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Sunday, March 01, 2015

Interpreting the BJP's 2015 budget

The BJP, armed with a clear majority in the Lok Sabha, with the desire to break with Nehruvian socialism, was expected to unveil a game plan for structural changes from here till 2019. In large part, Budget 2015 does not rise to the challenge. It has some good elements, and with good execution, they will make an important difference. But an array of important and pressing problems have been left unsolved.

The challenges faced in this 2015-16 budget

This was an unusual budget making exercise for three reasons:

  1. This was the first full year budget of the new BJP government, and they were expected to show a strategy for the coming 4.3 years.
  2. This is the first majority in the Lok Sabha in 30 years, and the campaign was fought on the platform of jobs and not dole.
  3. There is an unusual opportunity for fundamental change in expenditure because of shuttering of the Planning Commission, and 14th Finance Commission's recommendations on enhanced resource flow to state governments.

Fiscal consolidation

Mr. Modi was a fiscally prudent finance minister in Gujarat, and that kind of approach was expected in New Delhi also. Three factors have shaped the fiscal situation:

  1. The goverment got a windfall on account of reduced crude oil prices, which reduce the magnitude of oil-related subsidies. To their credit, they have also done a bit on reducing subsidies on some petroleum products.
  2. The 14th Finance Commission recommendation to increase the resource share of the states from 32% to 42% need not have any adverse impact for central finances, as it should merely send expenditures down to the state government level (where they belong). The combination of closing down the planning commission + the 14th finance commission adds up to the perfect opportunity to make substantial changes in the (broken) machinery of central expenditure.
  3. India's fiscal dynamics in recent years was greatly assisted by the inflation crisis. Inflation breached 5% in February 2006. From that point onwards, buyers of government bonds repeatedly experienced inflation that was greater than expected. This problem is now hitting India in reverse. The global deflation has given a collapse in inflation in India. Now bond holders are experiencing lower inflation when compared with what was expected at the time of bond issue. Debt dynamics in India is now worse.

The calculations of the budget are predicated on 8% GDP growth and 5% inflation. The new GDP data are indeed very exciting for they show better strength in the economy as compared with the old data. We wish the new data is right. However, if the new GDP data has problems, this could generate less tax buoyancy than expected.

When the Indian credit rating was teetering on the brink of sub-investment grade, the then finance minister, P. Chidambaram, made a fairly credible commitment to a certain fiscal adjustment trajectory. Financial markets decided this adjustment was good enough.

The budget speech has unfortunately decided to break with this fiscal adjustment trajectory by asking for one more year to reach the 3% target in 2017-18. In my opinion, this is unwise. The economy will be healthier if we had more fiscal prudence. If the public investments had to be increased, the resources should have come either from disinvestments from sectors where government is not required or from pruning the subsidy bill. Abandoning the fiscal consolidation is not a good way of achieving greater public investment. Para 24 says that the Finance Bill will amend the FRBM Act, thus showing that flouting the FRBM Act is all too easy for the administration.

A sound and elementary test of the correct fiscal stance is the following rule: "Barring a year with a bad business cycle downturn, we should have a primary surplus; Primary deficits should happen no more than (say) in two years out of 10". Last year's primary surplus was -0.8% and the next year's is budgeted at -0.7%. This suggests that the Indian fiscal situation is wrong by roughly 1% of GDP.

Non-interest expenditure is budgeted to grow by only 4.06%. The problem lies in interest payments, which are budgeted to grow at 10.89%. India's debt dynamics are now problematic; even though non-interest expenditure growth is modest at 4.06%, this is giving a gain in the primary deficit of only 0.1 percentage points.

A big area for cutting expenses is subsidy reform, but this has not been done.

It would have been better to run a tight ship, and get to a primary surplus of -0.2% this year and +0.5% next year. Debt/GDP only goes down when we combine small primary surpluses with high GDP growth.

In summary, the fiscal stance, with a reduction of the primary deficit of only 0.1 percentage points, and a break with P. Chidambaram's proposed adjustment trajectory by one year, is disappointing.

