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.
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Aversion of this article also appears in ET Blogs at http://blogs.economictimes.indiatimes.com/PolicyAnalysis/economic-reforms-in-budget-2015-16/

Budget 2015-16: What to expect

Introduction

     The forthcoming budget is expected by some to be ‘make or break’  or ‘path breaking’ , by others to provide a legislative or economic road map for the remaining term of the Govt.  Most likely it will focus on issues under the purview of finance ministry, namely macro management, taxation, expenditure, financial sector and Balance of Payments.

Federalism

   The abolition of the Planning Commission and Finance Commission recommendations on tax devolution, together makes it possible for this budget to initiate a structural movement back to the principles of Federalism embedded in the constitution and its Central, State and concurrent lists. Though the Concurrent list gives overall policy responsibility to the Central government for many sectors, the administrative responsibilities have been fairly well defined.  Thus the States are responsible for the basic Health, Education, Social Welfare (poverty) and Security (police) of the general population.

    The Finance Commission recommendations to increase non-discretionary tax devolution by 10% points to 42% from 32%. This calculation accounts for the actual & potential revenue receipts and expenditures of the States on all sectors that are the administrative & financial responsibility of the States. This effectively means that instead of an extra 10% being channeled through the Central Govt and the (erstwhile) Planning commission into Centrally Sponsored Schemes (CSS) on Health, Education, Social Welfare, these funds will go as untied funds to States to allocate in the manner that they feel is most appropriate for their State. The budget will inform us how quickly the old schemes in these sectors are to be phased out or abolished. This is the essence of Federalism: Financial funds, allocation rights and administrative  responsibilities must be located in the same level of Govt., whether it is the Center, State or Local Govt..

   The fiscal recommendations of the Finance Commission, a constitutional body,  has removed some of the uncertainty about government’s fiscal stance. The government now has clear backing to ignore demands for a fiscal stimulus beyond earlier targets of 3.6% in 2015-16 and 3% in 2016-17. It can also focus more strongly on reducing the Revenue deficit (RD), something I have argued for years. The RD mirrors the net dis-saving of the Central Govt. A reduction in the RD is therefore critical to raising the National saving rate. This in turn is linked to India’s net international asset position (NIA), stability of capital flows and the international credit rating of the country. The budget is expected to spell out its approach to Fiscal responsibility legislation and possibly to raising India’s credit rating over a decade.

Growth Imperative

   The Growth rate of the Indian economy has accelerated  by about 0.9% point in 20014-15 (compared to 2013-4). This is accompanied by (or partly due to) an acceleration in growth rate of private consumption growth and gross fixed capital formation.  However, available indicators also show that the growth of demand for the corporate sector is weak.  In the case of Automobiles, housing &  other consumer durables, high real interest are an important contributor. A clear and credible fiscal consolidation path will make it imperative for the Central Bank to reduce high nominal policy rates that are partly responsible for choking consumer demand.

Expenditure Priorities

  The budget is also expected to lay out a clearer approach to and road map of the Government’s new flagship programs, namely Jan Dhan Yojna, Sagar Mala, 100 cities, Digital India/e governance, e-health/education, Make in India, Skilling India, Swach Bharat(S) and  Beti Bachao-Beti Padhao. The move from price distorting subsidies to direct transfers to deserving poor will gather steam and help reduce corruption & admin costs. The consequent fiscal space will be used to increase spending on public goods infrastructure that can attract complimentary job creating  private investment.

Eliminating Tax Terrorism

    Tax administration and appellate procedures, their speed and effectiveness, are known to be an important focus of the Govt., since the BJP manifesto used the word “tax terrorism”. Both domestic and foreign tax payers are looking for more concrete measures to further these objectives and end the anti-deluvian practices of the tax administration and their replacement by a more modern, accounts based customer focused approach. Business is also looking forward to Initial steps towards GST implementation, a clear statement on the simplification of Income taxes and the Direct taxes code.  I am also hopeful the interrupted journey to a simple, uniform customs duty structure will resume. For instance the elimination of dozens of specific duties on textile products is overdue. Some steps towards rationalization of Agricultural import & export duties would also be welcome.

Minor Tax Sops vs Simplification

      An interesting question is the extent to which, government will go back to the pre-1990s practice of using deductions & exemptions to stimulate demand for or investment in, certain sectors like defense, electronics, real estate and automobiles.  I expect it to follow a middle path of some simplification coupled with modest incentives, which many budgets since 1991 have done. An increase in the housing (interest) deduction in the personal income tax can probably be justified on grounds of inflation adjustment and is likely to occur. Electronics suffers from an inverted customs duty structure because we bound ourselves to an IT0 agreement that eliminated tariffs on many final goods, but not on imported inputs. Tax incentive may be used for incentivizing job creation and employment opportunities in labor intensive sectors like tourism

Financial Reforms

     As financial and external sectors come directly within the purview of the Finance ministry, I would expect the budget to address the legacy problems of the Public Sector Banks, such as the NPA’s incurred by them due to Govt. forced lending by PSBs to unviable infrastructure projects. These projects were recognized by private banks to have excessive policy and regulatory risks to be viable for debt financing.  On the positive side one expects new policy and institutional reform initiatives relating to the financial and external sectors. For instance the stalled proposal for creating a global financial center in India, is likely to be revived in a new form.  Similarly, some reduction of controls on the external/BOP account can also be expected.

Conclusion

Overall I expect the budget to give us a sense of the Govt’s approach to fiscal and financial policy and to give an indication of economic reforms to accelerate and sustain the growth of the economy, jobs and employment opportunities.

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A version of this article appeared on the Op Ed page of the Indian Express on August 28, 2015 under the banner, “No Clean Slate.” http://indianexpress.com/article/opinion/columns/no-clean-slate-2/