Economic Reforms in Budget 2015-16

Introduction

    The Union budget has many objectives and constraints. My basic criterion for evaluation of the budget, or any other actions of the government, is very simple. Does it help in bringing about a sustained improvement in the Welfare of the average person and of the bottom 40 per cent of the population in particular? That is, will the measures taken or announced result in higher per capita GDP and less poverty ten years from now?  As this requires better policies and institutional reforms related to sustained economic growth, employment creation and efficient welfare transfers to the 40 per cent, it boils down to an identification of policies and institutional reforms that will achieve these objectives. Institutional reforms as defined in the economics literature includes the laws, regulations and rules that define a framework of incentives under which economic agents, including government bureaucrats and ministers operate.

Macro, Fiscal, Monetary Policy

     As per the new GDP series economic growth has revived over the last two years. This has been accompanied by and partly driven by an acceleration of private consumption growth and an acceleration in growth of Gross fixed capital formation. Inflation as measured by the implicit price deflator for consumption has declined sharply. However, corporate output growth has lagged the overall recovery, partly because of global demand and excess capacity in certain tradable sectors. However, sectors like automobiles, housing and real estate linked more closely to domestic demand have also contributed to the slow recovery.

       The Govt’s commitment to Federalism was amply demonstrated by the abolition of the Planning Commission and National Planning that inherently inclines towards centralized, “one size fits all” approach to programs and projects.   The fourteenth Finance Commission (FC14) recommendation for “increasing  the share of tax devolution to 42 per cent of the divisible pool..” complimented this approach, allowing a return to the fundamental principles of Federalism outlined in the constitution.  As the FC took account of the revenues and revenue expenditures of the States in deriving the new devolution norms an equivalent amount of revenue expenditures earlier incurred in Plan schemes on State and Concurrent Subjects under the administrative control of States (Education, Health, Welfare, Poverty, Irrigation, Roads etc.) could have been eliminated from the Central Budget.  However the Central Government “has decided to continue supporting important national priorities such as agriculture, education, health, MGNREGA, and rural infrastructure including roads”. One consequence of this decision is that the time path of fiscal consolidation supported by the Finance Commission, in terms of both fiscal deficit and revenue deficit targets will be exceeded in the next two years (New targets for FD are 3.9%, for 2015-16; 3.5% for 2016-17; and, 3.0% for 2017-18).

  Though many eminent economists support this decision to loosen fiscal policy, to stimulate demand, in my view a policy that adhered to the (earlier) fiscal targets through a greater reduction of revenue plan expenditures on State subjects, would have had a more positive effect on the economy and social welfare. This is primarily because it would have permitted a quicker easing of monetary policy in line with reduced inflation rates, giving a greater boost to demand for interest sensitive sectors like automobile, housing (consumer demand) and real estate (business).

   The budget speech indicated that Govt had signed the Monetary Policy Framework Agreement with the RBI. The agreed inflation target  of  less than  6%, will hopefully ensure an appropriate timing and phasing of monetary easing. The Govt’s intention to amend the RBI Act this year, to provide for a Monetary Policy Committee is one of the positive announcements in the budget speech.  My analysis indicates that the real repo rate is now at or close to previous peaks, and requires a reduction in the nominal rate by 1% to 2% points over the next 12 months. 

Subsidies & Expenditure

    In his budget speech the Finance Minister has proposed two new laws, which will help improve the efficiency of government expenditure and of government contracting and also reduce leakages and corruption (“malfeasance”). These include,

(1)       A procurement law and an institutional structure consistent with the UNCITRAL model.

(2)       A Public Contracts (Resolution of Disputes) Bill to streamline the institutional arrangements for resolution of such disputes

          The budget reiterated government’s welcome commitment to the “process of rationalizing subsidies” to create a “well targeted subsidy delivery” system that cuts “subsidy leakages, not subsidies themselves.”  The government also expressed its intention to bring in Mobile payments as a means of transferring subsidy benefits under the “JAM trinity.” There was however no indication of which subsidies would be rationalized after LPG, probably because it is political more appropriate to first work out a detailed implementation plan.

     The successful payment of govt scholarships through direct transfer to scholars bank accounts has encouraged Govt. to rethink how to ensure equal educational opportunity to all, irrespective of their financial situation. The budget proposal to create a “fully IT based Student Financial Aid Authority to administer and monitor Scholarship as well Educational Loan Schemes, through the Pradhan Mantri Vidya Lakshmi Karyakram, could be an important step in this direction.  However, it needs to be accompanied by two other shifts in Govts approach to Education. One, a shift from constructing and running Colleges & universities to regulating them more transparently & effectively and from Brick and Mortar Colleges to e-education that is digitally available in rural, hilly and remote areas.  

