses in the internal organisational structure of the banks, lack of sufficient delegation of authority and inadequate internal controls. Some of these weaknesses are common to both commercial banks and the Development Financial Institutions.

4.4.3 With a view to giving more operational freedom to the institutions and to inducing greater competition in the financial sector, some of the controls on the financial sector have been relaxed. Until recently, the lending rates of DFIs were fixed by the Government. As part of the recent policy changes, the DFIs are now allowed to charge interest based on market conditions subject to a floor rate of 15 percent. Similarly, the interest rates on corporate debentures, which were earlier fixed by the Government have been freed. The whole interest rate structure for commercial banks has been adjusted upwards. As a result, the minimum lending rate of commercial banks (on loans above Rs.2 lakhs), has been raised and banks are given the freedom to charge interest rates subject to this floor rate, depending upon their perception of the credit risk of the borrowers. In addition, the term deposit rates of commercial banks has recently been partially deregulated; banks are now free to set these rates subject only to a ceiling. In another important step, the mandatory convertibility clause, under which DFIs could convert 20 percent of their term loans into equity, has been scrapped, thereby removing a long standing irritant to industry. The Government has also discontinued the tax-exempt status of the Industrial Development Bank of India, the country's leading development financial institution so as to put it on a more competitive footing with the other DFIs. Similarly, the mutual fund business in the financial sector, which until now was reserved for the public sector banks and Financial Institutions, has been opened up to the private sector. More recently, the formula-based pricing of new issues of capital by companies, hitherto being enforced by the Controller of Capital Issues, has been abolished. Companies are now free to price their new capital issues based on market conditions. The overall thrust of the reforms of the financial sector during the Eighth Plan should be to ensure that the financial system operates on the basis of operational flexibility and functional autonomy with a view to enhancing efficiency, productivity and profitability. As a general principle, the Government should allow the entry of private sector into areas which were hitherto reserved only to the public sector, including the banking system.

Statutory Liquidity Requirements:

4.4.4 With regard to the banking system, the Statutory Liquidity Requirement (SLR), which was originally introduced as a prudential requirement, has, over time, become a major instrument for financing the public sector. The SLR which was about 20 percent of banks' net liabilities when it was originally introduced, has now increased to over 38 percent. Since the average interest rate on banks' SLR-related investments is artificially pegged at fairly low level, the increase in the SLR has adversely affected the profitability of the banks. The Central Government has already reduced its fiscal deficit from about 8.5 percent of GDP in 1990-91 to about 6.5 in 1991-92 and has initiated measures to reduce it further to about 5 percent in 1992-93. It has also expressed its intentions to reduce the fiscal deficit further to about 3 to 4 percent of GDP by the mid-1990s. As the fiscal deficit comes down, it should be possible to reduce the SLR substantially during the next few years. This would not only give flexibility to the lending operations of the banks but also enable them to lend a larger proportion of their funds to the commercial sector.

Directed Credit Programmes:

4.4.5 The directed credit programme under the priority sector lending operations of the banks have served a useful purpose in extending the reach of the banking system to cover sectors which were generally neglected before nationalisation of banks in 1969. The proportion of priority sector lending to total bank credit to the non-government sector was negligible in the beginning of the 70's but now it is about 40 percent. Since these priority sector loans are made at concessional interest rates, the banks' profitability has been adversely affected. Clearly, there is a case for a review of those categories who are entitled to borrow at concessional rates from the banking system. One immediate way of doing this is to eliminate large borrowers from the coverage of the priority sector. No more than two concessional rates of interest for priority sector lending should be prescribed so as to keep the burden on the banking system within limits.

Structure of Interest Rates:

4.4.6 The proposed reduction in SLR and the directed credit programmes should enhance the flexibility of the banking system a great deal. However, the benefits of these changes would be greatly reduced if the structure of interest rates continues to be administered by the Government. In spite of the recent emphasis on the deregulation of the interest rates, the structure of interest rates is highly complex and rigid. The financial system must clearly move towards an interest rate regime which is free from direct controls. Obviously, interest rate is an important policy instrument and monetary authorities the world over try to influence the level of interest rate through the various instruments that are available to them. It is not, however, argued that monetary authorities should abdicate an important function of theirs. The general level of interest rate should be influenced by the monetary authorities taking into account the overall economic environment, without necessarily imposing a rigid structure of interest rates. In moving towards a more deregulated structure of interest rates, there is considerable historical evidence to show that such experiments succeed only when the inflationary pressures are under control. Sharp increases in nominal and real rates of interest can result in adverse economic consequences. However, the broad outlines of the reform agenda on interest rates are quite clear. At least initially, from an elaborate administered structure of interest rates, we should move towards a more simplified system where only a few rates are prescribed by the monetary authorities.

