The fiscal deficit number is relevant for two reasons. First, it tells us about the ability of the government to match its expenditure and income; second, it gives an indication of the borrowing programme for the coming year. While theory suggests that the government’s budgetary exercise targets expenditure first and then works out how to garner revenue—with the fiscal deficit becoming a residual item—things are different today. The fiscal deficit ratio—the deficit as a percentage of gross domestic product (GDP)—appears to be the starting point of the exercise. But how much will the government in New Delhi be able to do about it?
Illustration: Jayachandran / Mint
As the government draws closer to presenting the Union Budget, two issues are being debated: Will the budgeted fiscal deficit ratio of 6.8% be maintained for 2009-10, and what would the ratio be for 2010-11? The Reserve Bank of India (RBI) has indicated that the number for 2010-11 could be in the region of 5.5%.
The Union government can take credit for keeping the fiscal deficit ratio at less than what was budgeted in the first four of the five years that comprised its first term in office (the exception was 2008-09). This was managed through the twin horns of controlling the numerator and growing the denominator: The lower numerator (fiscal deficit in rupee terms) suggests control of the deficit in nominal terms, while a higher denominator (nominal GDP at current market prices) was, in a way, fortuitous.
The 2009-10 Budget presented in July assumed that the denominator would grow by 10.1%, which is much below the normal growth of 14%. Based on RBI’s revised forecasts of 7.5% GDP growth and inflation at 8.5% for this fiscal year, the nominal GDP at current market prices would increase by 16%.
Based on the denominator growing at a higher rate, the government could actually increase the fiscal deficit from Rs4 trillion to Rs4.22 trillion for 2009-10, and still adhere to the target of 6.8%. This implies that the fiscal deficit in monetary terms can be exceeded by around Rs22,000 crore.
The government’s borrowing programme for this fiscal year is almost complete and further borrowing to this extent should not upset the apple cart. The fiscal deficit ratio target can still be met despite the fact that tax revenues may not have been very buoyant. Therefore, slippages on tax collection or expenditure will not affect the final ratio within this limit.
The other issue pertains to budgetary numbers for 2010-11. The view that the ratio can be capped at 5.5% is debatable. This is so because it would mean that nominal GDP has to grow by 17.5%: This will be difficult as real GDP growth could go up maximum to 8.5% and inflation would be at 5-6%, bringing the nominal GDP growth number, the sum of these two components, only to 14.5%. The only way out would be for the fiscal deficit number to come down in absolute terms. But is that possible?
The starting point would be expenditure, where around 70% comes under non-Plan expenditure—spending that doesn’t finance the Five-year Plans. The overall expenditure of Rs6.95 trillion for 2009-10 would be difficult to lower. Interest payments for the enlarged borrowing programme will anyway increase by at least Rs30,000 crore. Subsidies will be difficult to lower. In fact, subsidies would increase to alleviate the condition of the poor through interest rate subventions (in the aftermath of a drought year) and loan write-offs. Also, defence expenditure has never been lowered in the past.
The brakes then have to be applied to Plan expenditure, which again looks unlikely given that development schemes such as the National Rural Employment Guarantee Scheme have to be sustained to create the balance of inclusive growth. Besides, Plan expenditure has never declined: It has usually increased by 20-30% annually in the last five years. The onus thus falls on revenue generation.
With a delayed goods and services tax (GST) and a direct tax code still in draft form, tax reforms aren’t on the cards. The crux will be on having the economy grow at a rapid rate and using the inherent buoyancy in the tax system to generate revenue. In the last five years or so, indirect taxes such as customs and excise duty collections have tended to decline.
So corporate profits have to be more buoyant to provide funds for the government. Unless the government focuses more on service tax—a challenge given that only around 50% of the services are in the organized sector, the rest being virtually outside the tax ambit— the increase in tax collections can, at best, only keep pace with growth of individual sectors in the economy.
Therefore, it would be quite a task to rein in the fiscal deficit and, hence, the borrowing programme. That means RBI will have a tough time balancing liquidity and interest rates with growth and inflation.
So, one way or the other, the pressure may not be really on the finance ministry in New Delhi, but remains with the central bank in Mumbai, which will have to be accommodative to bring about growth and the requisite tax collections. But a buoyant economy triggers demand-pull pressures—more money chasing goods—which call for hardening rates and absorption of liquidity. RBI does have tools at its disposal. But the next year would nevertheless be one where, to borrow an analogy from the examination system, RBI has to appear for regular unit tests.
Madan Sabnavis is chief economist, NCDEX Ltd. These are his personal views. Comments are welcome at firstname.lastname@example.org