The upcoming Union Budget acquires importance as it will provide more visibility on the government’s economic agenda. This is an opportunity to outline its vision for the next five years. The government clearly understands the importance of high economic growth and job creation. Finance minister Nirmala Sitharaman has the tough task of balancing economic growth priority, social objectives, and fiscal challenges. While the clamour for various sector-specific incentives and expenditure, and tax cuts to boost aggregate demand has intensified, the challenges that the government faces are quite substantial. The government needs to provide a credible budget—one which allays the markets’ apprehensions on finances by sticking to macro-prudential norms and yet focus on policies and spending only on segments which provide a larger ‘multiplier’ effect.

Nuts and bolts: A credible budget is of paramount importance

It is essential to understand the current state of public finances to appreciate the policies and the need for more focussed government expenditure. The health of revenues (tax and non-tax) forms the base for expenditure that the government can undertake in the budget. If the revenues are disappointing, and the government is trying to stick to a particular level of gross fiscal deficit (GFD) (as a proportion of GDP), it has no option but to either reduce expenditure (and thus provide a lower impetus to growth) or resort to ‘off-budget’ expenditure (which negatively impacts interest rates in the economy).

The biggest disappointment in terms of revenues has been from goods and services tax (GST) collections. Compared to FY2019 budget estimates of Rs6 lakh crores of central GST, the government ended up collecting only Rs4.6 lakh crores with a slippage of Rs1.4 lakh crores. Similarly, the current run rate for CGST is around Rs39,000 crores compared to a required run rate of around Rs51,000 crores (as per the Interim Budget). At this rate, the slippage at the end of the year would be around Rs1.4 lakh crores—around 0.7% of GDP (again!). Evidently, it cannot really reduce tax rates (direct taxes) without losing revenue. If the government has to maintain the GFD/GDP at 3.4%, it would have no option but to reduce expenditure.

Surely, the government may choose to not reduce overall expenditure by passing off an equivalent amount of this shortfall as off-budget spending. In other words, some quasi-sovereign agency (public sector enterprises) such as the NHAI, FCI, IRFC, etc. will pick up the tab and spends on behalf of the government. Currently, these public sector enterprises are borrowing from the market to the tune of around 2-2.5% of GDP and these borrowings have actually increased over the last couple of years. Effectively, the central government’s deficit could be quoted around 5% of GDP if one were to include these entities, too! Further, the government has increasingly been relying on the National Small Savings Fund (NSSF) which includes Public Provident Fund, National Savings Certificates, postal deposit schemes, etc. These products are in direct competition with bank deposits and offer substantially higher interest rates than bank deposits. This at the margin also impedes the banks’ efforts of deposit mobilisation at lower rates.

The public sector borrowing (central and state governments along with central public sector enterprises) is to the tune of around 8-9% of GDP. Compare this with the available pool of financial resources in a year (or the gross household savings in financial assets such as deposits, mutual funds, insurance, etc.) of around 10-11% of GDP. We now have a classic “crowding-out effect” of the private sector by the government/public sector. What this effectively does is impede reduction in market interest rates, and the cost of funding in the economy does not reduce as desired. Over the last few quarters these issues have been impeding the Reserve Bank of India’s monetary policy transmission. In other words, asking the government to slip on its deficit targets to stimulate the economy would be counter-productive with demands of spurring private investment and consumption in the economy.

With this fiscal framework in the background, we have to realistically analyse whether the government can afford to be lax on its fiscal prudence. The government has fixed commitments of around 55% of its total expenditure in items such as interest payments, wages and pension of government employees, internal security, food subsidy, etc. If revenues continue to disappoint, the scope for expanding expenditure in remaining segments to spur overall demand will be limited. A more focussed approach will be required whereby the government gives precedence to the quality and implementation of expenditure rather than expenditure which looks optically most pleasing. To this extent, one should hope for a credible budget which factors in a realistic scenario of tax collections, and a judicious mix of expenditure which squarely places the focus on long-term economic growth rather than a myopic vision of quick fixes.

Focus areas: Stimulating domestic demand and generating employment

Keeping in view the aims of the government of stimulating aggregate demand and providing greater employment opportunities, the government should focus on some stimulus to housing (through expansion in affordable housing), which can have significant positive effects—(1) substantial ‘multiplier’ effect on the economy given the numerous direct and indirect linkages with other sectors along with labour absorption capacity (which will benefit rural labour through rural-urban migration), (2) fiscal impact may not be large in the near term as the cost will accrue to the government only after the houses are built and sold and (3) improvement in financials of housing finance companies (HFCs)/real estate developers along with lower stress in debt markets.

On the corporate tax front, the government should explore the option of a differentiated tax rate structure for the micro, small and medium enterprises sector, which can induce tax compliance and provide some relief for the sector, which is already facing funding challenges. The government can (1) introduce new tax slabs of 10-20% for smaller firms with turnovers up to Rs100 crore and (2) normalise these tax rates over two-four years such that they are not incentivised to remain small. On the personal income tax front, the government could look at increasing the overall exemption limit marginally to Rs 3 lakh even as it increases the existing surcharges for incomes above Rs50 lakh and Rs1 crore.

Finally, the focus on infrastructure should continue whereby the government continues to invest in ‘hard’ assets (roads and highways, railways, urban and rural infrastructure) and ‘soft’ assets (education and health). This should continue even if it is at the cost of lower allocation to some of the social schemes that the government runs. The RBI estimates that the central government’s capital expenditure has a multiplier of 3.25 while for revenue expenditure is 0.45—implying a Re1 increase in capital expenditure has a much higher impact on growth.

Beyond the Budget: The hard decisions for long term growth

The budget is only a part of the process of fulfilling the economic agenda of the country. The more difficult work remains in implementing the necessary reforms in the economy, part of which should be outlined in the Budget vision. In order to push growth to the range of 7.5-8% on a sustainable basis, India needs to implement the next set of reforms encompassing agriculture, financial sector, infrastructure, labour, land, and public finances. We will not go into the details right now but essentially, the focus should be to improve the productivity of the economy and more efficient use of factors of production—land, labour, and capital. These will require the government to overcome the challenges of utilising political capital, cooperative federalism, and consensus building with non-political stakeholders. Hopefully, the budget will outline the intent to achieve the long-term growth potential of India.

Suvodeep Rakshit is vice president and senior economist in Kotak Institutional Equities. Views expressed are personal.

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