Development Financial Institutions:

4.4.7 Over the years, the DFIs have been nurtured and developed by active Government support, especially in the form of concessional finance. However, active Government intervention in the functioning of the DFIs has also resulted in lack of operational flexibility and competition among these institutions. To remedy the situation, we need to have a two-pronged effort. On the one hand, the DFIs should be given adequate autonomy in matters of loan sanctioning and internal administration. On the other hand, the DFIs should be made to operate in a more competitive environment. For the latter, the privileged access of the DFIs to concessional finance through SLR and other arrangements should be gradually reduced. Instead the DFIs should obtain their resources from the market on competitive terms. In addition, the present system of consortium lending by the DFIs should be discouraged. Besides other things, this would require that the present system of cross-holding of equity and cross- representation on the Boards of the DFIs are done away with.

Prudential Norms and Guidelines:

4.4.8 The financial liberalisation measures proposed above should, however, be accompanied by formulation of clear-cut prudential norms and guidelines governing the functioning of the various institutions in the financial sector. This is especially important because, during the last decade or so, several new institutions have appeared on the financial scene. Merchant banks, mutual funds, leasing companies, venture capital companies and factoring companies have now joined the already existing institutions in extending a range of financial services. However, the regulatory framework for many of these institutions is still not developed. The Government should, therefore, formulate and enforce prudential norms and guidelines relating, among other things, to capital adequacy, debt-equity ratio, adherence to sound accounting and financial policies, disclosure, regulation and valuation of assets.

4.4.9 Two particularly important aspects of prudential regulation which have assumed greater importance in the recent period relate to capital adequacy and provisioning. The Indian system has so far been slack in relation to both these aspects. Capital adequacy did not perhaps receive adequate emphasis because of the dubious assumption that banks and financial institutions owned by the Government cannot fail or cannot run into problems. With major Indian banks now having branches operating in important money market centres of the world, this question can no longer be ignored. This apart, even banks operating domestically need to build an adequate capital base. Realising this, the Reserve Bank of India has recently prescribed that all banks with international presence should achieve the capital adequacy ratio (i.e. the ratio of un-impaired capital funds to the aggregate of the risk weighted assets) of 8 percent by March 1994 and other banks should achieve a capital adequacy ratio of 4 percent by March 1993 and of 8 percent by March 1996. This is a step in the right direction though this is a highly challenging task for the banks. Given the budgetary constraints and the overall resource crunch facing the Government, it may be difficult for the Government to provide additional capital to public sector banks in the future years. Hence if banks were to achieve the prescribed capital adequacy norms they may have to tap the capital market for raising funds both in the form of loans and equity capital. This would involve a dilution of Government ownership to a limited extent which may serve a useful purpose. What has been said about banks holds good in relation to term lending institutions as well as other financial institutions. Whether they be leasing companies or hire purchase companies or investment companies, prescription of appropriate capital requirements is a must since capital is the last line of protection for all depositors.

4.4.10 Another important aspect of prudential regulations relates to adequate provisioning for bad and doubtful debts. If the profits of banks and other financial institutions are to be a true reflection of their functioning, loan losses must be adequately provided for. It is feared that many banks may not have adequate profits to provide for bad and doubtful debts. Nevertheless, both in relation to banks and the term lending institutions, uniform accounting practices relating to income recognition and provisioning against doubtful debts need to be prescribed. Once again, in recent months the Reserve Bank of India has taken certain measures towards this effect. Besides requiring the banks to present their balance sheet and profit and loss accounts in a particular format so as to better reflect their actual financial help, banks are now required to classify their assets into different categories and make enough provisioning against bad and doubtful debts in a phased manner over a three year period. Such provisioning requirements should be gradually made applicable to other financial institutions too.

