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A file photo of finance minister Arun Jaitley. Photo: Pradeep Gaur/Mint
A file photo of finance minister Arun Jaitley. Photo: Pradeep Gaur/Mint

Progressive themes, realistic delivery

The finance minister should opt for a thematic budget that tries to revive investment, generate jobs and promote manufacturing in line with the Make in India vision

There are great expectations from the first full-year budget of the Narendra Modi government to be tabled in Parliament on 28 February. The budget has to satisfy the markets on three counts—it has to stick to the fiscal consolidation plan to signal that the government is serious about macro stabilization; it should allocate as much as possible to infrastructure spending, while reining in subsidies, in other words, improve the quality of spending; above all, it should provide more specifics of the new government’s vision and reform agenda.

Meeting, or exceeding expectations on all three counts is going to be a challenging task. A good budget might not be enough; the markets want a great one. We hope that finance minister Arun Jaitley opts for a thematic budget which tries to revive investment, generate jobs and promote manufacturing in line with the government’s Make in India vision. Trying to achieve many goals through a single budget might be a political necessity, but it dilutes its focus and thrust.

The backdrop to the budget is definitely favourable—inflation has fallen sharply, the rupee is stable, the economy is showing signs of a gradual recovery, foreign direct investment is up 27% with more in store, and lower oil prices will hand the government an additional spending power of close to 1% of the gross domestic product (GDP).

However, there are some headwinds as well. Implementation of the 14th Finance Commission recommendations would mean the share of central taxes going to states might increase significantly. Even if we adjust for lower central allocation to states for centrally sponsored schemes, the share of central taxes going to states can increase to 35% from 32% earlier.

Increased allocation to states will be the right step towards promoting fiscal decentralization, one hopes that the states are judicious in spending their windfall gains.

Also, last year’s budget had unrealistic assumptions for tax buoyancy and nominal GDP growth, which has resulted in a likely shortfall of close to 1 trillion in tax revenue. To make the markets believe in the numbers, the 2015-16 budget should present more realistic assumptions. Tax revenue growth should be close to 18% after adding the 70,000 crore bonanza from higher excise duty on petroleum products.

The dependence on divestment and non-tax revenue would continue in 2015-16 as well and the budget could have a potential revenue surprise from this. Re-imposing customs duty on crude oil could bring in close to 20,000 crore more revenue but, at the same time, there would be pressure on the finance minister to reduce customs duty on gold.

Budgeting in the higher revenue from oil, it should not be difficult for the finance minister to meet the 3.6% of GDP fiscal deficit target for 2015-16 mandated by the Fiscal Responsibility and Budget Management Act. However, the objectives of lower deficit and higher capital spending run counter to each other. If the finance minister wants to reduce the deficit, then he only has headroom to increase capital expenditure to just above 2% of GDP from 1.5% last year.

The inability to increase capital spending stems from two inherent structural weaknesses in the Indian budget. First, although marginal tax rates are quite high, successive finance ministers have not been able to take the tax-to-GDP ratio much higher than 10%. This is because only around 3% of the population in India pays tax. Second, 70% of the capital spending—interest payments, salaries, administrative expenses, defence and subsidies—is inflexible, leaving very little to the government for discretionary spending on physical or social infrastructure. The budget would be revolutionary if the finance minister is able to break out of the shackles imposed by either of these two constraints, which will be difficult.

Can the government unleash large infrastructure spending, even at the cost of temporarily slipping on fiscal goals? We think it will be a difficult proposition. India is still in the process of gaining credibility with foreign investors. It is too early for the government to rejoice on achieving macro stability, and, if rating agencies also express their concern, the risks of outflows from bond markets cannot be ignored. India has received $26 billion bond inflows in 2014. With the US Federal Reserve expected to raise interest rates in 2015, it will be prudent to keep the fiscal house in order and prevent any outflows.

Also, in the past, higher public spending has often led to inflationary pressures, and the central bank might become cautious about lowering interest rates any further. It might initially be difficult to convince the markets that the implementation capability of the new government is better than earlier ones.

Within the boundaries of fiscal consolidation, the budget could see higher spending on rural roads and highways, renewable energy, power distribution, railways, urban infrastructure and improvements to the food supply chain. The focus on infrastructure is one of the first steps to convert the Make in India dream into a reality. It could be further supported by targeted incentives for different industries which create jobs and serves India’s strategic objectives.

While more strategic reforms are often not part of the budget announcement, we could see some measures this week regarding the simplification and stability of the tax system including some small steps towards introducing the goods and services tax, a road map for making government spending more efficient through the targeted distribution of subsidies, alternative financing models for large infrastructure projects and urban development, a plan for recapitalizing the country’s public sector banks, and a new monetary policy framework.

Nevertheless, with a long list of pending legislation, the state of India’s reforms should be judged not at the end of the budget speech on 28 February, but at the end of the budget session on 8 May. By this time, the sum of policy changes may surprise on the upside.

Samiran Chakraborty is managing director and head (South Asia Macro Research, Global Research) at Standard Chartered Bank.

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