A Union Budget should be judged on four criteriamacroeconomic balance, tax changes, pattern of expenditure and policy initiatives. A look at how Arun Jaitley's fourth budget fares on these parameters
There are four criteria by which a budget should be judged. (i) Does it ensure macroeconomic balance given the circumstances? (ii) Are the tax changes consistent with the overall objectives? (iii) Is the pattern of expenditure and the design of programmes appropriate? (iv) Does it announce significant new policy initiatives in other areas? Here is my take on each of these for the Union Budget 2017:
The finance minister has achieved the fiscal deficit target of 3.5% of gross domestic product (GDP) that was set for 2016-17. He had targeted reducing it to 3% in 2017-18, but in the aftermath of demonetisation, which had a larger negative effect than anticipated, many had recommended a larger deficit to offset the shrinkage of demand created by demonetisation. Against this, there were legitimate concerns about how markets would react, given uncertainties in the global economy, weaker exports, and the possibility of capital outflows. The FRBM Committee reportedly recommended flexibility of up to 0.5 %. The finance minister has wisely opted to use only some of the space provided and revised the earlier target to 3.2 %.
Fiscal purists may regret the relaxation, but the expansion is small and the process of fiscal consolidation continues. Markets are unlikely to react negatively as long as the economy looks like returning to 7.5% GDP growth in 2017-18. The question to ask is, are we really on track for a 7.5 % growth? The Economic Survey estimated that the demonetisation would reduce growth in the current year to between 6.5 and 6.75%. Many feel it may be significantly lower, at about 6%. If so, the projected recovery to 7.5 % is unrealistic. Without it, revenues will fall short of what is projected, jeopardizing the fiscal target. We need to do whatever we can to ensure quick revival and it is not clear that the budget does that.
Tax Policy Reform
The most important development in tax policy is the implementation of the Goods and Services Tax (GST). Decisions on this issue lie with the GST Council, but the finance minister reported that progress is being made, and we may well have a GST in place by 1 September. Unfortunately, what the Council has agreed to is a flawed structure, with too many rates. There will be a zero rate that will apply to half the items, and other items will be distributed across five tax slabs—5%, 12%, 18% and 28% for luxury goods, with additional cesses on some luxury goods for compensating the states and also financing clean energy, the latter effectively constituting a fifth slab . The states have not agreed to including alcohol and real estate.
The ideal structure would have had only one, or at most two rates, other than a zero rate, and real estate at least should have been included, since it is a large part of the capital cost of setting up new factories. The flawed GST will still be an improvement on the existing structure of central and state taxes, but it will contribute much less to growth than a GST with far fewer slabs. There is probably no room at this stage to reopen the issue, but we should keep an open mind about raising it as soon as possible.
The promise to lower the corporate tax rate to 25% and abolish exemptions is receding into the future. It is now proposed to apply the 25% rate to all MSMEs (micro, small and medium enterprises with a turnover up to Rs50 crore). This will cover 90% of all companies currently paying tax, but they will account for a relatively small percentage of the total tax paid. However, despite its limitations, it is a good move which will support the employment creating end of industry and thus encourage job creation.
The reduction in income tax rates in the first slab from 10% to 5% has been widely welcomed, but I regret to say that it is not well conceived. We now have a very distorted rate structure, with the first slab, from 2.5 lakh to 5 lakh, taxed at 5% followed by a sudden jump to 20% for incomes from Rs5 lakh to Rs10 lakh and 30% for incomes above this limit. However, all this is complicated by a new surcharge of 10% for those with taxable income between Rs50 lakh and Rs1 crore, and a continuation of the old surcharge of 15 % for incomes above Rs1 crore. If the idea was to start with a lower tax slab to encourage tax payers to get into the net, the entire rate structure should have been rejigged to allow a more gradual transition from 5% to the highest rate, avoiding sharp increases as at present, from 5% to 20 %. The surcharges should simply have been abolished since they violate the spirit of cooperative federalism as they are not shared with the states.
A missing element on the tax side is modernization of tax administration to improve compliance. The finance minister rightly pointed out that there are too few people declaring reasonable amounts of income. The budget takes credit for a 25% increase in revenue from personal income tax, which is entirely reasonable if we look at the potential. But in the absence of reforms in tax administration that encourage tax payers to comply, it will be difficult to shield them from what is often called “tax terrorism". The Parthasarathi Shome committee had made a number of recommendations in this regard two years ago, but hardly any of them have been acted upon. Setting high revenue targets without modernization of tax administration will only lead to more complaints from harassed tax payers.
