By Anubhuti Sahay
Budget FY23 is likely to have two focal points: (1) striking 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 eventually, 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 rather than the upper end of the band, as nominal GDP growth of 17.6% and tax collections have been much better than budgeted.
The key question is whether such fiscal deficit consolidation will allow space for nurturing growth. We think so, for a host 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 support 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 estimate, even 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 still be close to 13.5% of GDP versus the pre-pandemic average of 12.8% of GDP. It is equally interesting to note that while most of this increase in expenditure since the Covid outbreak has been driven by subsidies, interest payments, etc,capital expenditure has risen too. For instance, 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 acknowledge 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 pace of consolidation to accommodate 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 potential tax changes, which would eventually 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 remain large (as the government needs to support growth amid a relatively narrow tax base), more sustainable sources of financing a persistent fiscal deficit are required. Currently, 1.5% of outstanding IGBs are owned by foreign portfolio investors. This underlines excessive reliance on domestic sources 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 broaden 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 potential GST rate revisions in FY23 and beyond to assess surprises to the FY23 fiscal deficit. Such an announcement is unlikely on the budget day as these decisions fall under the ambit of the Goods and Services 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 gradually to boost GST collections. This has become even 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 lead 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 benefit 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 rather than 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 estimate that an effective GST rate increase of 1% in a single move would have a proportionate impact on headline CPI inflation) and adversely impact demand.
Overall,we think the FY23 budget presentation will focus on continuity (policies and growth support) rather than announcing bold changes.
The author is Head (South Asia), economics research, Standard Chartered Bank