Modi’s first budget can be a great start

July 9, 2014

(Any opinions expressed here are those of the author and not of Thomson Reuters)

There are few opportune moments for a nation to enact bold economic reforms. For India, this week is one of them as Prime Minister Narendra Modi and his Bharatiya Janata Party (BJP) government unveil their first budget since sweeping to power in a landslide victory last May.

India needs the sort of shock therapy it administered in response to the 1991 crisis when foreign exchange reserves had dropped to just $1 billion. While current circumstances may be less urgent, they are no less critical. Economic growth has dropped to the 4-5 percent range, half the peak level of a decade ago. Inflation has risen between 9 and 11 percent over the past five years, crippling consumer purchasing power.

The government presence in the economy remains extensive through state-owned enterprises and wasteful subsidy programs that result in chronically high budget deficits. According to the Heritage Foundation’s 2014 Index of Economic Freedom, India’s global ranking was a dismal 120 (out of 186 countries). In the World Bank’s 2014 Doing Business Survey, India ranks 134 out of 189 countries, placing lower than Bangladesh and Pakistan.

Within the components of Heritage’s Economic Freedom Index, India scores very poorly in business and investment freedom (ranked 171st and 142nd, respectively). Launching a business takes more than 25 days on average. Licensing requirements cost almost 10 times the average annual income. (Modi was successful in streamlining licensing requirements in his home state of Gujarat.) There are many bureaucratic barriers to foreign investment. The state retains considerable ownership in the banking sector, and all domestic banks are required to do priority sector lending as directed by the government.

Thus far, the 63-year-old former chief minister of Gujarat has offered the Indian economy positive signals. He has already approved a number of infrastructure projects and appears to be moving quickly on trade diplomacy. But much real work remains to be done.

With budget deficits running at an estimated 4.1 percent of GDP in the current fiscal year (India has not run a budget surplus since independence in 1947), Modi must move aggressively in improving government finances. According to a senior government source, the finance ministry plans to raise up to a record $11.7 billion through asset sales. There are also expectations the first budget will trim subsidies for petroleum products, which currently cost taxpayers some $40 billion a year. With only 3 percent of Indians paying income taxes, the tax base will have to be broadened. While tax reform plans include a goods and services tax, it may take until next year to be implemented.

It is hoped that labour market reform will occur sooner rather than later. India’s working-age population of 750 million is expected to increase by 230 million by 2030, so job creation is India’s greatest long-term challenge. Lifting foreign ownership ceilings and enacting tax reform would go a long way in attracting more foreign capital. Many foreign investors have been deterred by tax disputes, such as that embroiling Vodafone. Government meddling in the labour markets will have to be curtailed.  Requiring government approval to lay off employees in firms with more than 100 workers discourages the large scale enterprises that India needs.

The timing could be just right for Modi to be bold in these areas and others. Labour costs have been rising rapidly in China; Japanese firms are shifting production from China because of military tensions; and the weakened rupee (until recently) has made exports more competitive. The Americans want a stronger India to offset China’s regional might and bullying, and Washington could be a valuable ally in India’s cause in areas of trade and investment policy.

Modi will not be able to work miracles overnight in a nation with so many economic obstacles to overcome. These are problems that have been allowed to fester for want of political will. But his first budget can be a great start.

(William T. Wilson is a senior research fellow in The Heritage Foundation’s Asian Studies Center.)

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