Thursday, May 31, 2012

Public Expenditure & Defence Budget of India

§ Public Expenditure

[Note: Other terms used interchangeably are Public Finance OR Government Expenditure]
As the name suggests, public expenditure (hereafter PUBEX) consists of all expenses incurred by Government on various activities under its remit. In the nineteenth century, PUBEX under the influence of the classical (the likes of Adam Smith et. al.), played a limited role in economic activity. PUBEX concentrated on the study of public revenue and issues pertaining to taxation rather than expenditure. In the post Second World War Period (1939-45), there has been phenomenal increase in level of PUBEX, both in absolute terms and in relation to National income.
Wagner in his “Law of Increasing State Activities” said that growth in PUBEX is a natural consequence of economic growth and therefore the percentage share of PUBEX increases with an increase in Gross Domestic Product (GDP) of a country.
[Quick Corollary: So, growth elasticity of PUBEX should be > 1??  Yes! It should be. Why? Becoz of the directly proportional nature of PUBEX and National Income :) ]
Wagner states that there is a persistent tendency both towards an ‘extensive’ and an ‘intensive’ increase in the functions of the government. New functions are continually being undertaken and old ones are being performed on an even larger scale that increases the spending of the Government further. Hence, more and more PUBEX is resorted for performing these activities. Thus social progress brings an increase in government activities which in turn would mean more government expenditure (or PUBEX).
[Note: Remember the Directive Principles of State Policy (DPSPs) as laid in the Indian Constitution and obligations of government towards it? Isn’t government spending also a result of meeting these DPSPs? - NREGSRTE etc]
Before we talk about how government is spending money (PUBEX), it will be a good idea to understand, the sources of income, which fund these expenditure. These sources of income can be classified under three broad categories:
  1. Tax Revenues - Income tax, Corporate Tax etc
  2. Non-Tax Revenue - Dividend collected from its share holding in PSUs , Money collected through allocation of natural resources(within its territories) e.g. Spectrum [ we are good at it - pun intended]
  3. Capital Receipts - Market borrowings, external debts, disinvestment of its PSUs etc.
Sources of Income of Govt. of India based on Budget Estimates 2012-13 (Click to enlarge)
Every year, Government prepares estimates of expenditure (PUBEX) it is projecting to incur or has incurred in past (in terms of past signed deals) and then puts it to parliamentary approval (Article 112 - Indian Constitution) in form of budget document. This budget document classifies various expenses under various categories for better reporting, accounting and financial management purposes.
Accounting Classification of PUBEX (Click to enlarge)
PUBEX in India has continuously risen since independence, when it took the responsibility of establishing a welfare state based on a planned economic development.
PUBEX Trend in India ; 2011-12 is RE and 2012-13 is BE; (Click to Enlarge)
Data Source: RBI Handbook of Statistics on Indian Economy
Few observations from graph above:
1. PUBEX has been constantly increasing over the years(except few years) with around a modest Rs 529 Crore in 1950-51 to whopping Rs 88,75,191 lakh crores (BE) in 2012-13.
2. The share of overall PUBEX to GDP has increased from 5.44% in 1950-51 to around 15% percent in 2012-13(BE). Contribution in increase of PUBEX is more due to ↑ of Revenue Expenses and less due to capital expenses.
3. While the share of revenue expenses to overall PUBEX have increased over years, capital expenditure share in PUBEX has decreased. The major reasons behind an increase in the revenue expenditure of the Central government are defence expenditure, subsidies, interest payments on borrowings, grants-in-aid to states etc.
It has been observed that government has always tried to suppress capital expenditures in the face of the inability to control revenue expenditure. This state of affairs raises extreme concern about the future growth prospects of the economy, of which one of the major indicator is the Gross Capital Formation (GCF) i.e. how much capital expenditure is being made.
Let's look at where is our Government spending (PUBEX) under the revenue expenditure category.