Dismantling the Planning Commission

The Planning Commission was not in the Constitution of India. The failures of the Planning Commission, and the concepts of plan vs. non-plan expenditure, are central to the failures of the Indian State. Mr. Modi took a big step forward by announcing the abolition of the Planning Commission on 15 August 2014.

This requires a corresponding re-engineering of government around the theme of accountability. The Ministry of HRD must be given a block of money, and in return must commit to the numbers for learning outcomes, measured by a non-government agency like Pratham, that they must deliver. Failure to deliver should have consequences. Once this is done, they should be free to design their own strategies for how to use this money. This is how fiscal systems in mature countries work, without a Planning Commission running a parallel fiscal system.

Some re-engineering that flows from closing down the Planning Commission has been done. But the bulk of it has not been done. Most `plan schemes' have not been dismantled. There is no articulation of what the post-Planning-Commission world will look like. The budget process appears to have trundled along as usual, without noticing that the Planning Commission has been shut down. There is no talk of even planning how to redesign the Indian fiscal system in this new world. This is disappointing.

Niti Aayog was supposed to be a think tank. It is a source of great concern that thousands of crore of resources are being allocated to it. A good think tank requires Rs.100 crore a year of expenditure. Anything more, and it becomes a fiscal mechanism. The "Planning Commission" was renamed to "Niti Commission", all the old staff were retained, and now we're slipping back into the spending ways of the old Planning Commission. Nehruvian socialism was an intellectual construct, and it is going to require intellectualism to dismantle it.

Tax policy and tax administration

India has an extreme crisis on low quality thinking and execution in tax policy and tax administration. The term `tax terrorism' has entered the lexicon. Badly structured tax policy and tax administration are hampering GDP growth. For many years now, the tax/GDP ratio has been declining. In 2014-15, gross tax revenues (net to centre) had a shortfall of Rs.113,133 crore or 8.3%. To do the (weak) fiscal adjustment of the coming year, MOF has has had to raise tax rates.

India has a tax rate of 44% on corporate income, combining corporation tax and the dividend distribution tax. This is one of the highest tax rates among comparable countries. In the budget speech, there are paragraphs which talk about a cleaner tax system being built in 5 years (para 60 and 97). But at the same time, the budget speech promises us (para 129) that the Direct Tax Code (version 1 of which was the best alternative for direct tax reform) is now buried. There is no display of an implementation mechanism through which the promises of Para 60 and Para 97 will be fulfilled. If the intent is to cut the rate of taxation of firms, why not start now?

Para 96 restates that a good GST will be built. The bottleneck is in implementation. As an example, MOF could have announced that in 2015-16 they will implement a `Central GST' covering only the Centre, which will be put into effect in 2016-17, and then in 2017-18 there will be a mechanism for states to connect into it.

An integral feature of the Modi campaign was the objective of reducing the complexity of doing business. One major element of the difficulties which firms have faced is the tax system. The lack of strategy on reforming tax policy and tax administration is disappointing.

Financial sector reforms

The announcements are:

Financial markets
Para 56 and 57: Merge commodity futures and the government bond market into SEBI, and setup the Public Debt Management Agency (PDMA). A nice gold-linked bond scheme will be an added instrument through which the PDMA will borrow.
International finance
Para 58: Regulation-making power on equity related capital flows to shift to Government. Para 87: Build out GIFT as an International Financial Services Centre (IFSC).
Monetary policy:
Para 13: A `Monetary Policy Framework Agreement' has been signed with RBI, which gives RBI an inflation target of "below 6%". The RBI Act will be amended to provide for a Monetary Policy Committee.
Deeper institution building
Para 88: Setup commercial divisions in courts of India. Para 59: Setup Task force for creating Financial Redress Agency. Para 59: Introduce Indian Financial Code "sooner rather than later"
Pension reforms
Para 40, 41, 42: There are a slew of social security proposals. Para 62: Employees will be given the choice of opting out of EPF and going into NPS instead.
Bankruptcy process
Para 36: Bring a comprehensive Bankruptcy Code in fiscal 2015-16, which will meet global standards, and provide necessary judicial capacity.
Taxation of finance
Para 106: Tax 'pass through' proposed to be allowed to both Category-I and Category-II Alternative Investment Funds, so that tax is levied on the investors in these Funds and not on the Funds. Para 108: Solve the problem of `permanent establishment' faced by global fund managers who locate in India.
Bad ideas
A `MUDRA Bank' which will be a PSU which will refinance micro finance institutions.