Demand Management Policies

4.5.1 Structural policy reforms such as trade liberalisation, industrial and financial deregulation, proposed above, would ensure an efficient use of resources. In the medium term, therefore, these policies would help augment aggregate supply. However, if aggregate demand continuously outstrips aggregate supply, it is difficult to maintain a reasonable degree of price stability and sustainable balance of payments. This, in turn, could lead to slow-down in growth, making it difficult to sustain the pace of on going structural reforms itself. Empirical evidence from a large number of developing countries shows that structural policy reforms, implemented against large macroeconomic imbalances, have generally failed to produce the intended beneficial effects. Appropriate demand- management policies, aimed at keeping aggregate demand largely in line with increases in aggregate supply, therefore, is a necessary prerequisite for successful macroeconomic management. The key policy ingredients required for this are a prudent fiscal policy and a conservative monetary policy.

4.5.2 A three-pronged fiscal and monetary policy package aimed at, (i) providing a better balance between aggregate demand and supply, (ii) minimising the distortionary effects of the tax system and, (iii) forcing public enterprises to minimise costs and maximise efficiency, should form a key component of such a set of macroeconomic policy initiatives.

Fiscal-Monetary Framework for Macro-economic Stability:

4.5.3 A common cause behind the twin problems of high domestic inflation and the worsening balance of payments in recent years has been the large and growing fiscal deficit of the Government. Fiscal deficit of the Government (Centre, States and Union Territories together) which was less than 7% ofGDP at the beginning of the seventies rose to about 9% by the beginning of the eighties and by 1990-91 constituted over 11 % of GDP. What is even more important, the increase in the growing fiscal deficit was almost entirely due to the sharp deterioration of the balance on revenue account. For example, in 1970-71 the Government had a revenue surplus of about 0.3% of GDP, but by 1985-86, it ran a revenue deficit of about 2% of GDP, which in 1990-91 rose to over 4%. Such high levels of fiscal deficits, both overall and on revenue account, are simply not sustainable. Hence, putting the fiscal house in order is a necessary pre-requisite to obtain a better balance between aggregate demand and supply.

4.5.4 Efforts have already been initiated on fiscal adjustment by the Central Government in its last two Budgets. Centre's fiscal deficit which was about 8.5 percent of GDP in 1990-91 has been reduced to about 6.5 percent in 1991-92 and is proposed to be reduced further to about 5 percent in 1992- 93. The Central Government has also announced its fiscal adjustment programme for the medium term according to which its fiscal deficit as a percent of GDP is expected to be brought down to about 3 to 4 percent by the mid-nineties. These efforts at fiscal adjust ment by the Central Government should be supported by similar efforts by the State Governments. Such adjustment is primarily required in terms of containing non-Plan revenue expenditure of the States. If this is accompanied by maximum resource mobilisation through tax and non-tax sources, the States' balance from current revenues (BCR) which has been negative during the last few years can be brought to a level consistent with the overall surplus requirements projected in the Eighth Plan. Some States would still have negative BCR which need to be limited to prudent levels. Overall, a major aim of fiscal policy should be to roll back the fiscal deficit of the Centre and States taken together as a percentage of GDP, from an average of 10.6 percent during the Seventh Plan and from about 11 percent in 1990-91 to an average of about 7 percent during the Eighth Plan period. 4.5.5 Such a fiscal adjustment would necessarily bring down the borrowing requirements of the Government, including the borrowings from the Reserve Bank of India. The Government should plan its borrowings from the Reserve Bank of India in such a way as to ensure that the annual growth of money supply is brought down from about 17% in recent years to about 11 to 12 percent during the Eighth Plan period. The income elasticity of demand for money in recent years has been about 1.5. Therefore, with the economy growing at about 5 to 6 percent per year, monetary growth of this magnitude should enable the Government to contain the trend rate of inflation to about 5 percent per year.

Government Expenditure Containment:

4.5.6 Since the fiscal imbalance in recent years has occurred at a time when the tax to GDP ratio has increased steadily, reduction in the fiscal deficit to GDP ratio needs to be brought about mainly by containing Government expenditures. Government expenditure which constituted about 19% of GDP in 1970-71 rose sharply to 26% by the beginning of the eighties and constituted about 31% of GDP in 1990-91. A sustainable fiscal scenario would require that Government expenditure as a ratio of GDP is reduced to an average of about 28 percent during the Eighth Plan period. While such expenditure containment is absolutely essential, enough care should be taken to see that Government's capital expenditures in key infrastructural and social sectors do not suffer. This would call for concerted effort at containing the revenue expenditure of the Government.

