30/01/2017
Three out of four engines of aggregate demand for India — private consumption, private investment, and external demand — are stuttering. Government spending is the only component of demand that is relatively robust. Capital inflows into India by foreign institutional investors (FIIs) have been slowing. There is considerable uncertainty over estimates of macroeconomic variables such as GDP, which makes the task of preparing budget estimates difficult.
India’s Central Statistical Organisation (CSO) has stated that it did not take into account the impact of demonetisation when calculating advance estimates of GDP. There is a need for measures to incentivise investment and consumption and promote exports. At the same time, it is essential to keep the fiscal deficit in check to maintain India’s creditworthiness in the face of an uncertain external environment.
A tough environment
With instances such as the election of President Donald Trump, Brexit, the prospects of further interest rate hikes by the US Federal Reserve, and relatively sluggish growth and continued quantitative easing in the Euro Zone and Japan, the global macroeconomic environment is expected to remain challenging. Increase in long-term yields in the US could result in capital outflows from emerging market economies such as India. Protectionism in trade, especially of services trade, will affect India’s export sector directly.
Despite weak export growth, India’s current account balance has improved partly due to subdued import demand, reflecting weakness in domestic demand. India’s sovereign rating of BBB- (Baa3) is just at the investment-grade threshold, while overall debt stock as a share of GDP is relatively high. Indian policymakers should demonstrate commitment to a predictable and transparent regulatory and tax regime for foreign investors. Frequent changes in regulations and use of discretion in the application of tax laws create additional uncertainty and raise costs for foreign investors.
India’s gross fixed capital formation (GFCF) in constant price terms has declined for three consecutive quarters on a year-on-year basis. Therefore, it is necessary to provide additional incentives for domestic investment. The planned reduction in corporate income tax to 25 percent should be brought forward to the next fiscal year, instead of reducing it by 1 percentage point each year as initially envisaged. This is of particular relevance since Trump is planning to reduce corporate income tax in the US from 35 per cent to 15 per cent, which could result in large capital outflows from countries such as India. Tax exemptions provided for corporate income should be eliminated gradually for greater transparency.
Household savings can be encouraged by raising the limit for tax deduction under Section 80C from Rs. 1.5 lakh to Rs. 2 lakh. Reduction of stamp duties on land transactions can bring in greater transparency in real estate investments. Recapitalisation of the banking sector will require allocation of additional funds, which may be difficult given fiscal constraints. Public sector banks have to make a stronger effort to raise capital if they are to meet the Basel-III regulatory requirements by 2019.
According to the IMF, demonetisation would shave off about 1 percent from India’s GDP growth in 2016-17, from 7.6 per cent to 6.6 per cent, translating to about Rs. 1.5 lakh crore of lost demand. Other analysts project an even larger fall. Targeted spending measures can alleviate the impact of demonetisation on consumption demand. A well-targeted basic income scheme could replace a number of subsidies and reduce leakages. Raising the minimum income tax slab could provide a boost to demand by raising the disposable incomes of the segments that are expected to have the highest marginal propensity to consume.
Credit and debt
Even as the Government implements an expected fiscal stimulus and undertakes reforms to boost aggregate demand, the task of maintaining India’s sovereign creditworthiness and keeping debt under control necessitates meeting fiscal deficit targets. This would help to signal credibility of the policy stance to international investors. An expansion in spending, therefore, should be financed by raising additional taxes.
The Budget should aim for a simplified and low tax regime with high levels of compliance for both direct and indirect taxes. The tax base should be broadened. The tax exemption for agricultural income should be reviewed since all agricultural income is currently exempt from tax, even for large landholders. A threshold above which agricultural income could be taxed should be considered. Over time, taxes on agricultural income should be harmonized with overall income taxes.
Stock market investment has enjoyed exemption from long-term capital gains tax as previous governments sought to foster participation of retail investors in capital markets. The Budget could consider lengthening the period for short-term capital gains tax from one year to three years and introduce a long-term capital gains tax on equities, with indexation benefits, to bring about parity between equity and debt instruments. There should also be parity in the tax treatment of the Public Provident Fund (PPF) and the National Pension Scheme (NPS) to encourage greater participation in the latter. Over a period of time, regulated interest rate on small savings schemes should be made market-determined, and there should be a move to direct cash transfers to eligible recipients.
Greater tax compliance
The government should find ways to improve tax compliance of professionals and business owners. Information from banking transactions can help to improve compliance, although greater scrutiny may reduce incentives to use the banking system and promote the use of other assets such as gold and real estate. The implementation of the Goods and Services Tax will also generate a paper trail of transactions, reduce incentives to maintain dual ( kaccha and pucca ) accounts, and generate better information on business income. Timely implementation of the GST will play a positive role in reducing inefficiencies and losses in the supply chain and potentially raise indirect tax revenues. Incentives for a ‘less-cash’ economy should take into account the sustainability of such measures and provide sufficient incentives for market participants to invest in digital infrastructure.
There is a risk that GDP and its components, upon which tax revenue and spending estimates are based, may turn out lower than expected. Lack of confidence about GDP data could also become an issue for investors, particularly after demonetisation. There are external risks, such as the risk of trade wars or spike in crude oil prices, that could upset calculations for revenues, while domestic risks such as poor monsoons could weaken the domestic tax base.
