The backdrop in which the finance minister will present the current government’s second Budget is significantly different from last year. In June last year, the world was staring at a severe recession. In the nine months since, the world’s economic outlook has stabilized and is gradually turning for the better. In India, economic growth has accelerated, and in spite of a severe drought, FY10 gross domestic product (GDP) growth will be higher than in FY09.
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We think this changed economic backdrop, together with restructuring of strained government finances, will be the principal theme of this year’s Budget.
With the economic backdrop improving significantly, India must now exit the loose policies that it used to stimulate growth last year. The Reserve Bank of India started normalizing the monetary policy with the hike in the cash reserve ratio in January. It is now for the government to normalize fiscal policy and to address India’s biggest medium-term macro headwind—bloated government finances.
We expect government revenues (both tax and non-tax) and expenditure to miss Budget estimates this year. Consequently, we expect fiscal deficit for this year to be around 20-30 basis points (bps) higher than Budget estimate—in spite of the favourable 30 bps effect from the upward revision of nominal GDP after the Central Statistical Organisation revised the base year.
Thus, the Union government’s fiscal deficit would be around 7% (twice as high as it was just two years ago) and the combined (the Centre and state) fiscal deficit would be above 10% in FY10 for the second consecutive year. Public debt as a proportion of the GDP is now rising, after declining for five consecutive years.
High deficits were understandable when the economy was growing at sub-par rates of 6-7%, but with growth likely to be above 8% in FY11, high fiscal deficit is unsustainable and needs to be brought back to sustainable levels (around 3%) on a priority basis.
Crowding out was not a major threat in FY10 as the private sector demand for credit was weak (bank credit will grow about 15% in FY10—an eight-year low). However, we expect credit growth to pick up in FY11 as domestic growth recovers.
We think the Central government needs to start the process of fiscal consolidation by announcing a 150-200 bps reduction in fiscal deficit for FY11 from around 7% of GDP for FY10.
Though this reduction will have to come through revenue augmentation and expenditure control, we expect revenue augmentation to play a larger role, given the rigidity in government expenditure. Additionally, we expect the government to put forth its medium-term fiscal consolidation strategy in terms of deficit reduction targets over the next three to four years.
We would like to see the government restore excise and service tax rates back to pre-stimulus rates, given the pressing need to raise revenues.
While there is understandable anxiety that removal of fiscal stimulus may affect growth in sectors such as auto, we do not expect any decline in growth rates beyond a couple of months.
However, in our view, the government is likely to settle for a partial rollback of the cut in tax rates.
We also expect government to set an aggressive disinvestment target for FY11. While it is likely that like in the last budget, the disinvestment target is not explicitly stated, we assume higher disinvestment proceeds during FY11 (around Rs25,000-30,000 crore, or around 0.4%, of the GDP) over FY10 in our fiscal deficit estimate. We are also including Rs35,000 crore, or 0.5%, of GDP, as proceeds from the much delayed 3G auction which we expect to finally conclude in FY11.
However, proceeds from 3G auctions are purely one-time in nature and, consequently, understate the true underlying fiscal deficit to that extent.
Two key tax statutes are currently pending before the government—direct tax code, and more importantly, goods and services tax. Apart from clarity on implementation of these statutes, we expect no material changes in the tax structure.
Graphics by Yogesh Kumar/Mint