No need to relax fiscal targets

The Indian government will present the 2017-18 Budget in a challenging environment. Apart from a busy States election calendar, there is considerable uncertainty over the impact of demonetisation on growth. Implementation of the Goods and Services Tax (GST) has been deferred for now to the second half of the year.

These factors have raised expectations that fiscal consolidation may be postponed next year. We expect a more balanced approach, with the recent gains from fiscal consolidation unlikely to be frittered away. Yet, the proceeds from a one-off revenue boost, including demonetisation, are likely to be channelled to support consumption and continue with social spending projects.

Despite the negative impact on growth from demonetisation, fiscal discipline will remain a priority. The Government is likely to meet the fiscal deficit target of 3.5 per cent of GDP for FY16-17, as bunched-up revenues catch up with front-loaded expenditure in the second half.

We expect the Government to retain the budget deficit target of 3 per cent of GDP set by the fiscal roadmap for FY17-18. Achieving this will depend on whether nominal GDP growth for FY17-18 comes in stronger, as expected. The Fiscal Responsibility and Budget Management (FRBM) proposals provide the Government some flexibility.

The FRBM committee may propose a shift in the budget deficit target from a point to a range, and the deficit target may be revised to 3.0-3.3 per cent. This could provide flexibility for more public investments to offset the recent drag on growth.

The risk of a fiscal slippage in FY16-17 is low despite the budget deficit totalling 86 per cent of the full-year target in April-November 2016. Over the remaining four months, we expect revenues to catch up with spending. December and March are seasonally strong months for direct tax revenues.

Most indirect tax revenue sub-heads are running above their budgeted pace. Indirect tax collections as a percentage of total tax revenues is likely to exceed direct receipts this year.

The Income Declaration Scheme (IDS), which ended last September, added an estimated ₹250 billion to revenues. There will be strong dividends of ₹660 billion from the Reserve Bank of India (RBI). Other non-tax sources, telecom spectrum collections and divestment receipts will also add to the kitty, but miss targets.

Revenues will get a short-term boost from demonetisation. Over 95 per cent of the scrapped notes are reportedly back with the banks. Of the remaining 5 per cent, changes in the RBI’s balance sheet might result in a one-off dividend (of 0.1-0.2 per cent of GDP) for the government, if deemed justified. Another declaration scheme is underway with the benefits to accrue next year.

On the spending front, funding for bank recapitalisation and the pay commission are unlikely to deviate from projections. With revenues coming in higher and spending on track, FY16-17 deficit target will be met at 3.5 per cent of GDP.

Unfortunately, the final deficit /GDP ratio could still be upset by the uncertain growth outlook. While the Central Statistics Office reckoned that nominal GDP growth could come in at 11.9 per cent for FY16-17, above the budgeted 11 per cent, this remains an estimate that could be downgraded later. Another challenge is the GDP deflator which is assumed to be 4.8 per cent, above the underlying CPI/WPI trends.

India is likely to adhere to its roadmap for fiscal consolidation and retain its budget deficit target at 3 per cent of GDP for FY17-18. It is possible the FRBM committee will introduce some flexibility with a proposal to adopt a deficit target range of 3.0-3.3 per cent instead of a fixed target. This could slow the pace of belt tightening.

As for next year’s fiscal math, indirect tax collections should continue to drive total tax revenues. Excise duties, the largest component of indirect taxes, could suffer if oil prices rally sharply and trigger fuel duty cuts.

An outright cut in personal income tax rates is unlikely, but exemptions may be tweaked. Corporate tax rates are already scheduled to be lowered by 5 per cent to 25 per cent over the next three years. To provide short-term relief, a part of these cuts might be front-loaded.

The focus of expenditure will be on boosting consumption after the post-demonetisation lull. The Government announced a host of measures last month. These included relief measures for farmers, affordable housing schemes, support for women/elderly and interest sops. These are likely to amount to less than 0.1 per cent of GDP. More sector-specific measures to reverse the slump in demand are likely.

Capital expenditure has stagnated in recent years. Capital spending was cut last year to make room for higher public-sector wage payouts and banks’ recapitalisation. We expect capital spending to be raised to 1.8 per cent-2.0 per cent of GDP, with a part of these outlays kept off the books. Revenue expenditure will stay high, with interest payments and subsidies making up for a considerable chunk, along with banks’ capital needs.

As a corollary to FY16-17, we expect a pick-up in the FY17-18 nominal GDP rates to provide a cushion to meet the year’s fiscal ratios, despite a slightly wider deficit in absolute terms.

The impact of demonetisation will continue to reverberate in FY17-18. Much of the structural benefits of a smaller parallel economy and less illegal money will accrue over the medium term. In the near term, much of the boost to revenues will be from the one-off declaration scheme and enhanced tax scrutiny.

The additional revenues from these measures may total 0.7-0.8 per cent of GDP over the next two-three years.

The other areas of the Budget will focus on tax reforms, steps to support agricultural output, social sector spending, push for infrastructure investments, accelerate usage of digital payment channels and promote financial inclusion.

Encouraged by its stable fiscal ratios, international rating agencies have maintained a positive outlook towards India. Wide-ranging reforms (including demonetisation), underlying growth drivers, low inflation and other improving fundamentals have been cited as the economy’s key strengths.

The scope for an upgrade, however, remains low in the near term. To move up the investment grade ladder, India needs to address the ongoing stress in the banking sector, the slow implementation of reforms such as the GST, and the still-high fiscal deficits at the Centre and in the States. The door for an upgrade in 2018, however, remains open.

The writer is an economist and vice-president of DBS Bank, Singapore