The Union government’s worsening fiscal trajectory with no meaningful measures to stop the deterioration, coupled with worsening state fiscal deficits, has raised India’s economic vulnerability sharply. What may act as a trigger for a loss of confidence in India’s economy—and when—is unknown, but the worsening trend is clear. Political parties should take note and come together with meaningful reforms to counter the worsening trend, else instead of political representatives, economic policy may end up being driven by the International Monetary Fund (IMF).

Despite the increased tax revenue from higher petroleum and services tax rates, and large savings from petroleum subsidies from 2013-14 to 2017-18—about 2% of gross domestic product (GDP)—the fiscal deficit of the general government (Union and states combined) remains broadly where it was at best, with a near certainty of worsening sharply in 2018-19. From 2014-15 to 2016-17, for which data are available, the combined deficit fell marginally from 6.7% to 6.4% despite these windfalls. In fact, the deficit may be larger as we do not yet have final numbers for the state governments for 2016-17. Given that the central government’s deficit has worsened in 2017-18, it is hard to imagine that the states would have done any better. This is compounded further by loan waivers to farmers by several state governments, possibly totaling 1% of GDP.

The revised estimates for 2017-18 compared with 2016-17 indicate that while income tax revenues increased by 0.43% of GDP, indirect tax revenues (on goods and services) declined by 0.06% of GDP. The numbers for 2017-18 are estimates and the growth in income taxes assumed to be 18.6% is higher than the actuals for April-December 2017 over April-December 2016, which indicate an increase of 17.1%. Indeed, if income tax revenues were to grow at 17.1%, the actual revenue collection will be lower by about Rs13,200 crore in 2017-18, indicating that the fiscal deficit out-turn may be higher than currently envisaged.

Most worrying in the 2018-19 budget is the assumption of indirect taxes as a share of GDP rising from 5.6% of GDP in 2017-18 (revised estimate) to 6.0% of GDP, especially after a slight decline compared to 2016-17 numbers. There seems little justification for this sharp increase unless the government plans to impose new taxes in future. There is thus a high chance that this increase will not materialize, leaving an additional gap of 0.4% of GDP in the fiscal deficit.

The IMF and the international community recommend that disinvestment proceeds be treated as a financing item and not as revenue since these can be one-time, lumpy and unreliable sources of revenue. Excluding disinvestment proceeds would add 0.4% of GDP to the internationally accepted definition of fiscal deficit. Additionally, the government is getting used to an unreliable source of funding—if disinvestment proceeds dry up (due to poor market conditions, for example), it may leave a large hole in the budget. Already, we have seen something similar happen with telecom spectrum licensing fees that cannot be relied on as sources of funding.

The government’s expenditure policy does not appear to be conducive to increasing investment or potential GDP in the near or medium term. The central government’s overall capital expenditure declined from 1.9% of GDP to 1.6% of GDP in 2017-18 and is expected to stay at 1.6% in 2018-19 at a time when investment has stagnated. Additionally, not all of the capital expenditures are for investment—some of these are for bank recapitalization. Moreover, expenditure on “social services", which include education, public health, water supply and sanitation, has been reduced progressively from 0.61% of GDP in 2016-17 to 0.59% of GDP in 2017-18 (revised estimate) and finally to 0.57% of GDP in 2018-19. Current expenditure for the Central government increased in 2017-18 by 0.5% to 11.6% of GDP from 2016-17 and it would be very difficult in an election year for this to be reduced even to 11.4% of GDP in 2018-19 as per budget estimates. At the same time, the government wants to provide a higher subsidy to the farmers as well that might prove to be too costly.

It is time for India to undertake meaningful structural reform policies that include a move toward market prices (food, pharmaceuticals, electricity, railways), reform of the legal and tax systems (simpler tax regimes with less discretion to tax officers and no retrospective taxes), and training to build technical skills to avoid mishaps such as the one at the Punjab National Bank recently, etc. This is necessary for India to grow faster and consequently yield more revenue to the government to keep the fiscal deficit in check.

The combined fiscal deficits of the centre and states in 2018-19 could easily increase by 0.5% to 1% of GDP over their target to 7% or more of GDP on account of ambitious indirect tax and disinvestment targets coupled with higher expenditures on account of increased salaries to state government employees as recommended by the last pay commission.

The situation could worsen from thereon as the growth outlook remains weak. India’s banking and corporate sectors are not in good health. Further increases in commodity prices would widen the current account deficit also leading to reduced liquidity at a time when global yields are on the rise. The fiscal vulnerabilities and, consequently, risk have increased sharply and a trigger could easily undermine confidence in the Indian economy leading to capital outflows further exacerbating the vulnerabilities.

Rajan Govil is managing director at Marketnomix and a former International Monetary Fund economist.

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