Contrary to widespread media speculation, the budget presented by India's suave Finance Minister Arun Jaitley on Feb. 1 was far from populist. The budget stuck, more or less, to the government's fiscal road map, and limited the fiscal deficit to a reasonably conservative 3.2% of gross domestic product. However, Jaitley missed an opportunity to pursue difficult reforms before the government gets locked into election mode in the run up to the next general election in 2019.
The relatively low deficit translates into reduced borrowings. Together with lower inflation, that will help keep interest rates low, boosting investment and consumption, and sustaining the growth momentum of the economy. This is the fiscal road map, and sticking with it makes sense. But investment, measured by gross fixed capital formation, has fallen by 1.9%, 3.1% and 5.6% year on year in the last three quarters. This remains the biggest downside risk. India cannot continue to grow at 7% a year unless investment picks up, especially from the private sector.
Demonetization -- the withdrawal from circulation of high value currency notes -- has badly affected the sales of Indian companies. Sluggish export demand is further adding to the piling up of inventories, and companies are being forced to operate well below their capacities. As a result, private sector businesses -- big and small -- are sitting on their capital expenditure plans, and may need strong incentives to add new capacity.
In his 2016 budget Jaitley promised to cut the corporate tax rate to 25% from 30% -- a level that was a major drag on India's relative attractiveness as an investment destination, despite high growth and cheap labor. Jaitley delivered on his promise, but restricted the impact to companies with annual sales turnover of 500 million rupees ($7.45 million) or below, excluding top private sector businesses.
Any reduction in corporate tax is positive for Indian business sentiment, especially as U.S. President Donald Trump prepares to cut corporate taxation to between 15% and 20%. In the long run, however, restricting the benefits of lower tax to smaller companies (along with tougher labor regulations for large firms) will discourage growth, depriving smaller companies -- and the economy -- of the benefits of economies of scale, and limiting the number of good new jobs, which are mostly created by large companies.
India is adding 1 million young people to its workforce every month. But jobs are becoming increasingly difficult to come by. Eight key sectors of the economy -- manufacturing, construction, trade, transport, hospitality, information technology, education and health -- added just 135,000 jobs in 2015, compared to 421,000 in 2014 and 419,000 in 2013.
There has been a lot of hype about the government's Skill India campaign, aimed at improving the employability of young people, but the project dealt with only 1.72 million people in its first year, suggesting that it may prove difficult to hit its ambitious target of 400 million in seven years. Meanwhile Indian corporates are facing difficulty in hiring suitably skilled personnel. Many positions remain unfilled.
Jaitley also failed to take a number of smaller measures that could have encouraged job creation by facilitating value added production. These include the problem of inverted duties, where duties on imported production inputs are higher than duties on imported finished products, discouraging domestic production in sectors such as chemicals, electronics and textiles.
The abolition of the Foreign Investment Promotion Board and Jaitley's announcement that the government will continue to liberalize its foreign direct investment regime are welcome. However, foreign investors are more worried about the scrapping of 57 investment treaties, which set out mutual rules for the treatment of investment, including recourse to international tribunals when disputes arise.
As a result, no such protection is available to new foreign investors. India is pushing a new model investment treaty that excludes tax issues and specifies that foreign investors must exhaust all domestic legal remedies in disputes before they can seek redress from international tribunals. That means they must first deal with the Indian judicial system, which is impartial but moves at a snail's pace. Only after that process is concluded can they request speedier international arbitration.
This is highly unsatisfactory, and could have serious consequences if significant numbers of investors are deterred. It is worth mentioning that although India received $43 billion worth of FDI in the April to November period of 2016, it also witnessed an outflow of $16.4 billion, cutting the net inflow to $26.6 billion. Unless the major concerns of foreign investors are addressed, net FDI inflows may fall further, threatening the stability of the rupee just as prices for commodity imports start to harden.
Jaitley also failed to address issues related to the quality of government expenditure. A big increase in capital expenditure would have helped to sustain economic growth, given that multiplier effects make each rupee spent on capital improvements worth about 2.5 rupees in national economic activity. That compares with a multiplier of less than one for revenue expenditure such as salaries and allowances of government employees, interest payments and fuel subsidies. However, the share of capital expenditure in total budgeted expenditure is planned to rise by only 0.5%, even though it will rise by 11% in absolute terms.
The budget raised rural spending by a whopping 24%. Increased allocations for irrigation and crop insurance are praiseworthy. However, the quality of their implementation will be an open question. Moreover, with global energy prices still low, the finance minister should have considered bringing urea under a nutrient-based subsidy regime. That would reduce the relative price gap between urea and non-urea fertilizers, promoting more balanced use of fertilizers and ensuring better returns per unit of subsidy while also checking soil degradation.
With the government's proposed goods and services tax already substantially diluted, and doubts remaining about its planned implementation from July 1, it now seems that reforms of direct taxes have been shelved, too. Jaitley reduced income tax rates for lower middle class tax payers, but increased them for the upper middle class in the form of a new surcharge. This is a kind of cross subsidization, which reduces the incentive to pay taxes honestly and runs counter to the bigger objective of improving tax compliance.
Jaitley should have attempted to widen the direct tax net (only 1.5% of Indians pay income tax; just 76 million of the population of 1.3 billion people declare incomes of more than half a million rupees) by taxing rich farmers, who appropriate most of the subsidized farm inputs and benefit from assured government procurement.
His decision not to deal with the issue of taxing agricultural income reflects the unwillingness of Prime Minister Narendra Modi's Bharatiya Janata Party government to introduce tough reforms. Likewise, budget measures to clean up political funding appear both inadequate and devoid of any deep analysis, given the economics of electoral politics in India. The maximum a political party can accept in cash donations has been reduced from 20,000 rupees to 2,000 rupees, but the system is very easy to manipulate, so politics will continue as usual; increasing the number of fake donors by 10 times is not a difficult job.
Similarly, the budget does little to deal with the threat to the banking system posed by nonperforming loans and an ever-increasing number of willful defaulters, which is leading to large scale loan write offs year after year. Jaitley provided an additional $1.5 billion for bank recapitalizations, and raised the tax break available for bad loan provisioning from 7.5% to 8.5%, but that needs to be seen in the context of total bad loans of more than $120 billion. The rising burden of nonperforming assets will reduce the ability and willingness of banks to lend at a time when credit growth is an all-time low. That will have implications for economic growth going forward.
India's budget is supposed to be an expression of long-term economic policy, not just a statement of account aimed at balancing revenues and expenditure. But Jaitley's latest effort fails to provide a clear road map to crucial reforms, and remains silent on critical issues such as jobless growth, which is threatening to turn India's demographic dividend into a demographic disaster.
Ritesh Kumar Singh is a corporate economist and former assistant director of the Finance Commission of India. Prerna Sharma is vice president and head of agriculture, food and retail at Biznomics Consulting, a research and policy advocacy specialist in Mumbai.