Road Map for Structural Reforms in Budget 2019
A Reality Check
M Govinda Rao (mgrao48@gmail.com)
is counsellor, Takshashila Institution, Bengaluru. The views are personal.
There were great expectations of
fast-tracking reforms in the budget. However, it disappoints in setting a road
map for creating a virtuous cycle of investment and growth. On the fiscal
front, the overambitious revenue projections raise questions of credibility and
feasibility of containing the deficits at the budgeted level. The wait for
banking and financial sector reforms continues. The selective increases in
import duties are retrograde, and increase in the taxes on the super-rich
complicates the tax system without much gain in revenues. The centralisation
through the levy of surcharges does not match the lip service given to
cooperative federalism.
The union budget presented on 5 July
was against the background of a difficult international environment and slowing
domestic economy. The International Monetary Fund (IMF) in its July forecast
for 2019 has lowered the growth rate of global output to 3.2% with downside
risks. The United States (US) growth is pegged at 2.6%, the euro area is
estimated to grow at 1.3%, and the estimate for the advanced economies taken
together is 1.9%. The growth rate in the emerging and developing economies
group is also subdued at 4.2%. The increasing trade tensions and tariff
increases between the US and China, the uncertainties caused by the Brexit in
Europe, and the adverse impact of the US sanctions on Iran and Venezuela have
caused much uncertainty about the global economy.
On the domestic front, the economy
has shown a continuous slowdown with the last quarter gross domestic product
(GDP) growth estimated at 5.8%, the lowest in the last five years. There has
been a steady decline in the rates of savings and investment since 2008–09,
though it has shown signs of bottoming out. The twin balance sheet crisis
continues to cripple the investment climate. The manufacturing sector gross
value added (GVA) growth was a low 3% in the last quarter and as the capacity
utilisation rate was already high, the acceleration in growth can be achieved
only with additional investments. The current account deficit has shown a
steady increase from 1.9% in 2017–18 to 2.6% in the first nine months of
2018–19. The agricultural sector is facing distress and micro, small and medium
enterprises (MSMEs) are yet to recover from the twin shocks of
demonetisation and suboptimal implementation of the goods and services tax
(GST). The exports have been stagnant and in fact, have shown a decline in dollar
terms. The withdrawal of the Generalised System of Preferences (GSP) by the US
comes as an additional setback. Among other growth engines, even private
consumption expenditure which had shown a strong growth momentum last year has
been slowing down. The fiscal constraints have curbed the growth of government
consumption from 15% in 2018–19 to 9.2% in the current year. In addition, the
unemployment rate at 6.2% was the worst since 1972–73.
The government, on its part, has set
very ambitious targets. It continues to reiterate its commitment to double
farmers’ incomes by 2022; proposes to increase the share of manufacturing GDP
from 17% to 25%; and wants to double exports by 2025. Most importantly, it
proposes to transform the economy from the current $2.7 trillion to $5 trillion
by 2025, which requires a minimum of 8% average annual growth, 4% inflation and
a constant exchange rate. All these require important structural reforms.
Against this background, after the
landslide victory received in the elections, there were high expectations that
the first post-election budget would kick-start the reform process to address
the structural problems to trigger a virtuous cycle of savings and investment
to accelerate growth, promote exports and create employment opportunities. The Economic Survey that preceded the
presentation of the budget, besides underlining fiscal austerity, emphasised
the need to generate a virtuous cycle of investment and growth. It underlined
that job creation, demand, exports and growth should be viewed as a part of the
overall strategy of creating a virtuous cycle rather than as separate problems.
The finance minister has tried to
bring in some reforms in the budget. The notable ones include the proposed
reform of regulation in higher education and the creation of the National
Medical Commission abolishing the Medical Council of India and it remains to be
seen how far the stated objectives will be met. There are proposals to redefine
the 51% controlling ownership in the public sector to include the stake held by
the government-owned financial institutions in addition to the government and
that is likely to provide greater room for disinvestment. The budget speech
also refers to the proposal to unify the multiple labour codes and it remains
to be seen how far this will go in initiating labour reforms. On the tax reform
side, the only important announcement is to extend the 25% rate to companies
with up to ₹ 400 crore turnover from the earlier limit of ₹ 250 crore.