4.5.7 The task of achieving the required containment in Government expenditure appears challenging. Among the components of Government expenditure, two items which have grown substantially in recent years are (i) consumption expenditure of the Government, and (ii) subsidy payments. The consumption expenditure of the Government consisting mainly of defence expenditure and the administrative expenditure has increased steadily from about 9% ofGDP in 1980-81 to about 12% in 1990-91. Almost all of this increase was due to the increase in administrative expenditure of the Government, from a little over 6 percent ofGDP in 1980-81 to about 9 percent in 1990-91, whereas defence expenditure after increasing sharply from about 3 percent of GDP in 1980-81 to 4 percent in 1987-88 has steadily declined to about 3 percent by 1990-91. With suitable deregulation of industry and trade and a movement away from detailed and discretionary "microplan-ning" of the economy, many of the supervisory and regulatory functions of the Government should be minimised. This would help a great deal in containing the growth of Government's administrative expenditure in the future. The recent efforts to reduce defence expenditure as a percentage of GDP is a positive development and should be continued during the Eighth Plan period so that valuable resources could be diverted to more productive sectors.

4.5.8 Subsidy payments which constituted less than one percent of GDP in the early seventies rose to over 2% by the early eighties and stood close to 4% in 1990-91. Since 1991- 92 the Central Government has taken measures to reduce its subsidy payments. A clearly enunciated policy to contain Government subsidies needs to be formulated with the objective of rolling back subsidy payments as a percentage of GDP substantially by the end of the Eighth Plan. The key components of subsidy payments, where there appears to be some scope for containment, are subsidies on fertiliser, food and interest subsidy. Among these, the interest subsidy can, and should be, reduced substantially almost immediately.

Fertiliser Subsidy:

4.5.9 Broadly speaking, the fertiliser subsidy consists of two major components, one which goes to the farmers and the other which goes to the fertiliser industry and its input suppliers. The latter component has been necessitated by a combination of higher domestic prices of capital goods, inputs to fertiliser industry and the plant-specific retention pricing of fertilisers. The plant-specific retention pricing does not give enough incentive to fertiliser plants to increase efficiency and reduce costs. Containing fertiliser subsidy would require moving away from the present policy of plant-specific retention pricing towards a more uniform pricing of fertilisers, with due attention to efficiency consideration. In addition, it is extremely important to streamline the pricing of capital goods to the fertiliser industry.

4.5.10 A drastic reduction in the component of the fertiliser subsidy going to the farm sector through large increases in the fanngate price of fertilisers may adversely affect agricultural production in the short run. Further, large increase in the farmgate price of fertilisers would also be somewhat inequitous in that it would hurt the most the small and the marginal farmers with little marketable surpluses. But, the fiscal situation is so grim that we simply cannot afford to continue with a system which imposes a large and growing burden of fertilizer subsidy. Realising this, the Government has already increased the farmgate price of fertilisers to large farmers by 30 percent in 1991-92. Even with this adjustment, the fertilizer subsidy burden is too large. If the Plan is to be financed in a non- inflationary manner, it will be necessary to take steps to contain the subsidy burden in the current year at the budgeted level and to reduce it substantially during the Plan period. Another, and perhaps a more effective, way of containing the fertiliser subsidy to the farm sector could be to ensure a more efficient use of fertilisers by the farmers. This would require emphasis on more scientific use of fertilisers by the farmers through strengthening of the extension services during the Eighth Plan period.

Food Subsidy:

4.5.11 By its very nature, the benefits of present Public Distribution System (PDS), are highly dispersed across the society and hence the benefits to the poorer sections of the population are not as much as they ought to have been. During the Eighth Plan period, a concerted effort needs to be made to target Public Distribution System more or less exclusively to the relatively poorer sections of the population. As a first step towards this, the P.D.S facilities should be discontinued to the non-poor segment of the population. Along with this, attempts should be made to extend the coverage of the P.D.S. to the poorer sections of the population both in the rural and urban areas. This would help to fulfil the social obligations of the P.D.S. Such a reorientation of the PDS may not lead to significant reductions in the food subsidy since it may mainly shift the subsidy away from the non-targeted groups towards the targeted groups. However, there is some scope to contain the food subsidy by making the operations of the Food Corporation of India (FCI) more efficient. Through efficient procurement and market intervention operations, it is possible to reduce the required buffer stock offoodgrains, which would reduce the carrying cost of food-grains. Coupled with measures to increase the efficiency of the working of the FCI, this should help reduce the food subsidy somewhat.

