a shadow budget for 2013-14

Shadow Budget What is and what should be! 3/15/2013

Aravind Maddireddy Indian Institute of Management, Roll: 12151 Room No: 1, Dorm No: 12 Mob: 8141912657 Email: [email protected]

Prashant Yadav Indian Institute of Management Roll: 12218 Room No: 21, Dorm No: 16 Mob: 8511676419 Email: [email protected]

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Shadow budget 2013-14

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Declaration

We, Aravind Maddireddy and Prashant Yadav, of Indian Institute of Management, Ahmedabad,

declare that this essay is entirely our own work and has not been submitted in any form to any other

media group. We also permit moneycontrol.com to use, alter, edit, publish or display the essay on-

line/ electronic or in print with due attribution

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Table of Contents

Problems facing Indian Economy ........................................................................................................ 4

High Fiscal Deficit ................................................................................................................................ 5

High Current Account Deficit .............................................................................................................. 6

Reforms undertaken ........................................................................................................................... 8

Analysis of Union Budget 2013-2014 .................................................................................................. 9

Shadow budget ................................................................................................................................. 12

Potential Reforms ......................................................................................................................... 12

Revenue Taxes ........................................................................................................................... 14

Revenue Non tax receipts .......................................................................................................... 15

Expenditure Subsidies ................................................................................................................ 15

Expenditure Leakages ................................................................................................................ 16

Current Account Deficit ................................................................................................................ 16

Investments and Infrastructure .................................................................................................... 17

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Problems facing Indian Economy

Indias macroeconomic imbalances have worsened over the last 4-5 years. Inflation continues to

remain high and the twin deficits (Fiscal deficit and Current Account Deficit) have gone up sharply.

The overall economy seems to be settling into a lower growth trajectory with the GDP number for the

third quarter coming at a dismal 4.47%. Not surprisingly, India has been put on a rating watch by the

credit rating agencies and is just one step away from a downgrade to the junk status.

The slowing down of the economy can be partly attributed to rising oil prices and weak foreign

demand. However, a major part of the damage is self-inflicted through a structurally high fiscal deficit

and a steep decline in the governance quality. Indias fiscal deficit that had fallen to 2.5% of the GDP

in FY08 from 6% of GDP in FY02 revised all its gains and rose to 5.9% in FY12 (and coming at 5.2%

for FY13 largely due to a sharp cut in planned expenditures and one off asset sales). Much of this

fiscal decline is structural.

Both higher government expenditure and weak tax revenues are to be blamed, but the composition of

the expenditure is a major concern. The governments revenue expenditure (spending on subsidies,

wages and interest payments) has risen at the expense of falling capital expenditure. Cost of subsidies

have gone up from 1.4% of the GDP in FY08 to 2.4% in FY12. Governments flagship Food Security

Bill will further add to the subsidy bill.

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On the revenue side, the general government (both central and state) tax revenues have declined from

a high of 17.6% of the GDP in FY08 to 16.1% in FY12. The crowding out of private investments

have hurt industrial activity and lowered excise tax collections from a peak of more than 3% of the

GDP to less than 2% now. The fall in the governance quality has not helped the investment climate

either. A spate of scandals over the last couple of years have hurt the psyche of government officials

and slowed down the decision making process.

High Fiscal Deficit

The very high fiscal deficit fuelled inflationary pressures by widening the consumption-investment

gap. Although the WPI inflation is showing signs of cooling (falling to 6.62% in the month of

February), it still remains much higher than RBIs target of 5%. CPI inflation continues to remain at

elevated levels.

Subsidized fuel prices and an increase in inclusive growth schemes (without increasing investment)

increased consumption demand to unsustainably high levels. Demand is now increasing faster than

earlier because the Indian middle class is reaching income levels at which the demand for consumer

durables and protein-rich food items goes up. Since half of the consumption price basket is composed

of food prices, it has resulted in increased inflation expectations. The higher MSP (Minimum Support

prices) on food crops have also fuelled food inflation. The election winning rural employment scheme

of UPA (United Progressive alliance), MNREGA (Mahatma Gandhi National Rural Employment

Guarantee Act) that has wages indexed to inflation has effectively set a floor on rural wages and

resulted in labour shortages in the urban areas, leading to a classic wage price spiral.

