The merits of fiscal prudence

By sticking to the fiscal consolidation roadmap, the Union budget has obviated instability. The focus should now be on state capitals, whose budgets need greater market scrutiny

Written by Neelkanth Mishra | Published:March 2, 2016 12:28 am
budget, state budgets, union budget, state budgets 2016, 2016 budget, 2016 budgets, budgets 2016, union budget 2016, budget analysis, budget news, india news States spend substantially more than the Central government. But there is limited attention paid by the media and even analysts.

Some are calling this a political budget. But that’s like blaming a businessman for focusing on profits — what he does to generate the profits should be judged, not the desire for profits. In a similar vein, an elected government targeting votes is stating the obvious — they need to be judged on how they go about it. If they go about their vote-seeking without creating medium- to long-term impediments to economic growth (my remit is purely the economic), the efforts should be lauded.

In the run-up to the budget, there seemed to be a temptation in some sections of the government to further push out the fiscal consolidation. It’s not hard to imagine the arguments favouring that — it’s not enough being the fastest-growing economy in the world and the political necessity is absolute growth that creates jobs; in fact, to offset the drag from a slower global economy, the government ought to do more. Further, the three critical risks of a higher fiscal deficit — higher inflation, higher interest rates and a weaker currency — could all be offset by global trends.

Most large economies are struggling with deflationary risks, negative interest rates, and widespread devaluation of fiat currencies.

This may have worked, but not before creating macroeconomic turbulence. Foreign investors in Indian bonds are the bond market equivalent of adventurers: The outstanding amount of Indian bonds that foreigners can buy is not large enough for India to be part of any major bond indices. So there is no necessity for these investors to be in India — the ones who are invested in India are attracted by the good yields and macroeconomic stability. A whiff of potential instability, and these investors could stampede out, putting in motion a scenario not unlike (though perhaps not as severe as) what happened in the summer of 2013. The discourse on India would quickly change to almost forgotten debates, like if the country has sufficient currency reserves or do rates need to be hiked. Bond markets were already starting to get jittery in the run-up to the budget. That the government chose to stick to the fiscal consolidation roadmap obviates this period of instability.

This episode highlights India’s institutional strength. The government by definition (given that it needs to be re-elected) would want to spend more; but the RBI, playing its role in the economy, stood its ground in demanding fiscal prudence. This balancing interplay of institutions is a structural positive for India, irrespective of whether the RBI follows through with a rate cut or not.

By sticking to the word it gave earlier, the government boosts its credibility. This trust is also bolstered by it being very conservative in its budgetary assumptions. It also makes the big uncertainties on the fiscal front dependent on government execution rather than overly aggressive growth or tax estimates that are harder to debate. There are four major fronts on which there is risk of slippage: An inadequate provision for the pay commission recommendations (the jump in salaries and pensions is provided for, but not the increase in allowances), no increase in the amount set aside for recapitalisation of PSU banks, a clearly optimistic assessment of proceeds from telecom spectrum sales, and a persistence with the strategic disinvestment figure despite repeated disappointments in prior years. Put together, these can add up to nearly Rs 90,000 crore, in our estimate. At the same time, we also believe overly cautious tax receipt projections have created a significant buffer that can offset slippage on some or all of these fronts. Proceeds from the tax amnesty scheme, currently not accounted for in the budget, should also support the achievement of the 3.5 per cent target.

The reliance on extra budgetary resources to continue its investment in (mainly) roads and railways is also a prudent choice. These heads of expenditure have a high fiscal multiplier — that is, according to separate RBI and NIPFP studies, for every rupee spent on these, nearly Rs 2 gets added to the country’s output in the very first year. The government has chosen to fund these through direct fund raising for roads and railways rather than through general government borrowing. This has two advantages: First, investors are more likely to provide funds for specific productivity-boosting investments backed by real assets than for general government borrowing that can potentially be frittered away. Second, a higher headline fiscal deficit pushes up bond yields throughout the economy, and thus raises the cost of borrowing for more than just the government.

On other fronts, there are several steps taken that seem retrograde or half-hearted — the dividend distribution tax on recipients of dividends, for example, is effectively triple-taxation, even if it’s politically hard to oppose. The much-needed boost to housing, one of the key self-imposed targets for the government, also seems inadequate and tentative. This is even as, encouragingly, deadlines for other targets on electrification and all-weather road connectivity for villages have been pulled forward.

The non-fiscal measures taken to simplify tax administration, in attempting to reduce the discretion available to tax officers (by reducing the upfront penalty that needs to be paid from 50 per cent to 15 per cent), or the set-up of new benches to speed-up tax dispute resolution, seem minor, but can have a meaningful impact in the day-to-day lives
of businesses.

At the risk of sounding like a broken record, the importance of the Union budget for the economy has fallen meaningfully in the past two decades. In addition to the growing role of the private sector, the amount of funds and the discretion available to state governments have risen as well. Put together, they now spend substantially more than the Central government.

But there is limited attention paid by the media and even analysts — note the surprise in the bond markets — when state governments’ fourth-quarter borrowing schedule was finalised. Attention should now move to state capitals — greater market scrutiny is necessary to improve the quality of their budgeting exercise.

The writer is the India equity strategist for Credit Suisse