See also Part I of India's Faustian Fiscal Bargain.
Improvements in the quality of core services and efficient redistribution are the basis for a stable fiscal bargain between taxpayers and government.
The fiscal challenge facing India can be framed starkly in the following terms. On the one hand, demands for greater redistribution are mounting, requiring bigger government. On the other, current and potential taxpayers are "exiting," seeking essential services such as health and education outside the state. This will increase their reluctance to finance bigger government.
Consider in turn redistribution and exit. The recent announcement by Congress to make the National Rural Employment Guarantee Scheme universal is just one illustration of the political imperative to respond to a longer term reality: The hitherto poor and socially marginalized, having acquired political power, are naturally seeking to, as it were, cash in on this power. And rapid economic growth will only fuel demands for greater redistribution, especially since this growth is seen as unequalizing. What is noteworthy, even disappointing, is that redistribution is sought partly through inefficient fiscal means such as subsidies for power, water, and food, and partly through nonfiscal means such as reservation. In fact, the newly empowered realize that the locus of action, the arena of economic possibilities, is no longer the government but the private sector which explains the growing calls for reservation in private sector employment.
There is a sanguine view in India rooted in a comforting, causal link between a burgeoning middle class and better democratic outcomes, including more redistribution and better government services. But exit is likely to attenuate, even sever, this link. Given the disappointing experience of the state with providing some of these services, the middle class essentially seeks other alternatives. So, even as prosperity increases, commensurately greater demands are not made of the state. Indeed, exit has the potential to create a vicious cycle: As government services deteriorate, taxpayers will be reluctant to finance government services and have less incentive to hold government accountable, causing further declines in service quality.
Education illustrates well the phenomenon of exit. Devesh Kapur and Pratap Mehta show that in the last few years, the deteriorating higher educational system has led the affluent to look outside the state-within and outside India. Within India, private engineering and medical colleges account respectively, for 90 percent and 40 percent of the total seats in their respective fields. And increasingly, well-to-do Indians are sending their children abroad to acquire not just the graduate but also the undergraduate education that Indian institutions are less able to provide.
Exit is not confined to the rich and higher education. Geeta Kingdon of Oxford University cites figures supporting the remarkable rise of the private sector even in basic education: For example, in urban India, virtually all the increase in enrollment in the period 1993-2002 was accounted for by private institutions.
To some extent, of course, exit is not only inevitable, it is also desirable. Public sector dysfunctionality being replaced by private sector quasi-competence is without doubt an improvement (private sector provision is not without its own problems, one example being the highly variable quality of private sector engineering and medical colleges).
On the assumption that exit continues, how should fiscal arrangements be structured both to accommodate the demands for redistribution while ensuring that exit is not so extreme as to fatally undermine the taxpayer-government relationship?
A desirable fiscal equilibrium would have the following elements. Income tax collections would increase as a rising share of the middle class and newly affluent become taxpayers. Increased taxes would lead not to a commensurate increase in government expenditures on services. Instead, it would lead to an increase in redistribution-through the fiscal channel-in the form of cash or similar transfers (for example, widely available educational "scholarships" for poor children) so that the poor can have better access to these services, even if they are provided by the private sector. In other words, ineptness in government provision does not take away the case for public financing: There are still too many in India who cannot afford to pay fully for all the essential services that they should have to lead fuller and better lives.
Some portion of the increased taxes should also go toward strengthening the government so that even as it sheds some responsibility it can better discharge its core services of providing public goods such as law and order and protection of property rights, as well as the public good of effective regulation in health and education. Achieving this would require, among other things, higher, even considerably higher, salaries for judges, police officers, bureaucrats, and other regulators in order to retain a modicum of competence and integrity in the public sector.
In this scenario, the size of government would increase with higher taxes, relatively minimal provision of government services, but greater and more explicit redistribution. Three points should be noted about this scenario. First, the role of the state would be a narrower one, confined to the provision of core services. Second, a necessary condition for taxpayers to go along with this arrangement is an improvement in these core government services. In return for a leaner state, taxpayers need to get a meaner, more effective one.
Third, the bulk of the redistribution would be carried out transparently through the fiscal channel and within that through efficient instruments such as direct transfers. Ideally, this would reduce the need for nonfiscal and inefficient fiscal redistribution.
Even describing this arrangement makes clear how difficult it will be to achieve. Expecting serious improvements in core government services looks improbable. More importantly, there is little evidence that the newly empowered want to achieve redistribution through efficient fiscal means such as transfers.
In the short run, India can probably muddle through with some mixture of modest redistribution financed by the higher taxes that rapid economic growth is generating. But over the longer run, if demands for fiscal redistribution increase hugely and/or the government is unable to improve the quality of core services, exit can become a stampede, making Indian taxpayers less inclined to keep up their side of the fiscal bargain. That would bring forward the day of India's fiscal reckoning.