In response to rising demand side inflationary pressure, the RBI embarked on a series of rate hikes

between March 2010 and October 2011. The burden of this adjustment fell disproportionately upon

investments, especially more productive private investments which were crowded out by the large

fiscal deficit.

Rising borrowing costs due to excessive government borrowings and a hawkish RBI resulted in a

crowding out of manufacturing investment, one of the key drivers of Indias capital expenditure

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during 2003-2007. Policy paralysis, lack of reforms in land acquisition and a delay in obtaining

environmental clearances have resulted in a sharp decline in infrastructure investment. Investment has

fallen from a high of 38.1% of the GDP in FY08 to less than 30% of GDP in FY13 hurting

productivity and thus the trend growth rate of GDP in India.

The sharp drop in private and public capital expenditures has the possibility of turning into a negative

spiral (high interest rates leading to low investment rates which in turn increases inflation leading to

further hike in interest rates) and is making it difficult to sustain growth.

India enjoyed the cushion of high savings rate that made investment sustainable due to an ample

availability of domestic funding. Over the years, however, this cushion has eroded with the gross

domestic savings rate falling from 36.8% of the GDP in FY08 around 30% of the GDP in FY13. Both

public and private savings have gone down due to a high fiscal deficit and higher cost of capital

respectively.

Another important problem related to savings is that the high inflation and the resulting reduced real

rate of return has changed the composition of household savings that is now more inclined towards

physical savings rather than financial savings. This shift has reduced the funds available for

investment locking savings in non-productive investments such as gold.

High Current Account Deficit

Slowdown in exports due to weak external demand (due to the subprime crisis in US and the

sovereign debt crisis in Europe) and relatively inelastic imports resulted in a sharp deterioration of

Indias CAD (Current Account Deficit). Imports remained inelastic in India because of multiple

factors including

Consumption biased government policies strengthening consumption demand

Shift in savings towards physical savings to hedge against inflation

Fuel subsidies leading to inelastic oil demand

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High coal imports due to lags in domestic production resulting from slow environmental

clearances

Increased import substitution due to supply side constraints (including power) and rising

domestic cost of production due to elevated inflation

To sum up, main reasons for Indias worsening CAD, which has been announced as the biggest

problem facing Indian economy currently by various government officials including Mr Raghuram

Rajan (Chief Economic Advisor of India) are

Crisis in the western economies resulting in a low external demand for Indias major

manufacturing exports like metal products, jewellery, handicrafts, leather, gems etc which are

demand sensitive and non-differentiable

High oil prices and increased dependence on diesel of the economy led to higher imports of

crude oil. Ever increasing domestic demand led to a slowdown in exports of refined

petroleum products

Structural increase in import of essential commodities such as edible oils, coal and fertilizers

due to supply side domestic constraints like the mining ban affecting coal production, low

agricultural productivity (edible oil) and a lack of domestic resources such as fertilizers

Slower growth in software services, outflows from non-software services and a sharp rise in

interest payments made on foreign investments in India have resulted in contraction of

invisibles balances

Sharp increase in CAD resulted in an increased dependence of the country on capital inflows to

finance the CAD. Indian currency, INR, is now highly vulnerable to portfolio flows in and out of the

country. Indias FX reserves stand healthy However, the use of FX reserves to counter sharp currency

depreciation due to sudden capital outflows is limited due to the following reasons

Use of FX reserves to stem INR depreciation will worsen the reserve ratio leading to an

increased medium term vulnerability

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Use of FX reserves to stabilize INR by selling USD and buying INR would further tighten the

domestic liquidity situation and would need to be countered by open market operation or

CRR cuts

Reforms undertaken

In response to the severe problems of fiscal deficit, declining investment and declining capital inflows

along with the looming threat of a ratings downgrade, the Indian government announced several long

overdue reforms in the past six months that resulted in providing a boost to the sentiment of high

growth.