   The budget’s emphasis on social insurance for life, accident, old age health, assisted living and pensions also suggests the possibility of a new federal division of labor between the Central and State governments: The Central Government should focus on providing help to the poor & needy through insurance and other financial products that come under its purview, while the States are fully responsible for basic health, education, welfare, poverty & employment program that require an administrative set up down to the Panchayat & Nagarpalika level.  I hope the next budget will move more decisively in this direction.

Taxes

     FMs reiteration of the Govt’s determination to institute the GST  by April 2016, as a state-of-the-art indirect tax system, gives hope that this land mark tax reform will finally reach fruition and translate into efficiency improvements during the next two years.

    The FM also indicted to reform Corporate income taxation so as to make it competitive with other major Asian countries. Even though the effective tax rate in 2015-16 may increase marginally because of higher surcharges, a revenue neutral reduction in marginal tax rate to 25% along with a reduction in exemptions over the next 4 years , will contribute to an increase in competitiveness of modern industry & service sectors.

Reduction in the rate of income tax on royalty and fees for technical services from 25% to 10%, aligns it more closely with capital gains taxation and will strengthen voluntary compliance and reduce tax disputes.

Financial Sector

    The FM, in his budget speech proposed a number of institutional reforms that will help improve the transparency and credibility of the Indian Financial system and thus improve the flow of equity and long term debt form individual Indian investors into the formal financial system.  This in turn will help improve the efficiency of intermediation between savings and investment and thus improve the growth potential of the economy.

      The proposal to merge the Forwards Markets Commission with SEBI has been stymied by vested bureaucratic interests for decades.  A decisive PM-FM team has clearly helped in clearing this proposal to modernize the regulation of commodity forward markets and thus ensure that farmers truly benefit from forward markets in agriculture.  Enabling legislation, amending the Government Securities Act and the RBI Act is proposed in the Finance Bill, 2015

The setting up of Public Debt Management Agency (PDMA) to manage Govt’s internal & external debt has been approved by the Govt. Such an agency was first proposed in the late 1990s early 2000s to take over this function from RBI so as to remove the conflict of interest with RBIs primary one of monetary policy & financial stability. There was so much resistence in RBI that even the report had to be buried in a file. The approval of this agency is another example of this govts ability & willingness to take quick decisions.

Other institutional reforms include the establishment of a  Financial Redressal Agency grievance redressal viz all financial service providers, a Financial Data Management Centre, a Financial Sector Appellate Tribunal, and a Resolution Corporation.  An Indian Financial Code (IFC) for integrating financial laws rules and regulations is also to be introduce in Parliament for consideration.

Agriculture, Infrastructure, Industry

        The FM also announced a number of initiatives for reforming the policy frame work for Agriculture, Industry and Infrastructure, which will facilitate productive growth:

(a)    “To increase the incomes of farmers, it is imperative that we create a National agricultural market, which will have the incidental benefit of moderating price rises.  I intend this year to work with the States, in NITI, for the creation of a Unified National Agriculture Market.”

(b)    “Ports in the Public sector will be encouraged, to corporatize, and become companies under the Companies Act.” As this is needed to both attract investment as well as leverage the huge land resources lying unused with them.

(c)      “The Government also proposes to set up 5 new Ultra Mega Power Projects, each of 4000 MWs in the plug-and-play mode.  All clearances and linkages will be in place before the project is awarded by a transparent auction system.    The Government would also consider similar plug-and-play projects in other infrastructure projects such as roads, ports, rail lines, airports etc.” Thought the “plug and play approach” has been suggested before, the emphasis on “transparent auctions,” will enhance public support and credibility of such projects.

(d)    “To have a common approach and philosophy in the regulatory arrangements prevailing even within the different sectors of infrastructure.  Our Government, therefore, also proposes to introduce a regulatory reform law that will bring about a cogency of approach across various sectors of infrastructure.” This another law that has previously been stymied by inter-departmental disagreements.

(e)     “Bankruptcy law reform,  that brings about legal certainty and speed, has been identified as a key priority for improving the ease of doing business. We will bring a comprehensive Bankruptcy Code in fiscal 2015-16, that will meet global standards and provide necessary judicial capacity.  It was incredible that a New Companies Law did not address this issue properly and focused on issues peripheral to the healthy growth of modern Companies.