Hopefully, this will eventually result in lowering of the rate to all
companies, but that should be followed by removal of various tax incentives to
broaden the base.
On the fiscal front, the situation
faced by the finance minister in preparing the budget was challenging primarily
due to the shortfall in the actual revenue collections in 2018–19, which is not
adequately reflected in the revised estimates. As against the revised estimate
of revenue of ₹ 17.3 lakh crore in 2018–19, the actual realisation according to
the Controller General of Accounts (CGA) was ₹ 15.9 lakh crore. The entire
shortfall was in tax revenues. Despite this, the fiscal deficit has been
contained at 3.4% of GDP by sharply cutting revenue expenditures (₹ 1.32 lakh
crore) and capital expenditures (₹ 13,700 crore). Much of the cut in revenue
expenditures is cosmetic, by cutting food subsidies of almost ₹ 70,000 crore
and asking the Food Corporation of India (FCI) to borrow from the National
Small Savings Fund (NSSF) with the liability borne by the government.
Credibility
of Numbers
This brings into question the
credibility of the numbers presented in the budget. While the budget speech
makes unflinching commitment to fiscal consolidation, a close look at the
estimates shows an increasing resort to obfuscate the deficit estimates. The
cut in food subsidy is not due to any policy reform but by temporarily
transferring the liability to the FCI. The Comptroller and Auditor General of
India (CAG) in his presentation to the Fifteenth Finance Commission seems to
have drawn its attention to the fact that the fiscal deficit of the centre in
2017–18 was 5.85% when off-budget liabilities are considered as compared to the
reported 3.5%. Apart from the deferred payments to the FCI and fertiliser
companies and deferred tax refunds substantial borrowings are done through
parastatals such as National Highways Authority of India (NHAI) and Indian
Railway Finance Corporation (IRFC). These are besides the cosmetic
disinvestment proceeds arising from one public sector enterprise buying the
shares of another and remitting the proceeds to the government. The estimates
show that for 2018–19, if all off-budget borrowings are considered, the
consolidated fiscal deficit of the centre and states works out to 8% to 9% of
GDP which is far in excess of the household sector’s financial savings of 7%.
In the event, liquidity problems are real and government has been indirectly
monetising the deficits through open market operations and currency swaps.
These practices raise questions of credibility.
The credibility issue is also due to
the unrealism of the budgeted revenue estimates when viewed against the actual
collections reported by the CGA. To achieve the target of ₹ 19.78 lakh crore in
2019–20, the revenue receipts are required to grow at 26.5%. The required
growth in net tax revenue is 25.3%, which implies a buoyancy of 2.1, and the
non-tax revenue is expected to increase by 27.2%. With the economy slowing down
and GST not kicking up the buoyancy contrary to expectations, it is not clear
how this staggering growth in tax revenues can be achieved. On non-tax
revenues, a major source of additional revenue projected in the budget is from
disinvestment. This is expected to generate ₹ 1,05,000 crore which is higher
than the interim budget estimate by ₹ 15,000 crore. The budget speech also
speaks about an active disinvestment policy beginning with Air India and
hopefully, the government will pursue this aggressively. Even so, the estimate
is far too optimistic. Another source of non-tax revenue which is expected to
increase is the dividend mainly from the Reserve Bank of India (RBI). The
dividend receipts budgeted at ₹ 1,63,528 crore are higher than the estimate in
the interim budget by ₹ 21,457 crore.
There are serious adverse
consequences of ambitious revenue projections. First, the inability to achieve
the targets results in unplanned cuts in expenditures and often, the casualty
are the capital expenditures. Presently, the growth in capital expenditure over
the pre-actuals reported by the CGA is 11.8% and even this looks unrealistic.
Alternatively, there will be slippages in realising the fiscal deficit target.