The reforms started with the announcement of a 12% hike in diesel prices which, though fiscally

insignificant, is politically significant in crossing the policy inertia threshold. This announcement

signalled a forward looking deregulation of fuel subsidies that would help the fiscal targets as well

reduce the inelasticity in imports, helping with the CAD. Immediately after, the government followed

on by pushing for opening up its retail, domestic airline, broadcasting and power exchanges for

foreign investments. It also announced a disinvestment drive to the tune of Rs.15,000 crore to fill the

widening revenue deficit every year. Other measures such as opening up insurance sector for FDI

investments, withholding tax on long term infrastructure bonds, restructuring power distribution

companys liabilities were also announced but some of these still seek parliamentary approval.

The resolution of the prevalent issues is contingent upon the implementation of the major reforms

addressing the fiscal imbalances. Indias rising inflation driven mostly by high food inflation and

supply-side constraints, helped along with minimum support prices and minimum rural wages can

only be addressed by measures aimed at improving agricultural productivity. FDI in multi-brand

should, in theory, help with the inflation by providing lower prices for consumers through better

logistics, competitive shops and expertise, and help reduce fuel subsidies by providing higher prices

for farmers through cutting the middle-men. But, the materialization of these advantages is sharply

dependent on the investment in back-end infrastructure. Similarly, the diesel price hike and the LPG

reforms are only effective to the extent of setting up stage (both together contribute to .1% reduction

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in fiscal deficit) for further reduction in the fuel subsidies which would make the imports much more

elastic, thus reducing the structural nature of trade deficit.

With the global export demand slow and uncertain, attractive investment opportunities are few. Along

with the issues faced by infrastructure sector in terms of stretched balance sheets and resource

availability, the drive for investments is meagre compared to consumption, a part of which is

supported by the continuing uptrend in the rural wages. In this context, many more reforms are

needed to effectively address the twin deficits and other issues listed along with the pending

implementation of a major chunk of the announced reforms. These should form the backdrop for

framing the future budgets.

Analysis of Union Budget 2013-2014

Threat of the ratings downgrade and the spate of reforms announced earlier by Finance Minister Mr P.

Chidambaram had raised the expectations of a fiscally prudent and reform heavy budget. Union

Budget 2013-2014 presented on 28th February 2013, although prudent, targeting a fiscal deficit of

4.8% for FY14 and trimming the fiscal deficit estimate for FY13 to 5.2%, disappointed on many

counts.

Analysis of Budgetary Measures

Taxes

The super-rich individuals and large corporates are more likely to invest and contribute to the

growth than others in a supply-constrained consumption focused current Indian economy. By

imposing additional tax surcharge on these individuals and companies, though higher tax

revenue projections for the fiscal year can be obtained, capital is diverted into inefficient

bureaucracy-riddled government departments, effectively destroying capital and jobs.

The new measures are expected to provide a Rs.13,300 crore revenue gains through direct

taxes and a Rs.4,700 crore revenue gains through indirect taxes helping to bridge the revenue

deficit

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However, the focus should have been on expanding the tax base rather than one-time higher

tax revenues which make the fiscal consolidation in medium term difficult.

Expenditure -

The decline in the expected budget expenditure by 8.1% in FY14 to that of FY13 helps in the

fiscal consolidation which is very important in boosting the investor confidence and

ultimately attracting and retaining foreign investments

Capital Markets

The reduction in the STT and the extension of RGESS shall improve the participation of retail

investors. This, when combined with the fact that RGESS has a 1year fixed lock-in period and

a 2-year flexible lock-in period allows the focus to shift partially from consumption towards

investment

The move to allow the FIIs in currency derivatives and allowing the usage of bonds as margin

helps increasing the FII flows. However, this still focuses on increasing only the debt flows

while significant incentives for more focus on equity FII flows still lack in the budget.

