Budget 2012: India Continues Modest Fiscal Consolidation, But Budget Lacks Bold Reforms

Continuing Focus on Medium-Term Fiscal Consolidation

India's Congress-led United Progressive Alliance (UPA) coalition unveiled the fiscal year (FY) 2012/13 budget on 16 March, proposing modest fiscal consolidation and reform, largely avoiding bold statements or many surprises. Finance minister Pranab Mukherjee's 14.9-trillion rupee (USD296.7-billion) budget for FY2012/13 (ending March 2013) highlights the government's plans to modestly shrink its deficit while boosting flagging economic growth. Following recent years' commitment to re-prioritising fiscal discipline and bringing down public finances, and in the wake of last year's significant overshooting of deficit targets, the government continues on its path of fiscal consolidation.

Key spending proposals have been made in important sectors including infrastructure, agriculture, and social programmes, and the budget aims to cap subsidy spending on oil and other products. The government is attempting to direct fiscal policy more prudently. The union budget also assumes tax revenue increases of 20% through modest changes to the tax regime and a cyclical increase in tax revenues. The UPA administration expects the removal of some exemptions on excise duties and broad-basing the service tax to balance out higher income tax exemptions. Corporate taxes remain unchanged. The proposals also expand divestment and privatisation initiatives to increase government revenue receipts.

On the expenditure front, the budget increases capital spending, slated to increase by 31% in FY2012/13, and current spending is aimed to grow by a 11% on last year. Concomitantly, subsidies are forecast to decline 14%, with oil and fertiliser subsidies falling and food subsidies rising marginally. The government seeks to cap subsidy spending at under 2% of GDP and to 1.7% of GDP in the next three years. With fast-rising oil prices from firm global demand and uncertainty in the Middle East, the subsidy numbers seem unrealistic. The government plans higher-than-expected market borrowing of INR4.8 trillion, but market borrowing could end up slightly higher with the uncertainties surrounding the deficit targets.

Mukherjee alluded to the controversial foreign direct investment (FDI) liberalisation of multi-brand retail, but seemed to tread cautiously, pointing to the need for a "broad-based consensus on FDI in multi-brand retail". Similarly, few details were provided about FDI in India's struggling aviation sector.

Key Elements of FY 2012/13 Budget

Taxes: Fiscal consolidation efforts are driven by an increase in tax rates in services and excise taxes. The government has also broad-based the service tax, levying tax on all services—except on a negative list of 17 items. But the timing of the implementation of key reform measures such as the Goods and Services Tax (GST) and Direct Tax Codes (DTC) remains unspecified, even though Mukherjee emphasised that the GST bill would be operational by August 2012. Corporate tax rates remain unchanged. Personal income tax slabs have been revised slightly, with higher exemption levels from income tax and new, higher income tax brackets.

Divestment/Privatisation and Telecoms Auctions: The government aims to raise INR300 billion rupee by selling stakes in state-owned companies during the year, following the sluggish disinvestment in FY2011/12, with the government realising only INR155 billion (from its targeted INR400 billion), the target for FY2012/13 looks similarly ambitious. Meanwhile, targets from telecom auctions of the 2G and 4G spectrum stand at INR582 billion, which also look ambitious.

Capital Markets: The government continues to encourage capital inflows to help finance the widening current-account deficit, and proposes tax incentives for small investors on equity savings schemes and reduced taxes on securities transactions; allowing qualified foreign investors in the domestic corporate bond market; providing easier norms for listing corporate bond offerings in exchanges, and simplifying the IPO process. The government has also allowed for easier access to external commercial borrowings for a range of sectors and reduced the withholding tax from 20% to 5% in interest paid in the infrastructure sector. Important legislation such as those governing pension funds, banking insurance, microfinance, and others are to be tackled in the current session of parliament.

Agriculture: Addressing supply bottlenecks in the agriculture sector is one of the five key objectives of the budget. New research and development initiatives are being introduced to increase productivity in the food and agriculture sector. The government introduced a new food security bill to support the poor rural sectors; new credit schemes to fund the farm sector and initiatives to attract private investment in irrigation, soil testing, fertilisers, and the agricultural consumer market.

Infrastructure: Government investment in infrastructure is to increase to INR50 trillion, with 50% investment expected from the private sector. More infrastructure sectors were added as eligible for viability-gap funding from the government, including rural infrastructure. The government doubled the amount of tax-free bonds that state-owned infrastructure companies can issue from INR300 billion to INR600 billion; increased spending on key infrastructure sectors (roads, ports, airports); and significantly opened external borrowing channels for highways, airlines, and low-cost housing. Increasing the investment limits for foreign investors will help spur foreign funds' investment into India's infrastructure sector.