Major expense heads under Revenue Expenditure ; 2011-12 is RE and 2012-13 is BE
Data Source: RBI Handbook of Statistics on Indian Economy (Click to enlarge)
Excel sheet with data and the two graphs that I have created (above) can be accessed here: RBI Statistics on PUBEX India (1950 - 2012) - Excel Sheet
As you see from the picture above that almost (~45-50%) of the revenue expense is spent on three major expense headings:
1. Interest Payments on Borrowings - Interest payments are a form of committed expenditures, over which the government has little discretion. Such expenditure often arises as a legacy of the past, i.e. Debts raised in the past, commit the government of the day to pay interest. Restricting interest payments requires a reduction in current account deficits so that interest payments reduce in the future. Technically, only if the government is able to generate what are called primary surpluses (more revenue generation than expenditure) can there be a reduction in debt and future interest payments. Unfortunately, the government has been running up primary deficits [more expenditure(on other items, apart from interest payments)  than revenue) each year so that the debt levels continue to increase.
2. Subsidies – Food, Petrol and Fertilizers - Ours is a government committed to providing for the welfare of the poor is compelled to spend on subsidies (Remember DPSPs). The difficulty with reducing subsidies is that it is political dynamite, more so in this coalition era.
3. Defence Services – There are some expenditure that must be incurred to provide protection to the country. Government cannot unilaterally change such expenditure.
The problems with growing revenue expenditures also manifest themselves in the growing revenue deficits, which have been accepted as one of the major cause of India’s FISCAL DEFICIT problems.
[What is fiscal deficit? - The difference between total revenue and total expenditure of the government is termed as fiscal deficit. It is an indication of the total borrowings needed by the government. Generally fiscal deficit takes place due to either revenue deficit or a major hike in capital expenditure.
What is revenue deficit? - A mismatch in the expected revenue and expenditure can result in revenue deficit. Revenue deficit arises when the government's actual net receipts is lower than the projected receipts. On the contrary, if the actual receipts are higher than expected one, it is termed as revenue surplus. A revenue deficit does not mean actual loss of revenue. 
Let's take a hypothetical example to explain revenue deficit. If a country expects a revenue receipt of Rs 100 and expenditure (only revenue and not capital, as we are computing revenue deficit) of Rs 75 and accordingly works on its budgetary allocations, expecting net revenue of Rs 25.
At the end of the year when actual are drawn and revenue counted, it turns out to be Rs 60, whilst expenditure already incurred for Rs 75. This situation leads to a revenue deficit of Rs 40. See how below
Revenue Deficit Example
What is primary deficit? - It is nothing but fiscal deficit without the “interest payments on borrowings” component. Hence it is always less than fiscal deficit.]
Table below shows the revenue deficit of India in recent past.
Revenue Deficit of Govt. of India. (Click to enlarge)
How has it been financing its deficits ? Well, by borrowing and more borrowing, year on year !! Don't believe me? Please look at the chart below.
Fiscal Deficit Financing; 2011-12 is RE and 2012-13 is BE
Data Source: RBI Handbook of Statistics on Indian Economy (Click to enlarge)
Excel sheet with data and the graph that I have created (above) can be accessed here: RBI Statistics on Fiscal Deficit Financing India (1980 – 2012) – Excel Sheet
What did you observe above?
Majority of funding of fiscal deficit (which includes revenue deficit as well) happens by borrowing money from market through issue of govt. securities. Govt. then pays interests on such borrowings(under revenue non-planned expense & also in non-developmental expenditure heading). So we see that an awkward situation has arisen, where Govt. borrows money to fund expenses which are non-productive or rather not used to create capital and additionally GOI has to also pay interest on such borrowings. If we were to use the borrowings to create assets it would have given us benefits (read cash flows) over the long run, but we are now simply using loans to run the day to day working of govt, which do not yield any benefits or cash flows. It is thus slowly putting GOI into a debt trap of which it is finding very difficult to come out.  For an efficient fiscal consolidation (reducing fiscal deficit), the revenue deficit have to be hammered down to zero through some tough and bold measures and start generating revenue surplus.
[Note: (i) FDI in Multi Brand Retail was one such instrument GOI tried to use recently. But political pressure it seems always wins over the economic logic. (ii) In this year’s budget (2012-13), GOI has also promised to check its subsidy expenses. Recent proposal to abolish Haj Subsidies ]
It has to be remembered that intention and action of govt. should be to use borrowings and revenue surpluses into capital expenditure, thus leading to creation of assets and conforming to the ‘golden rule’ principle of treating borrowings only for capital expenditure.