With the budgeted gross borrowing still standing at a high value, the long term rates are likely

to stay higher. Even if with the projected lower inflation, monetary easing is viable thus

reducing the short term rates, higher long term rates prevent an effective move towards

investment

Infrastructure

First time home buyers can get loans for lesser interest

Savings

As the inflation expectations remain high in the minds of Indian investors, they gradually

moved towards investing in gold and other alternative non-capital investments instead of

investing in paper that might prove to be worthless. The introduction of the inflation-indexed

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bonds and National Security Certificates is targeted towards providing the investors higher

inflation adjusted returns. This might help in diverting some of the current flows into gold

into these securities helping partially address the issue of capital flight. However, the utility

from these instruments might prove to be limited.

Though this move would improve household savings, it would not do much in addressing the

key decline in the private corporate sector savings which forms the major issue

Analysis of Budgetary Assumptions

The budgeted fiscal deficit of 4.8% for FY14 looks prudent and shows the right intent of the

government to consolidate its finances. However, we need to critically examine the assumptions made

in the budget regarding expenditure, revenue growth and planned asset sales, given the tendency of

the government to consistently miss the budgeted target in the recent years

The budget envisages a tax revenue growth of 19.10% for FY14 assuming a nominal GDP growth of

13.4% in FY14 (real GDP growth of 6.1% - 6.7%). This looks optimistic when we look at the

corresponding numbers for FY13 (tax revenue growth of 16.7% and a revised nominal GDP estimate

of 11.7%) Budget assumes a high tax buoyancy of 1.4 even though there have not been any

substantial changes in the tax rates. Tax buoyancy has been 0.8 on an average over the past 5 years.

The disinvestment target of INR 55,000 crore looks difficult to achieve given the fact that the

government was able to raise only INR 24,000 crore against a target of INR 30,000 crore in FY13.

The budgeted spectrum sale target of INR 40,000 crore also looks challenging in the light of

disappointing response to these auctions in FY13. (Give some more details here)

The expenditure assumptions, though reasonable on some counts, does not give the government any

leeway to cut expenditures to meet the fiscal deficit targets as was done in FY13.Planned expenditures

are budgeted at 29.4% for FY14.

The fiscal deficit target of FY13 was achieved through a combination of real expenditure cuts and

delay in payment of subsidies to government companies and lower income tax refunds. These rolled

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over payments would add to the financial burden in FY14. Further, the Food Subsidy Bill would add

to the subsidy burden and the budgeted reduction in fuel and fertilizer subsidies is contingent on

sustained hike in diesel prices and raising urea prices in FY14. This is easier said than done given

elections in five state in 2013 and General elections scheduled for May 2014. The three major

subsidies of food, fuel and fertilizer are capped at Rs.2.2 lakh crore. Food subsidies, after

incorporating a INR 10,000 crore allocation for the food security bill, moved to a INR 90,000 crore

from INR 85,000 crore of FY13. With a possible increase of fertilizer and fuel prices, the production

and transportation costs are expected to move to a higher number bringing the expected baggage to

INR 90,000 crore without even considering the impact of the food security bill, in light of which, the

estimates of the subsidy expenditure look rather dubious.

Shadow budget

Potential Reforms

To sum up the analysis so far, it is evident that India is not lacking in growth potential with huge

latent demand and low per capita consumption; it is the supply-side constraints that cannot keep up

pace with the growth of demand. Any moves to spurt demand without addressing the structural nature

of the deficits will only lead to a higher inflation. Keeping this context at the head of analysis, the

following broad reforms might prove to deliver the highest promise in the medium to long term.

