Anis Chakravarty| Will budget proposals deliver a revival?
Finance minister Arun Jaitley's budget is pragmatic and focused on reforms, but implementation of proposals will be key
On 10 July, the finance minister outlined the first budget of the new government with a pragmatic recognition of macroeconomic woes and a thrust towards structural reforms. The minister laid out his vision aimed at reinforcing confidence through a slow but steady rebuilding of the economy. He acknowledged that the prevailing economic situation posed a challenge and reforms were required. While this frank assessment may be lauded, the key question is, are the budget proposals sufficient for a revival?
There is no doubt that the economy has looked up from where it was last year. The current account deficit is low, with India having achieved trade surplus over the past few quarters. The fiscal deficit situation is also better, having achieved targets a few years in a row. The Sensex has peaked over the past month and foreign direct investment (FDI) inflow has been impressive in the fourth quarter of 2013-14.
However, all is not good. The Economic Survey revealed that considerable work is required to bring the economy back on track. Economic growth has stagnated below 5%. Sticky inflation, populist subsidy measures, oil price shocks and a falling currency have left the economy looking for a much-needed boost. Implementation of various structural reforms is necessary if the economy has to fulfil its potential.
While there was no expectation of big-bang measures, the finance minister’s speech was keenly watched to understand his chosen path to recovery and the direction of things to come. In line with expectations, he chose fiscal prudence over overtly populist measures and outlined his vision of controlling inflation, simplifying tax laws, reviving manufacturing growth and improving infrastructure. While there were still a few populist sops, one expects such announcements in every budget speech. The question, however, remains whether the measures announced are enough to bring the economy back on track.
To answer this, one needs to look at the issues itself. Here, I have focused on the key aspects of inflation, growth and fiscal health.
According to the Economic Survey, India is going through a phase of low growth and high inflation, known as stagflation. While the technical definition of stagflation also includes unemployment, let us put that aside for a minute and focus on the cause of inflation. Primarily, this can be attributed to the high price of food and fuel. Fuel price is largely inelastic and India is heavily dependent on external sources in the Middle East. If there is a crisis in the Middle East, crude prices go up, which in turn creates price pressures in the domestic market. Though fuel is largely subsidized, the recent de-administration mechanism means that higher prices are being passed on to consumers. A direct effect is on transportation costs, which go up and consequently affect retail prices.
Another significant contributor to inflation is food prices. This is largely supply side-driven, as hoarding, inefficient cold storage and supply chain inefficiencies ensure that even if there is a good harvest, retail prices remain high. Secondly, agriculture production in India is largely monsoon dependent and seasonal factors have played havoc with output.
With consumer price inflation remaining high and driven by supply-side issues, the monetary policy has largely been ineffective in reducing inflation. The Reserve Bank of India governor recently said he would reduce rates if consumer price inflation fell below 8% by January 2015. Till then, a situation of high inflation and high rates may prevail, eroding monetary value in the economy. It is imperative, therefore, that food and fuel price stabilization be an important factor of any government policy and the finance minister was expected to address this concretely.
Unfortunately, he did not say much. There was no major announcement on tackling fuel inflation. Nor did he mention how the Middle East impact on crude prices may be mitigated through alternate or domestic measures. On the food side, he suggested that the government will undertake open market sales to keep prices under control. In addition, he proposed a “price stabilization fund" to mitigate price volatility.
It may seem that this is not enough, but one needs to look at the fine print. Directly attempting to affect prices may, at best, be a short-term measure aimed at keeping them under control. However, this can never be the perfect solution in an open economy, even if one looks at this from a welfare perspective. Market forces should ultimately create a conducive environment to keep prices in check. Therefore, the root causes need to be weeded out, which are supply-side inefficiencies and the effect of seasonal variations in agriculture.
In this regard, some important announcements were made. The finance minister said an agri-tech infrastructure fund and a national adaptation fund for addressing the vagaries of climate change will be created. Further, he suggested a technology-driven “protein revolution" and reworking the Agriculture Produce Marketing Committee (APMC) Act. The corpus for rural infrastructure development was also raised by ₹ 5,000 crore and another ₹ 5,000 crore was allocated towards warehouse infrastructure improvement.
Besides this, a number of announcements were made towards improving the public distribution system and restructuring the Food Corp. of India to minimize transportation and distribution losses. Putting aside the funds allocated for a second, there is a clear message in this: the government is trying to address supply-side issues. None of these measures will really benefit in the short run, but if implemented correctly, long-term issues related to agricultural productivity, infrastructure, transportation and dependence on seasonal factors will be reduced. Consequently, effects of food inflation in the mid to long term will be curtailed.
