Big Story. Fixing the Fisc

The run-up to Budget 2016-17 has seen a raging debate on whether the Centre can , and should , stick to the fiscal deficit target, for the current financial year and the next.

The first question, ‘Can the government do it?’ arose following a downward revision of the expected GDP growth rate for 2015-16. When the fiscal deficit target of ₹5.6 lakh crore or 3.9 per cent (of the GDP) was fixed for 2015-16, it was done assuming a nominal GDP of ₹141 lakh crore.

With the GDP now expected to be lower, doubts have been raised about the government’s ability to meet the 3.9 per cent fiscal deficit target. Adherence to this target will require the government to slash its fiscal deficit by a further ₹27,000 crore approximately. A shortfall in direct tax (corporate and income tax) collections and a wide slippage on the disinvestment target have only added to the concerns.

For 2016-17, the additional burden of ₹1.1 lakh crore from the implementation of the Seventh Pay Commission recommendations and the One Rank One Pension (OROP) plan has become a major obstacle in the Centre’s path to achieving the fiscal deficit target of 3.5 per cent.

We spoke to a few economists to get a sense on whether the government is well-placed to achieve its targets.

Target achievable? Many economists think the Centre can meet the fiscal deficit target of 3.9 per cent for 2015-16, thanks to higher than expected tax collections. “With additional collection from indirect taxes helping offset the loss on direct taxes, the target looks achievable despite the miss in the year’s disinvestment target,” says Sonal Varma, Chief India Economist, Nomura.

“With the subsidy bill having fallen thanks to lower oil prices, meeting the deficit target looks likely,” adds DK Joshi, Chief Economist, CRISIL.

However, Varma feels that given the huge upcoming spending requirements in 2016-17, slippage from the targeted 3.5 per cent is expected. The slippage is, however, expected to be narrow, with the fiscal deficit likely to reach 3.6 per cent or slightly more.

She feels that measures in the Budget, such as an increase in the service tax rate, some sector-specific tax initiatives, such as higher customs duty for sectors facing competition from imports and higher taxes on items, such as those causing pollution are expected to help on the tax revenue front.

According to her, the incremental hikes in excise duty on petroleum products introduced this year, too, should help. Some of these hikes that have been introduced over the past one-and-a-half months have helped the government garner about ₹2,500 crore so far; their full-year impact, which will be felt only in 2016-17, will be much higher. On the non-tax revenue front, the government will be relying on higher dividend payments this year. Public sector companies have been asked to pay at least 30 per cent (up from the earlier 20 per cent) of their profits after tax or their equity, whichever is higher, as dividends.

According to Joshi too, the government might relax the 2016-17 target a bit to, say, 3.7 per cent, given that revenue expenditure will be very sticky next year due to unavoidable expenditure on implementation of the Seventh Pay Commission recommendations and the OROP plan. On top of it, the rural economy, which has borne the brunt of two bad monsoons, is in need of support.

Risk from overshooting The second question, ‘Should the government do it?’ has cropped up in the context of the weakness in India’s economic growth. With investment from the private sector not forthcoming, the government is being expected to step up spending to boost growth.

But, with the government already facing pressure on the consumption expenditure front, any additional spending raises the risk of possibly stoking inflation.

While a one-to-one relation between fiscal deficit and inflation may not be easily identifiable given that inflation is impacted by a number of factors (both domestic and global), a high fiscal deficit does pose the risk of fuelling inflation.

Push to Inflation : When expenditure exceeds revenue, the government runs a high fiscal deficit. Then the push that the additional spending gives to aggregate demand in the economy can have an inflationary impact. According to an RBI paper, a 1 percentage point increase in the fiscal deficit could cause about a quarter of a percentage point increase in the Wholesale Price Index (WPI).

Higher inflation, in turn, can limit the scope for the RBI to cut rates in order to stimulate growth.

Take, for instance, the fiscally profligate Budget 2008-09 that rolled out the massive farm debt waiver scheme and the Sixth Pay Commission award.

This was followed by tax cuts and higher government spending, pushing up the Centre’s fiscal deficit to 6 per cent in 2008-09 from 2.5 per cent in the previous year.

While the stimulus did not create any immediate inflation pressures, given that private consumption (accounts for a large proportion of GDP) remained depressed, the large fiscal stimulus is, however, believed to have stoked inflation in later years (2010-11). From about 2.4 per cent in 2009, inflation (based on the WPI) surged to over 9 per cent in 2010 and 2011. The failure of the south-west monsoon in 2009 only made matters worse.

Today, the concern over inflation is being raised in the context of the expected surge in government expenditure in 2016-17 on account of the implementation of the Seventh Pay Commission recommendations and the OROP plan. Indranil Pan, Chief Economist, IDFC Bank, explains the crux of the ongoing fiscal deficit versus economic growth debate.

According to him, what the RBI is probably trying to say is that you already have a situation where there will be consumption boost. So, if, on top of that, the government continues to spend at a very significant rate, leading to a higher fiscal deficit, then the overall aggregate demand in the economy will be higher.

If that happens, it will be difficult for the RBI to meet its inflation target of 5 per cent and so it will not be able to cut rates. But, if the government manages its other expenditure, then the aggregate demand push may not be to such an extent that it becomes inflationary.

According to Joshi, we need a less restrictive fiscal policy in order to support the economy. “Since the quantum of money released by relaxing the fiscal deficit won’t be more than ₹50,000 crore, it won’t have an inflationary impact, provided it is spent on investment,” says Joshi.

Also read: How the deficit was reined in

Borrowing gets expensive : But, the problem does not end here. A larger fiscal deficit has implications for government borrowing too.

The government can fund its expenditure using non-debt receipts, such as tax receipts, non-tax receipts, such as proceeds from spectrum auction, and disinvestment proceeds. The rest can be debt-funded — borrowing from the market by issuing bonds to banks and other financial institutions.

Significant borrowings (or expectations of it) by a fund-strapped government can spike up bond yields (interest rate upon bond price). Following the 2008-09 Budget, where the government went full-throttle on fiscal stimulus, its net market borrowings rose to ₹2.34 trillion, more than double the budgeted amount.

As a result, the benchmark 10-year government bond yield surged to 7 per cent by March 2009 from 5.24 per cent in December 2008, pushing up the government’s borrowing costs.

An increase in the supply of government bonds leads to a decline in bond prices and spikes bond yields. According to Varma, increasing borrowing costs are quite a realistic concern for the government today.

Besides, rising government bond yields also impact corporate bond yields and, therefore, the borrowing cost for companies. As the yields on the ultra-safe government bonds rise, so do the yields on corporate bonds, thereby raising companies’ borrowing costs.

Again, as the government turns into a large borrower, credit available to other corporates turns scarce, thus increasing the cost of available funds.

But, the quantum of government borrowing is not the only factor impacting bond yields; interest rate changes, too, are critical.

As interest rates rise, the existing bonds become less attractive, thereby reducing the demand for them, leading to a fall in the bond price and increase in the yield. “In 2013, when the RBI suddenly tightened interest rates, the 10-year bond yield shot up higher despite no change in the government’s borrowing programme for the year,” says Pan.

In the current context, any risk on the inflation front can keep the RBI from easing interest rates, with consequent implications for bond yields.

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