Lesson 3 of 70 7 min Premium

External Sector, Taxation and Reforms

Balance of Payments (BoP)

Account	Includes
Current account	Trade in goods (merchandise), services (e.g. IT exports), income, and transfers (e.g. remittances – India is the world's top recipient)
Capital account	FDI, portfolio investment (FPI), external loans, NRI deposits

A current account deficit (CAD) means we spend more abroad than we earn. Large CADs caused crises.
FDI is long-term and brings management control. FPI is shares and bonds – "hot money" that can leave quickly.
Foreign exchange reserves are held by the RBI (foreign currency assets, gold, SDRs, reserve position in the IMF).

Diagram of the current and capital accounts of the balance of payments with the 1991 reform sequence — Current-account deficit = spending abroad exceeds earnings.

The 1991 crisis and LPG reforms

In 1991, India's reserves fell to cover only about two to three weeks of imports. The government (PM P.V. Narasimha Rao, FM Manmohan Singh) started the LPG reforms:

Liberalisation – ended most industrial licensing ("licence raj").
Privatisation – disinvestment in public sector units.
Globalisation – lower tariffs, openness to foreign investment, rupee devaluation, and later current account convertibility (1994).

Taxes

Direct taxes (burden cannot be shifted)	Indirect taxes (burden passed on)
Income tax, corporation tax	GST, customs duty, excise on petroleum and liquor

GST came into force on 1 July 2017 (101st Amendment): CGST + SGST on supply within a state, IGST on inter-state supply. It is destination-based. Petroleum products and alcohol for human consumption are kept outside for now.
Progressive tax = higher rate for higher income (income tax). Regressive = takes a larger share from poor people (many indirect taxes).

Inclusive growth

Inclusive growth means everyone shares in growth – jobs, the MSME sector, women's work, regional balance and skills. The MSME sector is a big employer. MSMEs are classified by investment and turnover (the 2020 revision).

Background: the 1991 turning point

In 1991, India faced a balance-of-payments crisis: foreign exchange reserves covered only about two to three weeks of imports, oil prices had spiked (Gulf War), remittances fell, and the fiscal deficit was high. India pledged gold and took an IMF loan. The government then launched LPG reforms (liberalisation, privatisation, globalisation):

abolition of most industrial licensing;
reduced tariffs;
opening to FDI;
rupee devaluation followed by market-determined exchange rates;
financial-sector reforms.

Balance of payments (BoP) – structure

Account	Items
Current account	Trade in goods (merchandise), services (IT exports), primary income (interest, dividends), secondary income (remittances – India is the world's largest recipient, about $120 billion a year recently)
Capital account	FDI, FPI (portfolio), external commercial borrowings, NRI deposits
Change in reserves	The balancing item

India usually runs a goods trade deficit (oil, gold, electronics) offset partly by a services surplus and remittances. The current account deficit (CAD) is generally kept below about 2–3% of GDP to be considered sustainable.

Exchange rate and convertibility

The rupee follows a managed float: the RBI intervenes to smooth volatility, not to fix a level.
Current account convertibility has existed since 1994 (IMF Article VIII).
Capital account convertibility is only partial – committees (Tarapore 1997, 2006) suggested gradual opening.
Rupee depreciation makes exports cheaper and imports dearer, but it raises inflation on oil and electronics.
Internationalisation of the rupee: trade settlement in rupees (Special Rupee Vostro Accounts, 2022).

Foreign investment

	FDI	FPI
Nature	Long-term; 10% or more equity, management interest	Short-term portfolio, shares and bonds
Stability	Stable ("sticky")	Volatile ("hot money")
Routes	Automatic or government approval; caps in sensitive sectors (defence 74% automatic, insurance 100% announced in 2025 budget)	Regulated by SEBI and the RBI

Trade policy

Foreign Trade Policy 2023 – no end date; aims at $2 trillion of exports by 2030; promotes e-commerce exports and rupee trade.
FTAs and CEPAs: UAE CEPA (2022), Australia ECTA (2022), EFTA TEPA (2024), the UK (concluded 2025). India exited RCEP (2019) over concerns about Chinese imports and dairy and agriculture.

Taxation – structure and reforms

Direct taxes: personal income tax, corporate tax (cut to 22% for existing domestic firms and 15% for new manufacturing firms in 2019). The new tax regime has become the default, with simpler slabs. The Income-tax Act 2025 replaced the 1961 Act from April 2026 (simplified language).

Indirect taxes: GST (101st Amendment, effective 1 July 2017):

destination-based; replaced 17 taxes and 13 cesses;
CGST + SGST for intra-state trade, IGST for inter-state trade;
outside GST: alcohol for human consumption, five petroleum products (crude, diesel, petrol, ATF, natural gas – which can be brought in on Council recommendation) and electricity;
in 2025 the Council moved to a simpler two-main-slab structure (5% and 18%) with a higher rate for some demerit goods.

