Striking a Fine Balance between Populism and Fiscal Prudence
Goldman Sachs

India’s government announced an interim budget on February 1st. Although conventionally an interim budget is supposed to be a statement of accounts, it was different this year, as it included significant policy announcements. Against the backdrop of upcoming general elections, somewhat slowing economic activity, and food inflation at historic lows, the budget made several announcements including a flagship program for income support to farmers, and income tax benefits for the salaried class.

The reported fiscal deficit for FY19 did not deviate meaningfully from the target, with the shortfall in GST being offset by higher direct taxes, and lower transfers to states.

Despite being an election year, the budget does not envisage any additional stimulus, with the fiscal deficit in FY20 targeted to be flat at 3.4% of GDP (compared to FY19), but ~0.4 pp higher than the Fiscal Responsibility and Budget Management (FRBM) target of 3%. This is the third consecutive year of deviation from the FRBM targets. Net market borrowings are projected to increase significantly in FY20, and might exert pressure on yields going forward.

We believe that the revised estimates for FY19 and the targets for FY20 are still ambitious, and would require intensified tax collection efforts, particularly on GST.

While equity markets rallied, 10-year bond yields increased, and INR weakened following the budget announcement.

FY19 Budget Math

In the interim budget for FY20, the Indian government announced a revised fiscal deficit estimate for FY19 of 3.37% of GDP (~3.4% of GDP announced by the Finance Minister), compared to the budget estimate of 3.33% of GDP. GST tax collections are estimated to be short of the original estimate by 0.5% of GDP (~ 1 trn INR) by the end of FY19. This may be a conservative estimate of the shortfall – limiting the gap to 1 trn INR would require an average collection of INR 768 bn per month during the last quarter of the fiscal year, compared to the run rate of INR 455 bn so far.

The deficit in GST collections is expected to be offset in three ways. First, the revised estimates assume an overshoot of direct taxes, particularly of corporate taxes. Overall, direct taxes have performed well. They grew 16% year-on-year during April-November, compared to 14% in the budget, and an average of 11% over the previous four years. The FY19 revised estimates, however, assume a significant pick up in tax collection efforts in the last quarter, and a full year growth of 20%, in order to be able increase direct taxes by INR 500 bn relative to the budget estimate. This may be possible to achieve following the strong performance last year, but nonetheless appears to be ambitious compared to historical averages. Second, customs revenues are assumed to outperform relative to what was budgeted. We believe this to be realistic, as the current run rate is in line with the new assumption. Third, while gross tax revenues are estimated to fall short of the budget target by 0.2% of GDP, net tax revenues are expected to be exactly in line with what was targeted. This effectively implies a decline in the share of states in gross tax revenues by an equivalent magnitude, than what was originally budgeted. The FY19 RE estimates assume that the states would receive ~INR 270 bn less than what was assumed originally.

Non-tax revenues as well as disinvestment receipts are estimated to hit the budget target in FY19. There is variation, however, across different categories of non-tax revenues, with an increase in dividends from RBI and the other state-owned banks (SoB), balanced against lower dividends from PSUs and telecom receipts. Out of a total of ~INR 741 bn budgeted for RBI and Sob dividends in the revised estimates for FY19, INR 400 bn has already been received by the government. The rest, comprised mainly of dividends from the RBI, are expected by the end of the fiscal year.

No fiscal stimulus in the FY20 budget

Contrary to our expectations, the government did not stick to the path of fiscal consolidation recommended by the Fiscal Responsibility and Budget Management Committee. That said, despite being an election year, the budget does not envisage any additional stimulus through the reported fiscal deficit figures, with the FY20 targeted fiscal deficit flat at 3.35% of GDP, compared to 3.37% of GDP estimated for FY19, but ~0.4 pp higher than the FRBM target of 3%. The Finance Minister, in his speech, did note the government’s commitment towards fiscal and debt consolidation, with the goal to reduce the center’s fiscal deficit to 3% in FY21, and debt to 40% by FY25. This is the third consecutive year, however, of deviation from FRBM targets.