(f)     “Expert Committee to examine the possibility and prepare a draft legislation where the need for multiple prior permissions can be replaced with a pre-existing regulatory mechanism”

(g)     “Expert Committee for this purpose to examine the possibility and prepare a draft legislation where the need for multiple prior permissions can be replaced with a pre-existing regulatory mechanism”

Conclusion

   The 2015-16 budget lays out a substantial agenda of policy and institutional reform, as well as administrative and procedural improvements (not detailed above) that will help in accelerating economic growth to 8.5% and in sustaining it at that level for years to come. Some of the complementary reforms needed in land and labor laws, rules and procedures will of course be necessary to raise the employment elasticity of economic growth.
 ------------------
Aversion of this article also appears in ET Blogs at http://blogs.economictimes.indiatimes.com/PolicyAnalysis/economic-reforms-in-budget-2015-16/

Setting The Stage for Macro-Pivot: The 2012-13 Budget

Introduction

Many different words have been used to describe this budget. ‘Reasonable’, ‘Responsible’, ‘Sound’, ‘did no harm.’  The words that have not been used are ‘reformist’ or ‘big bang’. Those who were dis-appointed fall largely in the latter camp.  I would call it a “conventional budget,” where, by conventional I mean what one had begun to expect once the reforms of the 1990s were over.  Its main distinguishing feature is the determination to hold to fiscal deficit fixed in the budget and outlined in the long term policy stance.  This was a welcome and necessary departure from the budgets since 2009-10. For the rest it was the usual socio-political document, with a number of expenditure allocations to different groups to reassure them of its inclusive nature and incremental measure to correct small anomalies in infrastructure sectors, presumed to be the central propeller of government planned development programs.

Popular Expectations

 Some expected growth oriented budget and others feared a populist budget.  Neither the expectations nor the fears came true. Though the Finance Minister opened with a statement on the importance of economic growth for generating jobs, inclusive growth and revenues which could be used to help the poor, there was no headline making reform that could enthuse the stock markets or the domestic industrial community.  Measures to incentivize investment, savings, infrastructure, bond markets were neither much better nor much worse than those seen in earlier budgets.  Similarly there were a number of expenditures and increases in the same, directed at the Welfare of various groups, at food security and malnutrition, education and skill development, agriculture, textile workers and small industry.

Benchmark: Macro-Pivot

  Personally, the budget achieved the professed objective of the Finance minister to contain the fiscal deficit to 5.3% of GDP in 2012-13 and to reduce it to 4.8% of GDP in 2013-14.  Though the growth assumption on which this was based were optimistic, my view is that this finance minister is very serious about this objective and will therefore ensure that it is achieved.  This is an important step in restoring the fiscal sustainability and macro-economic balance, some of the most disturbing symbols of which are the current account deficit of 4.2% of GDP during the last two years and the high rate of consumer price inflation.

Why is this so important?  In a paper in 2012 I showed how many growth stars became shooting stars because they were not able to deal with macro-economic shocks emanating inside and outside their country. Thus it is essential to deal with this issue if we want to restore growth to a reasonable level and sustain it for the next few decades. Further, my analysis of the macro-economic situation in India, suggests that the best way to remove the cyclical down turn in the Indian economy is a “Macro-pivot,” which rebalances the fiscal and monetary policy, by tightening the former and loosening the latter.  Again this is based on research which showed that economies showing similar symptoms of macro imbalance as us, such a pivot led to an increase in the average growth rate in one to three succeeding years.  Further the evidence very clear when the fiscal tightening was the result of expenditure reduction but mixed or non-existent when it was the outcome of a tax increase

Fiscal Tightening

The finance minister has accomplished this reduction in the fiscal deficit by correctly focusing on the reduction of subsidies, which were the cause of the unsustainable rise in the fiscal deficit.  Further he has achieved it without cutting capital expenditure (government investment).  In fact capital expenditures are budgeted to increase by 27% in 2013-14.  There is however, one trend that has not been reversed, which needs to be, to put the fiscal deficit on a sustainable trend.  Revenue expenditures net of subsidies, are projected to increase at an even faster rate that the increase in GDP.  Thus the ratio of these expenditures to GDP is likely to increase significantly.

Further Reforms

 The finance minister has also mentioned a number of pending bills, such as the DTA, GST, Pensions and Insurance, that will help improve the investment climate.  If his expectation-hope of these bills in the budget of subsequent session of Parliament fructify, then enough momentum will be generated to return to a growth rate of over 6% in 2012-13.  If these and other administrative and procedural reforms, such as the setting up of an effective ‘Road Regulatory Authority,”  that have been talked about do not come through, then growth is likely to be around 6% (+/- 0.5%). 