One of the key reasons for low economic growth is industrial stagnation. The industrial sector, particularly driven by manufacturing and mining, contracted by 0.1%in 2013-14. Questionable allotments, scams, land acquisition issues and stalled projects have affected the sector, which, in the past, contributed significantly to the overall gross domestic product (GDP) and employment. Particularly, the small and medium enterprises (SME) sector, which forms the backbone of the industrial sector, required a boost. Elevated costs of raw materials, high borrowing rates and low savings for reinvestments had squeezed margins and resulted in the SME sector underperforming. Given that a significant contribution to GDP comes from the industrial sector, it was necessary to look for urgent remedial measures.
The finance minister did not disappoint in this regard. He continued the measures announced by the previous government as well as came up with some new prudent measures for the long term. The industrial corridor projects were brought under the newly formed National Industrial Corridor Authority. Master planning for the Kolkata-Amritsar corridor and the Bangalore-Mumbai economic corridor was announced, along with a host of others. In addition, the budget spoke of “smart cities" and industry clusters centred on this model. If implemented correctly, these have a whole host of benefits, most importantly, transforming industrial growth from being an urban phenomenon to a rural affair. Industrial clusters around highways will also allow the rural populace previously employable in the agricultural sector to move into the industrial sector. This, in turn, will foster demand for skilled labour and assist in skill set formation. While this may well be India’s future industrial revolution, such ideas are not new. What is required is a focus on implementation and ensuring that such ambitious plans see the light of day.
Linked to the industrial sector is the matter of addressing the SME sector’s woes. The finance minister said a committee would be set up to remove bottlenecks and give concrete suggestions on the financial architecture of SMEs in three months. One needs to wait and see how this pans out. In addition, infrastructure development also has linkages with the industry. The minister also spoke of mainstreaming public-private partnerships and mentioned shipping, roads, airports and renewable energy. Again, such announcements are not new. We have heard them in earlier budget speeches as well; however, what is important is how these plans will translate at the ground level.
The government inherited a balance sheet where its predecessor had contained the fiscal deficit to 4.5% of GDP, lower than the target of 4.8% set for 2013-14. The contraction in the fiscal deficit had been a combination of recovery in revenue towards the end of the year and substantial cutbacks in government expenditure. However, these numbers do not reveal the complete story. In order to reduce the deficit, there were significant dividend pull-outs from public sector enterprises, resulting in improved revenue for the year, but that was only a short-term measure. Also, the current government inherited a balance sheet where a large portion of the annual outlay had already been used up.
The Economic Survey made a case for reforms, fiscal prudence and importantly, lower subsidies. Subsidy rationalization, in particular, was the need of the hour. The survey also proposed reducing direct taxes and fiscal responsibility budget management rules with teeth. It rightly revived the concept of cash transfers instead of subsidized goods. Such proposals have been made in the past but never got implemented. Given this background, there were important expectations from the finance minister. Unfortunately, though his positive acknowledgment of all these issues was well received, he did not immediately address them in the budget.
First, he did not repeal retrospective amendments to the tax law which have seen legal challenges, though he specifically commented that the right of the government to undertake retrospective legislation needs to be exercised with extreme caution as it has a significant impact on the economy and the overall investment climate. He did not announce any big-bang reforms or rationalize subsidies. He also did not mention a clear implementation road map for goods and services tax (GST). What he did was similar to his actions in other areas, i.e. outline a plan for addressing a number of issues affecting fiscal prudence. Secondly, he did make some noticeable changes in tax policies aimed at giving a boost to a number of issues such as industrial revival.
He mentioned that his focus will not be only on expenditure, but also on the revenue side. He will not raise taxes, but focus on increasing the base itself. First, he provided a number of indirect tax incentives aimed at boosting manufacturing and infrastructure growth. He gave incentives to the real estate sector through the announcement of a modified real estate investment trust scheme. He increased FDI in insurance and defence production to 49%, and reiterated that a subsidy reduction with a focus on fuel will happen in a phased manner. He also clarified that GST will be introduced after consulting with the states and addressing their objections. Importantly, he addressed issues on reducing tax litigation by allowing the facility of advance rulings to resident tax payers, increasing the scope of the settlement commission, “rolling back" APA (advance pricing agreement) provisions, and introducing the arm’s length range and multiple year concepts. All of these measures are expected to significantly address tax litigation concerns.
While there are mixed views about the budget and multiple discourses have been held on what the finance minister has done versus what he has not, it is important to step aside and focus on the bigger picture. The Indian economy has been stuttering for a few years now, though recently, the winds have changed. However, a lot needs to be done to address structural issues and restore growth to 7-8%. Given that the government has been in office only for a short while, expectations of a big-bang change were not high. There were expectations, though, on presenting directions. The budget does not fail in this regard. It is pragmatic, short on hype and focused on reforms. More importantly, it acts as a precursor of things to come. As with all announcements, implementation will be the key. Proof of the pudding will lie in how many of these announcements indeed materialize at the ground level within the next six months.
The author is senior director, Deloitte Touche Tohmatsu India Pvt. Ltd.
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