Monday, February 28, 2005

A Reform Budget: Promised Reform have Fructified

The PM and the FM had promised extensive tax reforms in the budget for 2005-6. This transparency raised the possibility of over-expectations and disappointment. The budget has however met the expectations. The surprise element, that could perhaps have transformed this budget from a very good one to an outstanding one, was however lost. There is clearly a trade-off between transparency and pleasant surprises that characterised the two outstanding budgets (current account convertibility and income tax rate reductions).
In the Pre-Budget meeting that the Finance Minister had with economists I had suggested three areas of economic reforms for the 2005-6 budget. These were tax reforms, FDI policy and Infrastructure reforms. As all three areas have been emphasised by the government. it is interesting to see where the budget has fallen short or exceeded these implicit expectations. Taking FDI first, the presentation had emphasised the importance of FDI in raising the growth rate from the 6 to 6.5% level to the 7 to 7.5% level. Research done at ICRIER has shown that FDI has a positive impact on exports, efficiency and productivity of modern sectors where it enters. In contrast to the Interim budget last year this years budget merely talks of a committee to look at FDI in sectors such as mining and distribution. The completion of the FDI reforms promised in the previous budget with respect to Aviation and Telocom and the announcement of considerable liberalisation of FDI in Real Estate (construction development) is however quite encouraging. A paper and a project report by two different ICRIER scholars respectively, have recommended allowing FDI in the retail sector. I expect FDI in the retail sector to be allowed during the next 6 –9 months.
In Infrastructure, the presentation had emphasised the quality of infrastructure investment versus the quantity. The best way to improve infrastructure was to divide it into three different categories that required different emphasis, namely public goods (roads, town & village infrastructure, R&D, knowledge dissemination), quasi-public goods (rural infrastructure) and private goods (urban electricity, airports, ports, railway services). It was recommended that limited government revenues must focus on the first two categories while improving the productivity of these expenditures through institutional reform and innovation. In addition private-public partnerships, subsidy auctions and other innovative mechanisms can play a vital role. Though the budget has still not adopted this three-fold classification, in implementing the agricultural development and rural poverty alleviation objectives of the CMP higher expenditure allocations have sought to be made more effective by channelling them through new and or improved institutional mechanisms. In the case of private goods (infrastructure) the presentation had emphasised the importance of the policy and regulatory framework so as to minimise policy risk. The budget does not spell out these things in detail but one expects the planning commission and the infrastructure committee to do so in the next 3 months.
Tax reform is of course the core of this budget. The income tax and customs duty reforms have met or exceeded expectations, while excise duty reforms have fallen short. The presentation had emphasised the integration of goods and services in a comprehensive CENVAT with a uniform rate of 15-16% and exemptions for food products, medical goods and services and education services. Though the grand design has not been implemented, this can probably be justified the need for caution at the time at which the State Vat is coming into operation. There has also been progress in reducing the excise on PFY & tyres and in exempting some food products. A further rise in the SSI in the SSI exemption from 3 crore to 4 crore is however a retrograde.
On customs duty the presentation had suggested reduction of the peak customs duty to 15% this year and 10% next year along the lines of the Inter-ministerial Group report (Virmani, November 2001). The peak rate reduction will enhance the efficiency and competitiveness of the industrial sector. No steps have been taken to start reducing the very high import duties on some agriculture products and this will act as a drag on the agro-processing sector. Selective reduction of import duties on capital goods to 10% can also be justified in the interest of faster productivity growth.
Income tax reform has three key elements. The elimination of the standard deduction and other exemptions and the consolidation of the saving exemption into one integrated exemption of Rs 1 lakh. The extension of the 10%, 20% and 30% brackets to 1lakh, 1.5 lakh and 2.5 lakh respectively. Our presentation had emphasised the simplification of the system from the perspective of the honest taxpayer and the reform has met this expectation. The long-standing recommendation to bring the corporate tax rate to 30% has also been met, but it has been offset by the imposition of a surcharge and the reduction of the depreciation rate. Along with the MAT credit the effective tax rate is only marginally different.
The SSI reserved list has been further pruned by the removel of 108 items of which 30 are from the textile sector.
The finance minister has successfully balanced tax reform with the need for raising more tax revenue. He has also been reasonable successful in balancing social, agriculture and infrastructure expenditure requirement of the common minimum program against the requirements of fiscal balance imposed by the Fiscal reform and budget management act, even though he has had to suspend the revenue deficit reduction targets for next year. Thus he has neatly balance the political imperatives against the demands of economic rationality and reform.

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