How does a government stimulate growth when investors frown on any rise in fiscal deficit? How does it raise resources when capital is mobile across borders and can flee to friendlier shores if you increase taxes? These problems are faced by any finance minister these days. How did Arun Jaitley deal with them?

Perhaps his biggest achievement was to prune the centre’s fiscal deficit from 4.5% of gross domestic product (GDP) in 2013-14 to 3.6% in 2017-18. It’s a substantial reduction. How did he do it?

Jaitley didn’t hesitate to raise resources. The centre’s gross tax to GDP ratio increased from 10.1% in FY14 to 11.6% in FY18. As the accompanying chart shows, he achieved this in spite of a lower corporate tax/GDP ratio. It’s important to ensure the geese that lay the golden eggs do not fly away to less taxing shores.

From where did the finance minister get his taxes then? Part of it was due to a rise in income-tax collections. Taxes on income as a proportion of GDP went up from 2.1% in FY14 to 2.6% in FY18. That is commendable. The government has also not been shy to impose surcharges on higher income slabs, besides making a hesitant start towards taxing capital gains on shares, too.

Even so, the improvement in income tax, as a proportion of GDP, is not much. The big gains have come from “other taxes", predominantly indirect taxes such as excise and service tax, and now the goods and services tax (GST). These went up from 4.5% of GDP in FY14 to 5.7% of GDP by FY18.

Most of the increased resources, therefore, have been raised through indirect taxes. These taxes are seen as regressive, because they apply equally to all sections of the population, with no regard to the income levels. The masses and the middle classes are the taxpayers of last resort in these times of free capital mobility.

What did the government do with the extra resources? It shared a large part with the states. The centre could do nothing about it—the additional share of resources going to the states had been decided by the Finance Commission. The rise in net tax revenues for the centre, after sharing with the states, was much more modest—from 7.3% of GDP in FY14 to 7.6% of GDP in FY18, although the hope is for a big jump this year.

Since the extra amount they got to keep from the resources collected was meagre, how did the centre manage to rein in fiscal deficit? They slashed expenditure, of course. The chart shows that total expenditure as a percentage of GDP fell from 13.9% in FY14 to 13.2% in FY18.

So the 0.9 percentage point contraction in the fiscal deficit, as a proportion of GDP, between FY14 and FY18 is explained by a 0.3 percentage point rise in net tax revenues, while the rest was due to a cut in government expenditure. As the chart shows, capital expenditure as a percentage of GDP, too, has fallen a bit.

But if the government has had to rein in expenditure, where did it get the resources to build roads and bridges, and other public works? The answer lies in the pattern of spending. Instead of the 2.3% of GDP the government spent on subsidies in FY14, by FY18, this had been whittled down to 1.6% of GDP, thanks largely to the withdrawal of subsidies on petrol and diesel.

Indeed, the huge drop in oil prices was a windfall for the government, as it increased excise duties on petrol and diesel. These resources, from higher taxes on crude oil and lower subsidies, were available to the centre to spend.

In short, in the last four years, Jaitley was able to make people pay more taxes, reduce their subsidies, prune the government’s total expenditure as a proportion of GDP and yet find the resources for spending and sharing with the states—all the while dealing with demonetization and the introduction of GST. It is a remarkable feat. It’s also a very tough act to follow.

Manas Chakravarty looks at trends and issues in the financial markets. Respond to this column at manas.c@livemint.com

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