Indian finance minister Palaniappan Chidambaram will be a genius if his budgetary proposals, which he will announce in Parliament on Friday, don’t damage theeconomy.
The minister is in a tight corner. The ideal Indian budget at this juncture would be one that gives top priority to fiscal prudence even as it seeks to increase government investments in infrastructure, such as roads, ports and power stations, while lowering the burden of indirect taxes on manufacturers.
This is what is required to persuade the monetary authority to gradually lower interest rates without losing its grip on inflation. However, politically, this isn’t an option that Chidambaram could even consider.
This will be the fifth and final Budget for Prime Minister Manmohan Singh’s government before the general election this year or next. That in itself presents a big challenge for the finance minister, who will be expected by the ruling Congress party-led coalition to announce a populist spending plan.
If that wasn’t enough, there’s the spectre of a generous pay increase for 5.5 million Union government employees.
The pay commission, which recalibrates civil servant wages every 10 years, will formally submit its report to the government in April.
The state-owned Indian Railways, the country’s largest employer with its own budget, has already given an indication of the large financial allocations that Chidambaram may be forced to make in his Budget to fulfil the pay panel’s recommendations. This week, the railways set aside Rs5,000 crore to meet the additional wage bill.
The 1997 increase in the salaries and pensions of government workers cost the Central and state exchequers 1% of gross domestic product (GDP) annually for more than three years.
If that experience is repeated this time around, it would essentially mean surrendering the tax buoyancy that India has recently witnessed to paying government workers.
That would be a shame.
There are good reasons to be sceptical that tax collections will continue to be as strong as they have been recently.
With deceleration in external demand and some pullback in domestic consumption, the Indian economy may struggle to maintain the 8.7% pace of expansion expected in the current fiscal ending 31 March; that, in turn, is slower than the 9.6% growth in GDP a year earlier.
If the pace of increase in tax collection moderates, the pay commission’s generosity may degenerate into fiscal slippage. A weekly reading of price gains has shown inflation accelerating since early January. The so-called wholesale price index rose 4.35% from a year earlier in the week ended 9 February—a six-month high.
With the government forcing refineries to sell petroleum products at lower than international prices in the local market, inflationary expectations in India are still not firmly anchored even though there is tremendous political pressure on the central bank to lower its policy interest rate of 7.75%.
The combination of fiscal adventurism and monetary easing may, in this environment, become a lethal concoction, sparking capital outflows.
Chidambaram will have some room to make a direct attack on inflation if he cuts indirect taxes, especially the excise duties that manufacturers have to pay.
He is unable, however, to seek matching cuts in expenditure.
With elections near, the government has already committed itself to extending a rural job guarantee programme nationwide, even though audits have shown the project to be a disastrous failure, riddled with inefficiencies and corruption.
The local media are also speculating about a big debt waiver to farmers in Friday’s Budget.
If Chidambaram tries to satisfy demands for both lower taxes and higher spending, he may eventually end up missing the government’s legal obligation to eliminate the revenue deficit in the year ending 31 March 2009.
The choices before Chidambaram are so limited that if he tries to offer immediate gratification to investors by announcing deep and bold tax cuts, he might end up putting India’s long-term prospects at risk.
The equity market’s response to the Budget, considered the litmus test of how a finance minister has measured up against expectations, may be quite misleading this year.
With inflation as the No. 1 concern, it might be more prudent for investors to watch the yield on the 10-year bond. (Bloomberg)
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