A version of this note appeared in the Op Ed page of The Hindu on March 1, 2013 under the banner, “The path to Fiscal Sustainability,” at  http://www.thehindu.com/opinion/op-ed/the-path-to-fiscal-sustainability/article4463052.ece?homepage=tru

India Budget 2013-14: Pre-budget Q&A

1.      Q: What do you believe are the most critical issues that the FM should be focusing on when he delivers the budget?

A: The critical issue is to restore economic growth. To do this, two central problems have to be addressed in the budget.  One is the Fiscal deficit and the other is revival of private investment.
 

2.      Q: This is the last full year budget before next year’s general elections. Do you worry about populist measures being announced?

 A: There is still time for another pre-election budget in 2014.  The 2013-14 budget should focus on the revival of investment and growth, leaving any “populist” measures to the next budget. 

3.      Q: The government finances are a mess. We’d be lucky if the fiscal deficit comes in at 5.3 per cent as the FM has promised it will.  The CAD is set to end this year at a record high. But would you say the progress made by the FM in the months since he took charge give you reason to believe that we are on the path to recovery?

A: The administered price changes announced by the government during the last four months are a good beginning, but they are just that a beginning.  The next critical step is the budget.  More important than the precise number for the current year (5.3% or 5.4% of GDP) will be the steps taken to put government consumption, subsidies and transfers on a firm trend to fiscal deficit reduction.  Further action will also need to be taken to reassure tax paying investors that a simple, broad based tax structure that promotes voluntary compliance is still the objective of the finance minister, and not “revenues at any cost.”

       For instance, measures introduced in the last budget to tax equity investment in new entrepreneurial ventures as hypothetical unrealized capital gains is against the logic and practice of capital gains taxation.  This should be completely and unambiguously removed for young, small scale entrepreneurs who are trying to obtain funding from venture capitalists.

4.      Q: High fiscal deficit has supported consumption but crowded out investment. Isn’t this growth composition a self-defeating one?

 A: Yes. The rate of growth of investment during 2008-9 has fallen dramatically from that attained during 2003-4 to 2007-8.  At the same time government consumption and government transfers and subsidies for private consumption have increased during 2008-09 to 2011-12.  Though the objective of the government was to promote inclusive growth and poverty alleviation the collateral damage caused to growth was insufficiently understood and appreciated by policy advisors, policy makers and even private industry (till 2011-12). The focus of expenditure needs to be reversed.

5.      Q: Has enough been done on addressing supply-side bottlenecks? What would you like to see as first steps by the government?

 A: Much more needs to be done to address supply-demand gaps in Agriculture (APMC, ExIm regime), Energy (pricing, subsidy), Minerals (Exploration, auctions), Land – Rural (LAA, R&R), Urban (land use, market) and skills (certification, training of trainers, rural youth).

6.      Q: What should be the more immediate priority – revenue enhancement or quality of expenditure?

A: Expenditure reduction has to be the immediate priority. It will allow an equivalent easing of monetary policy and thus support investment and growth.  In contrast revenue enhancement will add to and worsen the dis-incentives for investment.  This is particularly true of short term, “revenue at any cost” measures that have additional negative effects on sentiments and “animal spirits.” An improvement in the quality of both taxes and expenditures would enhance efficiency and growth, but the macro economic situation requires a sharp reduction in expenditures coupled with a dramatic easing of monetary policy.

7.      Q: India’s fiscal deficit one of the highest among high growth economies. Would you put this down to high government spending or weak revenues, especially our low tax base?

 A: India’s fiscal deficit has historically been among the highest in the world, not to speak of high growth economies.  However, by 2007-8, t he central (national) fiscal deficit was reduced to 2.5% (4%) of GDP in 2007-8, a highly creditable performance, even in a global perspective.  The global financial crisis of 2008, changed this trajectory, by necessitating a fiscal stimulus (of 2.5%) to offset the dramatic fall in private demand. 

      The V shaped recovery of growth to 8.2% in 2009-10 justified this stimulus but was also an argument for cutting back the deficit over the next two years to the 3% prescribed by the FRBM.  Unfortunately, the fiscal stimulus was increased, with little protest from economic experts by an additional 0.5% of GDP (to 6.5 % of GDP) in 2009-10, so it became impossible to bring it back to 3% by 2010-11.  This was driven by 2.2% of GDP increase in revenue expenditure and a 0.8% of GDP increase in subsidies. Restoring subsidies and other revenue expenditure -GDP ratios to those achieved in 2007-8 will help bring down the fiscal deficit and restore growth and tax revenues to earlier levels.