[Note: Recently GOI has come up with an innovative way of showing lesser revenue deficit and coined a new terminology “Effective Revenue Deficit”. (Check Economic Survery 2011-12 for more details)
What GOI is saying is that the Revenue expenditure of the Central Government also includes releases made to States and other implementing agencies for implementation of Government schemes and programmes. The outcomes of many of these schemes are not in the nature of the outcomes related to revenue expenditure. In most of the cases these schemes are primarily in the nature of creating durable assets but these assets are not owned by the Central Government. Therefore, in technical classification of revenue and capital account, the Central Government is not able to show expenditure on these schemes as capital expenditure. Examples of such schemes are Rajiv Gandhi Grameen Vidyutikaran Yojana, Jawaharlal Nehru National Urban Renewal Mission, Pradhan Mantri Gram Sadak Yojana, Accelerated Irrigation Benefit Programme etc. Over the years, the number of such schemes funded by the Central Government and implemented by States/autonomous bodies has increased significantly. This has resulted in significant increase in funds transfer from Centre to States/autonomous bodies resulting in higher revenue expenditure. However, these revenue expenditures cannot be treated as unproductive in nature. On the contrary, they contribute to growth in economy. Hence this time in budget, this term was used to ascertain the actual deficit in the revenue account after adjusting for expenditure of capital nature. Hence the “adjusted or “effective” revenue deficit for 2011-12 is projected at 1.8 per cent of GDP as against the revenue deficit estimate of 3.4 per cent of GDP.]
§ ◊ §

Budgetary Process in India:

‘Budget System’ was introduced in India on 7th April, 1860, when the importance of financial policy for country was emphasized. Post independence, the first budget was presented on November 26, 1947 by India's first Finance Minister Sri R.K. Shanmugham Chetty. The national independence brought about budgeting reforms with the Government of India primarily through the launching of comprehensive socioeconomic development through five year plans, divided into Annual Plans. A sound system of sharing of resources with the States was also established through the successive Finance Commissions. By and large the system in place at present has evolved over a period of time.
Budget Process in India (Overview) (Click to enlarge)
  • Budget is prepared by “Budget Division” of the Dept. of Economics Affairs of Ministry of Finance, GOI
  • “Budget Circular” is sent across to all ministries and estimates are sought.
  • After receiving the estimates, it is then reconciled with figures available with other departments within Ministry of Finance(MoF) and then the Union Budget is prepared. During all this, MoF, poses several questions to the concerned ministries and its a continuous process on arriving at a final figure.
Article 112 of Constitution of India, states that the Government should lay before the Parliament an Annual Financial Statement popularly referred to as ‘Budget’. Budget preparation in India is an iterative process between the Ministry of Finance, Planning Commission and the spending Ministries.
Major Components of Union Budget of India (Click to enlarge)
As you see in the picture above, the “annual financial statement” (read budget) consists of several statements:
1. Statement I: Presents the consolidated picture of the Receipts (read Revenue) and Disbursements (read Expenses) of the GOI for that year.
[Note: Budget sets forth the receipts and the expenditure of the Government for three consecutive years – Budget Estimates (BE) of Current Year, Revised Estimates (RE) for year immediately preceding and Actual of second year preceding. So, this year’s budget has information of BE 2012-13, RE 2011-12 and Actuals of 2010-11. ]
Few observations:
(a) Statement-I is organised into “Revenue” and “Capital” accounts i.e. the expenses on consolidated fund of India. Other two funds do not have such breakups.
(b) Revenue Account
  • Receipts – All receipts through all types of taxes and other revenue streams.
  • Disbursements – Operational expenses – salary, pensions etc
So, suppose some country purchases defence equipments from HAL or DRDO*, then that entry will be made under Revenue Receipts heading, whereas salary of defence services, their pensions etc appear under “Revenue Disbursement” heading.
[Note: Defence Production is another big topic which we can discuss in detail in some future posts, though it meets only around 30% of India’s defence requirements and these Indian DPSUs make small revenue from sales abroad.]
(c) Capital Account
  • Receipts – All internal debts of GOI feature here (Treasury Bills etc)
  • Expenses – Expenses towards capital acquisition, defence modernisation etc. So, the Rafale deal signed with France, GOI will pay some 15% of the deal size [$20 Billion @ 2011 prices; with the recent weakening of the rupee, GOI would have to pay more (@Current prices) than what has been budgeted. That’s when the Revised Estimates are prepared].
