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 Tax Freedom
Stimulus: Sacrifice a little now or a lot later
Business Standard, India Monday, February 14, 2011

The government should pull back the fiscal stimulus to preserve growth and stability. The tightening will be a big first step and it will buy the government time to reform the agricultural sector and address regulatory uncertainties and corruption. But the market won’t be patient for too long. In a world awash with liquidity, there are many other places to fish, writes Jahangir Aziz in Business Standard.

Hopefully, in the Budget on February 28, the government will see the driver of current inflation for what it really is: an unsurprising consequence of loose monetary and fiscal policies stretching the economy beyond its capacity. If it does that and gives up the misplaced faith in miracle harvests and base effects, it will also do the right thing: pull back the massive fiscal stimulus that has been in play since the global economic crisis.

Why is this important? Think back to January 25. The market had fully priced in a 25 basis point rate hike by the Reserve Bank of India (RBI) and some were bracing for a higher increase. The RBI delivered a 25 basis point hike. But instead of a relief rally, the equity market has bled relentlessly since then.

To restore confidence, the government and the central bank need to assure investors that they plan to get ahead of the curve rather than stay behind. By letting food inflation fester, the government has allowed inflationary expectations to harden, which are now threatening to ignite a generalised inflation. In December, the monthly momentum of core inflation – which excludes food and fuel – was running at over 11 per cent and that of the narrower non-food manufacturing inflation at 8 per cent, having risen from 1 per cent six months ago!


Although there are several things the government can do to rebuild investor confidence, my guess is that these will be parsed over the course of the year as and when politically feasible.

The Budget will be an accounting exercise with minimal policy changes. On the surface, the Budget 2011 numbers will look good aided by the spectrum sales revenue and higher taxes collected. The deficit should be 5.2 to 5.3 per cent of GDP, much better than the budgeted 5.5 per cent. If the government runs oil subsidy arrears as it did last year, the cash balance could also be sizeable. Also, chances are that a significant portion of the two supplementary Budgets will not be spent. The government will parade that it brought the deficit down from 6.8 per cent of GDP in the financial year 2010 by 1.5 percentage points while still keeping growth at 8.5 per cent.


And this is where the problem lies. It was one thing to provide stimulus in the financial year 2010 when the economy was staring at the possibility of 6 to 7 per cent growth, but to continue doing so when growth was touching 9 per cent in FY11 questions macroeconomic judgment.


The government will try several options. Some tax bases (direct and indirect) are likely to be expanded such as those for education, health and new properties. Income tax exemption may be raised in line with the next year’s Direct Taxes Code, but this won’t be a major revenue drag. Disinvestment targets will be set higher since the unfinished initial public offerings of this year will be added. And a partial rollback of the excise tax cuts during the crisis may be on the agenda.

On spending, the Budget will use the space provided by the unspent supplementary budget to show only a modest increase. Oil subsidies will again be severely underestimated and the new big subsidy item, the Right to Food Security, will not be budgeted since it has not been passed by Parliament. It will likely be added through a supplementary budget later in the year. The gross borrowing will amount around the same level as this year, but with lower redemptions the net borrowing will be higher. This won’t upset the market much since the cash surplus will be seen as a buffer.


Will these be enough to restore investor confidence? Not really, but the tightening will be a big first step and it will buy the government time to reform the agricultural sector and address regulatory uncertainties and corruption. But the market won’t be patient for too long. In a world awash with liquidity, there are many other places to fish.

This article was published in the Business Standard on Monday, February 14, 2011. Please read the original article here.
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