Union Budget 2012-2013: Dalal Street seeks focus on fiscal discipline

Markets thrive on expectations and this time around, players on Dalal Street say they expect the coming budget to be less populist. Most believe that the United Progressive Alliance's, or UPA's, populist agendas should move to the low priority list, just as the policymakers take tough decisions on managing expenditures and levying stiffer taxes. Reflecting the mood, the BSE Sensex has gained 18.34 per cent between the beginning of 2012 and February 17.

Three years after the global financial meltdown, the Reserve Bank of India, or RBI, reversed its stance of loose, or accommodative, monetary policy after growth became a casualty, falling from 9.3 per cent in pre-2008 to 8.4 per cent in 2011. Projected GDP growth is 6.9 per cent for 2012. In a way, the economy is back at the point where the RBI is expected to reduce rates to boost growth. But the government's fiscal stimulus measures have yet to be reversed in totality. "The up-tick and moderation in GDP growth between 2009 and now have been registered alongside the stimulus un-reversed in totality," says the research head of a foreign broking firm. While the government reduced excise duty for specific products on the indirect taxation side, personal income tax rates were slashed and exemption limits were raised on the direct taxation side.   

In a recent research note focused on India, the Royal Bank of Scotland, or RBS, highlighted that the FY12 deficit will miss the target of 4.6 per cent of GDP by a wide margin.  The fiscal deficit is expected to touch 5.6 per cent in FY12. "Slowing tax collections, mounting energy subsidies and a near failed disinvestment programme have all taken their toll on the fiscal accounts," says Sanjay Mathur, RBS' Singapore-based analyst for economics research, in the note. "This slippage will not be unique," Mathur adds. Fiscal targets have routinely been breached post the Lehman crisis, if one-time windfall gains such as the sale of telecom spectrum are excluded.

And the persistence of high deficits has diminished the domestic savings rate from a peak of almost 38 per cent in FY09 to 32 per cent in FY11. India's potential growth might come under threat from the higher fiscal deficits. "We believe that the spending pattern of the government is partly to blame as it has imparted an inflationary bias and in turn reduced the incentive to save," Mathur notes.  

Specifically, the inflationary bias, according to Mathur, arises from three factors. Higher subsidies on food and energy ensure product specific stability in the short term. Further, they result in elevated levels of consumption demand. Two, the UPA's rural employment guarantee program has had the same effect in terms of bolstering consumption. In addition, as wages under this programme are above market determined wages, the supply of rural labour into urban areas and industries like construction has diminished. The net effect has been an all round increase in wages. And three, to keep aggregate spending in check, policymakers have had to compromise on productive and potentially non-inflationary capital spending. "It is interesting to note that subsidy spending is now almost as high as capital spending," Mathur pointed out in his note.  

Mathur is of the opinion that indirect tax rates (excise and customs) should be raised. Specifically, excise duty rates should be raised to 12 per cent from the current level of 10 per cent. Mathur says that the excise duty rate had been reduced from 12 per cent to 8 per cent to support domestic demand during the global financial crisis. "This would also facilitate the replacement of excise duties with a goods and services tax, or GST, in 2013," Mathur said. The proposed GST rate is also 12 per cent.

Further, the RBS note highlights that the energy sector is in need of reform. In FY12, the government had reduced import duties on crude, which is estimated to have eroded government revenues by around 0.3 per cent of GDP. On the expenditure side, there is a strong case for capping subsidies. The government has been able to liberalise gasoline prices but continues to subsidise diesel, cooking gas and kerosene prices. "It is now time to liberalise diesel prices now that inflation is cyclically trending lower," the RBS note suggests.

Finally, all new populist proposals need to be delayed if not disbanded altogether. Key amongst these is the food security bill which aims to provide subsidised food grains to large segments of the population. According to the preliminary division of the population into various eligible groups and their food entitlements, RBS estimates that the food subsidy bill could increase from 0.7 per cent of GDP to 1.1 per cent of GDP if this proposal is implemented.

With general elections still two years away, and reforms being the dire need of the hour, the UPA has little choice but to act. The deficits that have been the way of life post the Lehman crisis have to be tackled with utmost fiscal discipline. And UPA's chance to do so is a month from now.