This is fascinating and impressive in parts, but disappointing in many respects.

Financial markets: The vision for organised financial trading by all the expert committees has been : to harness economies of scale and economies of scope by unifying all organised financial trading. Government bonds and commodity futures will now be with SEBI. That leaves an odd collection of elements at RBI: corporate bonds with maturity below one year, credit derivatives, and currencies and their derivatives. It would have been much cleaner to do the full thing, instead of settling for such an awkward compromise.

The Bond-Currency-Derivatives Nexus is a deeply interconnected set of markets combining spot and derivatives markets on government bonds, corporate bonds, and currencies. All these markets are tightly interlinked through arbitrage. Achieving a liquid and efficient market on any of these sub-components requires achieving a liquid and efficient market on all these sub-components.

The old arrangement had problems: RBI was keen to prevent the Bond-Currency-Derivatives Nexus from emerging, and SEBI only had jurisdiction on corporate bonds with maturity over 1 year. The new arrangement consists of government bonds and corporate bonds of maturity over 1 year with SEBI, with everything else in the BCD Nexus with RBI. This is a better than the previous arrangement but unsatisfactory.

International finance: In similar fashion, it makes sense to shift regulation-making power on capital controls out of RBI. Capital controls are ultimately political, and the task of defining capital controls cannot be delegated to an independent organisation. In addition, RBI has a long history of writing capital controls regulations which drive up the cost of doing business. However, the formulation adopted -- that regulation-making for only equity flows will shift to the government -- yields small gains. Largely speaking, it replaces the de facto by the de jure.

There is room for improving capital controls regulations on equity flows, but the potential gains are small, as the Indian capital controls on equity flows are not grossly wrong. The big mistakes in the Indian capital controls are with debt flows -- whether ECB or the foreign investment into rupee denominated bonds. Thus, the reform announced in the budget speech is progress, but still unsatisfactory.

International Financial Services Centres (IFSCs) like GIFT City are a good idea. At a high level, the budget speech has made progress. The challenge is in management, execution and details. We will know GIFT City will actually work only when a concrete management mechanism is put into place and starts smoothly delivering results.

Monetary policy:: From 1934 onwards, RBI has had the power to create money, but there has been no monetary policy framework which created a `nominal anchor' for the Indian rupee, and delivers low and stable inflation. The July 2014 budget speech had promised that for the first time, a monetary policy framework would be put into place. The 80-year organisation would, for the first time, find a purpose. Now, we are told that a `Monetary Policy Framework Agreement' has been signed between MOF and RBI, which gives RBI an inflation target of "below 6%". This sounds like a good thing. However, the text of the agreement has not been released, so it is not possible to analyse this agreement and understand whether this has been done properly.

It is also stated that the RBI Act will be amended to provide for a Monetary Policy Committee. There are subtle design issues associated with setting up a Monetary Policy Committee. We have to wait and see the extent to which sound thinking has gone into the Monetary Policy Framework Agreement, and in the proposed amendment of the RBI Act.

Deeper institution building: Four `task forces' are in motion on establishing the institutional architecture of the draft Indian Financial Code. The speech says they are progressing well and will continue to work. One of the four institutions being created -- the Public Debt Management Agency -- will come into existence. The other three new organisations are : the Resolution Corporation (which will be ineffective until the Indian Financial Code is enacted), the Financial Sector Appellate Tribunal (which can yield gains in terms of a better functioning SAT, even before the draft Indian Financial Code is enacted) and the Financial Data Management Centre (which can yield gains by voluntary adoption by regulators, even before the draft Indian Financial Code is enacted).

