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Posted by: Deepa Vasudevan on Fri, Jul 18th, 2014

The Fiscal Deficit: How Achievable is it?

The Union Budget has proposed a fiscal deficit target of 4.1% of GDP for 2014-15, 3.6% for 2015-16, and 3% for 2016-17. The intent is to achieve fiscal discipline by steadily reducing deficits over the next three years. The aim to become fiscally responsible is praiseworthy; but the key question to ask is, how achievable is the fiscal deficit target? What are the assumptions on which the targets are based?

 

As Pic 1 shows, the government has projected a 17.7% increase in tax revenues this year. All categories of tax- direct as well as indirect- are expected to yield higher collections. The highest rate of growth (31%) is budgeted from service tax revenues, in keeping with its growth trends in recent years. Similarly, income tax revenues are budgeted to increase by 17.6%, slightly higher than its average annual growth rate over the last five years. The remaining tax categories- customs, excise and corporation tax- tend to have high tax buoyancy[1]. On the basis of a 13.4% growth rate assumption for nominal GDP, these taxes have been projected to rise between 14% to 15%.

 

Pic 1 Selected Items of Receipts and Expenditure of the Union Government

Pic 1 Selected Items of Receipts and Expenditure of the Union Government

Items where there is a significant % increase are highlighted

Source: Union Budget, various years

 

A 24% increase in revenues from spectrum auctions, and doubling of disinvestment proceeds as compared to last year, are the other important contributors to revenue. Note that interest and dividends from PSUs and RBI, which contribute more than half of the Centre’s non-tax revenues, are expected to remain at almost the same level as in 2013-14,.

 

Capital expenditure has been increased in order to boost investment. Total subsidies are budgeted to go up by only 2%, almost entirely due to a 7.4% rise in fertilizer subsidies. The rise in food subsidy (on account of the Food Security Bill) is matched almost exactly by a lower provision for petroleum subsidy. In all, total expenditure is budgeted to increase by only about 13% over last year. The net impact is that fiscal deficit, in absolute terms, is expected to rise by a marginal Rs.66.3 billion. And since nominal GDP is projected to increase by a rather high 13.4%, the budget ends up showing a lower fiscal deficit of 4.1% of GDP! 

 

How can we gauge whether the budget estimates are realistic or overoptimistic? A quick way is to compare growth projections made in the current budget with historical trends, keeping in mind any external factors that may impact government finances this year.  This simple exercise highlights three interesting points.

 

First, gross tax revenues are budgeted at 10.6% of GDP, marginally higher than the 10.2%-10.3% ratio observed over the last two years. The logic is like this: last year, when the real economic growth was 4.8%, the tax-GDP ratio was 10.2%.  With real growth projected at 5.8% in 2014-15, tax-GDP ratio is expected to rise to 10.6%[2]. However, all tax categories do not respond in the same manner to economic growth. Income tax and service tax revenues have been growing at fairly stable rates, but corporate tax and customs revenues have fluctuated with economic growth (Pic 2). High growth years see an increase in corporate profitability and corporate tax liability; as well as higher imports and customs collections. Budgeted tax revenues therefore hinge on the key assumption that nominal GDP will grow at least at the budgeted rate of 13.4%. If nominal growth was to fall to, say, 11%, final tax revenues would be lower and fiscal deficit higher than projected.

 

Pic 2 Historical Growth Rates in Selected Tax Revenues

Pic 2 Historical Growth Rates in Selected Tax Revenues

Source: Union Budget, various years

 

Second, subsidies were limited at just over 2% of GDP, as promised by the previous government. But the amount budgeted for fuel subsidy has been cut as compared to last year despite the strong risk of a fuel price hike later this year (arising from ongoing hostilities in Iraq and the Middle East). Since India imports most of its fuel, two key assumptions were made while budgeting for the fuel subsidy: an exchange rate of Rs.61 per US dollar and international fuel prices of Rs.110 per barrel. At this point, both assumptions seem reasonable. But if a situation like the rupee crisis of 2013 were to arise- when the exchange rate fell rapidly from Rs.54 per US$ in April 2013 to Rs.64 in September- then our fuel bill and subsidy payments would be much higher than budgeted.

 

Third, the quality of fiscal adjustment is poor. The government is heavily dependent on non-debt capital receipts such as disinvestment; and one- time revenues such as spectrum fees, to cover its expenses. As a result the fiscal consolidation process is vulnerable, and could easily be reversed under adverse circumstances. For instance, if disinvestment inflows declined to 2013-14 levels of Rs.25,000 crore, then the fiscal deficit would shoot up to  4.4% of GDP! Sustainable fiscal consolidation requires expenditure reform (for example, better subsidy targeting, direct cash transfers) and improved tax administration.  The aim of fiscal prudence should be to achieve a zero revenue deficit, so that all borrowing can be directed towards capital expenditure.

 

Achieving the fiscal deficit target depends on how well the conditions specified in the underlying assumptions are achieved. If critical assumptions such as growth rate, fuel prices, exchange rate or tax buoyancy rates are violated, the target is likely to be missed.  If structural changes to expenditure management are brought in, the deficit is more likely to be under control.


[1] If a tax has a high buoyancy, a 1% rise in GDP generates more than 1% rise in tax revenues

[2] This was stated by the Finance Secretary, Mr.A. Mayaram,in a newspaper interview. Downloadable from  http://articles.economictimes.indiatimes.com/2014-07-12/news/51392371_1_railway-budget-union-budget-road-map

T Kalyanaraman on Sat, Jul 19th, 2014 1:16:27 pm

Assume FM does not go back on new tax on Debt funds. It is floating around that about Rs 1.8 L crore is in 1 to

krishna kishor tiwari on Sat, Jul 19th, 2014 10:33:52 am

Very good,it is worth learning for us.

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