India Budget Preview: admirable fiscal restraint, but pivot needed from quantity to quality
With general elections expected to commence in less than two months, India’s government will present an interim budget (“vote on account”) to Parliament on Monday, February 17, which will stay in effect till the new government announces a full Budget after assuming office.
Like last year, there have been growing concerns about the government missing its budgeted fiscal target. But, like last year, we expect the government will not only meet its budgeted target (4.8% of GDP) but likely beat it, and we expect the FY14 outturn to be closer to 4.7% of GDP. On a cyclically-adjusted basis, after netting out asset sales, this would constitute a consolidation of 0.3% of GDP which – though smaller than last year’s 0.7% of GDP consolidation -- reveals admirable fiscal restraint, given the pressures of an election year. However, the quality of the consolidation remains a concern, with tax revenues continuing to slump, forcing the government to engage in non-tax one-offs, push out expenditures to next year, and run up arrears on the subsidy front.
For next year, we expect the government to target a deficit of 4.2% of GDP – per the fiscal road-map, corresponding to a gross issuance of government bonds to the tune of Rs 6-6.3 trn. Interim Budgets cannot amend tax laws, and so conventionally have avoided major tax changes—particularly on direct taxes – and so we expect a series of smaller proposals, particularly on the indirect tax front. Instead, interim budgets have typically been high on intent, focusing more on expenditure allocations – although this is only applicable for a few months – and laying out a vision for the future.
All that said, achieving a consolidation of 0.5% of GDP next year – as the budget is expected to propose – will be challenging and need a combination of accelerating growth, a greater mobilization of tax revenues through rationalizing rates or increasing the base, and rationalizing fuel and fertilizer subsidies to accommodate increased food subsidies under the Right to Food Security Act.
FY14 deficit to meet – and likely beat – budget estimates
It seems like ground hog day all over again, with due apologies to Bill Murray. Six months before the end of last financial year, there was a widespread belief that the government’s ability to meet the fiscal deficit number last year was nigh impossible. The Budget had proposed a deficit of 5.1%of GDP, and half way into the year a 6% handle was looming. To their credit, not only did the government meet their budgeted target, they actually beat it with the actual deficit printing at 4.9% of GDP. This has further been revised down to 4.8% of GDP with nominal GDP recently being revised up.
History is about to repeat itself, as a similar cycle of concern-resignation-wonder- relief has played out this year too. Till as recently as December, market participants were convinced of significant fiscal slippage, given that 95% of the budgeted deficit had been exhausted. However, just like last year, we expect the FY14 fiscal deficit --- faced with the external pressures of a sovereign ratings threat -- will stay within budgeted estimates (4.8% of GDP) and is, in fact, likely to over-deliver by printing closer to 4.7% of GDP.
A cyclically-adjusted consolidated of 0.3% of GDP
On the face of it, an outturn of 4.7% of GDP in FY14 versus 4.8% of GDP in FY13 would suggest barely any consolidation. But this is misleading for at least two reasons: , because it needs to take account of asset sales (which are simply an exchange of assets between the public and private sector and therefore do not result in a withdrawal of stimulus) as well as accounting for where in the business cycle the economy was.
With asset sales expected to contribute 0.4% of GDP in FY14, versus 0.5% in FY13, net of asset sales, the consolidation is 0.2% of GDP.
At the outset this may appear modest, but remember the adjustments have happened in a period of very low growth: the first time in 26 years that GDP growth has printed below 5% for two consecutive years, with a sharp fall in tax buoyancy as a result. Therefore one needs to adjust for business-cycle conditions to get a true measure of the underlying fiscal stance. On a cyclically adjusted basis, the consolidation was 0.3% of GDP which – while lower than the 0.7% of the previous year – still constitutes admirable fiscal restraint in an election year.
Quality of consolidation remains a concern
The larger concern, however, is the quality of the compression. Reaching the fiscal deficit target in the previous year (FY13) was a scramble and entailed a sharp compression of Plan expenditures (which are more productive) in the last few months of the year. Against that back-drop, this year’s Budget targeted a more desirable and balanced mode of consolidation. The gross tax-to-GDP ratio was budgeted to rise to 10.9% of GDP from 10.1% the previous year, Plan expenditures were budgeted to rise almost 30% -- so as to make amends for being slashed the previous year – and subsidies were budgeted to be reduced a whopping 0.7% of GDP, from 2.6% to 1.9%.
We had always found the tax buoyancy and subsidy rationalization proposals to be ambitious (see, “India’s workmanlike Fy14 budget disappoints markets,” MorganMarkets, February 28, 2013) but if the government had able to achieve the proposed mix, it would have been a balanced, efficient and desirable means to undertake the adjustment. As it turns out, however, the consolidation wasn’t able to be carried out in the aforementioned manner.
For starters tax collections have severely disappointed, with the gross tax to GDP ratio expected to print at 10.1% of GDP – a whopping 0.8% of GDP below target, and even lower than the 10.3% of GDP in the previous year. Tax buoyancy has fallen further on weak growth impulses.
The government also budgeted a hefty 2.1% of GDP in non-tax revenue, but this appears to be on course to being met, though through a different mix than was originally envisioned. Disinvestment proceeds will end up appreciably below the 0.5% of GDP that was budgeted. But this will be largely offset by higher dividends from public sector enterprises, and a better-than-expected telecom auction. Yet, substituting stake sales with dividends may not be the best mix, as the latter could end up compromising potential investment that would/could have materialized.
