Budget: FM will have to walk tightrope amid a trinity of challenges
February, 09th 2016
The Modi government faces a trinity of challenges in formulating the Union Budget. Even as the government tries to stay on the path of fiscal consolidation, it would have to keep up the pace of capital expenditure as well as account for higher expenditure on wages and pensions. The backdrop for the budget would be to revive domestic growth (especially rural demand), keep demand-led price pressures at bay, and provide the base for private sector investment cycle. These make it imperative for the budget to focus on good economics
However, one should note that a budget is typically not a template for reforms but a mode of taking forward the economic and governance agenda along with outlining the government accounts.
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One of the key focus areas would be to revive rural demand. A short-term solution will not be an optimal solution. The rural segment has been suffering due to weak domestic and global agriculture prices, real rural wage growth has been nearly negative to flat and 'easy' money through the government transfers and programs are more frugal. However, with a long-term view the budget should aim to provide more impetus to rural infrastructure spending.
Some of the schemes such as PMGSY (rural roads) and DDUGJY (rural electrification) should see some higher allocation and works under NREGA could be steered towards more rural infrastructure creation. The government should also provide resources to address constraints in logistics and warehousing space in the agricultural sector. This would also help in eliminating the price volatility in the short cycle crops.
The other key theme for the budget should be to channelize more financial savings - to create the resources for future investments. Incentives through higher deductions under Section 80C of the Income-Tax Act would be the more direct way to garner savings. However, providing deductions would come at the cost of lower direct tax collections which may not be acceptable when tax revenues in general are susceptible to the somewhat tepid demand conditions. Alternatively, Alternatively, higher duty on gold jewelry could act as a disincentive and hopefully channel savings towards financial assets.
The Subramanian Committee has also factored in an excise duty of 2-6% on precious metals in its calculation of the standard rate of 16.9-17.7% in the GST regime. A higher rate on precious metals would lead to a lower standard rate. Currently, 1% VAT is applicable on these in most states.
Admittedly, the fiscal arithmetic this year will be slightly more complicated as the government factors in Seventh Central Pay Commission recommendations. The government will have to provide for likely expenditure of around 2.5 per cent of GDP to fund for 7CPC (assuming a staggered roll out), OROP, and bank recapitalisation among others.
Funding will be a challenge, especially in the absence of much tax buoyancy and poor record of achieving divestment targets. However, subsidies rationalization through DBT in food and fertilizers is pending which can provide the next round of expenditure savings.
The current leg of investment cycle recovery will ride on sectors such as railways, roads, power (T&D) and renewable energy, and urban infrastructure which are primarily dependent on public spending.
Private sector investments remain nearly absent and it becomes all the more essential that the government at least maintains the capex-to-GDP ratio similar to the FY2016 budget. This would require capital expenditure growth of 10-15% over FY2016.
This should not be difficult provided it is matched through reduction in revenue expenditure or divestment proceeds. While the overall focus has been towards capex, the need to channelise expenditure into education and health to capture long term gains remains underappreciated. The two sectors combined receive only 5-6 per cent of the budget even as much scope remains to improve quality of such public goods.
The revenues front is unlikely to be too exciting. Corporate tax rates will likely be reduced by 1-2 per cent in line with the government's aim of reducing the rate by 5 per cent over four years. The budget will likely provide clarity regarding the removal of tax exemptions (date of removal of exemptions, treatment of extant tax exemptions including sunset provisions).
Windfall gains from lower crude prices through excise duties increases in FY2016 will continue to provide upside to tax revenues. Service tax rate could also be increased to 16 per cent as a transition towards the GST regime. However, the key point is that buoyancy in overall tax revenues will be limited given the low nominal growth and the lackluster aggregate demand in the economy.