Tax concepts:

progressive (rate rises with income) vs regressive (burden falls more on the poor – indirect taxes generally);
tax buoyancy (tax growth ÷ GDP growth);
the tax-to-GDP ratio (India's combined is about 18%);
the Laffer curve.

Case study: GST – a cooperative federalism experiment

GST created a common national market and an input tax credit chain that reduced cascading ("tax on tax"). It increased formalisation – e-way bills, e-invoicing. The GST Council (Centre plus states) is a unique federal body. In Mohit Minerals (2022), the Supreme Court said its recommendations are persuasive, not binding. Challenges have included:

compensation to states (ended June 2022);
complex rates (simplified in 2025);
compliance burden on small firms;
the exclusion of petroleum.

Common misconceptions

"A trade deficit is always bad." – It can reflect imports of capital goods for growth. Sustainability depends on financing and productivity.
"A weak rupee is always good for exports." – Many exports use imported inputs, so the gain is limited.
"GST is levied by the Centre only." – It is a dual GST levied by both Centre and states concurrently (Art. 246A).

How UPSC asks it

Prelims asks about BoP components, convertibility, FDI vs FPI, GST features, and direct vs indirect taxes. Mains themes include the effects of the 1991 reforms, the reasons for a persistent CAD, GST and fiscal federalism, and India's FTA strategy.

Mains answer framework

Q-type: "Assess the impact of GST on India's economy and federal structure."

Intro: the 101st Amendment; one nation one tax.
Economy: a common market, reduced cascading, formalisation, better logistics (check-posts removed), revenue buoyancy.
Federalism: pooled sovereignty, the Council as a forum, but states lost fiscal autonomy and depended on compensation.
Issues: rate structure (simplified 2025), petroleum outside GST, compliance, disputes.
Conclusion: a landmark reform; deepen it through simplification and trust.

Balance of payments in brief

Account	Contents
Current account	Trade in goods and services, income, remittances
Capital account	Foreign investment (FDI, portfolio), loans, banking capital
Reserves	Changes in foreign exchange reserves held by the RBI

India usually runs a merchandise trade deficit, partly offset by a surplus in services (especially software) and large remittances.

Goods and Services Tax (GST)

Introduced on 1 July 2017 through the 101st Constitutional Amendment (2016). It replaced many central and state indirect taxes with CGST, SGST and IGST (for inter-state supplies). The GST Council (Article 279A), chaired by the Union Finance Minister with state finance ministers as members, recommends rates and rules – an example of cooperative federalism.

Mains practice question

Q. Evaluate the GST as a reform. Outline: a common national market, reduced cascading of taxes, better compliance through invoice matching; challenges – multiple rates, compliance burden for small firms, compensation and revenue concerns for states, petroleum and electricity kept outside; way forward – rate rationalisation, simpler compliance, stronger dispute resolution.

Check your understanding

What is a current account deficit? When payments for imports of goods and services and income exceed receipts.

⚡ Quick revision

Remittances = current account; FDI and FPI = capital account
1991 crisis → LPG reforms (Narasimha Rao – Manmohan Singh)
GST from 1 July 2017: CGST + SGST / IGST; petroleum kept out

Investment by a non-resident that gives a lasting interest and a meaningful say in the management of an Indian enterprise, conventionally treated as a holding of 10% or more of a listed company's equity, as distinct from short-term portfolio flows.The gap that arises when a country's spending on imports of goods and services, plus income and transfers paid abroad, exceeds what it earns from exports, income and transfers received; it must be covered by net capital inflows or by drawing on foreign exchange reserves.Foreign exchange reserves are external assets held by a country's central bank, such as foreign currencies, gold, Special Drawing Rights (SDRs) and the reserve position in the IMF, which can be used to pay for imports, service external debt and stabilise the currency during shocks.India's central bank, set up on 1 April 1935 under the RBI Act 1934 and nationalised in 1949, which runs monetary policy, issues currency, regulates banks and payment systems and manages foreign exchange.A comprehensive, destination-based indirect tax on the supply of goods and services, introduced in India on 1 July 2017, that replaced most central and state levies with a single system in which tax paid on inputs is credited against tax on outputs.Micro, small and medium enterprises, classified by investment and turnover. Full coverage: MSMEs, Startups and Disinvestment.Total government expenditure minus total receipts excluding borrowing. Full coverage: The Union Budget, Fiscal Policy and the FRBM Framework.The International Monetary Fund (IMF) is an international organisation, created at Bretton Woods in 1944, that monitors the global monetary system, lends to member countries facing balance-of-payments problems and provides policy advice and technical assistance; it is headquartered in Washington, D.C.The market value of all final goods and services produced within a country's borders in a given period. This hub page shows where GDP turns up across the syllabus as a yardstick; the measurement methods are covered in the linked lesson.

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