Shadow Budget

What is and what should be!

3/15/2013

Aravind Maddireddy
Indian Institute of Management, Roll:
12151
Room No: 1, Dorm No: 12
Mob: 8141912657
Email: p12maravind@iimahd.ernet.in

Prashant Yadav
Indian Institute of Management
Roll: 12218
Room No: 21, Dorm No: 16
Mob: 8511676419
Email: p12prashanty@imahd.ernet.in

Shadow budget 2013-14

Declaration
We, Aravind Maddireddy and Prashant Yadav, of Indian Institute of Management, Ahmedabad,
declare that this essay is entirely our own work and has not been submitted in any form to any other
media group. We also permit moneycontrol.com to use, alter, edit, publish or display the essay online/ electronic or in print with due attribution

Shadow budget 2013-14

Table of Contents
Problems facing Indian Economy ........................................................................................................ 4
High Fiscal Deficit ................................................................................................................................ 5
High Current Account Deficit .............................................................................................................. 6
Reforms undertaken ........................................................................................................................... 8
Analysis of Union Budget 2013-2014 .................................................................................................. 9
Shadow budget ................................................................................................................................. 12
Potential Reforms ......................................................................................................................... 12
Revenue Taxes ........................................................................................................................... 14
Revenue Non tax receipts .......................................................................................................... 15
Expenditure Subsidies ................................................................................................................ 15
Expenditure Leakages ................................................................................................................ 16
Current Account Deficit ................................................................................................................ 16
Investments and Infrastructure .................................................................................................... 17

Shadow budget 2013-14

Problems facing Indian Economy

Indias macroeconomic imbalances have worsened over the last 4-5 years. Inflation continues to
remain high and the twin deficits (Fiscal deficit and Current Account Deficit) have gone up sharply.
The overall economy seems to be settling into a lower growth trajectory with the GDP number for the
third quarter coming at a dismal 4.47%. Not surprisingly, India has been put on a rating watch by the
credit rating agencies and is just one step away from a downgrade to the junk status.

Y-o-Y GDP growth rate(at 2004-05 prices)

12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
Dec-12

Sep-12

Jun-12

Mar-12

Dec-11

Sep-11

Jun-11

Mar-11

Dec-10

Sep-10

Jun-10

Mar-10

Dec-09

Sep-09

Jun-09

Mar-09

Dec-08

0.00%

Quarter ending in

The slowing down of the economy can be partly attributed to rising oil prices and weak foreign
demand. However, a major part of the damage is self-inflicted through a structurally high fiscal deficit
and a steep decline in the governance quality. Indias fiscal deficit that had fallen to 2.5% of the GDP
in FY08 from 6% of GDP in FY02 revised all its gains and rose to 5.9% in FY12 (and coming at 5.2%
for FY13 largely due to a sharp cut in planned expenditures and one off asset sales). Much of this
fiscal decline is structural.
Both higher government expenditure and weak tax revenues are to be blamed, but the composition of
the expenditure is a major concern. The governments revenue expenditure (spending on subsidies,
wages and interest payments) has risen at the expense of falling capital expenditure. Cost of subsidies
have gone up from 1.4% of the GDP in FY08 to 2.4% in FY12. Governments flagship Food Security
Bill will further add to the subsidy bill.
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On the revenue side, the general government (both central and state) tax revenues have declined from
a high of 17.6% of the GDP in FY08 to 16.1% in FY12. The crowding out of private investments
have hurt industrial activity and lowered excise tax collections from a peak of more than 3% of the
GDP to less than 2% now. The fall in the governance quality has not helped the investment climate
either. A spate of scandals over the last couple of years have hurt the psyche of government officials
and slowed down the decision making process.

