Dream budgets, fiscal nightmares

With five assembly elections ahead, the finance minister has to balance imperatives of coalition politics with the need to keep up the growth momentum and adhere to budget deficit reduction targets

N Chandra Mohan Delhi

Even if they later turn into fiscal nightmares, dream budgets are what union finance minister P Chidambaram is best known for. These hold out the promise of lower tax rates-making them hugely popular with the urban middle class and business-men—while boosting overall growth. As the ruling United Progressive Alliance (UPA) government is in power with left support, he also has to budget for higher expenditures as per the National Common Minimum Programme (NCMP) such as the national rural employment guarantee scheme and Bharat Nirman and still meet his revenue and fiscal deficit targets.

The union budget is an annual statement of the central government's finances. A revenue deficit is incurred when its tax revenues are not sufficient to meet its routine expenditures of administration. Like any individual or firm in a similar situation, it will perforce have to borrow or spend less. Another word for borrowings is the fiscal deficit. Even though the budget is also an occasion to articulate the UPA government's line and length on reforms—like further liberalising the regime for foreign direct investments, say, in the retail sector or insurance—the main effort is to meet the targets on deficit reduction.

What will complicate Chidambaram's efforts to spin another dream budget
on February 28, 2006 is the Fiscal Responsibility and Budget Management Act, 2004 (FRBM), according to which he has to reduce the revenue deficit by 0.5 per cent of GDP and fiscal deficit by 0.3 per cent every year, starting 2004-05. The left, for its part, has ruled out softer options to lower the fiscal deficit through disinvestment or partial sales of government's equity in public sector undertakings (PSUs) although the finance minister confidently states in every forum that the disinvestment process is very much 'on track'.

The UPA government and its allies also face the compulsion of fighting five state assembly elections in 2006, which further narrows Chidambaram's room for manoeuvre in reducing wasteful expenditure as on subsidies. Exemplifying such pressures is the recent decision of the UPA government to 'put on hold' its decision to reduce the food subsidy bill which has been budgeted at whopping Rs 26,200 crore in 2005-06. Accordingly, the decision to raise the issue price and cut allocations of rationed foodgrain to reduce the subsidy bill has been deferred till the elections are out of the way. 

'Terming it as a dream budget on the first day is very superficial. It should be made at the end of the financial year,' an understandably cautious finance minister recently told the Forum of Financial Writers. 'If a budget, together with other major policy initiatives taken by the government, promotes a growth of say, over, 7 or 7.5 or 8 per cent, it can be classified as a good one,' he added. While promising that tax rates will not be raised, he has also hinted that government will cut the revenue deficit by 0.5 per cent to 2.2 per cent of GDP and the fiscal deficit by 0.3 per cent to 4 per cent of GDP in 2006-07. Chidambaram's confidence to deliver such a budget stems largely from the robust growth momentum of the Indian economy, which grew by 8 per cent in two successive quarters in 2005-06 and 7.5 to 8 per cent for the year as a whole. All his budgets, in fact, assume that this faster pace will continue during the next few years—overall growth of 7 to 8 per cent with inflation of 4 to 5 per cent. It is this favourable context of faster growth-making India—one of the fastest growing economies in the world today—that enables the finance minister to fervently hope that his budget will boost growth.

GDP growth leads to buoyancy in tax revenues. With growth of 7.5 to 8 per cent in 2006-07 and beyond, the ratio of the central government's taxes to GDP will rise significantly. With a regime of moderate taxation, the finance ministry expects better compliance to add to the fiscal kitty. The tax administration is also being toned up with the ministry bringing more services into the net. Chidambaram is loath to forgo tax revenues and has indicated that unpopular measures like the fringe benefits tax introduced in his last year's budget will only be simplified but not abolished.

The compulsion to mop up revenues from all sources is largely due to heavy NCMP commitments on the Nation Rural Employment Guarantee Scheme in 200 districts and Bharat Nirman.  The former will be launched on February 2. Funds for the two remaining months of 2005-06 have been worked out through the merger of existing schemes like Food for Work Programme and Sampoorna Grameen Rozgar Yojana.

These would fund the scheme in 150 districts, while for the remaining 50 districts Rs 305 crore has been earmarked. The problem, if any, will start from 2006-07 onwards.
For Bharat Nirman as well, the funding requirements are huge at Rs 174,000 crore over a seven-phase period to build national highways, rural roads, houses for the poor, rural telephony and better irrigation facilities in rural India. Indications are that the UPA government must raise additional resources to the tune of Rs 18,000 crore every year from 2006-07 onwards to fund Bharat Nirman. How much of this will be met from the budget is a different matter but meeting such expenditures complicate the finance minister's efforts to make the budget NCMP-compliant while adhering to the FRBM discipline.

Ahead of the five state elections, the UPA government will also step up its aam admi rhetoric in the budget. The finance minister has indicated that the annual budgetary exercise would always focus on the masses-the common man and rural India. It is likely, therefore, that the atmospherics of his budget will be replete with Jai Kisan welfarism together with higher plan outlays on agriculture and rural development. Farmers will be encouraged to diversify into horticulture, floriculture, oilseeds and agri-business and mitigate their risks through various insurance schemes.

As for India Inc, the finance minister remains convinced that industry has so far disproportionately borne the brunt of taxation while agriculture and services have contributed marginally relative to their combined sectoral shares in the nation's GDP. For a sense of perspective, agriculture and services contribute direct tax revenues of less than 1 per cent of GDP while their sectoral share is as high as 73 per cent. Accordingly, the thrust of his proposals for India Inc will include a regime of moderate taxation and liberal depreciation allowances to boost investments that trigger faster growth.

The finance minister is also perfectly aware that consumption demand has gone up and that the increase in demand for goods was being reflected in fresh industrial capacities being created. For instance, there is an ongoing boom in demand for automobiles and all the domestic vehicle manufacturers are ramping up capacities. Chidambaram is aware that this virtuous cycle must be sustained and plans to encourage demand for small cars through lower taxes. These are the sort of pro-growth measures in prospect rather than higher rates for India Inc and tapping
conspicuous consumption as demanded by the left.

His budget, therefore, represents a gamble that the momentum of faster GDP growth of 7 to 8 per cent will continue to ensure buoyancy in tax revenue collections. This will enable him to meet the UPA government's commitments on NCMP and FRBM targets. However, this is far from easy. The finance ministry's mid-year review of the Indian economy in 2005-06, indicated that as per FRBM rules, the revenue deficit should not be more than 45 per cent of budget estimates while it was as high as 68.3 per cent during April-September 2005. Reducing, if not eliminating, the revenue deficit indeed
is the finance minister's major fiscal challenge.

Revenue deficits largely stem from the inflexible nature of burgeoning non-plan revenue expenditures on administration like wages and salaries, interest payments and subsidies while tax revenues as a share of GDP have remained stable. Capping such expenditures has eluded most finance ministers of coalition governments till now and Chidambaram is no exception in this regard. He definitely intends to budget for lower non-plan revenue expenditures, but coalitional pressures ahead of elections stay his hand. All eyes will, therefore be on whether he succeeds in restricting such expenditures.

This is why no effort is being spared to ensure that the ratio of tax to GDP improves significantly—even well beyond the targeted reduction in the revenue and fiscal deficit as the increase in revenue has to make up for the shortfall, if not evaporation, of PSU disinvestments. This script will run so long as the GDP growth party continues. If not—say, if there is an upset over a bad southwest monsoon in 2006—he will be unable to show lower revenue and fiscal deficits as per the FRBM Act. Shining in borrowed feathers only portends a full-blown fiscal nightmare of an internal debt trap.