A Budget for tough times?

As we await the Finance Minister's Budget speech this week, it is useful to preview the economy, and what it might portend in terms of tax and spend proposals. India faces two worrying macroeconomic headwinds from foreign shores.

Crude oil prices have crossed $70 per barrel, up nearly 60% from just six months ago. This translates into heavy outgo of foreign exchange, increased subsidy burden for the government and higher inflation. Low oil prices since mid-2014, which lasted for nearly two years, had helped the government keep the fiscal deficit in check, inflation under control and redirect the fiscal savings to large welfare and infrastructure spending. That advantage is now gone.

The second headwind is the tightening stance of the world's biggest central bank. The US Fed has begun raising interest rates, and reducing the size of its bloated balance sheet. This will cause a reversal of flow of dollars from the rest of the world, which means emerging markets like India might get lower inflows. This affects not just the stock and corporate bond markets but also domestic liquidity and perhaps inbound foreign direct investments.

In addition to the two macro headwinds from overseas, there are critical domestic macro concerns to take note of. Inflation has inched up above 5%, which means interest rates cannot go down. Indeed, the yield on the 10-year government bond, considered a benchmark interest rate, has gone up to 7.4%. The biggest adverse impact of higher interest rates is on the biggest borrower in the system -- the government itself. Its fresh borrowing needs are nearly Rs 6 lakh crore annually, and its outstanding debt is close to Rs 70 lakh crore. Even a 0.5% rise in interest rates can imply an increase of nearly 10% in interest burden on the government. That could be as much as Rs 50,000 crore, equal to the entire budget of the MNREGS. Higher interest rates also hurt industries like real estate, construction and housing.

So capping interest rates is a very high priority, and is primarily the responsibility of the government (which has to keep the borrowing pressure low). That is why fiscal prudence is so important. If revenues (both tax and non-tax) are robust, then there is less dependence on borrowing, which can keep the pressure off interest rates.

The other domestic concern is over GDP growth itself. The two quarters after demonetisation saw growth slow down to 5.7% and 6.3%. As former chief economic adviser Kaushik Basu pointed out recently, this growth is lower than India's 30-year average, which is 6.6%. If we take the average for the past 10 years, then the gap is even larger. No doubt the lower growth is because of the disruptive effects of demonetisation and teething troubles of GST, but it is certainly a cause for worry.

Finally, private investment is still sluggish. In particular, investment to GDP ratio for the country has dropped from 33 to 29% in the past five years. It used to be close to 40%, when India clocked 9.5% GDP growth. So, unless we get back to higher investment rates, GDP will remain tepid. Investment and consumption are drivers of growth when seen from the spending side. Exports (which is spending by foreigners) is also a major driver.

The world is experiencing high, synchronised growth this year. The IMF has revised most of its growth forecasts for various parts of the world upward. This is the best portent for India's exports, as they critically depend on the state of the world's economy. This fiscal, exports are growing at 12%. But the worrying fact is that cumulatively, over the past four years, from 2014 to 2018, exports have grown at 0%, or have slightly shrunk. Exports are linked closely to manufacturing. So, a resurgence in one is correlated with the other. Exports have also suffered due to a strong exchange rate. The strong rupee has also led to a surge of imports, which is a threat to domestic industry, struggling with large unused capacity.

Compared to this worrisome macro, there are many bright micro indicators, as also the promise of ongoing reforms. Thus, the stock market is scaling new peaks, and is already at record levels. This is good news for those companies seeking to raise growth capital. It also spells good news for the government's own disinvestment objective. The target for the present fiscal year has been exceeded, an unprecedented achievement. The progress of the insolvency and bankruptcy procedures is promising. The recapitalisation of banks means more credit will flow to industry, especially the small and medium enterprises.

As we look ahead at the budget, the five priority areas for the Finance Minister will be as follows. First, focus on job creation; second is agriculture and the rural economy; third is a revival of private investment; fourth is an impetus to exports and connectedly to manufacturing; and lastly, achieving all this within reasonable fiscal limits so as to not let interest rates climb.

For the last item, one untapped source of tax revenue is to make capital gains in stock markets taxable for short-term profits, that is, booked in less than three years. This will also enable parity with other asset classes. This can be coupled by removing dividend distribution tax, lowering corporate income tax to 25%, and taxing dividend income only in the hands of the receiver. This also addresses the issue of widening inequality between income classes, and also between capital and labour.

As for job creation, a specific employment-linked subsidy in labour intensive sectors such as textiles, construction, agro-processing and tourism can be pushed. A version of this was initiated two years ago only for the garment sector, which needs to be tweaked and expanded. For instance, why not allow private employers to give temporary jobs in textile within the NREGA framework. Or let NREGA workers work on affordable housing projects. Such innovation and experimentation is needed.

The long-term prospects of the economy remain sound, mainly owing to its demography and relatively high savings rate. But a growth and employment-friendly Budget within fiscally prudent limits would be very welcome at this time.

(The writer is an economist and Senior Fellow, Takshashila Institution) (Syndicate: The Billion Press)