Palaniappan Chidambaram, 61, is going to be the envy of most finance ministers when he rises to present the Union Budget for 2007-08. After all, it is not every day that the treasury manages to exceed even its most optimistic revenue targets, and, that too, by a comfortable margin. The finance ministry is expected to close 2006-07 with at least Rs 20,000 crore more than the Rs 4,42,200 crore that Chidambaram had estimated he would collect in taxes. And mind you, this wasn't an easy target by any stretch of imagination; it was as aggressive as it gets. Finance ministry officials point out that the target of Rs 2,10,000 crore for direct taxes was exactly double the actual direct tax collections in 2003-04-a 100 per cent growth in three years-and even that is likely to be exceeded. This has given rise to optimism that the Finance Minister may play Santa Claus on February 28. "If tax compliance improves, there is scope for moderation," he reiterated recently in a television interview. That's the positive part. On the flip side: Chidambaram will be under tremendous pressure from his own party, coalition partners and allies to allocate resources to populist schemes in a year when several states go to the polls.
For economy watchers, this abundance doesn't come as a surprise. It has been in the works for a long time, as the government, over the years, rationalised and simplified the country's complex tax structure. But the more immediate trigger for this bounty is the stupendous economic growth that India has been experiencing over the last few years. "Public finances are improving partly because growth is feeding revenues and partly because of improved tax systems," says Sanjeev Sanyal, Director, Global Markets Research, Deutsche Bank.
The economy has been galloping quarter after quarter. So have corporate profits (See In Step With Each Other). Gross Domestic Product (GDP) growth in the first-half of the current financial year topped the 9 per cent mark-close to the aspirational double-digit growth figure. If the services sector was the lone sprinter earlier, then industry has now joined the race, clocking 14.4 per cent year-on-year growth-nearly 3-4 percentage points over consensus estimates-in November, 2006. The rest is a no-brainer: rapid industrial growth naturally leads to higher excise collections (though they are still lower than what the fm would want) while higher imports swell the customs duty kitty. And corporate tax? This rose over 50 per cent during the first three quarters of the current financial year. It's a virtuous cycle-corporate expansion is fuelling a secular rise in salary levels that has fuelled an over 27 per cent growth in personal tax collections during the same period (See The Coffers Brimmeth Over).
The boom in the services sector, which accounts for 55 per cent of India's GDP, is also being reflected in the tax collections. Though the service tax to GDP ratio is still a low 1 per cent, it is growing rapidly on its still small base and helping sustain the over 20 per cent growth in indirect tax collections. New levies introduced over the last three years, such as the securities transaction tax (STT) and the fringe benefit tax (FBT), also help sustain the momentum. "These new taxes are easing the pressure on traditional contributors such as customs and excise," says Gaurav Taneja, Partner, Ernst & Young.
Improved Tax Systems
Across the economy, the emphasis has shifted from tax avoidance to wealth creation, says Rahul Garg, ED, PricewaterhouseCoopers. "Given the economic buoyancy, there is an increased ability and willingness to pay taxes," he says, adding that the tax department's systematic approach to investigations and scrutiny is also helping create a credible deterrent against non-compliance. "The department has become more aggressive; the intensity of the action is very high," says E&Y's Taneja. The numbers bear this out: tax demands made after scrutiny of a mere 2 per cent of returns typically yield around 10-12 per cent of the gross direct tax collections.
If this aggressive approach is working for the corporate sector, then it is also working in the personal income tax domain. The government is now tapping third party sources such as banks (see Big Brother is Watching) to collect data on "high value" transactions. "Unaccounted for income has to be either spent or invested. We are tracking both routes," says a senior finance ministry official.
Another associated factor, though not directly linked to Central government finances, is the switchover in most states to value added tax (VAT) from central sales tax. This has created, what economists call, a "self-generating, complex paper trail" for unaccounted wealth. And the effect on state government finances has been dramatic. During 2005-06, tax revenues of the 25 states that have implemented VAT grew 13.8 per cent year-on-year-higher than the compounded annual growth in sales tax collections in the previous five years up to 2004-05. As the tax regime gets streamlined, more such advantages will accrue.