Second, as 42% of the divisible pool of central taxes is devolved to the
states, shortfall in revenue collections from the budget estimate has an
adverse impact on the budget management in all the states. Finally, optimistic
tax revenue projections lead to high revenue targets to the collectorates which
in turn, results in exaggerated demands and erroneous assessments. The report
on direct taxes by the CAG for 2015–16 had pointed out that 65% of the cases in
tribunals, 79% in high courts and 71% in the Supreme Court were decided in
favour of assesses and the consequent interest payment by the government to the
assesses amounted to more than ₹ 70,000 crore!
Reform
Signals
On the reform front, while much was
expected, the budget has been clearly disappointing. There are very few
initiatives in the budget that can steer the economy to acceleration, leave
alone changing the gear to achieve the aspirational goal of achieving 8% growth
to reach a $5 trillion economy by 2025. On the contrary, some of the measures
take us back to the pre-reform era. Over the last couple of years, there has
been a steady increase in import tariff in the name of “Make in India” and with
the US dispensing with the GSP, it was hoped that there will be an attempt at
lowering tariffs and unifying the tariff rates. The act of increasing import
duties could invite reciprocal actions. While the attempt since 1991 has been
to bring down the tariffs to the levels in South- east Asian countries, the
last few years have seen its reversal.
Not much thinking seems to have gone
into the selection of items of increase in customs duty. We have abandoned the
import substitution policy for good reasons and to resurrect it in the name of
“Make in India” is clearly retrograde. It is not clear why the items like vinyl
flooring, tiles, metal fittings, mountings for furniture, some kinds of
synthetic raisins, auto parts, closed-circuit television (CCTV) cameras,
digital and network video recorders and even imported books and newsprint were
chosen for increasing the import duty. The problem with such a selective
approach is that it alters the effective rate of protection in unintended ways,
creates special interest groups and reduces competitiveness. The increase in
the import duty on gold from 10% to 12.5% is an invitation for smugglers!
The critical initiative now needed is
to deal with the twin balance sheet problem immediately so that the industry
can borrow, and the banks can lend. On the latter, the government has, yet
again provided ₹ 70,000 crore of taxpayers’ money for recapitalisation, but has
not initiated the much-needed reforms in the governance structure of public
sector banks. There is an urgent need to distance the functioning of the public
sector banks from the government and the consolidation of some banks is not
going to solve the problem. The Banks Board Bureau (BBB) has not achieved much,
and it is time serious governance reforms are initiated on the lines recommended
by the Nayak Committee including the creation of a holding company to exercise
control.
The Infrastructure Leasing and
Financial Services (IL&FS) crisis has brought to the fore the serious
lapses in both governance and regulation in non-banking financial companies
(NBFCs). There are failures in auditing and credit rating systems and proper
and effective regulation. Even more importantly, there is a serious structural
problem of time profile of credit–liability mismatch. The assertion that the NBFCs
should continue to get funding from banks does not solve the problem of
advancing short-term funds for long-term investments. Similarly, advancing
one-term six months’ partial credit guarantee to public sector banks during the
current financial year is a patchwork solution. Of course, vesting the
regulatory power of both NBFCs and the National Housing Bank (NHB) to the RBI
and the proposal to strengthen its authority helps to bring clarity to the
regulatory turf, but much more needs to be done to both improve their
governance and address their structural problems.
The recent Organisation for Economic
Co-operation and Development (OECD) study has shown that the corporate tax
rates in India are very high, estimated at almost 48% when the dividend
distribution tax and surcharges are included. It is important to have a
competitive tax system to ensure the flow of foreign direct investment into the
country. The 2015–16 budget promised to bring the basic rate down to 25%. This
was implemented for companies with ₹ 250 crore turnover in the 2018 budget and
the present budget has extended it for companies with a turnover up to ₹ 400
crore. Although these companies constitute 90%, their tax payment is less than
10%–15%. While the fear of revenue loss at this juncture is real, it is
important to revive the investment climate now, and reducing the rate on the
incomes of all corporates by removing various concessions in a revenue-neutral
manner would have helped.
