Business as Usual
The global situation is tense, marked with protectionism. The domestic environment is constrained by the twin balance sheet crisis. The dull investment climate was further jeopardised by the note ban. The budget has failed to create a policy environment to kick-start a virtuous investment cycle. It has failed to address critical issue of accelerating employment.
The presentation of the Union Budget in India, unlike in most other countries, is a big event. The reason for this has to be found in the legacy of a planned development strategy in which the budget was not merely a financial statement required to be placed in Parliament under Article 112 of the Constitution, but became a mechanism to transmit policy directions to the economy. The legacy has continued even as the planning process itself has got diluted. From that perspective, excessive focus on the budget is somewhat misplaced as policy pronouncements and decisions are taken not just through the budget announcement, but throughout the year.
Even from purely a fiscal policy stance, the Union Budget in India accounts for only a little more than a half of the deficits, 68% of outstanding debt, 60% of taxes collected, and 58% of actual spending are undertaken at the state level. Nevertheless, the Union Budget provides important signals on the extent of government interventions in the market, and has macro- and micro-economic implications from its stance on deficits and debt, tax and expenditure proposals, and intergovernmental finance.
In many ways, the Union Budget 2017–18 had a number of new features. First, the budget presentation has been advanced by a month to complete the process of passing it in Parliament within the financial year. Second, the merger of the railway budget with the main budget helps to plan and develop the transport sector as a whole. Hopefully, the commercial character of the railways will be retained, and eventually, it will be corporatised, and its social obligations will be taken account of by providing explicit subventions from a consolidated fund. Third, the abolition of the plan and non-plan distinction, which in fact was the recommendation of the Expert Group on Efficient Management of Public Expenditures chaired by C Rangarajan in 2013, helps to look at each of the sectors in a holistic manner, and avoids distortions in allocating resources between maintenance of existing assets and creation of new assets.
The budget this year has been presented in a difficult international and domestic economic environment. The international environment is marked by growing protectionism, particularly after the United States (US) elections, and is likely to constrain service sector exports to add to stagnant commodity exports. As the US is set to raise interest rates, the net capital outflow is likely to exert greater pressure on the exchange rate. The possibility of an increase in crude oil prices along with the pressure on exchange rate has the potential to affect domestic prices as well as fiscal and current account balances.
On the domestic front, the Central Statistics Office’s (CSO) estimate shows that even without taking into account the effect of demonetisation, the growth rate of the economy has decelerated to 7.1% in the current year from 7.6% in the last year, and in fact, every sector of the economy, except agriculture and public administration, has slowed down by varying magnitudes.
Gross fixed capital formation (GFCF) is estimated to decline from 29% in 2015–16 to 26% in the current year. The Economic Survey 2016–17 acknowledges the negative impact of demonetisation, but asserts that the slowdown is likely to be limited to 25 to 50 basis points, which considering the disruption in both production and consumption caused by the note ban seems to be a clear underestimation. The Centre for Monitoring Indian Economy’s (CMIE) estimate of new investment during the last quarter at ₹1.25 trillion was virtually a half of the average investments recorded during the nine previous quarters.
Fiscal Austerity and Risks
The finance minister must be complimented for continuing the process of fiscal consolidation. He has showed the intention not only to reduce the overall fiscal deficit but also improve the quality of deficit by compressing both revenue and primary deficits (Table 1). The estimate of fiscal deficit in 2017–18 at 3.2% is proposed to be lower than the current year’s estimate of 3.5% and the revenue deficit contained at 1.9%. Although the fiscal deficit estimate for 2017–18 is higher than the target of 3% set by the Fiscal Responsibility and Budget Management (FRBM) Committee, in the prevailing environment the slippage should not be grudged. Even as the committee recommended a relaxation of 0.5% for exceptional exigencies, the finance minister has continued the path of austere fiscal stance by not invoking this clause.
Unfortunately, the report of the FRBM Committee is still not available in the public domain to make any informed observations on it. However, it appears that the committee has set debt to gross domestic product (GDP) ratio as a target and derived the fiscal consolidation path from it. In other words, the fiscal deficit of 3% was derived to achieve the consolidated debt–GDP target of 60% and the union government’s debt–GDP ratio target of 40% from the prevailing level of 47%.
