As the Finance Minister enters the final stages of finalising his budget proposals for 2010, he is faced with serious issues vis-a-vis the fiscal state of the economy. On the one hand, Indian economy has recorded an impressive recovery from recession with growth of 7.9 percent in the second quarter of 2009 and on annual basis is expected to grow at 7.2 percent for 2010.

The primary drivers for this recovery has been domestic demand, in particular, rural India coupled with fiscal stimuli announced by the Government in the form of increased plan expenditure, lower excise and service rates and benign monetary policy. The RBI in its latest monetary policy has continued to hold the rates and has only increased cash reserve requirements to mop up some of the excess liquidity in the system.

The impressive economic growth is however tempered by grim reality of an ever burgeoning fiscal deficit, which is expected to be 6.8 percent of the GDP (10.3 percent for Centre and state combined) alongwith rising inflation rate currently at 7.8 percent, which is well in excess of the RBI annual target of 6- 6.5 percent driven primarily by food prices.

The fiscal deficit is expected to increase on account of an expected increase in the administered prices of fuel products given the upsurge in the global crude prices and also the fact that auction of 3G spectrum has been postponed to the next fiscal (the auction was expected to contribute Rs 35000 crore to the exchequer). The revenue deficit also continues to pose significant issues primarily on account of lower indirect tax collections (expected to be short of the budget target by approx Rs 22000 crore!).

The silver lining to the dark clouds surrounding the health of the Government finances is the increase in industrial output over the past two quarters and increase in direct tax collections (44 percent year on year increase). The policy makers are thus faced with the dilemma of whether one should potentially sacrifice growth by withdrawing stimulus measures albeit in a staggered manner and at the same time, continue to spend on infrastructure and social projects for which there is need for buoyancy in tax revenues.

On the direct tax front, the Government had released the draft direct tax code (DTC), a much awaited reform, for public comments. The Government has been examining industry reaction to the draft code and is in the process of fine tuning the same. On the corporate tax rate, one does not expect that there will be lowering of the rate from 30 percent to 25 percent for resident companies as envisaged in the DTC.

Given that industry is in recovery mode and that the developed economies have not made the same rebound as India has, it would not be prudent for the Government to do remove the existing sectoral/area based tax incentives. In fact, one could expect that tax holiday under Section 10A/10B of I-T act, with regard to the IT sector (lapsing in financial year 2010-2011) could be extended for another 3 years i.e. till 2014 given the slowdown in the sector.

Another tax incentive that could be extended given the significant forward and backward linkages associated with the real estate sector and at the same time provide housing to the economically weaker sections of society would be Section 80IB(10). Tax holiday in respect of profits derived from housing projects eligible for Section 80IB(10) of I-T Act was extended last year to projects approved between April 1, 2007 to March 31, 2008, if such projects were completed before March 31, 2012.

However, if the tax holiday could be extended for the next three years i.e. till 2015 it could result in the private sector providing a significant boost to such housing. On the minimum alternate tax, increase in rate last year to 15 percent has had an adverse impact on competitiveness of Indian industry specifically those engaged in exports, and one could expect some rationalisation in this area.

The DTCs version of minimum alternate tax based on gross value of assets has met with strong resistance from industry and experts alike and it is expected that the Government shall factor in the same while finalising its proposals.

Although the DTC is scheduled to come into effect from April 1, 2011, the Government could look at introducing some of the procedural proposals enunciated in the draft DTC in Budget 2010. This could include change definition of residency vis-a-vis corporate, income deemed to accrue or arise in India specifically with respect to indirect transfer of assets (an issue that is currently in litigation)and anti avoidance provisions.

It is important that if these proposals were to be introduced as currently outlined in the draft DTC, the same should be suitably modified to take into account concerns outlined by both domestic as well as foreign investors alike so as to mitigate any negative impact on the investment climate in the country.