In this post, Nirvikar Singh discusses what we can learn from the recently presented Union Budget about the possible direction of India’s economy. He contends that, though the Budget is positive in terms of its potential impacts on India’s economy, the difference from recent years is a need for focus and implementation with an urgency that has not been needed for some time.
This year’s Union Budget comes at a delicate time for India’s economy. On numerous occasions in the past, India has faced economic challenges, but those memories had receded as the nation seemed to be entering a new phase of development and growth. However, the months since the last general election, and since the last Budget have seen worsening economic news, and increased political divisiveness. What can we learn from the new Budget about the possible direction of India’s economy?
The Union Budget is a part of a larger national fiscal landscape. State governments are also critical, while local governments should be, but are not ─ they remain unduly stunted. Coincidentally, the Fifteenth Finance Commission just made its recommendations for tax sharing and other devolution from the Union to the states. There are also numerous public enterprises whose finances often do not show up directly in government accounts. All of these aspects of government finances matter for the Union Budget. But even putting everything together, India’s government is not large.
After allocating the states’ share of tax revenues and other devolution recommended by the last Finance Commission, the net revenue of the Union government, commonly referred to as the Centre, was just 9.45% of GDP (gross domestic product), based on 2019-20 Revised Estimates. Its expenditure was only 13.20% of GDP. The difference is the widely-quoted fiscal deficit, of 3.75% of GDP. But note that the Centre’s revenue was less than 72% of its expenditure, as measured by its budget accounts. This reminds us how fragile is the Centre’s revenue-raising capacity, and how limited is its ability to influence the economy directly through its expenditures.
The macroeconomics of the Budget
Fiscal deficits are bad to the extent that they are associated with unproductive government expenditures, crowding-out of productive private-sector investment, high future interest payments, greater inflation pressures, unsustainable commitments to foreign creditors, or any combination of these issues. These concerns are what led to legislation that provided guidelines and targets for fiscal deficits for the Centre. This year, the Budget had to use an ‘escape clause’ to allow for a planned deficit above the target. Indeed, last year’s deficit target has not been met in the face of a slowing economy and challenging implementation of the Goods and Services Tax (GST).
Economic theory does not tell us what the right level of the fiscal deficit should be. On theoretical grounds, one can also argue that the revenue deficit, which does not count net capital expenditures, is more pertinent, since government investment should lead to future growth. On the other hand, the Centre also borrows off-Budget, through public enterprises and captive household savings, adding 1-2% to the actual fiscal deficit. On top of that, there are the deficits of the state governments and their public enterprises, which are ultimately the responsibility of the Centre, since defaults at the state level would be disastrous.
The bottom line is that the Union Budget by itself provides limited information about macroeconomic consequences. On Budget day itself, markets seemed to think that the stimulative effect of the Budget was inadequate, but (as the Finance Minister herself suggested they would) they have reversed much of that initial pessimism. The stimulus also is in the context of rising inflation, though one might make an argument that the inflation is concentrated in food items, and ought to be tackled by structural reforms in agricultural production and markets, rather than contractionary monetary policy. Another complication in predicting any transmission to inflation (via monetary accommodation) is, of course, the continued use of financial repression – although it is less than it was in the ‘old days’. One also has to note that the projections of government revenue may be overoptimistic, in which case, if expenditure is sustained, the true stimulus will be higher. In the absence of any strong evidence to the contrary, perhaps one can say that the Budget did a reasonable job in terms of possible impacts on macroeconomic stability and short-term stimulus.
The impact of the Budget depends on the levels and types of revenues and expenditures, since who gets more or less, and how much they spend or save, will determine the aggregate impacts. Almost all Indians pay indirect taxes, since they buy goods and services, where the GST comes into play. The Budget continues a process of improving the design and implementation of the GST, which was initially too complicated and cumbersome. The GST will remain a work-in-progress for some time to come, but it may ultimately be a crucial component in improving India’s relatively low tax-to-GDP ratio.
On the other hand, relatively few Indians pay direct taxes, in the form of income taxes. That will take longer to change. The Budget’s attempt to simplify the income tax structure, by lowering rates in the middle tiers, but tying that to giving up various exemptions or deductions, is very promising. The government’s calculations suggest that many households in these middle-income tiers do not avail of all exemptions, and will be better-off opting for the new tax structure. Since they can also stick with the old structure if their exemptions are high, the net effect will be to put money in the pockets of some households, without taking away from others. Simplifying tax preparation and filing could have long-run benefits of encouraging people to file returns. But expanding the tax base significantly will require massive structural change in the Indian economy and creating many more formal-sector jobs – and that is yet to take place – even after almost three decades of economic reform. More on that below.1 The Centre had already cut corporate tax rates in an earlier year, and the main change in this budget is elimination of the Dividend Distribution Tax – dividends will instead be taxed as income of the recipients, so it is not a major revenue issue.