Room for Manoeuvre
The government's coffers are overflowing. The big question is: what will Chidambaram do with his bounty? Will he use the available headroom to undertake some much-needed but politically unpopular reformist measures or will he go down the populist path?
"The underlying momentum in the economy, coupled with the new-found efficiencies in the tax collection system, will definitely give the Finance Minister more leeway to invest in areas like infrastructure and education," says V. Balakrishnan, CFO, Infosys Technologies. Also, in the wake of widespread prosperity, there is greater acceptance of the government's "common man" agenda. "Demands for spending large amounts on social sector schemes should not be seen to be at cross-purposes with policies that spur economic growth. These will actually play a complementary role," says E&Y's Taneja. But Rajan Varma, CFO, Dabur India, adds a word of caution. "Higher allocations for the social sector will certainly be welcome if they are targeted," he says, highlighting widespread concerns about the leaky delivery channels for such spends.
However, the Finance Minister will be under tremendous pressure to deliver a populist budget. Elections are due this year in four states, including in the politically crucial Uttar Pradesh; and for the political class the Budget is still a great instrument to make its point. A sneak preview of this pressure was in evidence when excise duty concessions for hilly states, which were due to expire in March this year, were extended by three years. Uttaranchal, a beneficiary of this move, is one of the states going to polls. The same pressures seem to be driving the proposal for priority lending to minorities by banks.
Finance Ministry mandarins are tightlipped about the direction of the Budget, but the heartening point is that the government is making all the right (and responsible) noises about it. The indications are that Chidambaram will use this opportunity to initiate changes that are critical for long-term revenue buoyancy. And political backing for such changes was provided by none other than Prime Minister Manmohan Singh himself. "In the long run, our tax regime should not have too many exemptions which make tax administration an unnecessarily complex exercise vulnerable to misuse," he told an industry forum recently.
The focus on removal of exemptions comes with the need for lower taxes. And there is quite a clamour at least for lower rates on the direct taxes front. Recently, in an open letter to the Finance Minister, investment bank CLSA Asia Pacific Markets argued for a 3-4 per cent reduction in effective tax rates on income for corporates and individuals. His department's bulging coffers gives him sufficient room to grant this wish, and still spare some for correcting the fiscal imbalance. Though the Budget target for fiscal deficit will be easily attained this year, more clearly needs to be done on this score. Standard & Poor's Credit Analyst Sani Hamid points out that India's fiscal position, including its deficits, debt and interest payment liabilities, is still among the weakest of all the countries rated by the global credit rating agency. "India's average general government deficit, of 8 per cent over financial years 2003-2007, is well above the deficit of 2.2 per cent and 2.9 per cent for the bb and B medians, respectively, for the same period." S&P rates India bb+, just a notch below investment grade. Higher tax collections will give the Finance Minister space to begin fixing this problem as well.
"It is imperative that this (buoyant) trajectory be held. All that India needs to do is just stay the course," says Deutsche Bank's Sanyal. And the best part is that this time, Chidambaram can afford to please both the populists and the pragmatists.
YOU CAN EXPECT CHIDAMBARAM TO...
| Remove the 10 per cent surcharge on corporate and personal income taxes Reduce income tax rates on personal income Reduce peak customs duty rate by 2.5 per cent to 10 per cent Increase the service tax rate to 14 per cent and bring more services into the tax net Announce a clearer roadmap for transition to the Goods and Services Tax by April 2010 Reduce myriad exemptions across the tax system Make visible and probably enhanced allocations for education and healthcare Make a visible effort to spur growth in the lagging farm sector. He may set up a farmer infrastructure investment fund as proposed by National Commission for Farmers Announce a special package for unorganised sector workers and for minorities Reduce the excise duty on large cars from 24 per cent to 16 per cent. He could push this to the next year as well Take small steps on financial sector reforms, including capital account convertibility |