[Note: Remember all of these will go into Union Budget under “Ministry of Defence Services” heading and ultimately form part of Defence Budget.]
2. Statement IA: Things that would be charged to Consolidated Fund of India. Things like salary of President, Speaker, Deputy Speaker, and Supreme Court judge etc.
Since this expense is NOT put to vote in parliament, any expense under this heading, serves to provide “financial freedom” to that institution. E.g: CAG Office, Supreme Court, UPSC
[Two developments from recent past linked to this provision in our constitution:
  • Lokpal Bill suggested that the Lokpal Institutional expenses (salary, admin etc) be charged to consolidated fund of India. Along with several areas of difference, this was one such area where both GOI and Anna Hazare’s team were in agreement.
  • Election Commission’s expenses are currently “put to vote” and hence, recently CEC was seen strongly advocating it to be charged on consolidated fund.
This is what Shri Quereshi(CEC) said:
"We are going after politicians all the time and they will be then sitting in judgement and torpedo our proposals. It's a happy thing that they have not damaged us so far.”  Makes Sense, Isn’t it? 
3. Statement II: Expenses on Contingency Fund of India
4. Statement III: Expenses on Public Account.
The whole process of budget being presented to it being passed in parliament is shown in figure below.
Stages in Budget Process - Presentation to Passage in Parliament (Click to enlarge)
§ ◊ §

Defence Budget of India:

India has proved to be a key global power, driven by a robust economic growth and a past of longstanding moral leadership on core humanitarian and geopolitical issues. But, in recent past, the emergence of ideology linked terrorism, the spread of small arms and light weapons (SALW) (Somali Pirates etc), the proliferation of Weapons of Mass Destruction (WMD) (including Nuclear weapons) and globalization of its economy are some of the factors which link India’s security directly with the extended neighbourhood.
It then becomes imperative for her to have a strong defence capabilities, that would help safeguard the economic, cultural and social prosperity generated over last couple of decades and also protect key economic interests like trade routes, safety etc going forward.
[Note: India’s peninsular element gives it a vantage-point in relation to most vital sea-lanes of the world, stretching from the Suez Canal & the Persian Gulf on West and the Straits of Malacca on East, through which 55,000 ships and much of the oil from the Gulf region transit each year. 
You may also be interested to check my other post on South China Sea ]
National Security is one of the paramount objective of the Government and requires a comprehensive view of various political, social, economic, technological and strategic aspects. Defence policy making is one such part of overall National Security approach, but is more focused and concerned with the protection of the state and its citizens from direct and indirect military threats and actions of other states.
But merely formulating policies and strategy isn't enough. There should be proper economic resources to realize those policies. So, suppose we have brought together the best defence strategist (think tank), who have brainstormed together and have come up with the best possible defence policy (on paper of-course), but unless we allocate money against those policies, for its implementation - through capital acquisition (buying equipment) or indigenous manufacturing them or spending on defence R&D, there is no use of having such policies. Hence it is important to allocate optimal amount of resources in-order to strengthen our defence capabilities.
India is a federal country and its constitution(Part XI - Article 245 to 255) provides for division of legislative powers between the Centre and its states by dividing various matters into three Lists - Union, State and Concurrent. In this respect, Defence Services has been placed on the Union List (Seventh Schedule - Article 246, Indian Constitution) and thus comes under the legislative purview of the Central Government of India. It is the central government of India, which spends money on its defence services of India, thereby ensuring that we are safe. Expenditure of such nature form part of the overall central government expenditure also known as public expenditure.
Structure of Ministry of Defence(MoD):
Ministry Of Defence India (Click to enlarge) ToT - Transfer Of Technology
Defence Planning to Budget:
The process flow below demonstrates how does MoD arrives at the budget estimates for the Defence Budget. What needs to be noted here is that, defence budget does NOT include expenditure incurred by the Defence Secreteriat (which includes our IAS officers) and the pensions which Defence ministry gives to its ex-servicemen. Defence Budget purely consists of expenditure for the 3 major defence services, Ordinance Factories Board and R&D wing of MoD (i.e. DRDO).