Government Capital Expenditure:

4.5.12 Expenditure containment of the order suggested above would help a great deal in effecting a non-recessionary fiscal adjustment in that it would not put too much strain on Government's capital expenditures. Some reduction in capital expenditures as a percentage of GDP may, however, become unavoidable. An obvious candidate for effecting expenditure containment on the capital budget is Government's Budget support to public enterprises, both on Plan and non-plan account. During the Seventh Plan period, the Central Government's budget support to public enterprises constituted about 2.5 percent of GDP. It has been reduced to about 1.7 percent in 1990-91, to about 1.3 percent in 1991-92 and further to about 1 percent for 1992-93. Over the Eighth Plan period, such budget support to public enterprises should be further reduced. In future, budget support should be provided only for social sectors. Budget support to commercial public enterprises in such areas as industry, surface transport, steel and mines, tourism etc. should be phased out during the Eighth Plan period. These enterprises should be made to raise funds from the capital market rather than continue to rely on soft funding through budget.

Revenue Mobilisation and Tax Reforms:

4.5.13 The expenditure containment measures proposed above would substantially reduce the fiscal deficit during the Eighth Plan period. Yet, some efforts at additional revenue generation both through tax and non-tax sources may be necessary. Broadly speaking, Government revenues as a percentage of GDP may have to increase from about 20 percent in 1990-91 to about 22 percent by the end of the Eighth Plan, giving an average revenue-to-GDP ratio of about 21.5 percent during the Eighth Plan period. Given that the built-in revenue elasticity with respect to GDP is not significantly larger than unity, almost all of this increase in the revenue-to-GDP ratio will have to come from additional revenue mobilisation efforts. The required additional revenues may have to be generated by a judicious mixture of broadening the tax base, rationalising the tax rates and through non-tax sources. An overall simplification and rationalisation of the tax system would help not only in broadening the tax base but also in providing a simple and rational incentive structure which would be conducive to an efficient growth of the industrial sector.

4.5.14 On excise levies, the attempt should be to: (i) reduce the number and dispersion of tax rates; (ii) abolish commodity-specific and user-specific exemptions; and (iii) move the system further towards a value-added tax. At present, the revenue from Union excise duties form about 10 percent of registered manufacturing sector's output. However, only about 40 percent of the registered manufacturing output is subject to excise levies. Even a marginal increase in the coverage of excise levies along with a simplified and reasonable rate structure should yield fairly large additional revenues. As a first step towards this end, the multiplicity of rates should be reduced considerably and we should move towards a system with three to four excise rates on broad homogenous groups of commodities, with somewhat lower rates on intermediate and capital goods and somewhat higher rates on consumer goods. Along with this, all commodity-specific and user-specific exemptions should be abolished. Furthermore, the recent initiatives at moving the excise tax system towards a value added tax by the introduction of Modvat should be continued.

4.5.15 Ideally, the long run objective of our domestic indirect tax reform should be one of replacing the various indirect taxes which are prevailing at present by a unified value added tax. Realising that the value added tax is perhaps one of the most robust taxes which can be designed to raise substantial revenues with least distortions, a number of countries in recent years, both developed and developing, have carried out such tax reform measures. One of the major hurdles in the introduction of a complete value added tax in India is the constitutional sharing of taxing powers between the Central Government and the State Governments. Under the present system, excise duties are being levied by the Central Government whereas sales tax is under the jurisdiction of the State Governments. Introduction of a full-fledged value added tax would require some hannonisation of the taxing powers and a rational basis for sharing the proceeds of the tax between the Centre and the States. This would require modifications in the present constitutional arrangement governing the taxing powers between the Centre and the States.

4.5.16 On the customs tariff, there appears to be a dilemma. On the one hand, the task of fiscal deficit reduction that is needed over the next few years would require us to maintain the existing tariff rates or even to raise it so as to compress the fiscal gap. On the other hand, there is a growing consensus that since our tariff rates are one of the highest in the world, any growth-promoting fiscal and balance of payments adjustment would require both a lowering of the tariff levels and a reduction in its dispersal. We have been increasingly using tariffs as a fiscal instrument to raise additional revenues in the recent years. This tendency needs to be reversed during the Eighth Plan period. Instead, our objectives on the trade policy front, which have been discussed earlier, should be guiding changes in the tariff structure.

