Devangshu Datta: Focus on fiscal deficit

This will be one of the more interesting Budgets in living memory. The economy is still reeling from demonetisation.  At the same time, the Bharatiya Janata Party (BJP) has moved into the campaign mode and the policy thrust could be oriented to winning over voters. There must be contingency plans for scenarios where the goods and services Tax (GST) goes through and for scenarios where it does not. Above all, the Budget must maintain fiscal discipline. 

It could take years to figure out how deep the impact of demonetisation has been. The cash crunch could carry on for months. A random scan of ATMs indicates many are still out of cash for long periods, even in high-penetration metro areas. It is also unclear what level of cash as a percentage of gross domestic product (GDP) the government wants to keep in circulation. There have been blue-collar job losses across multiple sectors. There has been a drop in white-collar incomes for agents in commission-driven industries like automobiles, where sales have fallen off a cliff. 

Consumer behaviour has changed in the short term, with consumers becoming more cautious and prices falling in many sectors. Consumption patterns may even have changed for the long term. The Budget will have to address as many of these challenges as possible. If it cannot satisfactorily restore consumer confidence and trust in currency, the slowdown will last longer and, of course, the chances of poor election outcomes increase.  

There isn’t much money to spare, since there would be punishment for overshooting the fiscal deficit. So, policy tweaks will be needed to encourage investment, rather than mindlessly pumping money. 

Where there is spending on the social front, it may be via programmes like MNREGA (Mahatma Gandhi National Rural Employment Gurantee Act) to alleviate suffering at the bottom of the rural pyramid. 

That would also fit a populist election strategy. 

There are rumours of possible cuts on the corporate tax front as well as in cuts on personal income tax rates or perhaps hikes in exemption limits. There are also rumours of unpleasant surprises in terms of lengthening the period for long-term capital gains. There are also rumours of some sort of banking transaction tax. In addition, there has been lobbying to repeal the ‘Vodafone’ tax that acts with retrospective effect. Obviously all these tax-related rumours are inconsistent with each other and so, all of them can’t work out. My guesses follow. First, the retrospective Vodafone tax won’t go, regressive as it is, since the income tax department will fight tooth and nail to keep it. 

Income and corporate tax cuts could garner some popularity and win some corporate and middle-class hearts. Tax cuts may even have a Laffer Curve effect and enhance revenue in the long term. But, an expansion of the fiscal deficit could have serious consequences and tax cuts this year run very high risks of expanding it.  

If the GST does happen, there will be some inevitable chaos on the indirect tax front.  The Centre must assume a fall in net indirect tax revenue after it gives states their shares of GST revenue. 

So, any direct tax cuts this financial year would amount to a dangerous gamble. 

GST again lends itself to conflicting rumours. Cynics allege the Centre isn’t ready with processes and would be happy to let states short-circuit the GST and make political capital from the mess. 

Ignoring conspiracy theories, the changeover will be very complex and there's lots of ongoing state-Centre negotiations. Important details like proposed tax rates, exemptions and who collects revenue are still not fixed. A massive overhaul of back-end and re-skilling of many officials is required.  Also, unlike income tax, GST affects everyone, businesses and individuals. So, it is more sensitive. The history of GST-type switchovers in Europe indicates the new system takes two financial years or more to settle down and produce positive results. That is too long, given the Lok Sabha elections in 2019.  So, it’s possible the Budget will pay lip service to the GST, while tacitly assuming that it won’t happen. 

Historically, markets often respond negatively to Budgets after being over-optimistic in the run-up. This could happen again, unless the Budget is truly out of the box and those other variables like GST timelines, Assembly elections, are seen to favour the BJP.  In the absence of other benchmarks, focus on the fiscal deficit. A higher fiscal deficit will mean more exits from foreign institutional investors and that will probably mean a falling market.