The two biggest question marks and challenges on the revenue side are the projected revenues from spectrum auctions and disinvestment of public enterprises. Auctions are well-designed for revenue-raising, but the problem, as we are seeing now, is that achieving goals of a high-quality telecommunications infrastructure, wide access through affordability, and sustainable competition among providers are not necessarily supported by revenue-maximising auctions. On the other hand, the public telecom providers are inefficient, and allocating spectrum without using some kind of auction is subject to corruption, as we saw in the past. So, this is not an easy problem to solve, aside from the undue reliance of the Centre on revenue from this source. Disinvestment has continual problems of opposition from various quarters2. The design of disinvestment and achieving multiple goals of greater efficiency and raising revenue have proved to be ongoing challenges for the government, and the latest Budget gives no indication that the answers have been found.
Customs duties, or tariffs, are also taxes, although their importance as a revenue source is much less than in the past. This Budget, like many before it, has numerous tweaks to various tariffs, but these seem to be designed for protecting certain industries or types of firms, rather than for generating revenue. Whether Indian tariff policy is helping the economy is a complicated issue, but it does seem that there is an overreliance on such measures, when more direct ways of supporting particular types of firms or sectors would be more efficient3.
The Union government remains locked into a complicated mix of schemes and discretionary transfers, designed to achieve a wide range of economic policy goals, often aimed directly at household welfare (including health, education, and income support), but also at the level of infrastructure provision. The current Budget has no significant new schemes, and it is always difficult to assess the aggregate or distributional impacts of adjustments in spending plans (less for employment guarantees, more for payments to farmers, etc.). The real issues remain the quality of expenditures, the ability to monitor expenditures and evaluate outcomes, and whether the spending is assigned to the right level of government, where it can be done most effectively, with the best chance of accountability. These are all structural-reform issues that are beyond the basic scope of budgeting, though they are what ultimately matter. That said, at least conceptually, the Centre has an impressive array of more-or-less targeted expenditures, which, in a relatively poor country with a small government, provide its population with various safety nets.
Reforms and growth
Policy proposals that can influence the future course of the economy are not a core part of the revenue-expenditure-borrowing accounting of the Budget, but they have become an indispensable part of the exercise. Again, there are many specific proposals, often still remaining to be fleshed out, and their ultimate impact depends on these design details as well as implementation. In the Budget speech and associated documents, one can see the lingering influence of import substitution and mercantilist views, but also a major change from the ‘old days’ in the desire to attract foreign investment, whether in government bonds, or in new factories. Whether the overall effect is positive for the target groups of investors will also depend on whether the government can rein in its impulses with respect to cultural purity, and allow for India’s diversity to flourish.
The Budget rhetoric also speaks to fears of tax harassment, but there are proposals designed to make sure that globally itinerant Indians do not entirely escape the tax net in their home country. One can detect a continued tension between the moralistic streak that has often characterised Indian governments of all ideological leanings (but are perhaps particularly strong in the current government), and the acknowledgement that there have to be appropriate incentives for doing business in India. These moralistic tendencies will also need to be curbed to allow a rapid expansion of higher education, with more foreign entrants and internationally competitive salaries.
Ultimately, India needs to create many more formal-sector jobs than it is doing now, and that means creating many more firms, and growing existing firms more effectively. Some investors may have been hoping for scuppering the long-term capital gains tax, which did not happen, but continued attention in this Budget to making risk-taking more attractive for start-ups may be a good way to go. If ‘Assemble in India’ and its older relative, ‘Make in India’, can actually be made operational through targeted infrastructure investments and integration in regional production networks, then tax breaks – especially for large firms – may be less relevant. The failure of the share of manufacturing in Indian GDP to budge in three decades of economic reform is the biggest indictment of that process so far. Success will come not from major changes in revenues or expenditures, but from changes in governance and the behaviour of politicians, bureaucrats, and judges. And the elephant in the room remains the need to clean up balance sheets in the financial sector, which will require government budgetary resources, as well as speed and focus.
The latest Union Budget, like many in recent years, has a range of proposals and ideas, some promising, others less so. But on balance, it is clearly positive in its potential impacts on India’s economy. The difference from recent years is a need for focus and implementation with an urgency that has not been required for some time. That is not a matter of revenues, expenditures or deficits, but of people and organisations. On that dimension, one has to be more agnostic about India’s current government.
- As an aside, urban property taxes collected by cities are probably where major improvements can be realised, but that will be up to the states to tackle.
- Opposition to disinvestment is from both affected workers and those who think in terms of prestige (airlines) or equity (job protection).
- This is, of course, a basic feature of most economic models of international trade.