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Prepare for a taxing Budget
January, 25th 2012

Times have changed. The role that the pre-Budget Economic Survey has traditionally played appears to have now been perfected by the Reserve Bank of India or RBI. The Economic Survey, an annual document that the Ministry of Finance produces a few days before the presentation of the Union Budget, always outlines the key policy imperatives for the finance minister's budget exercise. Over time, however, the efficacy of such advice has declined. For instance, the Survey would recommend a strong dose of reforms by eliminating poorly targeted subsidies, but the Budget unveiled a few days later would do just the opposite.

Now, it seems the RBI has taken upon itself the task of reminding the finance ministry of the policy imperatives that it must keep in mind while presenting its next Budget. And it is doing so with a degree of firmness and clarity that has understandably been missing in similar advice in Surveys of the past several years. Yes, you got it right. We are talking about the monetary policy review statement made by the RBI yesterday.
Four key points in yesterdays monetary policy statement by the RBI stand out. One, the finance ministry should not yet begin its celebrations over its victory over inflation. It is the sharp fall in vegetable prices that is creating the impression of a moderating inflation rate. Manufactured goods inflation is still at around 8 per cent. Two, the government's fiscal consolidation programme is under stress and the fiscal slippage already seen continues to be a threat to tasks of ensuring inflation management and achieving macroeconomic stability. Three, the government should initiate policy and administrative actions in a manner that they encourage investment in areas that help ease supply constraints in food and infrastructure. And the fourth point underlines the need for the government to augment the supply of skilled manpower through policy interventions, so that skill mismatches are reduced and the upward pressure on wages remains under control.

Not everything that the RBI has listed in its policy prescriptions can be achieved in one Budget. For instance, it is difficult for one Budget to redress the existing labour market imbalances. Steps can of course be initiated through a package of incentives so that skills shortages in identified sectors of the economy do not worsen and sector-specific wage spirals remain under check. Even more investment in infrastructure and food sectors can be encouraged through fiscal incentives provided through the Budget, but they will yield results only after some time. Similarly, inflation management is a long-term challenge and while the government needs to be aware of it and it should take necessary corrective steps, to believe that it is under control could be suicidal. To that extent, the Budget should not rush into any policies that can again stoke up inflation. The RBI warning, therefore, is timely and justified.

The most important advice from the RBI pertains to the government's fiscal consolidation efforts. This is one area where steps initiated in the forthcoming Budget should yield the desired results for the economy fairly early. Indeed, the RBI monetary policy review statement says quite unequivocally that only after the Budget outlines a credible fiscal consolidation plan will it consider the options of reducing the policy rates. In other words, the central bank has put considerable pressure on the finance ministry to rein in the fiscal deficit for 2012-13. If the government does not respond with adequate steps towards achieving fiscal consolidation next year, the RBI could well review its interest rate cut options and that could be bad news for both the Indian economy and India Inc.

So, the big question in North Block, the headquarters of the finance ministry, today, is how feasible it will be to cut the fiscal deficit next year. In the current year, all its fiscal deficit calculations have gone haywire. All efforts are being made to reduce the slippage in the fiscal deficit target set at 4.6 per cent of gross domestic product or GDP for 2011-12. Even the most optimistic estimates place the final fiscal deficit figure for the current year at close to 5.5 per cent of GDP. What then should the finance minister do to rein in the fiscal deficit for the coming year?

The way out, it would appear, does not lie in expenditure cuts. Given the large share of obligatory allocations (interest payments at almost 18 per cent and tax-sharing with states at 17 per cent of the total spend) and expenditure in areas like defence (11 per cent) and subsidies (9 per cent) where any cut is strategically or politically unfeasible, the scope for expenditure reduction to achieve fiscal consolidation is limited. It is perhaps time, therefore, for the finance minister to look at the revenue side for raising more resources and not just through disinvestment of government shares in public sector undertakings or through one-off routes like auctioning of mineral rights or spectrum.

The tax-to-GDP ratio for the Centre has been falling since 2007-08 quite steadily, after reaching a peak level of close to 12 per cent. It is now time for the finance minister to look at raising resources through direct taxes, since the road to raising more revenue through indirect tax reforms with the help of the goods and services tax remains blocked. Twenty per cent of Indian households, according to one survey, account for more than half of the total income and 40 per cent of total private consumption expenditure. A similar skew exists in the corporate sectors earnings. It is time affluent Indians and the top profit-making firms prepared themselves for a higher dose of taxation.

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