New Delhi: The Prime Minister’s economic advisory council (EAC) on Wednesday said the Indian economy could bounce back next fiscal to grow at 7.5-8% with moderating inflation and a modest improvement in the investment climate, a projection that suggests that the worst is over.

The council, which said the economy could expand 7.1% in the year ending March, marginally higher than the 6.9% estimated by the Central Statistics Office, however, cautioned that the high level of fiscal deficit, pressure on the balance of payments and fuel subsidies were downside risks to these projections.

The EAC, headed by chairman C. Rangarajan, had earlier projected the economy would grow at 8.2% in the current fiscal in its Economic Outlook released in July last year.

“It is likely that third quarter growth will be significantly weaker than that reported for the second quarter (6.9%), but the final quarter of 2011-12 should show some improvement,” the council said in its latest Review of the Economy report.

Samiran Chakraborty, head of India research at Standard Chartered Bank, said the growth expectation was optimistic, given the current investment rate.

Gross fixed capital formation, signifying investment demand in the economy, is estimated to fall to 29.3% of the gross domestic product (GDP) in 2011-12, a decline of almost 4 percentage points over the last four years, which, the EAC admitted, has resulted in a slowing of economic activity.

The EAC, however, argued that with the return of price stability, appropriate supportive policy and administrative measures, it is possible to visualize an improvement in the investment rate, despite difficult conditions in the international financial markets. Price stability is also expected to normalize consumption demand, thus, further boosting investment and growth.

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Mint’s Asit Ranjan Misra says that while the PMEAC has projected growth of 7.5-8% in 2012-13, it has sounded a warning about fiscal challenges and external pressures.

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The council said the government must set ambitious targets for both capacity creation in key infrastructure and operational performance, especially in the coal sector, so as to provide a fillip to the economy in the next fiscal.

According to the EAC, the easing of inflationary pressures would give room to the Reserve Bank of India (RBI) to adjust its monetary stance over the next several months. In January, RBI signalled a shift in focus from concerns over inflation to growth. It reduced the cash reserve ratio (CRR) by 50 basis points. On Tuesday, RBI deputy governor Subir Gokarn signalled that the central bank may further cut CRR to inject more liquidity into the system. CRR defines the amount of money banks need to keep with RBI. One basis point is 0.01 percentage point.

The council supported RBI’s stand of linking its future course of monetary policy easing to the moderation in inflation and to the extent to which the central government can trim its borrowing requirements in 2012-13. However, Rangarajan said he supports open market operations (OMO) over a cut in the CRR as RBI can calibrate the injecting of liquidity into the system through the former (OMO is the buying and selling of government securities in the open market so as to increase liquidity, the amount of money in the banking system, or reduce it.)

The EAC feels that inflation based on the Wholesale Price Index may remain at the current 6.55% till the end of March. However, it expects inflationary pressures to ease through 2012-13 and average around 6% for the year. “Given good harvest of rice and wheat and assuming that the monsoon is moderately normal, the government should be able to maintain stability in food prices, especially given that global food price pressures seem to have eased,” it said.

The council advocated an increase in prices of liquified petroleum gas and kerosene at the central level and electricity tariffs by the state governments in a phased manner. It said the delay in the revision of these rates has led to suppressed inflation, which may reflect in headline inflation numbers next year.

The EAC said the government will cross its fiscal deficit target of 4.6% of GDP for the current fiscal because of higher-than-budgeted subsidies on petroleum products. It, however, stopped short of putting a number to the fiscal deficit. M. Govinda Rao, a member of the council, said the fiscal deficit could overshoot by 1 percentage point.

Rangarajan said it was now clear that the fiscal consolidation road map suggested by the 13th Finance Commission cannot be achieved and added that the government should come out with a new plan.

Rao said the government could still achieve the fiscal deficit target of 4.2% of GDP for the next fiscal if it succeeds in its attempt to auction 2G spectrum freed by the Supreme Court’s recent decision to cancel 122 telecom licences.

According to N.R. Bhanumurthy, a professor at the National Institute of Public Finance and Policy, a fiscal policy think tank, while a new road map for fiscal consolidation is one option, it needs to be taken very seriously in the coming budget to avoid macroeconomic destablilization. “On the revenue side, this can be done through disinvestment,” he said. “On the expenditure side, it can be done by substantially pruning allocations for some flagship programmes.”

The EAC said the persistence of a large current account deficit next fiscal seems likely, even though it is not desirable. It expects the current account deficit to be 3.6% in 2011-12 and 3% of GDP in 2012-13 due to reduced capital flows and rising merchandise trade deficit. The council holds that while the position with regard to capital flows has greatly improved, it will, however, be judicious to try and limit the current account deficit to the range of 2-2.5% of GDP. The current account deficit is an aggregate of the trade deficit and the difference between receipts and payments on account of services.

“Once it begins to exceed that level, investors tend to be concerned and are reluctant to commit risk capital. In consequence, the funding of higher current account deficit is not only harder, but the quality of financing can also become an issue,” it said. The current account deficit in the first half stood at $32.8 billion (around Rs1.6 trillion today), or 3.6% of GDP. In the second half, it is likely to be only marginally different at $33.9 billion, or 3.5% of GDP.

The EAC is of the view that the current account deficit will continue to be under pressure in 2012-13 . Crude oil prices are expected to increase by about 10% on average in 2012-13 over the $110 estimated for the current fiscal. In the current and previous fiscals, crude oil prices rose by 30% and 25%, respectively.

The council also advocated raising excise and customs duties to the levels at which they were before 2008’s economic crisis. The government had cut both the indirect taxes in 2009 by 2 percentage points to 10% to support consumption and growth. It also suggested that the finance minister raise tax on tobacco products that, it said, are far below international standards. Rao said that only by raising indirect tax rates to 12% can the government hope to mop up an additional Rs35,000 crore tax revenue.

Chakraborty, however, said increasing indirect taxes will have little impact on bringing down the fiscal deficit. “The gap between 5.8% and 4.2% is huge and not easy to tidy up,” he said.

According to him, much will depend on the size of the gross budgetary support (GBS) in the forthcoming budget. “If it is 18% (which the Planning Commission has asked for), it will be difficult to reduce the fiscal deficit,” he added. GBS refers to the amount of assistance provided by the central government to so-called Plan schemes.

The EAC suggested that some elements of Direct Taxes Code (DTC) be implemented in this budget itself to enhance revenue collections: “The enactment of the concept of residence in the case of companies incorporated outside India and amendment of general anti-avoidance rules (GAAR) will help bring in clarity when there is a conflict between double tax avoidance rule and domestic law.”

DTC, as an anti-avoidance measure, proposes that a foreign company whose place of “effective management” is India be treated as a resident of India and, thus, be liable for taxation in India on its global income.

It also has GAAR provisions under which any arrangements made between entities to deliberately avoid tax can be invalidated. Currently, the Income-tax Act does not have any provisions that authorize the department to study deal structures and “look through” subsidiaries in multi-jurisdictional transactions. But GAAR has provisions that will enable the department to do so.

With the roll-out of the goods and services tax (GST) being held up due to opposition from state governments, the EAC also made a push for introducing taxation of the services sector based on a negative list approach in this year’s budget. A negative list-based approach, where all the services part of the negative list are not taxable, could expand the tax base significantly, minimize litigations and facilitate the introduction of GST.

asit.m@livemint.com

Remya Nair contributed to this story.

Graphics by Sandeep Bhatnagar/Mint

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