A fifth task force will be created: To construct the `Financial Redress Agency'. This is a one-stop-shop which will hear aggrieved customers of financial services, across the entire Indian financial system. This task force will presumably utilise the management techniques which have proved successful in the other four task forces. It constitutes one more building block towards enacting and enforcing the Indian Financial Code.

Commercial divisions in courts have been debated for a long time. Now they will come into existence. We will have to wait to find out the implementation mechanisms that are adopted for this laudable venture, given the spotty performance of court automation initiatives in the past in India. The developmental work done by the Task Force on Establishing the Financial Sector Appellate Tribunal could potentially be useful here.

Finally, the budget speech promised to introduce the Indian Financial Code in Parliament. This is the centrepiece of the Indian financial reforms: a single, coherent, modern, well thought out law that replaces the haphazard 61 laws which govern finance in India today.

Pension reforms: EPFO is mandatory for most employees of non-trivial private firms. The National Pension System (NPS) works much better than the EPFO, both on client servicing, and on returns obtained by the worker. Now that the institutional machinery of the NPS is working, it will be given as a choice to workers in the EPF. This is a big step forward in terms of developing pension planning for millions of households, and long-term institutional investment in the country.

However, alongside this, paras 40, 41 and 42 offer announcements of `social security' proposals. If there is any element of `defined benefits' or assured returns in these, it can be quite dangerous. Extreme care is required on understanding the fiscal consequences of these kinds of statements, with number crunching going out into the next 75 years. It would be tragedy if, alongside expanding the well structured pension system (the NPS), the government also grows old-style socialist programs.

Bankruptcy process: The Vishwanathan Committee is working on improving the bankruptcy process. A first report has been released, which proposes incremental modifications. The Budget speech has promised a much more ambitious objective in Para 36: to Bring a comprehensive Bankruptcy Code in fiscal 2015-16, which will meet global standards, and provide necessary judicial capacity. The work process that was used for the Indian Financial Code should inform the construction of the Indian Bankruptcy Code. There may be a connection between this problem and the establishment of commercial divisions in courts.

Taxation of finance: There is an array of mistakes in tax policy when it comes to the financial system. The budget speech promises to solve two of them : the problem of `permanent establishment' of foreign fund managers, and the problem of tax pass-through for two categories of Alternative Investment Funds. Both these have been attempted before, without success. Careful analysis of the Finance Bill is required to understand whether this time, the drafting by DOR/CBDT is done correctly.

Bad ideas: `Mudra bank' is an old style socialist initiative, which is inconsistent with all the other modern elements of financial sector reforms.

Overall, there are many good ideas in the work on financial sector reforms. There is, however, a disconcerting incompleteness of the initiatives. Many of them are half hearted; a line of thought is begun but not completed. Much more is required in terms of thorough follow through in conception and execution.


Before the budget speech, there was a lot of talk of a great wave of public investment in infrastructure which was going to revitalise the economy. The numbers are now visible and do not pass muster. Para 46 says that spending on roads will go up by Rs.14,000 crore and spending on railways will go up by Rs.10,000 crore. Para 47 proposes off-balance-sheet borrowing of Rs.20,000 crore a year. Even if all these are summed up, this comes to less than 0.4% of GDP. In addition, there are the usual problems of low quality investment process with public investment, which have not been addressed. This is not going to make a significant difference to the demand side of the economy, even if we are optimistic and think that all this spending hits the economy in 2015-16 itself. So, if this is the excuse for breaching fiscal discipline, it is not a good one.

The FM has proposed revisiting and revitalising the PPP model of infrastructure development. The proposal is to rebalance the risk in infrastructure projects, by making the government bear a major part of the risk. This just a sentence but it will have major consequences for the infrastructure sector. This risk shift could very easily turn into a `heads I win, tails you lose' proposition for the private sector, or it may translate into the government running the entire infrastructure development process with the private sector stepping in for construction only.