Defence Planning to Budget Estimates - Indicative , exact process might differ  (Click to enlarge)
Article 113 of the Indian Constitution, requires that any expenses which are to be made on Consolidated Fund of India, needs to be voted in Parliament in the form of "Demand for Grants". It also draws distinction with the ones which are "charged" on the Consolidated fund and need not be voted in parliament.
Since, major part of the Defence Budget falls under the "voted" category, it needs to be voted in the Lok Sabha. Generally, one Demond for Grant is presented in respect of each ministry or department. However, in respect of large ministries like MoD, more than one Demands are presented.
The demands for grants of Ministry of Defence are of two types:
1. Civil Estimates of Ministry of Defence – This is for Ministry of Defence Secretariat (the IAS babus sitting in the Raksha Mantralay @ South Block :P), Defence Accounts Dept, Coast Guard Org., Military Canteen Stores Dept., Pensions to Ex-Servicemen etc.
[Note: This also includes the operating expenses (OPEX) for Indian Coast Guard Services]
2.  Demand for Grants: Defence Services - This is for the expenses of three services and includes both Revenue and Capital Expenses.
There are 6 Demand for Grants prepared for Defence Services. 5 of them are for revenue expenses and one for capital outlay.
Ministry of Defence - Demand for Grants (Click to Enlarge)
The revenue expenses include expenditure on pay and allowances, transportation, revenue stores (ration, petrol, oil etc) and other miscellaneous expenses. The capital expenditure includes expenditure on land, construction works, acquiring equipments from foreign companies (like the RAFAEL from Dassult, TATRA trucks from BEML etc.). So as you see, capital outlay is basically for asset building and in business parlance is also called CAPEX, whereas the revenue expense is more to do with day to day functioning and operations and is called OPEX.
Defence Budget Breakup  BE 2012-13(Click to Enlarge)
Few observations from above diagram:
1. Demands for Grants are always “Disbursements” and never “Receipts” as it is a demand! :)
2. Demand for Grants is always “Gross” expenditure, for which approval is taken from Parliament. This is the max. Limit of spending for that particular expense heading.
On the other hand, the annual financial statements, popularly called the “Budget”, will consist of the “net” expenditure. So, any receipts or recoveries, which include items like sale proceeds of surplus/obsolete stores, receipts on account of services rendered to state government and other ministries are deducted from the gross expenditure to arrive at the net expenditure of the defence services and this is what we call the “Defence Budget”.
3. There are NO capital receipts for Defence Services.
Defence Budget of India 2012-13 - Analysis:
In his budget speech (2012-13), The Union Finance Minister Shri Pranab Mukherjee said the following about the Defence Services Budget:
“In the Budget for 2012-13, a provision of Rs 1,93,407 crore has been made for Defence Services which include Rs 79,579 crore for capital expenditure. As always, this allocation is based on present needs and any further requirement would be met.”
What he essentially meant can be understood as follows:
Defence Budget Calculations (Click to Enlarge)
Total Defence Budget = Revenue Budget (Rs 1,13,828.66 CR) + Capital Budget (Rs 79,578.63 CR) which totals up to Rs 1,93,407.29 CR, which is what the FM had said above.
Excel sheet with data and the graph that I have created (above) can be accessed here: Union Defence Budget 2012-13 – Excel Sheet
[Note: You should be able to add and subtract things above and also be able to tally it with the diagram immediately above it.]
So, as you see in diagram above, the defence budget is the net expenditure on the Revenue and Capital Accounts. The expenditure as part of Civil Estimates of Ministry of Defence is NOT considered as part of the defence budget.
The Union Budget 2012-13, presented to the Parliament, hiked the defence outlays to Rs. 1,93,407.29 crore (US$ 40.44 billion). This represents a growth of 17.63% over the previous year’s outlays. The increase in the latest defence budget was made possible by the expansionary fiscal policy adopted by the government in general.
You all must have read the Economic Survey 2011-12 which states that the GDP growth is projected at 6.9% in the present fiscal year and at 7.6% in 2012-13. These growth rates, which are significantly lower especially in comparison to the nearly 10% growth registered in 2006-07, has however not forced the government to tighten its spending. Instead, it has resorted to what can be termed as fiscal profligacy, by increasing the overall central government expenditure by a hefty 18.55%, with little regard for the fiscal situation. Consequently, the fiscal deficit, which the Finance Minister had promised in his previous budget speech to reduce to 4.1% of GDP in 2012-13, is now projected to increase to 5.1%. This expansionary fiscal policy has been the prime mover for the large increase in the budget of the defence ministry, which would otherwise have come under severe budgetary pressure if the Finance Minister had chosen a tight budget.
