Monday, February 28, 2005

The Economics and Politics of the Budget

When Dr Manmohan Singh became Prime Minister, the middle class by and large was very happy that an educated professional had become the Prime Minister of India. Still many among his supporters and well wishers wondered whether he had the political savy to be effective in the dog-eat-dog world of politics. The way in which the ‘dream team’ and the finance minister (who has been in politics the longest) have balanced economic rationality against political imperatives has been quite masterful. There are three sets of issues that have been balanced: (a) Tax reform (revenue neutral) and raising tax revenue (tax GDP ratio). (b) Fiscal prudence & revenue deficit reduction and new expenditures mandated by the Common Minimum Program of the government. (c) Broader economic reforms and narrow budget issues (taxes, expenditures) within the purview of the finance ministry. Let us start with the last one first.
Since 1991 most finance ministers have used part A of their speech to send a broader reform message by announcing reforms that do not fall strictly within the purview of the finance ministry. These reforms have often been left unimplemented for many years. For instance three years ago the budget speech promised labour policy reforms, but they could not be implemented by the government in the remaining two years of its tenure. The 2005-6 budget has minimized the announcement of specific non-fiscal/financial reforms that would require action by other ministries. Even in the case of FDI, though the possibility of raising FDI caps has been indicated, there is no specific announcement in contrast to the previous budget. Criticism of the budget by the left has therefore been minimized, while FDI actions including liberalization of FDI in ‘Real Estate’ were announced the previous week and liberalization of FDI in retail is likely to follow after the budget has been passed. Relatively non-controversial financial sector reforms have been carried forward. The SSI reserved list has been rightly pruned further so as to take on the challenge of labour intensive Chinese exports in global markets.
The second set of balances is that between tax reform and raising the tax-GDP ratio so as to finance new expenditures or bring down the revenue/fiscal deficit. Reforms have been carried out in all three areas though to different degrees. The most radical reform is in personal income tax followed by Customs duties and Corporate tax and Excise. The so-called ‘Peak rate’ that applies to all manufacturing and mining has been reduced from 20% to 15%. Though there was scope for reducing the very high agricultural tariffs these have not been touched for political reasons. Duties on capital goods imports have been reduced to 10% in the expectation of greater productivity boost from machinery investment. Excise tax reforms are modest but significant in that PFY duty has finally been brought down to the basic rate along with that on tyres and ACs. The reduction in customs and excise rates on oil products can be justified as a temporary response to high oil prices, though in the long term they should not be given special consideration and must have uniform ad valorem rates. Personal income tax reform has been the most radical with the raising of tax brackets, elimination of the very complex standard deduction and the unification of the savings deductions into a single integrated one of Rs 1 lakh. Corporate tax changes are a mixed bag with a reduction in the rate from 35% to 30%, the imposition of a surcharge of 10% and the reduction in the depreciation rate.
The third set of balances has been that between the social imperatives of the CMP and the requirement of Fiscal Responsibility and Budget Management Act. The CMP asserted the need for raising expenditures on education, employment, health, agriculture/rural and infrastructure sectors. As some of us have pointed, out throwing more public money at these problems will not solve them unless the effectiveness of these expenditures in achieving their objectives is enhanced. Thus higher allocation for the social sectors and rural infrastructure have been balanced by a search for innovative ways of making these expenditures more effective in reaching those who are in greatest need. An output based approach to monitoring and evaluation is promised, in place of the current input/expenditure based approach. Though the FRBM targets have been largely met during the year, they will be held in abeyance during 2005-6. In my view this is better than the alternative of raising effective tax rates under the guise of tax reforms (what I have earlier referred to as ART)
Overall the finance Minister has produced a Very good budget by minimising the opportunity for political criticism while introducing substantial reforms in taxation.

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