An unusual budget

This budget was unusual on many counts: the rail budget was amalgamated, GST was on the agenda and so was demonetisation.

The tax system will change as and when goods-and-services tax (GST) is implemented. Not much data has been released about demonetisation yet. Hence, many projections will be subject to change.

Let’s run through the items mentioned above.

Goods-and-services tax
GST has a deadline of September 30, 2017. The entire tax structure will change and so obviously will budget projections as and when it is implemented. Importantly, political action is needed either way to implement GST or to carry on with the current system. So, assessing if it will happen is a political call. Negotiations continue between the states and the Centre. The finance minister has said proceedings are on schedule.

Going by the experience in well-run nations like the European Union members, some economic chaos can be expected in the first two fiscals of GST. There will be disputes, recalculations, and renegotiations. Eventually, GST will iron out distortions, ease friction and unify India as one market.

Strictly from a political angle, it may therefore make sense for the BJP to pull back from GST. An extended period of chaos could derail the chances of it getting re-elected in 2019. What’s more, India will have a very complex GST. The EU nations tend to have three rates – one rate for normal goods, one rate for services and one for ‘special items’.  India is looking at seven different rates for goods and at least one more rate for services.  That means more scope for confusion.

The Economic Survey has an intriguing chapter on interstate trade. This says there’s already a surprisingly high quantum of inter-state trade. If inter-state trade is already high, maybe GST is not so urgently required. 

Indian Railways
Indian Railways (IR) is struggling. This is partly due to economic slowdown and partly due to many years of misguided policy and rigid internal management.

IR plays three broad roles. It has a strategic role in linking regions like the North East, Konkan and Jammu & Kashmir.  It is impossible to quantify the impact of this with a straightforward cost-benefit analysis. IR must continue to play this role. It is non-negotiable.

IR also provides a basket of social services. It absorbs a large workforce

(and the wage bill inflates with every Pay Commission award). It offers affordable travel options. While it loses money on this account, the positive external benefits are high.

Last but not least, IR plays a vital commercial role as the nation’s largest goods transporter. It subsidises the passenger carrier and the social servant. The recent foray into surge pricing has not been very successful. Airlines are more convenient and can match surge railway fares. Tariffs of goods have been hiked to a point where IR has lost market share to the private operators using roads. Customer satisfaction is low for passengers and freight customers.

The statistics are miserable. Freight tonnage  (April–December 2016) carried was 808.6 million tonnes versus 815 tonnes in the previous fiscal (April–December 2015). Earnings from freight were at Rs74,925 crore versus Rs80,668 crore in April–December 2015. Passenger earnings were up marginally, at Rs34,355 crore versus Rs33,077 crore. The total earnings are Rs1,16,763 crore versus Rs1,20,095 crore in April–December 2015. Working expenses on freight and passenger side are much higher, at Rs97,647 crore, versus Rs85,198 crore.

The current operating ratio is very high, at 95 per cent. The lower the operating ratio the better it is. Railway’s equivalent of operating profit margin (100 minus operating ratio) is  about 5 per cent. Once interest expenses are deducted, IR is not really profitable.

To add to the challenge, IR needs massive investments.  Far from paying dividends, programmes must be supported by central funds. IR is also borrowing from the market via subsidiaries such as Indian Railways Finance Corporation.

Railways Minister, Suresh Prabhu, is aware of the issues. Can he run IR on commercially viable lines and invest for the future? It’s an uphill task. Finance, accounting, reforms, safety, development works, cleanliness,  all are focus areas in the budget. IR’s subsidiaries IRCTC, IRFC and IRCON are to be listed to give investors a clearer picture and give the subsidiaries operational flexibility. 

Demonetisation and beyond
Demonetisation will lead to reductions in 2016–17 GDP estimates. But key data are missing. Multiple references to ‘digital’ in the budget indicate the intent to follow through. Massive investments will be needed in Internet infrastructure. The BharatNet rollout is one sign of political will. A lot will be up to telecom operators as well.

One underlying assumption is that some behavioural changes caused by demonetisation will not be long term. Another assumption is that some of those behavioural changes will be long term!