4.5.17 On direct taxes, we have already initiated a set of rationalisation measures over the last few years. The rates of both personal income tax and corporation tax have been reduced and a few exemptions and allowances have been abolished. This is a desirable development in line with successful experience in other countries. At present, the number of personal income tax payers is only about 4 million, accounting for about 0.5% of the total population and about 2% of the urban population. The income assessed for personal income taxation at present is only about 10% of our national income (net National Product) and about 15% of the non-agricultural income. Certainly, enough scope exists for widening the income tax net and broaden its base. Even some widening of the tax base should yield substantial increases in the revenues. Towards this end, a comprehensive review of the tax system has already been done by an Official Committee of the Government. The Government has already implemented many of the recommendations of this Committee in the 1992-93 Union Budget. Among other things, the Government has already introduced a form of presumptive tax with a fairly low rate on certain categories of potential tax payers. During the Eighth Plan period, the coverage of this presumptive tax should be enlarged further. Another potential source of broadening the direct tax base is to bring the relatively richer farmers into the direct tax net. The ratio of direct taxes relating to the agricultural sector (which includes land revenue and agricultural income tax ) to agricultural GDP has fallen over the years from about 1.2 percent in 1950- 51 to less than 0.7 percent in 1989-90. At the minimum, this trend needs to be reversed. It is, therefore, high time that the Government introduces some version of agricultural taxation, which have been recommended by various official Committees for more than a few decades now.

4.5.18 With regard to business taxation, our practice has been, and continues to be, to combine generous fiscal concessions with relatively high statutory tax rates. Not only does this lead to an erosion of the tax base but also to wide variation in the effective rates of tax for different businesses. Phasing out these fiscal concessions, combined with more unifom statutory rates across various types of business, will be desirable on efficiency as well as administrative considerations. Overall, the Government's objective should be one of evolving a simple and stable tax regime with reasonable tax rates but stricter enforcement.

User Charges on Public Utilities:

4.5.19 An area where there appears to be a significant potential for additional revenue mobilisation is in the case of user charges on public services. User charges on many publicly provided utilities such as, irrigation, electricity, water and higher education are much below their costs of provision. Studies have indicated that the volume of unrecovered costs on such services in recent years could be as high as about 14% of GDP for the Government sector as a whole and about 5% of GDP for the Central Government alone. The overall recovery rates (i.e.the cost of publicly provided services recovered from the users) on services provided by the Central Government is as low as about 35 percent; it is even lower at about 14% for the services provided by the State Governments. The rate of recovery on publicly provided economic services is a little over 40% for the Government sector as a whole. Among the economic services provided by the Government, the recovery rates are as low as 35 % on electricity and power and a little over 20% on irrigation.

4.5.20 Because of the inherent inefficiency of the Government departments which provide these public utilities, the actual costs of provision of many of these services themselves are much higher than what they ought to be. To that extent, the whole of the unrecovered costs on these public utilities does not constitute a subsidy to the users of these utilities. Nevertheless, it appears reasonable to assume that at least a part of these unrecovered costs of public utilities is, in fact, a subsidy to the users. In view of this, some increase in the user charges on some of these public utilities, especially utilities like electricity, irrigation, water and transportation, would become necessary during the Eighth Plan period. At the same time, the Government departments providing these utilities should be forced to become more efficient by imposing harder budget constraints on them. Since many of these public utilities fall under the jurisdiction of the State Governments, cooperation from them would be required for any significant additional resource mobilisation from the public utilities, be it through raising the user charges or through cutting down the costs of provision of these utilities.

Summing Up

4.6.1 The set of macroeconomic policies proposed above, if effectively implemented, should help a great deal in achieving the growth targets of the Plan with reasonable price stability and a sustainable balance of payments. Moreover, since these policies would help allocate national resources largely in line with the principle of comparative advantage and hence in favour of labour-intensive sectors, the resultant pattern of growth should help achieve a better employment growth. Overall, therefore, these policies should help achieve efficient labour-intensive growth. By expanding employment opportunities at a faster pace, such a growth process should help raise the living standards of the bottom layers of the population. However, the size and the dimensions of the poverty problem is so large that the trickle-down process by itself may not be sufficient to make a significant dent on the socio-economic problems of the bottom layers of the population within a socially acceptable time horizon. It is keeping this in mind that the recent Five Year Plans have emphasised the importance of the direct anti-poverty programmes. This is a highly relevant approach and the Eighth Plan should continue with this approach, even though the specific nature and contents of the anti-poverty programmes may need certain modifications for a more effective direct attack on poverty.