FISCAL SYSTEM AND POLICY FROM 1858 TO 1947

FISCAL SYSTEM AND POLICY FROM 1858 TO 1947 The fiscal system of British India has figured prominently in debates on the political origins of under-development. The question often asked is: Did India's political status compromise the government's capacity to make investments?

Federal Structure

Two features persistently influenced the fiscal system of British India: the federal structure, and susceptibility to external shocks. Before British Crown rule began in 1858, the finances of the three major presidencies—Bombay, Bengal, and Madras—were nearly autonomous. The basic structure of federal finance was established in the first twenty years of British rule. Under the new arrangement, customs, salt tax, opium tax, and railway income were the main revenues raised and used exclusively by the central government. Receipts of provincial administrative departments, such as law and justice or education, went only to the provinces. Land revenue and excise taxes were shared. Only the central government could borrow. As for expenditure, the central government was responsible for defense, while the provinces were left in charge of local administration, education, and public health.

This structure caused persistent friction between the central government and the provinces. The provinces believed they had control over sources of income that were too few and too limited. The Government of India Acts of 1919 and 1935 and the legislative assemblies that were created after 1920 restructured federal finance and exposed it to organized pressures from elected representatives. Major changes were introduced: the divided heads of revenue were abolished, land revenue was given over to the provinces, and the central government took the income tax. The central budget now had to be balanced by contributions for the provinces, which increased contention. These changes did not alleviate provincial grievances over their minimal sources of revenue, while they remained responsible for expanding expenditures for a growing population. The 1935 Act, however, went somewhat further in giving a larger share of revenue to the provinces.

One outcome of this system of divided sources of revenue was the growing inequality between the provinces in per capita tax burden and expenditure. Bengal, with its "permanent settlement," raised less revenue than its land was worth and thus spent less. Bombay and Madras raised more land revenue and spent more.

Instability

Under normal conditions, the government balanced its budget, that is, balanced current revenue and expenditure. In the pre–World War I period, government investment was financed out of public saving, but increasingly thereafter it had to be financed by borrowing. The equilibrium was often upset by famines, wars, and depressions. The wars fought by the British East India Company, the uprising of 1857, and the famines of 1876 and 1896 each imposed a burden of growing debt. Until the war, the main source of borrowing was London. Usually these debts were paid back from current revenues, but military expenditure during World War I created a crisis. It not only forced the government to borrow, but also forced it to turn to Indian sources of funding since London was no longer an easy money market. Another debt crisis appeared at the time of the Great Depression, when the creditworthiness of the Indian government came into question for the first time in history.

World War II again found India in serious deficit. The government spent larger sums and proportions of the budget than ever before on defense, for its own troops and also on behalf of Great Britain's war expenses. Taxes and borrowing proved insufficient to cover the deficit. But this time there was a central bank and substantial monetary autonomy. Consequently, the money supply increased to finance the deficit as never before. The supply of essential goods, including food grains, on the other hand, was being diverted to support the war effort. The net effect was massive inflation, with disastrous consequences for India's rural poor. The last days of the war saw government controls imposed on supplies of essential commodities. This was the precursor of the public distribution system, with which independent India has become familiar. The end of the war also saw the liquidation of India's accumulated foreign debt. Given Britain's sterling debt to India throughout the war, India began its independence with an ample credit balance in sterling.

Revenue and Expenditure

There were two major types of governmental expenditure in British India: expenditure in India and expenditure abroad. The two most important expenditures abroad were pensions paid in sterling to retired British employees and the interest on public debt raised in London. The government could finance its expenditure by three means. The first was current revenues, 70 to 80 percent of which were raised in taxes. The second was borrowings from abroad, and the third borrowings at home.

In the nineteenth century, the most important tax was the land tax. In 1858, it accounted for as much as 50 percent of total revenues. Next in importance were the opium and salt taxes. The government had a monopoly on the production of opium, and a near monopoly on the production of salt. Together, these two taxes accounted for 24 percent of all revenues in 1858. The income tax and customs and excise taxes together yielded no more than 12 percent of revenue. Clearly, the tax structure was both income-inelastic and regressive. Over the next sixty years, the pattern changed: the share of the land tax decreased to about 20 percent of all revenue in the 1920s, opium and salt taxes dwindled, and income tax, customs and excise expanded their combined share to over 50 percent.

The land tax as a proportion of the value of agricultural production declined from possibly 10 percent of net output in the mid-nineteenth century to less than 5 percent in the 1930s. At the same time, financial stringency forced the government to experiment with more elastic sources of revenue, such as customs and income tax. Until the interwar period, pressures from British exporters were too strong for comprehensive revenue tariffs to be introduced. The pressure eased, and counter-pressures grew stronger. Income tax again became the scene of a battle, though a more subdued one. The government was unable to impose that tax on self-employed people. The groups that could be more easily targeted and assessed were those closest to the government, including prominent landlords, government employees, and owners of modern industry, many of whom were Europeans. Though some of these groups stoutly resisted being taxed, their resistance weakened over time.

For most of this period tax revenue as a proportion of the national income remained small and almost static at about 5 to 7 percent. Shifts in the composition of tax revenues made little difference to the government's spending power, even as the economy grew, leaving it ever more dependent on borrowing.

The main items on the expenditure side were defense, civil administration, and debt service. Each of these items was politically controversial. The Indian army was not only costly to maintain, it was repeatedly drawn into serving Britain's imperial interests outside India. The cost of imported administrative personnel was frequently excessive, and debt service was imposed by the poverty and dependence of the state itself.

Drain

The most controversial item of all was the "Home Charges," or the government's payments abroad for "services" received. These payments were called by Indian nationalists an imperial "drain" or "tribute," seen as intolerably wasteful. The "drain theory" became an explanation for the political roots of India's poverty and underdevelopment. There was some truth, and some exaggeration, in the drain theory. The truth was that British government employees serving in India were indeed often overpaid. The exaggeration was that measures of drain tended to lump all factor payments together, whereas a lot of these payments were for technical services that had no substitutes in India. The broadest measure of drain (Home Charges or net factor payments abroad as a ratio of national income) was about 1.5 to 2 percent in 1901. The real drain was considerably smaller, and therefore quantitatively insignificant. Further, the drain theory assumed that the amount potentially saved on this account would have been available for investment, which was not necessarily the case.

Investment and Growth

Gross investment as a proportion of expenditure declined from 24 percent in the period from 1898 to 1913 (annual average) to 16 percent in the 1930s. Net investment was smaller still and falling faster. The three main areas of investment were railways, irrigation, and roads and buildings. The railways' share in gross investment fell from 51 percent in the period from 1898 to 1913 to 27 percent in the period from 1930 to 1938. Irrigation accounted for about 11 to 16 percent throughout. The share of roads and buildings increased from 31 to 46 percent. In the prewar period, public investment was mainly financed from public savings. But in the interwar period, the percentage dropped sharply.

Unquestionably, the primary objective of this fiscal system was governance and not development, on which it had a mixed effect. Did it actually contribute to underdevelopment? The question remains.

Tirthankar Roy

See alsoBalance of Payments ; Money and Credit, 1858–1947 ; Trade Policy, 1800–1947

BIBLIOGRAPHY

Kumar, Dharma. "Fiscal System." In The Cambridge Economic History of India, vol. 2, c. 1757–1970, edited by Dharma Kumar. Cambridge, U.K.: Cambridge University Press, 1983.

Roy, Tirthankar. The Economic History of India, 1857–1947. Delhi and New York: Oxford University Press, 2000.