More spending on education and health
India's budget, unveiled on February 28th, was low on structural reform but high on spending that will aid the economy's long-term prospects. The finance minister, P. Chidambaram, has used the backdrop of very strong economic growth to invest heavily in education and health—essential if India is to make use of the much-talked-about "demographic dividend" of a young and growing labour force. He also plans to invest heavily in rural infrastructure, which again bodes well for long-term development. With worries over inflation grabbing the headlines, the budget also includes some anti-inflationary measures--although the budget is in no way counter-cyclical as these measures will be outweighed by higher public spending. Nonetheless, although the finance minister could certainly have done more to tackle the fiscal deficit, rein in inflation and promote economic reform, he has done nothing that will derail the current high-growth story. The old adage, "If it is not broken, don't fix it," largely applies.Government spending in the new budget is to increase by 21% to Rs6.81trn (US$154bn), while the government expects its revenue to rise to Rs4.86trn, also up 21%. Including non-debt capital receipts of Rs432bn, this should leave a central fiscal deficit of Rs1.51trn, equivalent to 3.3% of GDP, according to the government's projections. This outcome, if achieved, would be a marked improvement on the government's estimate of 3.7% for fiscal 2006/07. It would also be vastly better than the levels of around 6% of GDP recorded five or six years ago, indicating the encouraging progress India has made in tackling its fiscal problems. That said, the new budget still allocates Rs1.59trn to servicing the interest on its debt—almost a quarter of total government spending—indicating there is more work to be done on fiscal consolidation. Paying interest on government debt limits the room for spending on more productive purposes.
Focus on social spending
In the case of this budget, the term "productive" largely means spending money on agriculture, education and health. If the budget has a unifying theme, it is in what Mr Chidambaram describes as "faster and more inclusive growth". This means creating the conditions to allow more of the population, and not only the urban middle classes, to benefit from the country's rapid economic growth. Although the budget still aims to improve the fiscal position, Mr Chidambaram has largely chosen to spend the expected windfall from rapid growth on social programmes rather than on reducing the deficit and public debt further.
As such, the budget raises total expenditure on education by 34.2% to Rs324bn (US$7.3bn), and that on health and family welfare by 21.9% to Rs153bn. In the Economist Intelligence Unit's view, this is one of the most positive features of the budget, as if implemented properly (always a big if) these measures have the potential to alleviate some of the worst effects of poverty and boost India's long-term economic prospects.
Also prominent—and welcome, in our view—is the budget's focus on the ailing agricultural sector. The government aims to raise average annual growth in the farm sector from an average of 2.3% in the past five years to 4% by 2011/12, the end of its 11th five-year plan. The budget raises substantially allocations for several flagship programmes. The biggest of them, Bharat Nirman, a massive rural-infrastructure programme, is to get 31.6% more funds, bringing spending to Rs246bn. The budget also increases credit to the farm sector by 29%, to Rs2.25trn (US$51bn).
The focus on agriculture has two dimensions. The first is political. The Congress party, which heads the United Progressive Alliance (UPA) coalition government, has to be seen to be doing enough to raise the raise the living standards of the poor to ensure future electoral success. Secondly, the government's aim to raise annual economic growth to 10% by 2011/12 crucially depends on higher growth in the farm sector. Agriculture accounts for around 18% of Indian output, but its importance to the economy is even higher because of its impact on rural incomes and consumption; about two-thirds of India's labour force is employed in the farm sector.
Not so good for business?
The budget has disappointed businesses and stockmarket investors, as it does not cut the corporate tax rate, raises the dividend distribution tax from 12.5% to 15%, and makes employee stock options taxable as fringe benefits. This latter measure is expected to hit information technology (IT) companies. So, too, will a new budget measure that subjects firms in this sector to a "minimum alternate tax", which will increase their effective tax rate.
Because of IT's emblematic status as one of the economy's most dynamic sectors and its importance to the global outsourcing industry, Indian technology firms have typically enjoyed substantial tax exemptions. Although one could justifiably argue that many IT firms are profitable enough to absorb a heavier tax burden—particularly given the need for India to widen its tax base—overall we regard this as a negative feature of the budget. The competitiveness of Indian IT companies is crucial to the country's continued appeal to foreign business. More generally for business, a 2% education "cess" on all taxes is to rise to 3%—good for the government's development objectives outlined above, but not so good for corporate profits.
Despite this, the budget is by no means disastrous for business. Indian firms in many sectors will continue to enjoy a variety of exemptions and other tax breaks that lower their effective tax burdens--indeed, the government claims the effective rate of tax rate actually paid by companies is only 19.2%. Small businesses with a taxable income of Rs10m or less will benefit from the removal of a surcharge on income tax. And the basic rate of corporate income tax has been left unchanged at 30%, although the increase in the education cess lifts its effective rate (before exemptions) to almost 34% from 33.66%. On balance, the budget's position on corporate tax is probably a reasonable compromise for all concerned: the corporate sector can at least console itself with the knowledge that the main income tax rate has not risen further; while from a fiscal point of view it is useful for the government's revenues that tax has not been cut to appease business. India's share of budget revenue to GDP is one of the lowest in Asia, at barely 13%, and the government needs all the revenue it can muster. A tax cut would also have potentially added to inflationary pressures.
Lower duties
Inflation remains a major macroeconomic concern, and one that carries political risks for the UPA coalition as well. The budget includes some notable anti-inflationary measures. It reduces the peak rate of import duty for non-agricultural products from 12.5% to 10%, a move that will help to limit import-led inflation. It cuts customs duties on various items, including plastics, chemicals, fibres and yarn. It also cuts excise duties on petrol and diesel.
Reform-lite
If the budget takes a distinctly long-term view in its focus on education and farming, it largely omits bold structural economic reforms in areas such as privatisation, the labour market and the retail sector. Nor does it seek to remove foreign direct investment caps in insurance and banking.
Of course, this is unsurprising given the reality of coalition politics. The government's economic-reform agenda has often met resistance from the leftist parties on which it relies for political support. The Left Front is partly behind the government's focus on social spending. For example, the budget extends the National Rural Employment Guarantee Scheme (NREGS), a public-works programme introduced under the Congress-led UPA government and supported by the Left Front, from 200 to 330 districts. The budget allocates Rs120bn to the NREGS.
Liberalising reforms are likely to become even more politically unpalatable to the Congress-led coalition as the general election, which must be held by May 2009, gradually approaches. In this context, the 2007/08 budget just announced was arguably the government's best chance before the next election to implement major change. Next year's budget and, if an election has not taken place by then, the following year's will be more heavily overshadowed by pre-election considerations. While the term "inclusive" is certainly an apt description of the government's budget, "missed opportunity" is another phrase that arguably applies.