Defence Budget Breakup - Revenue Vs Capital Expense (Click to Enlarge)

Defence Services Share in Defence Budget (Click to Enlarge)
As is evident from the chart above that the majority of defence budget goes to meet the OPEX (i.e pay and allowances, stores, Works, transport etc) part of the defence services, with Army eating the lion’s share at 68%!! Why? Well, Army is a manpower intensive force, given our mountain borders. Indian Army employs around 11 Lakh soldiers!!
[Quick Corollary: Does it then mean that Indian Army’s is slowly degeneration into a low technology, manpower-intensive force that spends most of its money on day-to-day running i.e. OPEX?]
If we see the capital expenditure side of the budget, Indian Airforce occupies the largest share. Why? Well, remember Ministry of Defence recently announced the decision to acquire 126 Rafale Medium Multi-Role fighters from Dassualt Co. France. Large part of the money given to Air Force CAPEX will go towards meeting that. Then there are other contracts (signed in past) for which it needs to make payments.
Even Navy if you see has the next highest share. It is also working on Scorpene Submarines (Called Project 75) at Mazagaon Dock Ltd., Mumbai and then there are other warships programmes under Indian Navy.
This way, we see that, more than two-thirds of any year’s capital budget is pre-committed towards annual installments for defence contracts concluded earlier, because as you know, weapons platforms are often paid for over a decade or so. This leaves just around 30% of any year’s capital budget goes towards new contracts.
[Note: Did I just say less money left with defence services to spend ?? Well recently there was CAG report on defence services which has several criticised MoD for large amount of unspent funds which it surrenders at the end of the year. This I would say is due to poor financial management and budgeting foresight on MoD's end.]
Apart from this, Ministry of Finance (Budget Division) has from time to time, issued instructions to maintain an even pace of expenditure throughout the year, but it seems Ministry of Defence (MoD) pays no heed to it, as there has been a trend in MoD to spent almost 40-50% of the Budget estimate in the last quarter of the fiscal year [ Jan-March] !!
Why?  The capital component of the defence budget involves multi-year expenditures and planning, which annual budget cycles are unable to accommodate effectively. The current defence budget formulation largely involves incremental budgeting (8-10 per cent increase in nominal terms over the previous year), with usually no separation between inflation-induced and real increase in expenditure.
Remember, Shri P Chidambaram (when he was Fin Min in 2005) had introduced an interesting concept called outcome budget. The sole motive of such budget was to change the culture of measuring performance in terms of the amount of money spent against the budgeted allocations. It instead advocates measuring performance in terms of the delivery of the outcomes using the outlays. So its the Return On Investment (ROI) that is measured. It is an important document to ensure executive accountability to Parliament and that the achievements of the Ministry are scrutinized by virtue of being quantified.
Outcome budget, though introduced in 2005 has hardly been followed by major Ministries. Recently Standing Committee on Defence (which analyses the various Demands for Grants of Ministry of Defence) criticized MoD for not being able to come up with Outcome Budget and lay the same in Parliament along with the Demands for Grants, even after pursuing it year after year.
[Note: As you know Defence Budget allocations of the Ministry are under the non-Plan segment and as such are not subject to scrutiny by Planning Commission, which adopts a rigorous Zero Based Budgeting on various schemes of the GOI. So Defence Services skip this assessment, which might explain why Defence Budget allocates money only non-Plan expenditures. :)]
At the moment, no groups at the planning or strategic levels, whether at the Planning Commission or at the Prime Minister’s Economic Advisory Council, appear to be analyzing the defence budget from forward strategic planning perspective incorporating current and prospective threat perceptions. The budget proposals are also not subjected to analysis from the perspective of defence economics as a distinct sub-discipline and profession.
This is a serious gap, which needs to be urgently addressed in an era when geopolitics and geo-economics are increasingly inter-related. While this is recognised by other major powers, particularly China, India has been relatively slow in integrating the two to enhance its economic and security space and leverage.