An important trend seen is to
increase the exposure of the Indian economy to international flows. The recent
decision to buy longer duration foreign exchange amounting to $10 billion
through rupee swap under the liquidity management facility by the RBI has
increased the exposure to some extent. The decision to borrow from the
international capital markets by selling sovereign bonds taken in this budget
increases the vulnerability. Given the fact that the public sector domestic
borrowing exceeds the household sector financial saving, this is thought to be
the easy way to manage liquidity. In fact, in 2018, the RBI undertook open
market operations amounting to about ₹ 3 lakh crore which is nothing but
indirectly monetising the deficit. Now with the decision to sell sovereign
bonds in international capital market, another route for monetising the deficit
with exposure to international currency is created. The argument that this is a
cheap source is misplaced because, in addition to the interest rate, it carries
the exchange rate risk as well. Presently, the rupee is said to be overvalued
to the tune of over 25%. Correcting this would sharply increase the cost. If
the exchange rate is not changed to limit the increase in liability, it will
hurt exports.
Another disappointing measure in the
budget was the introduction of super tax surcharge on the very high income
earners. It is proposed to impose an additional surcharge on income earners
between ₹ 2 crore and ₹ 5 crore at 3% and those above ₹ 5 crore at 5%. While
there is nothing wrong with the super-rich being asked to pay more, if the high
rates of tax lead to the flight of investors, the measure will be
self-defeating. Our past experiences have taught that extortionary taxes do not
yield revenues but cause economic harm. More importantly, the measure has led
to complicating the tax system. While the need of the hour is to rationalise
the tax system by weeding out concessions and preferences, imposing additional
surcharge only helps to complicate the tax system.
Cooperative
Federalism
The budget is eloquent in stating that
during the last five years the government has followed the centre–state dynamic
and cooperative federalism. However, a close examination of the proposals shows
that the intention is exactly the opposite. The problems that the states will
face in their budget management in the event of shortfall in tax revenue have
already been pointed out. The central government continues to encroach on the
states’ subjects by expanding the centrally-sponsored schemes (CSS). At the
same time, it is reported that an additional term of reference is being given
to the Fifteenth Finance Commission to explore creation and operationalisation
of a “separate fund for funding defence and internal security,” which appears
to be a pressure tactic to nudge the commission to reduce the share of states
in the divisible pool.
The two important developments
impacting on fiscal federalism in India that the government has done after the
Fourteenth Finance Commission’s recommendation of increasing the states’ share
in the divisible pool were: (i) to increase the states’ contribution to various
CSS in the name of rationalisation; and (ii) make discretionary changes in
taxes to raise cesses and surcharges to deny the states the share in the new
revenues. This budget has continued the practice of raising additional tax
revenues predominantly through cesses and surcharges. As mentioned earlier, the
income tax rates on the super-rich are being raised through additional
surcharge. In the same vein, the Special Additional Excise duty and Road and Infrastructure
Cess were raised by ₹ 1 each on petrol and diesel. The total revenue from
cesses and surcharges administered by the Ministry of Finance as a ratio of the
centre’s net revenue which was just about 3% of net tax revenue of the centre
in 2015–16 is estimated at 9% in 2019–20.
Concluding
Remarks
Considering the difficult global
environment and continuing deceleration in the Indian economy, the budget was
expected to initiate reforms to provide a clear road map for growth
acceleration. The unprecedented electoral mandate reinforced this belief. With
the Economic Surveyemphasising the
need for creating a virtuous cycle of saving and investment and the narrative
of reaching the $5 trillion economy being advanced, the budget was expected to
lay down a clear road map for accelerated growth and development.
Unfortunately, a closer analysis
shows that not much can be seen on the reform front. The fiscal numbers are
disturbing. There is overestimation in revenues and either the expenditures
will have to be cut drastically, or the fiscal deficit target will be breached.
The fiscal management of the states too will come under severe pressure if the
budgeted revenues are not realised. The selective increase in import duties is
retrograde and increase in the taxes on the super-rich complicates the tax
system without much gain in revenues. The decision to access the foreign
capital market to sell sovereign bonds may not be as cheap as it is made out to
be and will increase the vulnerability. On federalism, while the generous lip
service promoting cooperative federalism has by now become common, the attempt
at fiscal centralisation continues.
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