Fiscal Policy
Oct 11, 2006
Chetan Ahya (Mumbai) and Mihir Sheth (Mumbai)
Summary
Fiscal discipline and flexibility are the basic principles for budget management policy. While fiscal discipline is important for macroeconomic policy credibility and sustainability, flexibility is necessary for managing unexpected shocks to the economic environment. A fiscal policy following both these tenets would help the government intervene during times of economic difficulties. Such a policy can give a government the ability to use the budget as a counter-cyclical policy tool to regulate aggregate demand. Unfortunately, India’s fiscal policy appears not to have followed either of these two sound budget management principles over the last few years. Headline numbers understate deficit While the headline combined fiscal deficit (central plus state governments’ deficit) is estimated at 7.5% of GDP for F2006, down from 9.5% in F2001, we believe it is understating the underlying deficit. The central government has been excluding a large part of the oil subsidy burden from the fiscal deficit calculations and treating it as an off-budget liability (passing it on to the oil companies). A large part of the recent improvement in the headline deficit would be offset by the increase in off-budget oil subsidies over this period. Similarly, state governments have been excluding large amounts of electricity subsidies from their deficit estimates (although this subsidy burden has been reducing at the margin). The consolidated deficit for F2006, including the two major off-budget items, oil subsidies and state electricity board losses, would increase the headline deficit level to 9.3% from 7.5%. Missed opportunity India’s recent strong economic growth has provided a great opportunity to correct the underlying deficit levels, building a buffer for down cycles. Indeed, during the growth up cycle of the early-to-mid-1990s (coinciding with the previous emerging market cycle), budget management was significantly better, resulting in reductions in the deficit and public debt. In the current cycle, India is probably the only emerging market to have witnessed a relatively smaller correction in its deficit over the last five years. India’s deficit is the highest among those in major emerging markets, and about two to three times those of major developed economies on a percentage of GDP basis. Although there has been some improvement in the fiscal deficit trend at the margin, there is little evidence that the government is implementing any major structural reforms to reduce revenue expenditure, which we believe is critical to achieve a sustainable reduction in the deficit. National government expenditure management shows no improvement On the surface, the government’s fiscal management seems to be improving. The government has been able to cut its national fiscal deficit (including the off-budget subsidy burden) from a peak of 11.1% in F2002 to 9.3% in F2006. However, a large part of the reduction was due to a higher ratio of tax to GDP. We believe that the improvement in tax to GDP is largely cyclical, reflecting a leveraged, consumption-driven growth cycle supported by global liquidity and low real interest rates. Indeed, most of the increase in tax to GDP is due to higher corporation taxes because of higher profits. Personal income tax compliance has remained weak. Of the total employed workforce of 363 million, as of March 2005, only 30.9 million (8.5% of the total) submit annual income tax returns. The actual number of taxpayers is even lower. For a structural decline in the deficit, we believe that the government would have to initiate expenditure reforms, but there is no sign of such a move yet. Indeed, since F2001, non-interest revenue expenditure has declined by only a 0.3 percentage points of GDP. Current share of development expenditure very different from 1980s/1990s’ levels Over the last 15 years of reforms, the declining share (in terms of seats in the lower house of the parliament) for the single largest political party (due to the emergence of smaller regional parties) has been reflected in the fall in development expenditure. Although the share of development expenditure has been largely steady in the last five years, it remains significantly lower than average levels in the 1980s and 1990s. While national government development expenditure is estimated to decline to 14.8% in F2007 from 17% in F1991, non-development expenditure rose to 12.5% of GDP in F2006 from 11.2% in F1991. The major areas where non-development expenditure has risen are interest costs, explicit subsidies and pension expenses. Bottom line India’s current pro-cyclical loose fiscal policy is playing a big role in pushing the country’s growth significantly above potential. However, this leaves little scope for fiscal policy to play a counter-cyclical role in offsetting the adverse effects of any potential external environment-led economic slowdown.
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2006 Policy Address - People and the Environment
Oct 11, 2006
Denise Yam (Hong Kong)
Chief Executive Donald Tsang presented his second Policy Address this morning to the Legislative Council, titled Proactive, Pragmatic, Always People First. Nevertheless, as Tsang has not yet publicly confirmed his candidacy for the next term, the speech today represented a policy blueprint that covers only up to June 2007, and therefore shied away from unveiling long-term projects and controversial proposals. Much of the discussion centered on the people as the title suggests, including initiatives to promote harmony in the society. No minimum wage legislation, for now. Much anticipation with respect to today’s speech was for an update of the government’s stance on the minimum wage debate. Despite increasingly vocal demands from the labor sector (even during the Policy Address presentation) for formal legislation of statutory minimum wage and standard working hours, the government decided at this stage to refrain from such legislation, and instead proposed the launch of a Wage Protection Movement (WPM), where employers will be encouraged to participate on a voluntary basis. This, however, only applies to the cleaning and guarding services sectors, which had caused the most concern with respect to unfavorable labor rights. The Labor Advisory Board is made responsible for monitoring the effectiveness of the WPM, and the consideration of the necessity of introducing formal legislation, again only for these two sectors, will take place after two years. It appears that business sector voices continue to claim a heavy weight in the government’s policy considerations, and it is probable that the latest decision has disappointed the labor sector and could cause heightened protests. Nothing new on renminbi business in Hong Kong. Today’s audience is reminded that the bottleneck in the further expansion of renminbi business in Hong Kong remains the State Council. The most imminent developments that Hong Kong is anxiously awaiting include the settlement of direct imports from China in renminbi, and the issuance of renminbi-denominated bonds in Hong Kong. Subsidy for early childhood education consistent with population policy. With compulsory subsidized education provided to children aged 6-15, pre-primary education has proven to be a rather significant financial burden to Hong Kong parents. Tsang outlined the plan to provide an annual subsidy of HK$2 billion out of the government budget by 2011-12, equivalent to HK$16,000 per 3-6-year-old student per year. We welcome this gesture, as it helps strengthen households’ financial capacity to support more children, as encouraged by the government’s population policy in response to the aging society. The environment matters. As expected, the Policy Address dedicated considerable length to environmental issues, covering issues such as emissions from power plants and vehicles, as well as waste and sewage disposal. In particular, the government plans to spend HK$3.2 billion to accelerate the replacement of old diesel vehicles with modern environmentally friendly models. Limited market impact. Proposals in the latest policy speech highlight the continuation of ongoing initiatives, and therefore do not prompt us to revise our cyclical outlook. Our current forecasts for 5.6% real GDP growth in 2006 and 4.5% for 2007 look comfortably achievable while, over the medium term, Hong Kong remains dependent on and will see its economic cycle increasing synchronized with Mainland China. We believe that more tangible and economically significant policy proposals will come through after the election in March 2007 of the Chief Executive for the next term.
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