Conceptually it is difficult to justify taking debt–GDP ratio as the target, and fiscal deficit as a means of achieving this target as it is difficult to define and measure optimum debt. In fact, debt–GDP ratio can be brought down without reducing the fiscal deficit by simply inflating the economy! While it makes sense to target the primary deficit going by the debt-dynamics equation, and as persuasively argued in the Economic Survey, it must be noted that interest payments at the union level constitute over 36% of the revenues, and therefore, it is important to bring down both the fiscal deficit and the outstanding debt.
In fact, the consolidated fiscal deficit target of 6% set by the 12th Finance Commission was based on the size of the household sector’s financial saving. The argument was that as the household sector’s financial saving relative to GDP was 10% and foreign inflow was 1.5% pre-empting 6% to the government (3% each to centre and states) and 1.5% to the public sector enterprises will leave 4% borrowing space to the private sector.
An important aspect of the budget this year is that the projections have not been too optimistic, and therefore, risks to achieving the fiscal deficit target are not substantial. The most important source of risk, however, is the disinvestment estimate of ₹72,500 crore as against current year’s revised estimate of ₹45,500 crore.
Apart from this, it appears that the budget has not adequately factored in the impact of demonetisation in the revised estimate of the current year, particularly with respect to personal and corporate income taxes. The budget simply reproduces the budget estimates for these taxes as revised estimates at ₹3,26,463 crore and ₹4,93,923.5 crore, respectively. In the case of personal income tax, the projections for 2017–18 are higher than the revised estimate (as well as the budget estimate) by almost 25%. Perhaps, this is predicated on the assumption that the “surgical strikes” on suspicious bank accounts in which deposits of more than ₹5 lakh were made will yield substantial revenues next year.
There has been a clamour to implement a universal basic income (UBI) scheme in the run-up to the budget, and the finance minister has eschewed the temptation of accepting the idea. As discussed in the Economic Survey, this is an idea whose time for implementation has not yet come. In particular, this cannot be an additional scheme and requires discontinuing various subsidies and transfers to release the required resources. At the same time, the budget has done precious little to rationalise explicit subsidies, which at ₹2.7 trillion constitute 1.6% of GDP. In fact, subsidies claim as much as what has been allocated to defence and is just a little lower than capital expenditures. Food and fertiliser subsidies alone constitute ₹2.4 trillion.
Reviving Investment Climate
The difficult international environment and the poor domestic climate marked by the twin balance sheet crisis required a strong impetus, and in this task, the budget has failed. The growth so far has been sustained only by private consumption and even public consumption is not likely to be important as the impact of pay revision wanes. As regards exports, it has merely started in the positive territory after several months of decline. Private investment activity is completely stalled and as mentioned earlier, the CMIE’s estimate of investment during the last quarter at ₹1.25 crore is virtually half of the average investment during the previous nine quarters. The GFCF at 26% of GDP in 2016–17 has fallen to the lowest level during the last 15 years.
In a situation where the growth scenario is severely hampered by a poor investment climate, the most important initiative the government should have taken to revive the investment climate is to substantially step up public investment. There is no possibility of private investment kicking anytime soon because of the twin balance sheet crisis. The corporates are burdened with the overhang of indebtedness and poor returns, and the banks are unwilling to lend due to surging non-performing assets (NPAs).
In this situation, it is not certain that the virtuous cycle of investment will kick in even at low rates of interest. The demonetisation adventurism has only complicated the investment climate further. The only viable option to revive the investment climate at present is to substantially increase public spending on infrastructure, and that would require phasing out unproductive subsidies and transfers on the one hand, and increasing tax–GDP ratio on the other. On either count, the budget has failed.
Enhancing public investment in infrastructure would have helped to crowd in private investment and create a virtuous cycle. Although the revised estimate of investment spending in 2016–17 at 1.8% of GDP was marginally higher than budgeted (1.6%), the capital expenditure remains at the same level at 1.8% in 2017–18 and this is just about 10.7% higher than the revised estimate of the previous year. In fact, even within this, the capital expenditure under defence is about 0.5% of GDP, the impact of which will spill over through imports. Thus, the capital expenditure planned for next year at 1.8% of GDP is only marginally more than the subsidies (1.6%), and almost a half of the interest payments.
As mentioned earlier, the revised estimate of both personal income and corporate income taxes for 2016–17 are exactly the same as the budget estimate of the year up to the last number! This implies that either the tax departments have acquired unforeseen skills in forecasting, or that given the uncertainty following the note ban, the government simply decided to repeat the budgeted numbers in the revised estimate. The problem is that the revenue from personal income tax is assumed to increase by 31% in 2016–17 over the previous year, and in 2017–18, it is assumed to increase further by 25%. The increase in the tax–GDP ratio during 2016–17 and 2017–18 (Table 2) is primarily predicated on the strength of this assumption. Without having an authentic revised estimate, there is strong suspicion that the budget estimate could be optimistic.
