Indian Budget Sustains Slow Consolidation; Signals Reform

The Indian government in its budget released last week continued with gradual fiscal consolidation and signaled its continued commitment to a broad reform agenda, with a greater focus now on widening the tax base.

The target of reducing the central government's fiscal deficit to 3.0% of GDP has been pushed back by another year, but the general goal of addressing relatively weak public finances over the medium term is still in place, says Fitch Ratings.

Fitch views most of the government's assumptions for the FY18 (April 2016-March 2017) budget as achievable. The budget forecasts nominal GDP growth of 11.8%, and tax revenue growth of 12.7%. The subsidy bill is set to be stable at around 1.6% of GDP, leaving the bulk of consolidation to come from cuts in other expenditure, such as defense spending.

Optimistic

The divestment target - which has been consistently missed in recent years - looks optimistic again, and there is a risk that the government will need to allocate more than 0.06% of GDP to bank recapitalization in FY18.

The decision to raise the deficit target for FY18 to 3.2% of GDP, from 3.0%, means slower near-term consolidation than was previously planned.

The finance minister's budget speech suggests that the main reason for the change is the plan for increases in central government capital expenditure. However, this is actually set to remain broadly stable as a percentage of GDP in FY18 at 1.8%, according to the government's forecasts.

An official committee that has reviewed the fiscal framework has recommended that general government debt be brought down to 60% of GDP by 2023, from nearly 70% of GDP in FY17. That would move debt closer to the median of 40.6% for sovereigns rated in the 'BBB' range (India is rated BBB-/Stable).

The committee also recommends the central government deficit target for the coming three years to be 3.0% of GDP, but with escape clauses for deviations up to 0.5% of GDP. This would imply general government deficits, including other public entities such as the states, of around 6.5% of GDP, which is also significantly higher than the 'BBB' median.

Hit budget deficit target

The government expects to hit its budget deficit target of 3.5% of GDP for FY17, which would be down from 3.9% in FY16. Our own forecasts for FY17 are in line with those of the government, but there is a small risk the final outcome will be higher due to the impact of demonetization - which has affected economic activity since November.

The government signaled that it is looking at measures to attract more FDI and simplify labour laws, but did not announce any concrete significant new reforms to improve the business environment, apart from abolishing the Foreign Investment Promotion Board. Instead, it will continue to work on the implementation of the many pending reforms, most notably the goods and services tax.

The government currently appears to be most focused on bringing more of India's large informal economy into the formal sector and widening the tax base.

Demonetization a bold step

Demonetization - regardless of the uncertain eventual benefits - was a bold step aimed at curbing the use of 'black' money. The finance minister followed up with a speech that explicitly recognized the low number of direct taxpayers, stating that India is "largely a tax non-compliant society," which is a significant change in rhetoric.

There are plans to address the problem through the use of electronic systems, better enforcement and simplification of the tax administration.

“At this stage, however, we view a significant increase in tax compliance only as an upside risk to revenue forecasts in the next few years, given the difficulties involved in achieving it. The fact that income tax still does not apply to the agricultural sector, which accounts for nearly 50% of employment, will also limit the potential effectiveness of measures to raise income tax,” says Fitch.

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