Economic Realism

THE UNION BUDGET HAS TRIED TO make the best of the grim fiscal situation. There really wasn’t much more Finance Minister Nirmala Sitharaman could have done. There have been only two previous occasions when the Budget has been prepared in such difficult fiscal circumstances. This is the context in which the Budget for 2020-2021 must be judged.

The first time was in 1966 and the second was in 1991. In 1966, as now, it was an internal fiscal crisis because the money ran out. In 1991, it was an external financial crisis because the foreign exchange ran out.
In response, in 1966, India turned inwards. In 1991, it turned outwards. The first response led to two decades of slow growth. The second response led to two decades of rapid economic growth. In this year’s Budget, the response is a halfway house. Only time will tell if it is the correct balance.

That said, it is important to bear three things in mind while evaluating this Budget. None is a reason for even mild elation. That’s perhaps why the stock market has reacted a bit negatively.

First, the Government is really short of money. That’s why the expenditure is up only by about 10 per cent, which is not the fiscal stimulus that that many economists had in mind. Second, therefore, it’s by and large a procedure-easing Budget in the hope that this will make everyone feel better. But the danger here is the faith reposed in the bureaucrats without whose cooperation these initiatives will remain unfulfilled. Third, however, the Budget does attempt to help taxpayers by reducing taxes at the lower end of incomes. But these are not the people who spend large amounts on industrial goods, which means the growth of output from the manufacturing sector will remain sluggish.

Overall, therefore, much will depend on how different elements and segments of the economy view the Budget. And it is here that the Budget gets on firmer ground.

There is, for example, quite a lot in it for micro, small and medium enterprises (MSMEs), startups, energy, infrastructure and healthcare. MSMEs with turnovers of Rs 5 crore and less have been spared the hassles and costs of auditing, provided they conduct 90 per cent of their business digitally. For startups, the employee stock options plan (ESOP) regime has been relaxed so that tax liability now comes down to zero till five years.
For energy, some major subventions are planned for discoms and in healthcare a new public-private partnership (PPP) between private medical colleges and district hospitals has been announced.

But as of now many of these are just proposals. Whether these, when being implemented, improve the businesses of these sectors remains to be seen. For example, much depends on how the Rs 1.7 lakh crore of expenditure announced for infrastructure is distributed among different segments. On the whole, though, it appears grossly inadequate.

AT THE MACRO LEVEL, THE BUDGET seems to be seeking foreign savings to make up for the shortfalls in domestic savings. A number of measures, such as the one pertaining to the dividend distribution tax (DDT) that has been abolished for companies, have been announced. There is also the idea of an initial public offering (IPO) for the Life Insurance Corporation of India (LIC). Much will depend on whether it is listed abroad, say, on the New York Stock Exchange (NYSE).

That said, whether these measures will be enough to attract foreign capital will depend on several other factors. Once again, bureaucratic obstruction and incompetence could slow things down.

On the trade side, there is an attempt to tackle the problems created by the numerous free trade agreements (FTAs) of which India is a member. Rules of origin are to be implemented more strictly, but this is something that has to do with administrative corruption and isn’t strictly a Budget issue. But still, it’s good that the Government has put India’s traders posing as manufacturers on notice.

On the main issue that a Budget must deal with, namely, revenue and expenditure, the Budget seems to have done quite well in keeping the fiscal deficit down to 3.5 per cent. But the off-Budget expenditures are not clear, so the deficit may well be higher. A former finance secretary had recently blogged about these. They seem to be very considerable. At some point, the Government will have to make a statement in Parliament on these.
There are two other hugely important announcements. One is about how much capital the banks actually need under Basel III. This was a problem created by a former Reserve Bank of India (RBI) governor who, simultaneously, also insisted on solving the non-performing assets (NPA) problem in one stroke. Together, these two policies crippled the banks. Now the Government has decided to adopt the international practice of bilateral netting, which means capital requirements will be based on the net amounts owed by banks to each other and not the gross amount.

As Sanjeev Sanyal, Principal Economic Adviser in the Ministry of Finance, tweeted, bilateral netting ‘allows two financial institutions to set off exposures to each other for the purposes of capital & margin. If Bank A has an exposure of Rs 100 to Bank B, and Bank B has an exposure of Rs 90 to Bank A. The gross exposure is Rs 190. With the imposition of capital requirements, the banks have to keep aside capital for Rs 190. However, the net exposure is only Rs 10. With bilateral netting, banks will only have to look at the net position thereby freeing up capital.’

The other is about allowing foreigners to invest in government securities, the limits for which have been increased substantially.

Once again, as Sanyal tweeted, ‘This was an issue that was discussed at the Bloomberg conference attended by PM Modi in NY in Sept. Global bond indices represent trillions of US dollars of ‘sticky’ money. Being included in the indices, therefore, would provide a cheap & stable source of foreign capital.’

