Budget 2016 goes for prudence over populism

Fiscal consolidation implies that the budget will at best preserve growth

In the past four years, the gap between budgeted and actual fiscal deficit has narrowed to zilch, underscoring that budget-making in India has clearly become more accurate.

That’s in stark contrast to the frequent overshooting seen before.

True, there has been some deviation from the goals envisaged under the Fiscal Responsibility and Budget Management Act to support investment activity. But the overall direction has been the correct one of consolidation: fiscal deficit as a percentage of gross domestic product (GDP) narrowed to 3.9% in 2015-16 from 4.9% in 2012-13, and revenue deficit as a percentage of GDP has come down to 2.5% from 3.6%.

What’s good to see is that unlike between 2012-13 and 2014-15, fiscal consolidation in 2015-16 is not being achieved by paring capital spending but through subsidy reduction afforded by sharply lower crude prices. This has improved the spending mix of the government with a tilt towards infrastructure.

So, what lowered the fiscal deficit? Structural and transitory factors. This differentiation is important because structural factors would result in long-term deficit reduction and easing of interest rates, while transitory factors merely provide short-term relief. Savings on oil subsidy and additional revenues from higher excise duties on oil are clearly transitory factors.

To be sure, these have helped offset the shortfall in direct tax collections because of weak manufacturing activity, poor corporate performance, increased food subsidy, and lower-than-anticipated nominal growth. Nominal GDP growth was 8.6% in fiscal 2016 against 11.5% assumed in the budget.

As for crude prices, they are expected to average $10 per barrel lower next fiscal compared with $45 in the current one.

This means the transitory benefit of lower oil prices will continue and afford an offset to the extra spending being made based on the One Rank One Pension and Seventh Pay Commission recommendations. Increased excise duty on oil will benefit the next fiscal year more, because these came into effect only from November 2015.

And what are the structural factors aiding the fiscal math? Improved coverage and higher tax on services. In the current fiscal, service tax collections were marginally higher than budgeted despite slowing growth in the services sector.

Another structural factor that has imposed the culture of fiscal discipline is the Fiscal Responsibility and Budget Management Act, which has been a moral compass for the government this year, too.

As tasks go, fiscal consolidation is an onerous one in an environment of intensifying headwinds to growth. Yet, and to the Narendra Modi-led government’s credit, the budget for 2016-17 sticks to the commitment made under the Fiscal Responsibility and Budget Management Act by keeping the fiscal deficit target at 3.5% of GDP.

The overall budgetary arithmetic also looks credible. Based on 11% nominal GDP growth assumption, tax revenue growth of 12% is realistic.

The two sources of risk to the fiscal deficit target are the forthcoming spectrum auction and divestments. The experience of the past few years and the state of the markets suggests that the government will need to frontload its divestment efforts to meet the goal.

Fiscal consolidation also implies that the budget will at best preserve growth. It will not pump-prime the economy but, at the same time, it does open the doors for repo rate cuts in 2016. The upshot is that we see real GDP growth at 7.9% next fiscal if the monsoon is normal and the global situation does not deteriorate much from here.

However, for durable fiscal consolidation, it is necessary to structurally reduce the fiscal deficit. In the context, the case for raising revenue buoyancy is far stronger than that for cutting expenditure.

Government spending will have a critical role in improving both social and physical infrastructure, and provision of subsidies to the needy. There is certainly scope for the restructuring of government expenditure towards investment and better targeting subsidies using the Aadhaar platform.

Two characteristics of tax collections in India make us believe that the way to fiscal consolidation is through revenues. While India’s expenditure to GDP ratio is comparable with other emerging economies, its revenue collection to GDP lags (International Monetary Fund, 2014).

The root cause of high deficits is, therefore, the low revenue yield of the government. The problem has been exacerbated by the fall in gross tax revenue from 12% of GDP to 10% between fiscals 2008 and 2015. By merely restoring the tax to GDP ratio to 12%, fiscal deficit will be halved to 2%—or approximately 100 basis points below the ultimate Fiscal Responsibility and Budget Management target of 3%.

This budget has focused more on the redistributive side of taxation by making it more progressive. Future ones will need to do much more structurally and improve tax collections.