Why Arun Jaitley May Breach Chidambaram's 'Red Line' on Fiscal Deficit

Finance Minister Arun Jaitley's comments about the need to check "mindless populism" has fired hopes of tough fiscal consolidation measures in the budget due next week. Analysts say Mr Jaitley's hawkish tone has impressed Dalal Street investors, who think the new finance minister has set the agenda for a reformist budget.

The BSE Sensex hit a record high this week, while bullish bets on the Nifty have increased. Some analysts predict the 50-share bluechip index to cross 9,000 in the next month. (Read the full story here)

In an interview to Reuters, Jagannadham Thunuguntla of SMC Global Securities said, "The government is giving the right messages and the market has taken it in its full spirit. We may not see all announcements in one shot in the budget, but the messages in between the lines are more important."

Economists are, however, skeptical with many of them raising question mark on Mr Jaitley's ability to contain 2014-15 fiscal deficit within 4.1 per cent of GDP, a level described as the "red line" by former Finance Minister P Chidambaram.

In all likelihood, Mr Jaitley will announce a higher fiscal deficit target in his maiden budget speech. Here's why:

1) The fiscal deficit for the current fiscal has already risen to Rs. 2.4 lakh crore, or 45.6 per cent of the full-year target. This is the highest deficit run-rate in the last seven years, said Barclays Research, which expects the subsidy to remain at 4.5 per cent of GDP this fiscal year.

2) Deutsche Bank economists Taimur Baig and Kaushik Dassay the new finance minister should realistically target a fiscal deficit of 4.5 per cent of GDP "assuming total receipts of 9.1 per cent of GDP (versus interim budget estimate of 9.6 per cent of GDP) and total expenditure of 13.6 per cent of GDP (versus interim budget estimate of 13.7 per cent of GDP)."

Mr Chidambaram's deficit targets were based on "overly optimistic" revenue projections, note the Deutsche Bank economists. Mr Chidambaram provisioned for 19 per cent rise in gross tax revenues (300 basis points higher than the long-term average), 26.8 per cent growth in personal income tax receipts (700 basis points higher than the averages), 18.8 per cent rise in indirect tax receipts (versus long-term average of 14.1 per cent).

Mr Chidambaram also budgeted non-plan spending growth at 8.3 per cent year-on-year against long-term average of 13.4 per cent growth, they say.

3) Over the last two years, Mr Chidambaram met aggressive deficit targets by resorting to spending cuts, often in capital expenditure, and by rolling over subsidies. However, cutting productive expenditure (such as on building roads, reservoirs, airports, etc.) is not an option for Mr Jaitley as the new government's mandate is to revive growth and jobs.

"Capex as a share of GDP has been systematically declining from a peak level of 3.8 per cent in 2003-04 to 1.7 per cent in 2013-14. We expect the government to begin the task of unwinding this trend by increasing capex as a share of GDP in FY15 to 2 per cent from 1.7 per cent as per the interim budget for 2014-15," says Ritika Mukherjee of Ambit.

4) The new finance minister will also not have the luxury to raise income or corporate taxes to boost spending because the economy is in the midst of its worst slowdown in over 25 years. Besides, high inflation will limit the government's ability to push through aggressive indirect tax increases.

5) The partial rollback in rail fare hikes and the fierce opposition to cutback in subsidies, which accounted for 2.2 per cent of GDP in 2013-14, shows the government has little elbow room to rationalise non-plan expenditure. There were hopes that kerosene and LPG subsidies might be brought down the way the UPA government cut back diesel subsidies, but the new government seems unwilling to take that route. (Read)

The only ammunition Mr Jaitley seems to have up his sleeves is to drastically hike disinvestment targets. (Read the full story here)

But will that be enough to bring back 8 per cent growth? Analysts say Mr Jaitley must go past his predecessor's deficit target to bring India's economy back on tracks.

Latest News