On the tax side, GST, corporate and income taxes are projected to increase, partly offset by lower excises taxes on items not under GST, e.g. oil. Income taxes are assumed to increase by 0.14% of GDP, a less ambitious growth rate of 17% compared to an estimated 23% in FY19. The lower growth rate in income taxes is likely due to key policy changes introduced in the budget: (i) an increase in the tax exemption limit from INR 200,000 to INR 250,000, with a tax rebate for those up to an income of INR 300,000 (ii) a reduction in tax rate from 10% to 5% for the tax slab of INR 250,000-500,000, and (iii) higher deductions – increase in deduction on savings, and on interest for self-occupied houses. Our estimates suggest a loss of ~0.2% of GDP from these measures. GST revenues are assumed to increase from 3.4% to 3.6% of GDP, and a growth of 18% which might appear realistic, but would still require about 40% increase in the average run rate per month (from INR 455 bn per month in FY19 so far to INR 633 bn). Overall, the budgeted nominal GDP growth of 11.5%, and an assumed tax buoyancy of 1.2 appears reasonable, but would still require intensified tax collection efforts, particularly on GST.

Importantly, expenditures are forecasted to match higher revenues, such that the budget is fiscally neutral. Revenues expenditures are projected to increase by 0.3 pp of GDP, largely explained by the flagship “PM-Kisan” program announced in the budget. Under this program, INR 6000 per year would be transferred in three equal installments to all landholding farmers, having cultivable land of up to 2 hectares, with the first installment to be transferred to the farmers by March 31st 2019. This program is estimated to cost INR 200 bn (0.11% of GDP) and 750 bn (0.36% of GDP) in FY19 and FY20 respectively. Strikingly, despite higher spending on the PM-Kisan program, the overall spending in the FY19 RE estimates remained unchanged vis-à-vis the budget. This is due to offsets in spending on other items, particularly, transfers to the GST compensation fund, which are likely to underspend, as compensation to states is projected to be lower given better run rates on states’ collection.

On subsidies, while food and fertilizer are projected to decline slightly, petroleum subsidies are forecasted to increase in FY20, such that the overall outlays on subsidies remain changed at 1.4% of GDP. The increase in budgeted petroleum subsidies is surprising, given that oil prices are broadly projected to fall between FY19 and FY20. We conjecture that this increase might reflect some deferring of subsidy payments in a cash accounting framework, given that the government has already spent more than what was budgeted.

While revenue spending is projected to increase, capital spending is assumed to decline by ~0.1% of GDP, making the budget increasingly skewed towards current spending, which may not augur well for a pick up in overall investment and growth. To the extent that there is scope to increase the quality and efficiency of the spending within the budget, or some of the spending happens through public enterprises as off budget allocations, it may reduce some of the concerns.

Net market borrowing projected to pick up

For FY19, the net market borrowing is projected to be lower than was initially budgeted by INR 393 bn. This is mainly due to a shift from market loans to increased borrowings from the National Small Savings Fund (NSSF). Net market borrowing is projected to increase by another INR 500 bn in FY20 to reach INR 4,731 bn (US$66bn). Gross market borrowing is pegged substantially higher, at INR 7,100 bn, driven by repayments of INR 2,369 bn.

Market reaction to the budget differed across equities and bonds

Bond markets had already started reconciling themselves for some fiscal slippage, driving a meaningful increase in yields on 10 year bonds (~7.5% just before the budget announcement from a low of 7.2% in December). Bond yields increased further following the budget announcement, reporting an increase of 13 bp on the day. The INR weakened by 0.64%, coincident with net debt outflows. Equity markets, on the other hand, rallied, with the benchmark equity market index reporting an increase of 0.6%, and FII equity inflows post Budget.