The bicycle theory of the 2023 Budget

Lowering the fiscal deficit to sustainable levels will be the biggest challenge for the government, but there are enough reasons for it to keep pedalling hard

“It never gets easier; you just go faster”

— Greg LeMond, pro road-racing cyclist

The government’s push to cut the fiscal deficit will require a herculean effort over the next few years. Think of it like a long-distance cyclist that needs to keep pedalling hard to reach the finish line no matter what the weather conditions are or how challenging the course.

Still, each of the Budgets in the last three years has championed big changes. The one presented in early 2020 quantified off-budget spending. The 2021 Budget focused on repaying the large dues owed to the Food Corporation of India. The 2022 Budget chose conservative revenue estimates over rich ones, a strategy that provided some headroom to deal with shocks like soaring commodity prices. Alongside, government capex continued to rise over these three years.

So what will 2023 bring? We believe the Budget should champion a lower fiscal deficit as the government has previously pledged to lower it to 4.5 per cent of gross domestic product (GDP) by FY26. Sticking to that path in a linear manner means lowering the fiscal deficit from a budgeted 6.4 per cent of GDP in FY23 to 5.8 per cent in FY24. 

It’s not hard to see why lowering this is a priority. Currently around 50 per cent of the central government’s net tax revenue is spent on paying interest on debt. That leaves too little for spending on important areas like health, education and infrastructure.
 

Illustration: Binay Sinha

The only way to overcome this problem is to lower the fiscal deficit to sustainable levels. That would also put the economy on a firmer footing as, while it would mean lower growth, it would help keep inflation low, lead to a more sustainable current account balance and lower the large public debt load.

Having said that, all this will be challenging over the next 12 months. One, tax revenues are lower and fiscal consolidation is harder when nominal GDP growth is falling, something we expect in 2023. Two, the formalisation of the economy over the pandemic raised tax revenues, but this bounty may now soften once the informal sector roars back. Three, 2023 is a pre-election year, which generally means low privatisation receipts and pressure for more government spending. And four, capex spending as a percentage of GDP is now 1.1 percentage points higher than the pre-pandemic period. Lowering the fiscal deficit without cutting capex will require extra effort.   

Thankfully, there’s some help. Oil prices are down from their highs, which takes away pressure to cut taxes further. Credit growth is strong, and if it remains so, banks will have to work hard to attract deposits, which will create demand for government bonds helping finance the deficit.

The central government has also already taken some important policy steps to help contain the fiscal deficit. One, it has restructured the food subsidy scheme in a way that, we estimate, will lower the food subsidy bill by Rs 50,000 crore. And two, it has launched the Single Nodal Agency (SNA) dashboard which tracks the transfer of funds to states for centrally-sponsored schemes. This will provide information about what a state has spent, with the central government only releasing the next tranche of funds when the previous tranche has been utilised. That will help save on interest costs as money will only be released when needed.

All of these steps are likely to help the government consolidate the fiscal deficit in FY24. Yes, revenues will likely decline given the lower nominal GDP growth and a likely recovery in the informal sector, but current expenditure could fall by even more, led by less spending on fertiliser, food and other items.

But it’s not just the fiscal deficit that markets will focus on in the Budget.

One of the strengths of the Budgets in recent years was stability, continuity and predictability on the tax front, important prerequisites for reviving investment, in our view. On direct tax, we expect more incentives to encourage the adoption of the new personal income tax regime. And we hope there is some indication that the entire tax code will be simplified in the near future, with a focus on lowering tax disputes which have soared in recent years. Improvements in the goods and services tax (GST) regime have stabilised tax revenues, but much more is needed in the form of fewer rate levels and more products under the GST umbrella.

The one big change necessary, in our view, is putting a stop to the rising import tariff levels in recent years. This hurts India’s competitiveness and even dilutes the benefits of the celebrated Production Linked Incentive (PLI) scheme.

New innovations like the SNA discussed above are also leading to high government cash balances with the Reserve Bank of India (RBI) and hence tight liquidity in the banking system. As a result, the RBI may have to become far more proactive in injecting temporary liquidity. Some recognition on this front would be useful for financial markets.

Even if the fiscal deficit falls to 5.8 per cent of GDP in FY23, gross market borrowing by the central government will likely rise to around Rs 15.5 trillion, led by a large repayment bill. Add to that higher borrowing by India’s states, and the overall government bond supply could be close to a record Rs 24 trillion. The RBI may step in with open market operation (OMO) purchases, but only if there is a case that liquidity is very tight. Our rough rule of thumb is that the RBI may undertake OMO purchases to the tune of the balances of payment deficit over the year.

To conclude, while a narrower fiscal deficit will likely result in a negative fiscal impulse for the economy, though some of that will be offset by the lagged effect from higher capital expenditure in recent years, it will likely help keep a lid on inflation and India’s external imbalances, the two problems that haunted us through 2022. It will also help keep a lid on India’s elevated public debt, particularly at a time when lower nominal GDP growth can push it up further.

There are all the reasons for the government to keep pedalling hard.

---

The writer is chief India and Indonesia economist at HSBC