What the Budget must present in a tough global and job environment

As the Union Budget nears, the focus must shift to debt, deficits, and borrowing from household savings, and how these choices affect private investment, manufacturing growth, and jobs

A few days from now, Nirmala Sitharaman, in her seventh year as Minister for Finance, will present the Union Budget. Judging by the past, a long part of the presentation will be a narration of programmatic changes in schemes that are not the direct responsibility of the finance ministry but of other ministries. What really matters are the decisions presented in the Budget about the overall expenditure of the government, how it will be funded, and the proposed changes in taxation. That part of the presentation — the macroeconomic and fiscal impact — is what truly matters.

 

One crucial decision of macroeconomic significance is the scale of the budget deficit. How it is financed determines the accumulated liability of the government. In the past Budget presentations, the focus has tended to be on the fiscal deficit as a percentage of gross domestic product (GDP). The government has now shifted its goal from the annual rate of fiscal deficit to the overall debt-to-GDP ratio.

 

The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 specified a 2024-25 goal for the overall debt-to-GDP ratio of 60 per cent, of which 40 per cent would be for the Centre and 20 per cent for the states. As against this, the overall debt-to-GDP ratio at present is around 80 per cent,  with the Centre’s share at around 57 per cent as of March 2024 and remaining around this level since then. Note also that the asset-to-liability ratio of the Central government, which had reached 100 per cent between the mid-60s and the early ’80s, is now around 45 per cent.

 

Part of the explanation lies in the sharp rise in the Covid year; the  debt-to-GDP ratio rose to 87.7 per cent by March 2021. But do note that the pre-Covid year level in March 2020 was 75.1 per cent, which was already well above the FRBM target. Hence, a crucial element in the Budget is the Central government’s debt-to-GDP ratio set for 2026-27, as well as the medium-term goal for 2030, which would indicate a decisive step towards the FRBM targets.

 

The shift of emphasis from the annual fiscal deficit to the stock of debt-to-GDP is understandable. However, the annual fiscal deficit still matters because the manner in which it is financed has a significant impact on the private sector. The principal device used by the Central and state governments is market borrowing, and most of it is purchased and held by banks, insurance companies, and other financial institutions. The other major device used is a set of small savings schemes. The direct and indirect source of finance for both these devices is essentially households. Hence, one should look at how much of the net financial savings of households are absorbed by the Central and state governments to cover their deficit.

 

The table shows some relevant percentages in recent years. There was a sharp upward shift in market and small savings borrowings by the Central government in the years leading up to the pandemic. Since then, there has been a decline as a percentage of GDP, but it still remains higher than the level in 2018-19.

 

However, a more important measure is these borrowings as a percentage of net financial savings of households.  These savings, channelled substantially through banks, insurance companies and other financial institutions are the principal source for supporting investment by public and private enterprises. As the data shows, the proportion taken by the Central government has risen dramatically and in recent years it exceeds the volume of net household financial savings available. Part of the reason for this is the sharp increase in recent years in the financial liabilities of households and the resulting larger gap between the gross and net financial savings of households. But another part is the acceleration of investment by the Central government, with the amount shown as effective capital expenditure in the Budget rising from 2.6 per cent of GDP in 2018-19 to 4.3 per cent in 2025-26. Household financial savings data is not available for recent years. However, the percentage decline in the Central government’s borrowings in relation to capital expenditure suggests that there could be an improvement if the net financial savings of households as a percentage of GDP has not declined.

 

The substantial absorption of household savings by the Central and state governments increases the cost and limits the availability of investment funds for the private sector, particularly for new entrants and small enterprises. The manufacturing sector is much more dependent on access to investment finance.  The fall in the private corporate sector’s share in gross fixed capital formation from 40.3 per cent in 2015-16 to 32.4 per cent in 2023-24 may be partly attributable to this sharp shift in the direction of household savings.  Another source of adverse impact is the interest rate offered on small savings, which limits the possibility of interest rate reduction in bank transactions. Hence the Budget that will be presented at the end of this week must show a reduced impact of Central government market borrowing and promote small savings.

 

The other key decisions of the Budget are on tax rates. I am not sure that much can be expected or is required on these rates. The corporation tax reduction in 2019 did not have a significant impact on private corporate investments. The only impact was the decline in the share of corporation tax collection from 32 per cent of gross tax revenue in 2018-19 to 25 per cent in 2025-26BE. The share of income-tax  collection rose in the same period from 23 to 34 per cent. What I would look forward to, though, is some reduction in cesses and surcharges, which have increased substantially since 2010-11. More important, however, is a continuing rationalisation and reduction of tariffs. There are indications that we can expect this in the forthcoming Budget.

 

My focus has been on the macroeconomic balance and the tax issues that are the main responsibility of the Ministry of Finance and which should be the main focus of the Budget, rather than the lengthy presentation of government schemes.  At present, the primary drivers of the Budget proposals should be the difficult global environment, the inadequate growth in manufacturing whose share of GDP has come down, and the urgency of job creation.  My hope is that the Budget speech’s explanation of macroeconomic and tax changes  and its elaboration of government schemes will focus on these priorities so as to influence household and private sector expectations in the right direction. 

 

desaind@icloud.com