This proposed risk shift may be solving the wrong problem. Is it clear that the problems lies in private parties holding risks they cannot manage? For example, the airport sector has similar risk sharing as other sectors but it has been fairly successful in getting investments and ensuring availability of infrastructure. Moreover, the government's own record of choosing projects for investments has been so poor that shifting the responsibility to the government may be worse that the performance of the PPP model. We have to choose the model that is most likely to work, and then make it work. In all cases, risk and return must move together.

However, there is a group of initatives which are not mere old Indian socialism, which could actually constitute genuine progress on the field of infrastructure. Para 53 promises legislation on replacing multiple prior permissions by a pre-existing regulatory mechanism. Para 72 promises a new law on procurement. Para 73 promises a new law on disputes. Para 74 promises a new law on infrastructure regulation.

There is, of course, the challenge of execution. Many laws are drafted in India, but all too often, the quality of work is poor and the new laws do not solve problems. But given high quality execution, these could be transformative initiatives. A lot of the work on establishing financial regulators, that was done for the Indian Financial Code, could potentially easily carry over to the problem of drafting law for infrastructure regulators.

Other reforms

Para 33 promises that NITI will work on creation of a Unified National Agriculture Market. This is a very important area. We have to cautiously see the extent to which modern thinking, and high quality execution, is brought into the work of NITI on this question.

Para 103 proposes a draconian policing environment on overseas assets. This is a throwback to Indira Gandhi's world, and is highly regrettable.


Narendra Modi showed a willingness to solve problems at the root cause in some sectors in Gujarat. The first budget shows glimmers of the Modi way in a few areas, but all too often, it settles for the conventional approach of compromise and defence of the status quo. Transformative initiatives, like the abolition of the Planning Commission, have not been followed through to their logical conclusion. This yields low gains.

The budget is weak on strategy, on coherent thinking. A variety of dilettantish two-page policy notes have been cobbled together in most areas. To make progress, one needs to start from full picture of where we want to go (i.e. a "grand scheme"), think it through in all its ramificiations, and undertake a series of chess moves which take us to that ultimate goal. Instead, we have got defeatist statements that in democracies, fundamental progress is not feasible. On taxation, expenditure, infrastructure, etc., there is no evidence of this kind of big thinking.

It is one thing to get through the political conflicts and agree on a line in the budget speech. It is a very different matter to get execution. The Government of India is riddled with weak teams, a lack of clarity on the direction for reform, low execution capabilities, etc. In many places, hard political battles have been fought to get a line or a paragraph into the budget speech, but this will come to naught owing to inadequate execution. The subset of the budget speech where results will be obtained will be the subset where sound teams are put into motion. The sound teams will, in turn, feed good ideas back into the next budget process. The management challenge, of establishing high quality teams on the policy priorities, is the defining question about the Indian government. Arun Jaitley and his team at the Ministry of Finance will need to carefully strategise how the good stuff out of the speech is turned into project management, that can deliver valuable change over the year.

The BJP, armed with a clear majority in the Lok Sabha, with the desire to break with Nehruvian socialism, was expected to unveil a game plan for structural changes from here till 2019. In large part, Budget 2015 does not meet the bill. It has some good elements, and with good execution, they will make an important difference. But on an array of important and pressing problems, we do not have solutions.

It is interesting to contrast this against what a UPA budget might have been. A UPA budget might have had elements like:

  • More public expenditure on infrastructure.
  • Weak fiscal consolidation, apologies for lack of deficit reduction.
  • Lack of subsidy reform.
  • Not abolish the planning commission or plan schemes, inability to re-imagine the fiscal system without central planning.
  • Increased the peak income tax rate by 2 percentage points for the rich.
  • Continue to have a 44% tax rate on firms (combining corporation tax and DDT).
  • Continue to have `bad taxes' like the STT.
  • Not remove the 2% corporate social responsibility expense in the Companies Act.
  • Indira Gandhi vintage measures on foreign assets.

It is disappointing to see how little has changed.

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