Even doubling current consolidation efforts won’t help. However, setting the GST right could raise the necessary revenues to meet the debt target.
Given the rapid changes in the Indian economy over the last decade, there were calls for a new and updated FRBM law. The new FRBM framework was released in January 2017 and enacted in the parliament in March 2018. It makes public debt the main anchor of the fiscal framework. It stipulates that the Centre’s debt should not exceed 40% and the overall Centre-plus-states debt should not exceed 60% by the end of FY25, from ~70% now.
The updated FRBM Act also makes the fiscal deficit the operational target. The Centre’s fiscal deficit should be limited to 3% by FY21. And by our calculations, the overall Centre and state fiscal deficit should be no higher than 5% of GDP to meet the 60% debt target. If divided equally, as suggested by the new FRBM report, both the Centre and aggregated states should run deficits of no more than 2.5% each, by FY25.
But we note that the new fiscal rules were enacted around the same time that some new “permanent entitlements” with big fiscal costs were announced. Growing indebtedness, weak incomes and the scorching summer of 2017 triggered a demand for farm loan waiver programmes across the country (see India’s rural distress puzzle: Where from, where to? HSBC Global Research, July 10, 2017). About six states announced detailed plans to waive farmer loans. The Centre’s budget followed this by raising agriculture procurement prices to 1.5x of the cost of production.
Separately, the budget also announced a revamp of the health policy. Each of these permanent entitlements have implications for the government’s deficit and debt. In addition, the government announced a bold package of Rs 2.11 trillion to recapitalise public sector banks. Of this, Rs 1.45 trillion will be in the form of bank recapitalisation bonds and show up in India’s government debt.
The big question is whether these new FRBM targets will be met in the face of new spending pressures.
The evolution of debt depends on two things—one, nominal borrowing costs being lower than nominal GDP growth, and two, the evolution of the primary deficit.
Thanks to the disciplined fiscal stance of the state governments in the early 2000s, their aggregate debt stock is less than half that of the Centre’s (21% of GDP for states versus 49% for the Centre). However, the picture is rapidly changing. With the Centre bringing down its primary deficit meaningfully (except in FY18), its debt has been falling. And if it continues on the consolidation path, its debt will continue to fall.
On the other hand, the aggregate state primary deficit has risen meaningfully (from 0.4% in FY12 to 1.8% in FY17). And more importantly, its borrowing costs have been soaring as the state development loans (SDLs) spread over the 10-year government bond continues to rise. Putting the two together, we find that only if the overall government cuts its fiscal deficit by 1.4ppt (from 6.4% GDP in FY18 to 5% of GDP), will it be able to reach the 60% debt target by FY25.
To put this in context, despite heroic efforts, the overall government has only been able to lower its deficit by 0.7 ppt in the current consolidation cycle. In short, we estimate that the debt target of 60% will only be met if the government is able to double its efforts (1.4 ppt versus 0.7 ppt consolidation).
And here too, the split may turn out to be different from what the new fiscal rules prescribe. Our analysis suggests that debt dynamics are expected to lower Centre’s debt to well below its target of 40% (~38%) while state debt is likely to hover above 20% (~22%).This could potentially lead to some differentiation between the state SDL and the Centre’s G-sec markets.
And so far, we have not even accounted for the permanent entitlements. Once we factor these in, we find that, all else remaining equal, the four pressures will keep overall debt higher than the 60% of GDP target (chart 16). And even a doubling of consolidation efforts, as outlined above, will not suffice, based on our calculations.
The collateral damage from the collision between rules (updated FRBM Act) and discretion (the new permanent entitlements) could prove costly on several fronts. One of them is likely to be the bond market.
Our analysis shows that the inability to lower fiscal deficits enough (in order to meet debt targets), could stoke policy uncertainty, which in turn could impact bond yields.
So is it all doom and gloom? Not necessarily. The cost of permanent entitlements must be met by a revenue source that is stable and long-lasting. We find that setting the GST right could raise the necessary revenues to meet the 60% debt target despite the burden of permanent entitlements. If the average monthly collection rises from Rs 0.9 trillion today to Rs 2.4 billion by FY25, implying a CAGR of 15.4% for 2018-2025, there could be a chance of meeting the 60% debt target while funding the permanent entitlements. But such a dramatic rise will need a dramatic overhaul of the GST policy, which we believe include the following:
* Including goods/services such as alcohol, petroleum and energy, electricity, land and real estate, health and education, which are currently outside the ambit of the GST.
* Simplifying the process of filling returns: A near-term aim should be to improve the GST returns fillings rate (currently, around 70% of the total taxpayers required to file monthly returns actually did so).
* Moving towards a simpler tax structure with fewer rates and exemptions.
* Dedicated support and hand-holding for producers who have enrolled in the composition scheme so as to bring them more sustainably into the formal economy, thus increasing the tax base.
* Zero tolerance for tax evasion: E-way bills are the first step in this direction; however, reinstatement of the invoice matching system could further help plug leakages in the GST revenue collections.
The Writer is Chief Economist, India, HSBC Securities and Capital Markets (India) Pvt Ltd (Views are personal)
Co-authored with Aayushi Chaudhary and Dhiraj Nim, associates, HSBC Securities and Capital Markets (India) Private Limited
Edited excerpts from HSBC Global Research’s When rules and discretion collide: A study of India’s state and Centre finances (April 23, 2018)
(Concluding part of a two-part series)