It will be hard for the Finance Minister to balance various priorities in the forthcoming Union Budget. He needs to juggle with plenty of issues. Inflation being the most important, the others are: containing fiscal deficit (FD) and current account deficit (CAD), reversing the slowdown in manufacturing, arresting the decline in FDI inflows, and sustaining growth.
The absence of a serious effort to reduce the FD and CAD could lead to an adverse change in market sentiment. A higher FD and CAD would lead to an increase in inflation, high interest rates, low private and public investment, and thereby lower growth.
The global financial crisis derailed the FRBM Act. The fiscal deficit has increased to around 6.5-7 per cent of GDP from 2.7 per cent in 2007-08, subsequently leading to a combined deficit surpassing 10 per cent of GDP in 2009-10.
The actual numbers are higher, at least by 1 per cent of GDP, as some items were kept off the balance sheet. During 2010-11, government was lucky to get substantial receipts from the 3G auction to keep up with the budgeted figure of fiscal deficit at 5.5 per cent of GDP, but it appears difficult in the current scenario to follow the 13th Finance Commission's (FC) roadmap for fiscal consolidation and keep the deficit at 4.8 per cent in the 2011-2012 Budget.
Given the numerous scams and poor image of the government, it would be difficult for the Finance Minister to take tough decisions on fiscal consolidation. Most likely, the FM would emphasise popular and flagship social programmes, like NREGA, food security Bill and other subsidies to petroleum products, fertilisers, leading to more subsidies on the whole.
The 13th FC's recommendations to eliminate revenue deficit to make way for revenue surplus and bring down consolidated debt to 68 per cent of GDP by 2014-15 looks difficult. The differential growth momentum between India and its trading partners (basically developed countries) has resulted in a widening current account deficit (almost reaching 4 per cent of GDP).
CAPITAL FLOWS
An increasing trade deficit, stagnant invisibles due to slow recovery of the West and fall of the FDI component in capital inflows are some worrying factors affecting current account. The latest data shows that FDI flows into emerging countries jumped in 2010, whereas it declined by almost a third in India. The problem of twin deficits may lead to downgrading of India's sovereign ratings, which will see a reversal of volatile component of capital flows, putting pressure on the Indian rupee. Given the slow recovery of West and the rise in oil prices, which constitutes the biggest component of India's imports, current account deficit could surpass 4 per cent of GDP soon.
REVENUE REFORMS
The problem of twin deficits like in the eighties is not a good sign and the forthcoming budget should take right steps to follow the 13th FC's road map for fiscal consolidation.
This may include rationalisation of expenditures, improving the efficiency and delivery system rather than mere increase in expenditure, cutting down subsidies (on petroleum products, fertiliser etc).
The Government should also focus on revenue mobilisation by extending the tax base, particularly in services, and improving tax administration for better compliance.
It's time to expand the tax net of the service sector which has a share of 58 per cent in GDP but only contributes 10 per cent of total tax revenues (little more than 1 one per cent of GDP).
The reforms in indirect taxes, whose contribution has declined over last few years, apart from reversing some of the fiscal stimulus packages with respect to customs and import duties, would help.
GROWTH CONCERNS
More importantly, if growth slows down, it will have negative impact on revenue mobilisation leading to a higher deficit. Continuous high fiscal deficit along with increase in subsidies will raise revenue expenditure, forcing the government to cut essential capital expenditure in infrastructure and agriculture. Given our relations with the neighbouring countries, nothing can be said about defence expenditure, hence reforms in the current subsidy regime are a must. The subsidies ought to be transparent and directly targeted, and if possible phased out gradually by increasing user charges.
We should take care not to repeat the experience of nineties where fiscal improvement was brought about the wrong way, namely by cutting back capital investment (from 5.6 per cent GDP in 1990-91 to 2.3 per cent in 2000-01).
One way to improve efficiency in the system is to follow a wide range of reforms across sectors, which have slowed down in recent years. Maybe, it's time to gradually move towards outcome-based budgeting.
(The author is Associate Professor, Institute of Economic Growth, Delhi. The views are personal.)