This is the fourth budget of the Narendra Modi government, but the first one to be framed under the challenging backdrop of a slowing economy and rising global risks. The time to prepare was also less given that the budget date was advanced by a month. And, more importantly, those preparing had to work with less reliable data because the Central Statistical Office’s estimate of 7.1% gross domestic product (GDP) growth for fiscal 2017 did not capture the impact of demonetization.
One of the notable trends of the advance GDP estimate is the fall in private consumption to 6.5% in fiscal 2017 from 7.3% the year before. Final private consumption spending could fall further as this estimate does not capture demonetization’s impact. Although the International Monetary Fund expects the world economy to pick up this year, there is low confidence in the forecast. The outlook, therefore, remains tentative and fraught with risks, most of which have a political texture.
While the task before the budget was cut out—to protect the economy from domestic and global headwinds—there wasn’t much fiscal elbow room to do so. What does the budget mean for the revival of consumption and investment demand?
We expect the economy to grow at 7.4% in fiscal 2018 assuming another normal monsoon. Steps such as tax relief to the middle class and focus on rural spending will provide mild support to consumption demand. The thrust on construction (roads and low-cost housing) will create assets, generate employment, and support consumption demand as workers in this sector have a high propensity to consume and almost a quarter of their consumption is on discretionary items.
The budget aims to lift public investment by direct budgetary spending (capital expenditure through the budget has been raised by 10.7%) as well as by prodding the public sector to invest using internal and extra budgetary resources (IEBR). However, compared with fiscal 2017, the government is committing more resources as dependence on IEBR has been reduced, in favour of budgeted capital expenditure.
There was also a marked improvement in actual spending done in fiscal 2017. In contrast to the previous fiscals, where a significant portion allocated through IEBR remained unspent, fiscal 2017 saw IEBR overshooting by 2%. Moreover, government capital expenditure overshot its 2017 budget goal by 13%. Private investment was expected to take another year to recover even before demonetization. The cash crunch that followed demonetization curbed demand and capacity utilization, which remains below trigger thresholds for many sectors. The budgetary proposals do not have the muscle to turn around consumption demand in a big way. Private consumption expenditure will, therefore, grind up.
As a matter of rule, governments should stick to their fiscal commitment. The previous two budgets resisted the temptation to get the economy firing through loose fiscal policy even when the monsoons failed. By targeting fiscal deficit at 3.2% of GDP, the finance minister has reiterated his commitment to fiscal consolidation.
The transitory deviation from the fiscal deficit target of 3.2% can be justified because a slower economy can do with some budgetary support. This also finds support in the recommendations of the new fiscal responsibility and budget management (FRBM) committee, which gives leeway to deviate from 3% under certain exigencies.
We believe that fiscal rectitude was needed for three distinct reasons. First, India has already postponed achieving the FRBM target in the past. Originally, the 3% target was to be achieved by fiscal 2009, but the FRBM Act was amended twice—in 2012 and 2015. According to the Finance Act, 2015, the target dates were further extended by three years to March 2018. Not adhering to the target dents credibility. Second, over the past few years, the government has managed to rein in the debt-to-GDP ratio from over 56% in fiscal 2005 to 45.4% in fiscal 2011. Since then, however, the ratio has moved up, and despite attempts at fiscal consolidation it stood at 46.7% in fiscal 2017. The trend is true of the debt indicators of both the Central and state governments. Third, lack of fiscal discipline sends a wrong signal to monetary authorities, which now follow an inflation-targeting framework to engender a low and stable inflation regime in India.
This signal on the government’s commitment to fiscal consolidation will be received well by the markets. It will not only reduce the borrowing cost for the government, but also create conditions for the Reserve Bank of India to cut its policy rate.
The one-time gains from excise duty hikes in oil and the income disclosure scheme (IDS) will be missing next fiscal. The focus, therefore, must shift to improving tax collections on a durable basis. The government’s medium-term fiscal strategy should be to create space by improving the tax-to-GDP ratio, which was 11.3% in fiscal 2017 and is budgeted at 11.3% in fiscal 2018. That’s still below the peak of 11.9% seen in 2007-08.
The goods and services tax (GST), though disruptive in the near term, will help improve tax compliance over the medium term by moving activities from the unorganized to the organized sector and by improving growth prospects. In addition, the government needs to continue to reduce the cash intensity of the economy, introduce new measures to improve tax compliance, and widen the scope of GST. The good part is, the budget does throw some hints to this effect.
Dharmakirti Joshi is chief economist at Crisil.
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