Is the fiscal deficit phony?

March 19, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The stock market did not respond positively to the budget in spite of the cut in Securities Transaction Tax (STT) and the provision of tax benefits to retail investors for investment in equity because of the trust deficit in budget arithmetic. The fiscal deficit is too high and could also escalate during the year considering that the assumptions on which it is based are not realistic.

In the 2011-12 budget, the fiscal deficit overshot the target by a huge margin. The finance minister had planned for 4.6 percent; it turned out to be 5.9 percent. The budget was messed up by the RBI with its interest policy which brought down growth and therefore tax revenues, and by the government which let expenditure shoot up under political pressures.

More precisely, a third of the increase in fiscal deficit came from the fall in tax revenues, mainly corporation tax, and two-thirds from the increase in subsidies, mainly food. That put the budget in a strait jacket. The finance minister did try to bridge the gap with the increase in service tax and excise duties which, along with a concession in direct taxes, would mop up 414 billion rupees. That was not enough and the finance minister had to have a go at the bulging subsidies.

Currently, subsidies are 2.4 percent of GDP and to that extent inflate the fiscal deficit. The finance minister has therefore resolved that subsidies will be curbed next year. Not all but those on petroleum products and fertilisers which are regressive and together account for about two-thirds of total subsidies. The latter will be chopped down in 2012-13 to 2 percent of GDP.

That is undoubtedly brave on the part of the finance minister who had been rebuffed by the Trinamool Congress for the minor offence of permitting an increase in railway passenger fares. That was also how this critical ally in the UPA had reacted to earlier increases in petroleum prices. Against this background, the initiative of the finance minister to slice off petroleum and fertiliser subsidies seems presumptuous in spite of the assurance by the prime minister that, when the time comes, he would bite the bullet. Probably what he means is that time may not come if international oil prices ease.

Not to be discouraged by the fall in tax revenue in 2011-12, the finance minister has budgeted for a 19 percent increase in tax revenues because he expects the economy to grow at 7.6 percent in 2012-13. Even if it does, the 19 percent increase, excluding additional taxation, in unlikely to come. The experience of 2011-12 is that a 1 percent increase in GDP generates 2 percent increase in tax revenues. On that basis, a shortfall in tax revenues in 2012-13 is not unlikely.

It looks like the finance minister has been deliberately optimistic. The political space for curbing subsidies is limited; and with relentless inflation, the chances of RBI cutting interest rates adequately to revive investment are low. The 5.1 percent fiscal deficit that is planned, therefore, appears presumptuous.

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