Long-term strategy for Budget 2005

Systemic reform and countering the business cycle should be the ingredients


The most important characteristic of Budget 2005 would be whether it incorporates a long-term view of fiscal policy or not. Given that the government’s National Common Minimum Prog-ramme (NCMP) has made promises that need higher spending in coming years, it will be for the finance minister to find the money. Since his ministry is unlikely to be able to resist the political pressure for raising spending, the prudent policy will be to take it as exogenous and think about raising resources in the long term.

Unfortunately, an evaluation of the Budget is complicated by the fact that it is possible to perform well on short-term indicators, including the revenue deficit, without having a long-term view. For example, the FM could raise more from a tax amnesty scheme, but as has widely been debated, this offers wrong incentives to tax evaders. It may be good for the year’s tax collections, but is not the best way to increase the share of the ‘white’ economy. The FM needs to not merely look at his revenues this year, but to initiate steps to help him raise revenues in the next three years, in a more efficient and equitable manner.

Similarly, more taxes can be raised from the salaried sections, who are captive taxpayers, by raising cesses and surcharges. This could show up in good tax collection targets and reduce revenue deficit numbers but increasing the incidence of tax on a small section is not good long-term fiscal policy. What is needed is to change rates and slabs, improving tax administration and lowering the cost of compliance. It would make sense in this Budget, for example, to raise the exemption limit to Rs 1 lakh and to raise the slab at which the highest rate sets in to Rs 2.5 lakh.

The Kelkar task force recommendation that there be two slabs, with the maximum rate of 20% setting in at Rs 4 lakh, needs to go along with removing exemptions. The FM may not be ready to do this at one go. But he needs to start the process of removing exemptions on savings by grandfathering existing schemes and bringing savings into the exempt-exempt-tax (EET) system. The point is that even if everything cannot be implemented today, because politics imposes constraints, Mr Chidambaram’s responsibility does not end with this year’s Budget. If the political system is going to demand increased social sector expenditure, he should do it in a manner that is least distortionary and least harmful to the economy. He must improve tax administration and policy even if that yields him nothing this year, but is good only for the coming years.

Raise social spending in the least distortionary manner
This year’s revenue deficit cut should exceed the FRBM target
The second element of the Budget that will reflect if the FM is thinking short-term or long-term will be the stance of fiscal policy. The need to prop the economy by increasing government spending or giving tax breaks this year is not necessary, because industrial growth is currently on an upswing. But if in a year or two, as happens with every industrial cycle, the growth rate of industrial production starts slowing, it may make sense to run larger deficits. In other words, fiscal policy needs to be counter-cyclical. When the economy is booming, the government does not need to prop the economy. This means spending must shrink and taxes must go up. Higher deficits can be harmful in an upswing, as they could increase inflationary pressures in the economy. Thus, when growth is high, the deficit must be smaller.

The FRBM rules have set targets that do not respond to the business cycle. But this approach does not take into account the fact that there have been structural changes in the economy. Industry is now much more influenced by cyclical behaviour, as in a market economy, than when it was administered through quotas and industrial licences. Fiscal policy can no longer afford to be insensitive to the business cycle. This means the year’s revenue deficit should be reduced by more than the 0.5% required by the FRBM rules.

Reconciling the long-term requirements of the NCMP with the FRBM is difficult enough. Adding counter-cyclical fiscal policy to the FM’s plate makes his life even more difficult. All this requires significant tax and expenditure reform. Budget 2005 must indicate the finance ministry is on the path of doing so.


Ila Patnaik

Ila Patnaik