Budget 2020: Nirmala Sitharaman will have to make difficult choices
Growth at a 10-year low and inflation at a five-year high is not an ideal backdrop for presenting a Union budget. Often, it is argued that the budget should be just an exercise of stating the government balances, but given the extreme macro situation, the expectation is that the budget should go far beyond that. Not only a Keynesian-style fiscal stimulus but deep structural reforms are also on the list of expectations. While the expectations are high, the resources are limited — posing critical choices for the finance minister.
The first choice is between staying fiscally prudent versus stimulating the economy. Extraordinary times might require extraordinary responses. While fiscal prudence is an essential component of macro-stability in normal times, strict adherence to fiscal targets could generate headwinds to growth when the economy is severely demand-constrained. Although expansion in fiscal deficit does not improve the trend rate of growth, it may be able to provide some support when the growth rate has fallen much below trend. However, this justification for a more expansive countercyclical fiscal policy loses some sheen because of two reasons: The government’s track record of withdrawing the stimulus has been poor in the past, and with public debt to GDP on the rise again (we estimate the ratio at 72.5% now), the pressure from rating agencies could be mounting.
In fact, under the current circumstances, the government might be forced to defer the Fiscal Responsibility and Budget Management (FRBM) Act, 2003-mandated financial year (FY) 2025 timeline of reaching the public debt-to-GDP ratio of 60% by a couple of years, even under optimistic assumptions on fiscal prudence and growth recovery. This could become a serious constraint in forming an expansionary budget unless the FRBM Act is once again redrafted. Although some fiscal slippage in FY20 to 3.6% of GDP appears to be inevitable, the government might have to reluctantly opt for a more cautious stance for the FY21 budget.
In case the government considers the option of using the 0.5% of GDP deviation flexibility offered by the FRBM Act, the stimulus needs to be timely, targeted and temporary.While there would be less argument over this broad principle of choosing the stimulus, the second critical choice for the finance minister would be whether to stimulate through lower taxes or higher expenditure. Some form of income tax cut satisfies the two conditions of timely (quick to implement) and targeted. Depending upon how the tax reduction is tailored (changes in tax slabs/rates/exemptions), the cost to the exchequer could be around 0.1 – 0.4% of GDP. However, its effectiveness could be questioned on several grounds. Only 2-3% of the population pays income tax making it too targeted. In an uncertain environment with high consumer leverage, the beneficiaries from such a tax cut could increase their savings rather than spending the additional income.It is also extremely difficult to reverse any such income tax cut, going against the principle of being temporary. In our view, the rate revision should be done in conjunction with the streamlining of other multiple tax incentives to simplify the system.
If the preferred mode of stimulus turns out to be expenditure increase then there is an obvious choice (the third important one) between revenue and capital expenditure. But before we delve into that, we have to appreciate that 66% of expenditure is pre-committed (interest payments, wages and subsidies), leaving very little flexibility to reallocate expenditure. Generally, higher proportion of capital expenditures (capex) is considered to have a larger multiplier effect on the economy but it might take time to spend the money. On the other hand, revenue spend would be quicker to implement, easier to roll back but might have smaller medium-term gain for the economy.
The budgetary allocation for agriculture and rural development ministries have steadily increased from 0.77% of GDP in FY15 to 1.26% of GDP in the FY20 budget, primarily because of the farm income support scheme. While, to some extent, it has addressed the concerns of the rural agrarian economy, the crucial area deserving attention now would be the non-agricultural informal rural segment which is hurting from growth slowdown and efforts to formalize the economy. Some support towards this sector is surely expected. Growth rate in spending on infra has decelerated in recent times and going by the current trend, ministries like roads, railways and urban development might not be able to spend their full year budget in financial year 2020 if the 25% of BE expenditure restriction for the last quarter is strictly implemented. We would like to see infra spending growth of 15% in the FY21 budget with a particular focus on social housing which has strong forward and backward linkages.
Apart from the fiscal math, the budget can always surprise with its reform intent and sectoral pushes. Untangling the real estate-non-banking financial company logjam, a push towards encouraging Make in India, reviving private sector interest in infrastructure and opening up the economy towards more foreign savings could be some of the possibilities. While these reforms are potential growth enhancers, the near term focus would be on how the finance minister balances the impossible trinity of demand stimulus, fiscal consolidation and credible accounting.