Social spending: A key objective of the UPA government, social spending continues to rise to promote inclusive growth. Expenditures on education will increase by around 20%, and more funds are earmarked for improving literacy. Social spending on health and development initiatives increases about 15%, with rural development spending aimed at rural employment guarantees, rural infrastructure, and drought-mitigation schemes. Additional spending encompasses poverty alleviation initiatives, concessionary housing loans, and other targeted specific programmes.

Subsidies: The government is restricting subsidies to 2% of GDP and aims to cap subsidies at 1.7% over the next three years. It is taking initial steps to move to a direct cash transfer pricing system for poor families rather than subsidising prices. On the fertiliser subsidy front, the authorities are seeking to increase production of a single super phosphate fertiliser to reduce dependence on phosphate and potassium imports.

Outlook and Implications

The budget continues to re-emphasise fiscal consolidation, and takes significant steps toward improving government finances. The government aims to reduce the central fiscal deficit from an estimated 5.9% of GDP in FY2011/12 (far higher than the originally targeted 4.6% of GDP), to 5.1% of GDP in FY2012/13, with the absolute fiscal deficit tagged at INR5.1 trillion.

The budget arrives at a critical time for the economy, when there has been a significant deterioration in the government's finances. At the same time, high borrowing costs from two years of aggressive monetary tightening and a tepid global environment have hit India's economic growth hard, and the economy is grappling with troublesome inflation (even as it retreats), tight liquidity, large trade and current-account deficits (from elevated oil prices and weak exports). Although the short-term impact of the fiscal consolidation on domestic demand will be slightly negative, the adverse impact will be relatively minor when compared with the benefits of fiscal consolidation in the medium term, the gains in sovereign credibility, and the space for more meaningful, expansionary monetary policy.

On much-needed structural reform, the budget was fairly tame in its proposals, in line with our expectations. The highly politicised FDI in multi-brand retail and aviation were alluded to only in passing. There is some hope that 51% FDI in multi-brand retail will be pushed through in upcoming months—after all, 100% FDI in single-brand retail was quietly passed in January—but the government does not have the political space to push through big-ticket reform at this juncture. The Congress-led government has been hobbled by a fragile coalition, recent humbling losses in state elections, and policy inaction and missteps. The government also mentioned its intention to bring in amendments to the pension, insurance, and banking bills in the current budget session in parliament, but there is a low possibility of these passing. Certainly, hopes that this budget would boldly rein in spending and subsidies, curtail the fiscal deficit, and reinvigorate reform and investment have faded somewhat. Even small-scale reforms to improve the operational environment for doing business seem to have been overlooked. But overall, the budget is a step in the right direction.

The reduction in the subsidy burden will probably be the largest risk to the budget targets, particularly given rising global oil prices with uncertainty in the Middle East. With the subsidy caps, the government would be forced to pass on an increase in global oil prices to the consumer, which would be extremely challenging for the government, and highly unlikely. Similarly, the outlay for food subsidies remains unchanged from last year's budget, and does not allow for any increases arising out of the food security bill currently being debated, with the government assuming that the bill would only be implemented in FY2013/14. Finally, the fertiliser subsidy is expected to decline even as commodity prices are likely to rise.

Certainly, fiscal consolidation is imperative in India, whose central and general fiscal deficit is among the highest in emerging growth markets. Its deficits stem from a low tax base, rather than too much spending (though the bloated subsidies and civil servant salaries do not help). Crucially, the government needs to increase the tax-to-GDP ratio. Although the budget begins fiscal consolidation, it does not have the difficult, structural reforms necessary to sustainably and dramatically tackle public finances. But, although the large fiscal deficit is a key macroeconomic issue, it is not an immediate vulnerability in India. The deficit is financed almost entirely domestically, by banks, pension funds, and insurance funds. Although this leads to a captive demand for government bonds, there is little danger of large-scale selling by foreigners, and government debt has been high, but stable in recent years.

Improvement in India's troublesome public finances will probably occur at a gradual pace, but the measures announced today further the path towards getting India's fiscal house in order, albeit slowly. In this budget, moves toward fiscal consolidation are measured, and with the new public spending programmes, the government will probably overshoot deficit targets next year as well. Nevertheless, with this budget, IHS Global Insight remains cautiously optimistic about medium-term fiscal consolidation from higher projected GDP growth—following the current cyclical downturn—and increased tax revenues over the next five years.