To compensate for these shortfalls, authorities have adopted the same approach as last year – a sharp squeeze in Plan expenditures towards the end of the year – estimated to be between 0.8- 1% of GDP. In particular, given the current run-rate of capital expenditures, we expect non-military capital expenditures to likely print about 0.3% of GDP below what was budgeted.
Separately, the three major subsidies (food, fertilizer, fuel) have already consumed 1.8% of GDP in the first nine months of the year, against a full year budget allocation of 1.9%. Given the current run-rate, we expect subsidies to end the year close to 2.3% of GDP, but we expect the revised budget to reflect a cash subsidy outgo of between 2.0-2.1% of GDP, with the rest being accrued as arrears to be paid in the next financial year.
So while authorities deserve credit for the degree of fiscal restraint, the focus must be on improving the quality of the adjustment. Postponing Plan expenditures for a second successive year, running up arrears, and relying on one-off dividends from public sector enterprises cannot be a strategy for sustained consolidation. That said, one can argue that authorities had little choice. Given the concerns around India’s twin deficits, the pressure that currency was under, and the risk of a ratings downgrade, fiscal slippage had to be avoided at all costs. With growth weak and revenues disappointing, the government had limited degree of freedom. All this cries out for more fundamental fiscal reform – more base broadening, a goods and services tax, bringing all subsidies under the gambit of the UID to reap the savings from de-duplication – if the medium term path of fiscal consolidation is to be made sustainable.
Interim budgets typically high on intent, but constrained on tax front
With this being an election year, the government is not authorized to present a full budget, but instead a “vote on account” whose main purpose is to seek parliamentary approval for expenditures to run the government for the next few months until the next government is in place (in May) and presents a full Budget for the rest of the fiscal year.
Given this, the government will not be able to propose major tax changes that entail amending any law on the books (Income Tax Act, Customs Act or Excise Act). But changes to the rate structure of indirect tax, for example, which simply entail a notification in Parliament can be introduced, as was done in the interim budgets of 2004 and 2009. Conventionally, therefore, vote on accounts have avoided major direct tax reforms or changes. However, we believe a number of small changes on taxes and duties are possible, including:
However, like in previous interim budgets, we expect the focus to be on the expenditure side, with the government likely announcing healthy increases in current programs, even as no new schemes are typically announced. Interim budgets have therefore typically been high on intent, with the incumbent government using it as an opportunity to lay out a vision and road-map for the future, and we expect that to continue this time around too.
FY15 fiscal target likely at 4.2% of GDP; will be challenging to achieve
In line with the medium-term road-map set out by the government, we expect the FY15 budgeted fiscal deficit to be 4.2% of GDP, which would entail an adjustment of 0.5% of GDP next year
But unless growth were to accelerate sharply, significant base broadening measure or tax rate changes are proposed in the budget by the new government, or subsidies are appreciably rationalized it will be challenging to achieve.
For starters, some of the burden of the adjustment will have to be borne on the revenue front. In FY14, the gross tax to GDP ratio slumped (to 10.1% of GDP from 10.3%), as tax buoyancy waned further in the face of weak growth and compressed corporate margins. This put disproportionate burden on the expenditure front and has resulted in a meaningful reduction in Plan expenditures for a second successive year. Already, the total expenditure envelope (at 13.9% of GDP) has seen a significant compression over the last three years and is even below the average levels in the three years pre-crisis (14.1% of GDP). So there are limits on how much more expenditure compression can be exercised.
This is particularly true because food subsidies are expected to rise in FY15 as the Food security Act gets rolled out, and will pressure the total subsidy bill. We expect the FY15 budget to peg subsidies at 1.75% of GDP – in line with the target set out 3 years ago, and down from an assumed 2% of GDP this year. But for that to happen in an environment of higher food subsidies, fuel and fertilizer subsidies would need to be significantly rationalized.
Given all this, some of the burden of the 0.5% adjustment in FY15 will have to be borne by tax revenues (since there are limits as to how much more can be garnered in non-tax revenues), which would need to entail some combination of stronger growth, a broader base, and selective increase in rates in the Budget later this year.
All this suggests the need for more fundamental tax reform – especially the goods and services tax (GST) – could not be more urgent.
Expect gross borrowing in the range of Rs 6.1-6.4 trillion
Under our assumption of a fiscal deficit of 4.2% of GDP in FY15 and the fact that 90% of the deficit is typically funded through government securities (vis-a-vis small savings schemes, drawdown of cash balances etc), we expect a net borrowing requirement of Rs 4.7 trillion. With total redemptions of Rs 1.56 trillion coming due next fiscal, the gross borrowing requirement is expected to be close to Rs 6.3 trillion (see, “FY15 India gov bond supply INR6.25tn, 11% up vs. last year,” MorganMarkets, February 13, 2014) – a number that markets appear primed to expecting. The risks could be slightly skewed to the downside given the government is expected to end the year with large cash balances which it could run-down to finance next year’s deficit. Also, small savings mobilizations have been stronger than budgeted, and if that is assumed to hold next year as well, it could induce authorities to potentially finance a slightly smaller fraction of the deficit through market borrowing. All told, we expect gross borrowing to be in the Rs 6.1-6.4 trillion range.
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