Fiscal Challenges Remain Despite Gains From Oil

Last year, government set out a fiscal deficit target of 3.9% of GDP and going by the trend so far, it will most likely to be achieved. Massive windfall gains from crude oil fall did the trick. Government absorbed the gains through higher taxes which allowed them to meet fiscal target as well as give some boost to infrastructure spending. However, from the upcoming Budget's perspective, things are a bit challenging. Firstly, the windfall gain from oil is largely absorbed, so incremental gains will be limited. Indeed, in case crude oil rebounds, it can pose a fresh challenge. Secondly, the government has to absorb the effect of 7th Pay Commission recommendations on pay and allowances of the central government employees (0.4% of GDP). Thirdly, disinvestment can become more challenging if the market environment does not improve. Finally the sharp slowdown in nominal GDP growth could hurt tax revenue buoyancy as well. Despite these headwinds, the Centre needs to narrow the fiscal deficit from 3.9% of GDP to 3.5%. This is certainly an uphill task especially when government needs to spend to revive demand in the economy.

So what should be done? My sense is that there is a reasonable case for relaxation in fiscal consolidation targets to create space for public spending as private sector is facing either large idle capacities (manufacturing) or witnessing stretched balance sheets (infrastructure). Two areas need special attention in my view. One is the infrastructure because this is an area which does not suffer from over capacity (and is not a global tradable sector) and private sector has taken a back seat due to balance sheet stress. So government needs to step up its spending on roads (where we are already making progress), railways, etc. Other is rural sector, given the mounting distress (substantial decline in international food prices, weak output etc), the sector needs government support in the form of spending on rural roads, rural housing, irrigation, education and health services. Of course government needs to avoid being populist and refrain from sharp increases in MSPs etc but spending in constructive areas is quite critical. This is particularly so because state governments may scales back their expenditure in social sector given slowing tax revenues, impending burden of wages and pensions hike (7th pay Commission) and also implementation of UDAY scheme of the power sector which can add to fiscal burden of states.

Note that case for relaxation in fiscal consolidation is not a case of fiscal imprudence. First fiscal deficit of the Centre is not as high as 6% (as was the case in FY11-12 period when fiscal consolidation was a priority). Second, incremental spending by the government is more on public investment, rather than subsidies. Third, once growth comes back, government tax revenues will revive and take the fiscal consolidation forward rather than just relying on expenditure cuts. Surely, government needs to continue to push for GST reform which will safeguard the government fiscal position through higher tax base and economic efficiency gains over a period of time. This will inspire confidence among investors at large, ratings agencies as well as economic participants.

For now, on the taxation side, one may see some more hikes in indirect taxes (custom duties on crude may go up, service tax could be hiked again next year etc) but on the direct taxes front, I expect the upcoming Union budget to implement the previously proposed reduction of corporate tax to 29% from current 30% (which will eventually be reduced to 25% in next four years). Lower corporate tax rate will further aid "Make in India" and meanwhile instil India as more attractive destination for investment.

Overall, I expect a balanced budget with some relaxation in fiscal consolidation target to keep up the public investment with infrastructure and rural India being the key focus areas.