However, the Government should make a statement in Parliament on the extent of its liabilities that are not public at present. This can only help attract foreign investment in government security (G-Sec) because no one likes to lend to a country whose full debt profile is unclear.

THE MOST IMPORTANT OF THESE ARE WITH RESPECT TO personal income taxation. One element tackles the problem of rates. The other tackles the double taxation of dividends.

The Budget has followed up the corporate tax rate cuts Sitharaman recently announced with a new personal income tax rate structure. The new structure adds some tax slabs and reduces the tax for all but the highest category, which sees its tax rate unchanged. Under the new system, those earning up to Rs 5 lakh a year will not be taxed. Those earning between Rs 5 lakh and Rs 7.5 lakh will be taxed at 10 per cent. Income between Rs 7.5 lakh and Rs 10 lakh will be taxed at 15 per cent. Earlier, the Rs 5-10 lakh category was taxed at 20 per cent. Income above Rs 10 lakh used to be taxed at a flat 30 per cent. Now, income between Rs 10 lakh and Rs 12.5 lakh will be taxed at 20 per cent and income between Rs 12.5 lakh and Rs 15 lakh will be taxed at 25 per cent. Those earning above Rs 15 lakh will have to continue paying tax at 30 per cent.

Like the corporate tax announcement, the Finance Minister said these reduced tax rates would apply only on the condition that the taxpayer give up the various exemptions and deductions available under the Income Tax Act. So far, she said that about 70 of more than 100 exemptions and deductions have been done away with. This includes house rent allowance and all the Section 80C deductions. But the Finance Minister has said that she plans to remove all of them over the next few years.

Also, as she did with the corporate tax rate cuts, the Government made the new system optional—you get either the lower rates with no deduction or the higher rates with all the existing exemptions. It needs to be seen how many of the already minuscule number of income taxpayers switch over to the new system. From the face of it, the new system seems to make sense for those who aren’t currently investing in tax-saving instruments.

As the name suggests, the dividend distribution tax is a tax paid by companies at the time of distributing dividends to its shareholders. The rate of DDT has increased over the years to the current 15 per cent (plus surcharges and cess). Now, the Government has suggested shifting the onus of paying the tax to the shareholder. That is, the recipient of the dividend will have to treat it as additional income and pay tax on it according to their income tax slab. This means dividends will be taxed entirely in the hands of the recipients. This affects promoters the most, who will now pay at the highest marginal rate of nearly 43 per cent. But most of them have trusts and now we can expect more to be formed. Also, as Harish Damodaran has pointed out, ‘…many companies may now prefer coming out with bonus issues, rather than declaring dividends, in order to reward shareholders.’

BUT ARE BOND MARKETS REALLY STICKY? ARE THEY NOT algorithmically traded, very volatile and sensitive to risk and changes in the yield curve? We need to bear in mind that exposure to the global bond markets increases the penalties for fiscal recklessness as Argentina and Greece have discovered. Country ratings do affect investor behaviour. Also, for all practical purposes, G-Secs and country ratings are identical. So we will have to be very careful.

As to investments by pension and sovereign funds, both are at the long-term end of the market and are always looking for yield, so Indian G-Secs will be evaluated against, say, Indonesian G-Secs. So, depending on against whose G-Sec, there could be some stickiness.

Another problem can arise with the US money markets. If quantitative easing starts reversing in the near term, punishment could come quite soon.

Therefore, it’s possible that these policy initiatives will yield a small short-term gain but the potential for a big long-term punishment. Given successive governments’ inability to cut back on subsidies and freebies , we should not underestimate the longer-term risk. But if tax revenues do not pick up and government deficits do not drop, the stickiness will vanish. This is the danger.

The other big caveat is with respect to disinvestment. Can the Government really sell off Rs 2 lakh crore worth of the public sector? That too when the valuations are likely to attract huge political opposition?

There’s also the worry about the raiding of the small savings fund. What is, however, more worrying, is that the Government intends to borrow Rs 1.36 lakh crore from the National Social Security Fund (NSSF) in 2020-2021 to meet its food subsidy bill while the food subsidy bill for next year is only Rs 1.15 lakh crore. Moreover, the Government borrowed a little over Rs 1 lakh crore from the NSSF. But even if it had borrowed only as much as needed, the question remains: should it be borrowing from the NSSF at all? This is similar to a private sector firm raiding employees’ savings. Quite simply, it’s bad practice.

HISTORICALLY, ALL BUDGETS ARE A triumph of hope over experience. This one is like that as well, but less so because most of the changes it proposes are more than usually practicable.

Also, its real message is clear: the Government has finally given up excessive populism and its dread of the suit-boot label. It’s finally doing what comes to it naturally: turning to private enterprise to rescue the economy.

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