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Item Measure Term

Revenue

Expand the tax base Medium

Reduce the complexity of the current tax regime Medium

Set concrete disinvestment targets Medium

Focus on efficiency of tax collection system Short

Expenditure

Reduce the subsidies Medium

Eliminate the minimum support prices Long

Prevent leakages direct cash transfer (mention its

shortcomings)

Medium

Trade deficit

Reduce the inelastic nature of imports Medium

Increase exports Medium

Inflation

Focus on raising the productivity of agricultural sector Medium

Eliminate the minimum support prices Long

Creation of a strong cold-chain infrastructure for agriculture Medium

Increase private sector participation

Investments

Shift the focus from consumption to investment Short

Transparency in the land procurement process and

environmental clearances

Medium

Power sector reforms Medium

Faster approval of projects Short

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Remove infrastructure bottlenecks Medium

Focus on reducing the long term rates Short

Open more areas to FDI investments; raise FDI limits in key

areas

Short

Savings

Shift the focus of savings from physical assets such as gold

into financial assets

Short

Increase the corporate savings Short

Capital markets

Promote the development of a corporate debt market Medium

Promote deficit financing through domestic debt Medium

Promote FII flows in debt and equity markets Short

The moves outlined in the table above are categorized into three terms Short, Medium and Long.

The short term activities need decisive actions outlined in the budget, the medium term ones require a

concrete measure in the budget to stress upon the governments drive to achieve the target and the

long term reforms need to be communicated by having measures indicative of these reforms. Keeping

this analysis as a guiding principle, a shadow budget has been presented in the next section.

Revenue Taxes

Goods & Service Tax:

o Definitive road map for single Goods & Services tax of 20% on the value add created

at various stages in the importing producing distributing value chain of the tax-

applicable products.

o This tax would replace all the indirect taxes levied such as VAT, CST along with

other indirect taxes. This would make the tax system much simpler and tracking

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easier. Tax burden would be equitably shared between manufacturing and services.

Tax rates shall be reduced and tax base would be widened helping the buoyancy. In

the current taxation method, inter-state state sales were avoided by sending the

finished goods to the depots in the state where sales would be made to save the CST,

thereby creating a large number of inefficient small depots. GST would thereby

increase supply-chain efficiency by keeping the taxation independent of the supply

chain route.

Direct tax code:

o Definitive road map for the implementation of the Direct tax code. The DTC should

remove most categories of exempted income other than Educational loans. Tax

regime should be simplified by unifying the tax brackets and exemptions across the

country.

o A concrete plan for recovering Rs.50,000 crores in the Rs.4 lakh crore currently

under the tax disputes.

Revenue Non tax receipts

Set disinvestment targets of reducing the stakes of Government in major Public Sector Units

to 50% by 2018.

Divestment through fund creation and offer exchange traded funds.

Expenditure Subsidies

Reduce the food subsidy allocations in the budget to Rs. 50,000 crore stressing on the

removal of the minimum support prices.

Reduce the fuel subsidy allocations to Rs.40,000 crore by increasing the diesel prices and

placing a cap on other subsidies.

Reduce the fertilizer subsidies to Rs.40,000 crore while focusing on measures to increase the

agricultural productivity.

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Rs.61,000 crore of the freed up expenditure from the deduction of subsidies shall be utilized

in building infrastructure for increasing agricultural productivity. The remaining Rs.30,000

crore shall be distributed through direct cash transfer mechanism.

Expenditure Leakages

Stress the importance of increasing the momentum in issuing Aadhar cards and set a target of

issuing 40 crore UID cards by the end of FY14

Start a separate mechanism to issue bank accounts for the Aadhar holders and link these

accounts to UID on a fast track basis. Set a target of 30 crore account by the close of FY14

Rs.30,000 crore shall be distributed through direct cash transfers to these accounts

The main issue for the implementation of this would be the absence of banks in a large

number of villages. Banking industry should be incentivized to open branches in the rural

areas with diffused reach. RBIs supervisory power should be increased to accelerate the

issuance of licenses to the rural non-banking entities to increase the rural penetration of the

banking system. Provisions should be laid down to increase the number of rural branches for

the regular banking organizations.

Direct cash transfer system should be implemented in the areas with banking facilities. For

other regions, regular subsidy flows shall continue till 2018 while steadily reducing these

areas.

