With only three days to go before Finance Minister P Chidambaram delivers the Budget in Parliament, market expectations with respect to reforms are running high. Rating agency Fitch expects the team of proven reformists in the government (Prime Minister Manmohan Singh, Chidambaram and Deputy Chairman of Planning Commission M S Ahluwalia) to pursue fiscal consolidation.
However, the government will need to balance tight fiscal policy with a need to present policies aimed at helping the poor and demonstrating social responsibility. It remains to be seen if the government will be able to contain pressures from the Left parties (that provide outside support to the Congress-led coalition) to increase populist spending.
As the Budget also encompasses policy statements on structural reforms, announcements that could give indications of the government's appetite for future reforms will be monitored closely.
Budget is likely to focus on:
Deficit target: An ambitious fiscal deficit target based on realistic GDP, revenue and expenditure growth would be welcome. According to the Fiscal Responsibility and Budget Management Act, the revenue deficit should be eliminated by 2008-09 from a budgeted 2.5 per cent of GDP in 2004/05. In the medium-term fiscal policy statement, central government seeks to reduce its annual fiscal deficit to 4 per cent of GDP in 2005-06 from a budgeted 4.4 per cent of GDP in 2004-05. According to Fitch, a faster pace of fiscal consolidation, whereby the fiscal deficit target is cut by around one per cent of GDP annually would signal the government's serious commitment to containing the Budget deficit.
Tax reform: As mentioned earlier, the country needs to implement wide-ranging tax reforms to simplify the system and expand the tax base. In this regard, the recommendations made by the task force headed by Vijay Kelkar under the previous government provide an important guide to possible tax measures that could boost revenue.
The main recommendations were to cut tax rates, broaden the base and close various loopholes. The task force also recommended that agricultural income should be taxed, with a few exemptions, and that the ceiling on the amount of home loan interest deductible for taxable income purposes should be reduced. More importantly, it proposed that tax rebates offered to various personal saving schemes should be abolished.
To make the corporate sector more competitive, the task force recommended that corporate income tax rates be lowered, but various exemptions abolished. In addition, the task force recommended increasing the tax administration's effectiveness by making more extensive use of technology.
Measures to extend the services tax net will be viewed positively, as they would help the government to tap additional resources, particularly because of the rapid growth in the services sector. Currently, the tax on services accounts for only 5 per cent of the total tax intake, compared to its share of 50 per cent in GDP.
Implementation of VAT: After long delays, the finance minister is expected to announce the implementation of the state-level value-added tax scheme, which will replace the current system of state sales taxes from April 1. This will simplify the indirect tax system, improve transparency and help reduce tax evasion, thus providing the basis for higher revenue growth in the future.
In the prevailing sales tax structure, several states impose a wide range of taxes, such as turnover tax and a surcharge on sales tax. However, with the implementation of VAT, these taxes will be abolished, and the central sales tax will also be phased out over time.
As a result, the overall tax burden will be rationalised and some expect prices in general to fall, benefiting consumers. In the initial three years, the central government is expected to compensate the states for losses from the implementation of VAT.
However, experience from other countries suggests that VAT tends to be revenue positive in the medium term. Moreover, Harayana (the only state that has implemented VAT) has experienced a very healthy growth in its VAT collections.
Expenditure management: Because of the inflexibility in public finances, the government needs to cut the bloated system of subsidies (on food and fertilisers). In the previous Budget, the finance minister refrained from cutting subsidies, but announced that a blueprint would be prepared for improving targeting of subsidies. Measures to phase out subsidies in the budget will be viewed positively. However, Fitch will look to see if the government succumbs to pressure from its more populist coalition partners to increase subsidies for the poor.
Infrastructure spending: The current government is likely to build on the success of the previous government in promoting infrastructure development. It remains to be seen how effectively the government uses extra resources from potential tax reforms to expand its investment in infrastructure. It is vital that extra revenue is used for capital rather than current spending, which is already very high.
Moreover, policy announcements that encourage public-private partnerships in expanding the network of highways, ports, airports, power and water supply and sanitation will be viewed positively. In this regard, the government has recently raised the foreign direct investment cap on civil aviation from 40 per cent to 49 per cent.
Spending on social services: The Congress-led coalition is aiming to increase spending on education to 6 per cent of GDP. To accomplish this, the government imposed a 2 per cent education cess on direct and indirect taxes in the 2004-05 Budget. Policy announcements to increase resources for this area will be positive. Similarly, the government is aiming to expand healthcare spending to 2-3 per cent of GDP; however, it remains to be seen how efficiently it can reallocate spending to meet this objective.
Agriculture: This sector is likely to be a priority and steps to increase investment in this sector could benefit overall growth (agriculture makes up 22 per cent of GDP) and foster consumption (as two-thirds of the population is employed in agriculture).
Efficient implementation of agricultural programs will be key to their success. Investment in irrigation facilities, development of rural infrastructure, crop diversification and increasing credit to the sector are likely to be the main elements of the government's strategy in this sector.
However, the increasing policy-based lending to the agriculture sector should be monitored closely as it could increase non-performing loans in the banking system.
Other policy statements regarding structural reforms:
Trade liberalisation: In recent budgets, India has been reducing its tariffs, which boosts competitiveness in the economy. The present government is committed to bringing tariffs in line with the ASEAN countries, and a further reduction in the maximum import tariff (20 per cent) will be welcomed.
Privatisation: The Congress-led coalition has scaled back the more aggressive privatisation plans of the previous government. Instead of strategic sales, the present government is likely to focus on selling unprofitable state-owned enterprises and residual stakes in partially-privatised companies.
Fitch expects a much more modest divestment target from this government (in the 2004-05 budget the present government trimmed the target to Rs 400 crore (Rs 40 billion), which was much lower than the Rs 16,000 crore (Rs 160 billion) the previous government had targeted in the interim budget for 2004-05).
An announcement regarding dilution of government stake in public sector banks will be viewed positively, although implementation of this measure could face opposition from the left-wing parties.
Foreign direct investment: FDI in India remains very low at 1 per cent of GDP and the restrictive FDI regime impedes growth. As such, a broad policy framework on FDI and liberalisation of FDI in key sectors is essential. However, resistance from Congress's coalition partners could inhibit any significant moves. As such, Fitch expects the government to continue with its piecemeal approach to increasing FDI caps in certain sectors.
For example, the government increased the cap on FDI in telecommunications to 74 per cent from 49 per cent previously, though so far it has been unable to increase the cap on FDI in the insurance sector (as announced in the 2004-05 Budget) owing to stiff opposition from the Left parties.
Interest rates on small savings schemes: The National Democratic Alliance government was gradually reducing interest rates offered on small saving schemes, which is essential for improving the health of public finances. Moreover, as the interest rate on small savings acts as a floor to bank deposit rates, the artificially high rates on this scheme reduces the effectiveness of monetary policy.
Unfortunately, the new government halted the decline in these interest rates and in view of its proclivity to boost rural incomes, it is unlikely that it will move aggressively to cut rates. On the contrary, the government recently increased the interest rate paid out on the Employees Provident Fund, India's largest pension fund. This step was widely portrayed as a move to appease the Left parties in return for their support in raising the cap on FDI in the telecom sector.
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