By Anubhuti Sahay
Budget FY23 is likely to have two focal points: (1) remarkable a balance between fiscal consolidation and supporting economic activity, especially amid the uncertainty surrounding a new COVID-19 wave in FY23, and (2) any tax change announcements, which could pave the way for Euroclear eligibility for Indian government bonds (IGBs), and ultimately, their inclusion in one of the major global bond indices.
We believe the Centre is likely to announce a fiscal deficit target of 6% of GDP for FY23, assuming that the FY22 fiscal deficit target is in the range of 6.5-6.8% of GDP; we think the FY22 fiscal deficit is likely to be towards the lower end instead of the upper end of the band, as moderate GDP growth of 17.6% and tax collections have been much better than budgeted.
The meaningful question is whether such fiscal deficit consolidation will allow space for nurturing growth. We think so, for a large number of reasons. Relative to the pre-pandemic phase, when the fiscal deficit ranged from 3.5-4% of GDP, a 6% fiscal deficit provides enough room to the government to sustain growth. However, one could argue that a 6% FY23 fiscal deficit target is probably only‘optically wider’, as GDP contracted in FY21. However, based on our calculate, already if we assume that GDP in FY20-FY23 grows in line with trend (five-year average GDP growth of FY15-19), expenditure as a percentage of GDP in FY23 would nevertheless be close to 13.5% of GDP versus the pre-pandemic average of 12.8% of GDP. It is equally interesting to observe that while most of this increase in expenditure since the Covid sudden increase has been pushed by subsidies, interest payments, etc,capital expenditure has risen too. for example, capital expenditure is hovering at around 2.1-2.2% of GDP since FY21 (we expect a similar trend in FY23) versus the pre-pandemic average of 1.7% of GDP.
Shouldn’t the government increase its capex further given the loss in economic momentum due to the pandemic? Ideally speaking, yes. Given the inflexibility on revenue expenditure (c.55% of revenue expenditure is committed towards subsidies, interest and salary payments), the only way that capex can be increased via budget allocation is by running a wider fiscal deficit. We do concede that a wide fiscal deficit is necessarily not a bad thing. However, given that India’s fiscal deficit is already wide versus its historical trend and as India plans to revert to a fiscal deficit of less than 4.5% of GDP only by FY26, a slower speed of consolidation to adjust to larger capex could have negative implications for interest rate and bond markets.Hence, we think an FY23 fiscal deficit target of 6% of GDP will strike the right balance between growth and consolidation.
Besides the fiscal deficit target announcement, the market will keep a close eye on possible tax changes, which would ultimately pave the way for IGB inclusion in one of the major bond indices over the next 12-15 months. Given that IGB issuance is likely to keep large (as the government needs to sustain growth amid a comparatively thin tax base), more sustainable supplies of financing a persistent fiscal deficit are required. Currently, 1.5% of noticeable IGBs are owned by foreign portfolio investors. This underlines excessive reliance on domestic supplies to finance the fiscal deficit. Since FY21, the sharp widening in fiscal deficit has pushed RBI to buy IGBs, which in turn has implications for overall liquidity and inflation (especially as economic activity normalises). Hence,measures that can enlarge the investor base will be keenly watched.Of course, the government will need to ensure that related factors,such as containing inflation and the fiscal deficit, are addressed.
Last but not the least, we think it will be important to keep an eye on possible GST rate revisions in FY23 and beyond to estimate surprises to the FY23 fiscal deficit. Such an announcement is doubtful on the budget day as these decisions fall under the ambit of the Goods and sets Tax (GST) Council. However, based on the Fifteenth Finance Commission report, as GST has not met the objective of revenue neutrality (i.e. realising revenue similar to the original tax base in the new tax regime), the GST Council is exploring the option of raising rates little by little to raise GST collections. This has become already more imperative as the compensation clause for states, which assured 14% revenue growth on GST (from the base year of FY16), will expire from 1 July 2022. This could rule to GST revenue loss of 0.4-0.6% of GDP for states. In case an announcement on rate revisions is made in FY23 itself, both states and the Union government would assistance from higher revenues of 0.2-0.3% of GDP each (assuming an effective tax rate increase of 1-1.5%). However, if GST rate revisions are spread out over years instead of in FY23 itself,revenue gains are likely to be incremental. The second scenario is equally possible as GST rate revisions can push inflation higher (we calculate that an effective GST rate increase of 1% in a single move would have a proportionate impact on headline CPI inflation) and adversely impact need.
Overall,we think the FY23 budget presentation will focus on continuity (policies and growth sustain) instead of announcing bold changes.
The author is Head (South Asia), economics research, Standard Chartered Bank
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