On tax proposals, the picture is mixed. Reduction in the rates of tax for companies with less than ₹50 crore turnover to 25% from 30% potentially benefits 96% of the companies. However, the measure is not likely to improve the investment climate because only a fraction of the companies below ₹5 crore turnover earn profits and after demonetisation, quite a few of them have joined the ranks of loss-making firms. At the same time, very little has been done to rationalise tax preferences and reduce the tax rate to 25% for all corporates by 2019, which was promised by the finance minister in the 2015–16 budget.
On personal income tax, the reduction in the tax rate to 5% for individuals with up to ₹5 lakh income does provide some relief. At the same time, the scope of the surcharge has now been expanded to people earning taxable income of ₹50 lakh to ₹1 crore at 10%, and the present surcharge on those earning more than ₹1 crore at 15% will continue. Interestingly, the loss of revenue due to a reduction in the tax rate is shared between the union and states, whereas the gain from levying the surcharge on incomes accrues only to the union government!
On indirect taxes, given that the Goods and Services Tax (GST) is scheduled to be rolled out in July 2017, some rationalisation in excise duty could have helped to make the transition smoother. There are 300 commodities exempt from excise duties and the list could have been pruned. Similarly, there are several rates of tax, some of them specific, and these could have been aligned to the rates decided by the GST council. It would also have been useful to increase the threshold for service tax to ₹20 lakh, the threshold for GST decided in the council.
Transfers to States
The total current transfers to the states as a ratio of GDP show an increase after the implementation of the Fourteenth Finance Commission’s (FFC) award. The increase in 2015–16 over the previous year was by about 60 basis points (from 5.5% to 6.1%) and the revised estimate for 2016–17 shows an increase of another 50 points due to both higher estimate of tax devolution and grants. However, the realisation of this will depend on whether or not the actual collection of revenues is equivalent to the revised estimate. As mentioned earlier, the revised estimates do not seem to have taken account of the adverse effects of demonetisation and the actual could well be lower.
There has been a vociferous claim that the FFC has been overly generous in recommending higher transfers to the states. A close look at the table shows that the transfers to states as a ratio of central gross revenues are lower in 2015–16, the first year of the FFC award, as compared to 2011–12, the second year of the Thirteenth Finance Commission’s award (Table 3). In fact, the trend in transfers shows a decline in the share of states, and this is partly due to the practice of raising additional revenues from taxes by levying cesses and surcharges. While the share of tax devolution increased in 2015–16 substantially owing to the FFC’s recommendations, there was a sharp reduction in the grants, thereby reducing the overall share of the states in central tax revenues.
A careful analysis of major centrally sponsored schemes shows that in 2016–17, significant additional allocations are made for Mahatma Gandhi National Rural Employment Guarantee Act (24.7%), National Health Mission (NHM) (30.7%), Integrated Child Development Services (ICDS) (27.6%), and Swachh Bharat (44.8%) over the budget estimate. Some of these sectors, particularly NHM (20%), ICDS (25.2%), and Swachh Bharat (26.9%) received substantially higher allocations in 2017–18 budget over the revised estimate of the previous year. Other sectors receiving higher allocations in 2017–18 are Prime Minister’s Awas Yojana (38.7%) and Rashtriya Krishi Vikas Yojana (32.6%). Perhaps, sustained advocacy to increase the allocations to social sector schemes seems to have had their effect in enhancing outlays for ICDS and the health sector.
On the whole, this is a “business as usual” budget which could have passed the test in ordinary times. These are unusual times and much was expected in the budget to kick-start a virtuous investment cycle. It does well to be prudent in proposing to control the fiscal deficit. A marginal relaxation in the target by 20 basis points may not be grudged in the prevailing difficult economic climate. However, it does very little to revive the investment climate in the country.
The capital expenditure as a ratio of GDP is static and the promised clean-up of tax preferences to reduce corporate tax rates is yet to be initiated. The finance minister has lost the opportunity to prune the exemption list and align the excise duty rates in preparation of implementing the GST. Finally, the measures to reduce cash donations and introduction of bonds to political parties are more cosmetic and unlikely to have any impact on cleaning up political funding as long as anonymity of donors is assured.
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