Companies provide guidance to investors about what business conditions could look like in the year ahead. There are strong incentives to provide conservative guidance, because investor expectations tend to form around them. Shares rise when the company eventually beats guidance at the end of the year. And share prices fall when companies miss their guidance. Often, the fall is asymmetrically steeper than the rise, making conservative guidance a more attractive strategy for corporate managements.

Finance minister Pranab Mukherjee. (File photo)

But that usually ends up as a problem. The entire budgetary arithmetic is based on some estimate of real GDP growth plus inflation. Estimates of tax collections and government spending as based on the initial guess (for that is what it is) about nominal GDP growth.

On the one hand, spending programmes are very difficult to cut once commitments have been made in the budget. On the other hand, the tax revenues needed to fund these spending programmes tend to fluctuate with economic growth. Slower economic growth will pull down government revenues, while spending will go ahead according to plan.

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This is a simple distillation of a much more complex process, which includes factors such as subsidies, global oil prices, one-off revenues from the auction of telecom spectrum, the success of disinvestments. But the basic logic is this: start with an optimistic growth estimate, and there are high chances your entire budget will unravel by the end of the fiscal year.

We saw this happen in FY11 as well, though the government was eventually bailed out by a bumper auction of 3G and WMA spectrum, as well as high inflation which boosted tax collections. What about this year? Finance minister Pranab Mukherjee finally admitted on Wednesday that the Indian economy would grow at less than 8% in FY12, as against his initial estimate of 9% growth.

The upshot: watch for all signs of fiscal deterioration.

Why are government’s budget estimate always carefree? Tell us at views@livemint.com

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