In ordinary times, government budgets, pretty much like household financial plans, are about prioritising spending, earning funds, setting medium to long-term goals and creating assets that yield returns for generations.
The initial let-down after the first budget of the Narendra Modi-led NDA government had more to do with unrealistic expectations than with any disinclination to reform the economy. Anticipation has been building up over the past few months that Union finance minister Arun Jaitley will take a strong pro-reform stance in his first full budget.
Given the spending imperatives — economic, political and social — Jaitley’s tax changes will have to be designed to be revenue-neutral. Altered exemptions and surcharges in income tax will bring relief across the spectrum, while a lower minimum alternate tax will be applauded in boardrooms. Customs, excise and service tax have kinks to be ironed out of them and there is the need for convergence to a single tax rate for manufacturers. Imposts placed by the predecessor government have to be jettisoned because they were too onerous and contentious, like the retrospective tax on corporate acquisitions.
For the minister, the constituency for reforms is as important as reforms themselves. If income redistribution helps the aam aadmi see the logic of growth-enhancing structural adjustments that is where Jaitley should put his money. Last year, the reforms were there, but not in your face. The minister’s touch was a subtle one, given the fiendishly complex job for a new government of keeping the economy afloat while delivering on a populist mandate. This gradualism was more sensible than a big-bang approach for a new government.
That said, a major part of the economy’s current problem stems from a slump in investment activity. There is a strand of thought that the economy is in the boondocks because the Reserve Bank of India (RBI) did not aid growth and investment by offering a benign interest rate regime. The industry would have us believe that when growth falls, it is usually expected that the central bank cuts interest rates to boost demand and spending. High borrowing costs, the argument goes, have forced companies to put brakes on their capital expenditure plans.
This can only be partially true, for, as RBI governor Raghuram Rajan has argued, growth and investment is as much a function of low and stable inflation as it is of benign interest rates. So, some of the reasons for slowdown lay elsewhere, not on high borrowing costs. As also the solutions.
Broadly, there could be five types of measures that Jaitley can announce in the budget to drive investment. First, enable the creation of a greater pool of investible funds among banks and financial institutions that companies can dip into. Gross savings, as a percentage of GDP have fallen from a peak of 36.8% in 2007-08 to just above 30% currently. This fall gets directly mirrored in the extent to which companies are adding capacity lines. Gross fixed capital formation (GFCF) to proxy to gauge investment activity has fallen from a high of 33% to about 30%. Part of this solution could be in making it more attractive for households to park savings in financial instruments, deepen savings and wean people away from investing extra money in unproductive assets such as gold.
Second, a lower fiscal deficit is vital to increasing household savings and making more, and eventually cheaper, funds available for the private sector and push investment. A high fiscal deficit — shorthand for the amount of money the government borrows to fund its expenses — can ‘crowd out’ the private sector from the credit market by shrinking the banks’ pool of lendable resources to industry and households. With subsidies at Rs 260,657 crore, three out of every `10 Jaitley budgeted to spend in 2014-15 was borrowed. It is, therefore, absolutely essential to stick to the medium-term fiscal policy roadmap and peg the fiscal deficit at 3.6% of GDP in 2015-16.
Third, the minister should not lose sight of the significant complementarities that exist between private industry and government investment. There is enough empirical evidence to show that higher public spending on infrastructure is followed by greater private investment as the multiplier effect plays out across sectors. Jaitley should, therefore, be acutely conscious that he should not wield the knife to cut capital expenditure. Capital expenditure as a proportion of the Centre’s total spending has fallen from 12% in 2013-14 to 11.7% in 2014-15. For a capital-scarce economy this is quite low and needs to be pushed up.
Fourth, as the majority shareholder of several cash-rich State-owned firms, the government should enable an investment push by such companies. Many of these companies are in the infrastructure space, and investment in these can catalyse asset creation and income growth from farms to factories.
Fifth, investors would still want to see tangible action on the government’s promises to eliminate red-tape to make India a favoured investment destination with a predictable tax system and easier rules. One of the proximate risks of the roiling investor sentiment is policy unpredictability.
Of the three challenges confronting Jaitley — regaining 9% GDP growth, making development inclusive, and catalysing investment — much more can reasonably be expected to be done in this year’s budget. The economic and regulatory landscapes, at least on intent, have turned different over the last nine months. The minister, as well as the market, has also had a longer gearing time to manage expectations. Reforms do not follow the fiscal calendar. It is a continuum of policy moves. Having begun well, Jaitley will now have to go the distance to decisively shift the policy mix. India cannot tarry its tryst with economic destiny forever.