Expect higher tax rates and massive disinvestment in the coming Budget to help reduce the huge fiscal deficit from 6.8% of GDP this year to 3% over the next five years. Finance minister Pranab Mukherjee will package his higher indirect tax rates as an exit from the fiscal stimulus of 2008-09 and a return to the path of fiscal responsibility.

Such sound finance will not, however, be politically popular, and critics will complain that it is inflationary. Hence, the tax hikes are likely to be introduced in small instalments increases of 1% or 2% at a time over a long period.

The finance minister is entering that part of the political cycle that calls for fiscal toughness rather than populism. When a government serves a full five-year term, its fifth and last budget is typically a giveaway budget, attempting to buy votes in the coming election. The first budget of a new government is also typically populist, to thank voters. But the second and third budgets have belt-tightening measures to make up for the earlier populism. And we are about to witness the second budget of the UPA-II government.

No changes in direct tax rates are expected till the Direct Tax Code is fully discussed, and that will take another year. But, given the high inflation of the past two years, the income tax exemption limit could be raised a bit to provide relief to middle-class families.

The Goods and Services Tax (GST), to replace the existing spectrum of indirect taxes levied by the Centre and states, cannot be implemented by April this year, as earlier hoped by the finance minister. The target date may be put off by a full year. State finance ministers are yet to determine what GST rates they will levy.

Optimists hope for GST rates of 8% each for the Centre and states. In that case, the Central excise duty can stay at its current 8% level, making any rollback unnecessary. However, the FM shows no sign of being so optimistic.

The Budget will assume fast GDP growth of up to 9% for 2010-11, with a correspondingly high boost in tax collections. Tax revenues could rise by over Rs 1,00,000 crore. At the same time, outlays on the governments flagship programmes such as Bharat Nirman and NREGA (National Rural Employment Guarantee Act) may be hiked only modestly, after steep increases last year.

The combination of these two factors, plus massive disinvestments of public sector shares, could reduce the fiscal deficit substantially.

The Budget may, however, have to provide a much higher sum for the food subsidy with the expansion of cheap food supplies under the proposed Food Security Act. Many state governments are already providing voters with cheap rice or wheat, and it is unclear how the burden of the Food Security Act will be shared by the Centre and states. The same is true for burden-sharing of additional costs entailed by the Right to Education.

Inflation is a political hot potato, and food prices have risen exceptionally fast. However, this cannot easily be countered as long as Indian food prices remain below global rates. Hopefully, a bumper monsoon, along with a good global crop, will bring down prices later in the year. However, metal and manufactured prices may continue to rise, as the world recovers from the recession. The base effect will tend to produce lower inflation figures as the year progresses. The FM may target an inflation rate of just 4% by the end of 2010-11.

Indian stock markets are likely to be buoyant, and this in turn should help the government raise unprecedentedly high sums by selling minority stakes in public sector corporations. Investment banker Uday Kotak expects inflows into the market of $15 billion (almost Rs 70,000 crore) each from foreign institutional investors and Indian insurance companies, plus another $5 billion (Rs 23,000 crore) from retail investors. This inflow can support disinvestments of well over Rs 50,000 crore, if the government gets its act together.

The Central sales tax is currently at 2%. Possibly, the finance minister will cut it to 1% in the Budget, and say it would be abolished when GST is introduced in April 2011.

There is no sign of the political will to abandon price controls which translate into massive subsidies for fertilisers, petrol, diesel and cooking gas. The Kirit Parikh Committee is looking into fuel pricing. But the recommendations of many earlier committees on the topic have been ignored, and the Parikh committee may not fare much better.