Consumption dropped during the demonetisation period due to the cash crunch. It’s being assumed that consumption will recover quickly. A bounce in GDP growth rates can only come on the back of more confident consumer spending and such a bounce is being assumed.

Individuals started using multiple cashless instruments, ranging from cheques to mobile wallets to UPI and credit/debit cards during November–December 2016. It’s being assumed that this cashless usage will continue, allowing income and expenditure to be easily tracked and hence taxed.

On the basis of these two contradictory assumptions, the budget assumes an increase of 25 per cent in income-tax collections in 2016–17. Part of this jump may come from an analysis of deposit patterns in demonetisation. But there is also an assumption that the usage of cashless instruments will continue, allowing for better tax collections.

We don’t know whether these assumptions are correct or not. What little data there are on digital usage suggest that the usage of cashless instruments dropped in January as the cash crunch eased slightly. It’s still unknown how much cash returned to the system.

One thought: If the IT department gets aggressive, consumption will disappear. People will sit on their hands for fear of being targets. That’s happened every time there’s been a ‘Raid Raj’. There are ominous signals in the retrospective changes that allow taxmen to raid without giving reasons.

GDP projections
There could be major changes in budget estimates for 2016–17 and revised estimates for 2016–17. Growth could surprise pleasantly or unpleasantly. Q3 2016–17 results suggest that the formal economy has ridden out the ill-effects of notebandi on the back of strong agro performance and a favourable global commodity cycle. The informal economy has done badly.

Metals, sugar, and energy stocks have done well. But construction, realty, FMCG have taken a beating and these are all consumption-related. In the auto sector, tractor stocks (Escorts, Eicher) have done well. Maruti has gained from a weaker yen. But Bajaj Auto,  Hero Motors, Ashok Leyland have seen drops in unit sales and profits.

Perhaps the most crucial indicator is that non-performing assets (NPAs) and stressed-asset ratios have worsened for most public-sector banks (PSBs). The government will direct Rs10,000 crore in 2017–18 towards recapitalisation of public-sector banks. But gross NPAs amount to Rs6 lakh crore. It’s hard to see how PSBs can disburse more credit and support economic expansion with balance sheets in such a bad shape.

Most estimates for GDP growth have been cut by anything ranging from 0.5 per cent to 1 per cent or more. Most estimates see some growth recovery in 2017–18. However, there are no concrete GDP numbers yet for Q3. 

Fiscal deficit
The finance minister has been rightly praised for his consistent adherence to discipline. He cut the fiscal deficit in 2014–15 and 2015–16. He aimed to cut it in 2016–17 to 3.5 per cent of the GDP and he says he is targeting 3.2 per cent of the GDP for 2017–18. 

But the fiscal deficit is likely to climb in 2016–17. By December 31, 2016, it had hit 94 per cent of the targeted amount for 2016–17. This makes it likely that there will be an overshoot of the 2016–17 deficit target in absolute terms. An overshoot in percentage terms is almost guaranteed.

It’s unlikely that expenditure will tighten enough in Q4 for 2016–17 to stay within the absolute target. It’s guaranteed that the GDP estimates for 2016–17 are down. Simple arithmetic says a higher numerator (the fiscal deficit) divided by a lower denominator (the GDP) will mean a higher fiscal deficit in percentage terms.

It is also very unlikely that the 2017–18 fiscal deficit will be 3.2 per cent of GDP. It may be more or it may be less but there’s likely to be a large error margin. Don’t forget to factor in the 4 per cent that the states add to the fiscal deficit. The Economic Survey estimates the combined fiscal deficit as 7.5 per cent of GDP with UDAY and 6.5 per cent without UDAY.  That number, a combined fiscal deficit of over 7 per cent of GDP, has not been reduced for a long time.

To sum up, budgetary estimates and the tax structure itself could see massive changes. Those changes will not necessarily be for the worse. It’s  hard to make concrete judgements since demonetisation on this scale was an entirely new event and GST will be an entirely new system. Just stay braced for big changes.