A positive feature on the expenditure side is the absence of new populist schemes. The Economic Survey seemed to be pushing for an unconditional Universal Basic Income, which could be financed by abolition of other subsidies. There was a real danger that the scheme, if introduced, would have been applauded, without the subsidies being abolished! It is best to make progress in this area gradually, by substituting existing subsidies with cash transfers. The ongoing experiment with the public distribution system in Puducherry and Chandigarh needs to be carefully studied to see if it can be expanded.
There is wide support for the idea that there should be a focus on infrastructure development, and more generally towards capital expenditure. The infrastructure emphasis is not evident in the budget because expenditure on infrastructure schemes has increased by 13.5% (budget estimates to budget estimates) whereas the total expenditure on all “developmental schemes" has increased by 17.8 %. The picture may well look better if “off budget" expenditure in the railways, ports, highways etc. is included.
Capital expenditure in the budget has increased by 25.4%, which is impressive. However, this is certainly not enough to compensate for the slowdown in private investment. A revival of investment in the economy cannot be achieved simply through the budget, or even the private sector. The constraints holding up private sector investment need to be directly addressed.
Revival of bank lending
A disappointing feature of the budget is the absence of a credible plan to ensure a revival of bank lending. Commercial credit expansion by banks has slowed down considerably, and if personal loans are excluded, lending to industry is actually contracting! There is no way the economy can get back to 7.5% growth without a robust revival in bank lending.
A mistaken notion commonly expressed is that because bank deposits have increased following demonetisation, the banks will now be able to expand lending. In the first place, much of the increased deposits are likely to flow back into the system when the existing restrictions on withdrawals are removed. The budget could have given a clear road map for when these restrictions will go. Even if the decision is to be taken by the Reserve Bank of India (RBI), that could have been done in parallel and announced in the budget as a signal of impending return to normalcy.
The real problem constraining bank lending is that state-owned banks do not have enough capital to support higher lending. A credible scheme for recapitalization should therefore have had top priority, but the budget only provides Rs10,000 crore, which is hopelessly inadequate, based on the estimate of need made two years ago. Since then, RBI’s asset quality review showed that non-performing assets (NPAs) are much larger than expected. This will force the banks to make larger provisions, shrinking their capital base considerably. The government could use this opportunity to reduce its shareholding below 51%, and there is much to recommend this course of action, but if this is not possible, then much larger amounts would be needed from the budget.
The problem of cleaning up the balance sheets of the banks is intimately linked with the weaknesses in the balance sheets of corporate borrowers. The problem has been comprehensively analysed in Chapter 4 of the Economic Survey and it is, therefore, all the more disappointing that no corrective steps are proposed. Unless it is believed that a sudden return to high growth will reduce stress on corporate balance sheets, we need to take hard decisions to clean up the existing NPAs relatively quickly.
Cases where there is clear malfeasance on the part of defaulting borrowers obviously call for punitive action, but cases where defaults reflect adverse commercial outcomes, including over-optimism on the part of the borrowers, call for a different approach.
What is needed in such cases is that both the borrowers and the banks take a haircut. This will be necessary even if it is decided to hand over the companies to new owners, since these investors will only take up a project if it is felt to be viable.
Public sector bank managers are understandably reluctant to agree to their bank taking a haircut for fear of being accused of collusion to benefit the private party. This is the real reason why we may need a “bad bank" type of solution, in which the bad bank takes the asset off the books of the bank, with some haircut to the bank. Public sector bank managers will be more willing to take a haircut demanded by another government entity, which then deals with the defaulting borrowers to seek a resolution. This problem has been pushed under the carpet for too long, and it is not going to go away.
There are many other initiatives in the budget that are well intentioned, including initiatives to roll out the digital infrastructure, new initiatives for skill development, reforming the University Grants Commission, etc. How effective these are will depend on the detailed design and the manner of implementation, but I do not have the space to deal with these issues.
The big picture is that there is much that is sensible in the budget, and nothing that does any harm. But there is a great deal more that needs to be done if we want to get back to 7.5% growth.
Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.