As the tax base and tax buoyancy increases and non-tax revenues gathered, while at the same time

subsidies reduced along with plugging the leakage holes in the subsidy delivery system, the fiscal

deficit decreases and fiscal consolidation shall no longer be a distant dream.

Current Account Deficit

Large current account deficits are financed by large capital inflows in India.

With the reduction in fuel subsidies, the structural nature of the imports shall be reduced and

market forces automatically reduce the amount of imports.

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To counter the regularly rising gold imports, place a surcharge on gold imports.

To improve the exports, policy and infrastructure barriers have to be removed and

manufacturing sector has to be incentivized.

Investments and Infrastructure

Land Acquisition:

In India, 48% of land is dedicated to agriculture which is abnormally huge while in China it is

limited to 15%. Financial return on Indian agriculture is very low at 3-4%. Iconic projects like

Tata Nano have suffered due to the lack of a harmonious process for the transfer of land from

agriculture to industry. The Land Acquisition Rehabilitation and Resettlement (LARR) bill in

the parliament should be championed with all the government behind it. To make the process

of land acquisition fair, the following measures have to be taken.

o A portion of the mining profits should (Mining tax) should be used for developing

the local community

o Instead of upfront payments to the farmers, annuity payments should be made for

acquisition of lands

o Proper ownership entitlements to land have to be documented. To this extent, all the

land in India should be surveyed in the next 3 years and the absolute ownership rights

should be digitized.

Mining reform:

o Mines and Minerals bill has to be passed at all cost. This bill categorizes the mines

and sets appropriate standards for awarding licenses and compensations for the

displaced.

Power sector reforms:

o Adequate power should be made available to the industry usage.

o Once land acquisition and Mining reforms are in place, many power projects would

be fast tracked and industries would have access to more power.

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o A coal regulatory authority has to be set up to create a well-defined structure to

regulate the coal prices and to make the auctions competitive. The dependence on

imported coal should be reduced and fuel linkages have to be assured to this extent to

the state electricity boards.

Manufacturing:

o Provide a 25% accelerated depreciation allowance for industries with the highest

export growth potential.

o Targets should be set to increase the manufacturing sectors contribution to GDP,

20% by 2018 and 7 crore jobs have to be added in the manufacturing sector.

Agriculture:

o Private sector participation in the agricultural sector should be encouraged to boost

productivity

o Rs.61,000 crore saved from subsidies should be invested in developing cold chain

infrastructure

FDI:

o More sectors have to be opened up for FDI investments

o A commission has to be set up to track the FDI inflows and identify illegal FDI

inflows from black money

o FDI limits in multi-brand retail, insurance and aviation sectors have to be increased

o Cost of doing business in India should be reduced by way of reducing corruption

Project clearance:

o A national investment board has to be set up on a fast track basis to accelerate the

clearances for projects greater than Rs.500 crores

Financial sector:

o Corporate bond market has to be developed to address the Indian infrastructure needs.

o Pension systems should be opened up to private firms

o Voting rights in private banks have to be increased.

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o Inflation indexed instruments should be provided to both household sector and

corporate sector to incentivize savings.

Labor market:

o Flexible labour laws aimed at achieving economies of scale should be incorporated

o Minimum wage support should be stopped to reduce the rural demand for

consumption. Instead, labour markets should be allowed to clear automatically.

Corruption:

o One time window for a period of six months should be opened for the corrupt to

surrender their corrupt wealth anonymously. A one-time tax shall be levied on this.

o After the window is closed, strict measures have to be taken to curb corruption. The

first step would be curb corruption at the lower levels. Cost of doing business in

China is low despite high corruption levels primarily due to its centralized corruption

model.

o Incentivize the lower level corrupt to surrender the corrupt money by waging

relentless rides on these.

o Give a break after a while and open the black money surrender window during which

the corrupt tax of 40% would be levied.

o The big sharks of corruption would not object to this as their black money is safe.

o This would change the model into a centralized model

o Once the window closes, focus on the corrupt in the middle and higher levels.

Identify ways to locate the accounts in tax havens.

a shadow budget for 2013-14

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