High Fiscal Deficit

The very high fiscal deficit fuelled inflationary pressures by widening the consumption-investment
gap. Although the WPI inflation is showing signs of cooling (falling to 6.62% in the month of
February), it still remains much higher than RBIs target of 5%. CPI inflation continues to remain at
elevated levels.
Subsidized fuel prices and an increase in inclusive growth schemes (without increasing investment)
increased consumption demand to unsustainably high levels. Demand is now increasing faster than
earlier because the Indian middle class is reaching income levels at which the demand for consumer
durables and protein-rich food items goes up. Since half of the consumption price basket is composed
of food prices, it has resulted in increased inflation expectations. The higher MSP (Minimum Support
prices) on food crops have also fuelled food inflation. The election winning rural employment scheme
of UPA (United Progressive alliance), MNREGA (Mahatma Gandhi National Rural Employment
Guarantee Act) that has wages indexed to inflation has effectively set a floor on rural wages and
resulted in labour shortages in the urban areas, leading to a classic wage price spiral.
In response to rising demand side inflationary pressure, the RBI embarked on a series of rate hikes
between March 2010 and October 2011. The burden of this adjustment fell disproportionately upon
investments, especially more productive private investments which were crowded out by the large
fiscal deficit.
Rising borrowing costs due to excessive government borrowings and a hawkish RBI resulted in a
crowding out of manufacturing investment, one of the key drivers of Indias capital expenditure
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during 2003-2007. Policy paralysis, lack of reforms in land acquisition and a delay in obtaining
environmental clearances have resulted in a sharp decline in infrastructure investment. Investment has
fallen from a high of 38.1% of the GDP in FY08 to less than 30% of GDP in FY13 hurting
productivity and thus the trend growth rate of GDP in India.
The sharp drop in private and public capital expenditures has the possibility of turning into a negative
spiral (high interest rates leading to low investment rates which in turn increases inflation leading to
further hike in interest rates) and is making it difficult to sustain growth.
India enjoyed the cushion of high savings rate that made investment sustainable due to an ample
availability of domestic funding. Over the years, however, this cushion has eroded with the gross
domestic savings rate falling from 36.8% of the GDP in FY08 around 30% of the GDP in FY13. Both
public and private savings have gone down due to a high fiscal deficit and higher cost of capital
respectively.
Another important problem related to savings is that the high inflation and the resulting reduced real
rate of return has changed the composition of household savings that is now more inclined towards
physical savings rather than financial savings. This shift has reduced the funds available for
investment locking savings in non-productive investments such as gold.

High Current Account Deficit

Slowdown in exports due to weak external demand (due to the subprime crisis in US and the
sovereign debt crisis in Europe) and relatively inelastic imports resulted in a sharp deterioration of
Indias CAD (Current Account Deficit). Imports remained inelastic in India because of multiple
factors including
Consumption biased government policies strengthening consumption demand
Shift in savings towards physical savings to hedge against inflation
Fuel subsidies leading to inelastic oil demand

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High coal imports due to lags in domestic production resulting from slow environmental
clearances
Increased import substitution due to supply side constraints (including power) and rising
domestic cost of production due to elevated inflation
To sum up, main reasons for Indias worsening CAD, which has been announced as the biggest
problem facing Indian economy currently by various government officials including Mr Raghuram
Rajan (Chief Economic Advisor of India) are
Crisis in the western economies resulting in a low external demand for Indias major
manufacturing exports like metal products, jewellery, handicrafts, leather, gems etc which are
demand sensitive and non-differentiable
High oil prices and increased dependence on diesel of the economy led to higher imports of
crude oil. Ever increasing domestic demand led to a slowdown in exports of refined
petroleum products
Structural increase in import of essential commodities such as edible oils, coal and fertilizers
due to supply side domestic constraints like the mining ban affecting coal production, low
agricultural productivity (edible oil) and a lack of domestic resources such as fertilizers
Slower growth in software services, outflows from non-software services and a sharp rise in
interest payments made on foreign investments in India have resulted in contraction of
invisibles balances
Sharp increase in CAD resulted in an increased dependence of the country on capital inflows to
finance the CAD. Indian currency, INR, is now highly vulnerable to portfolio flows in and out of the
country. Indias FX reserves stand healthy However, the use of FX reserves to counter sharp currency
depreciation due to sudden capital outflows is limited due to the following reasons
Use of FX reserves to stem INR depreciation will worsen the reserve ratio leading to an
increased medium term vulnerability

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Use of FX reserves to stabilize INR by selling USD and buying INR would further tighten the
domestic liquidity situation and would need to be countered by open market operation or
CRR cuts

Reforms undertaken
In response to the severe problems of fiscal deficit, declining investment and declining capital inflows
along with the looming threat of a ratings downgrade, the Indian government announced several long
overdue reforms in the past six months that resulted in providing a boost to the sentiment of high
growth.
The reforms started with the announcement of a 12% hike in diesel prices which, though fiscally
insignificant, is politically significant in crossing the policy inertia threshold. This announcement
signalled a forward looking deregulation of fuel subsidies that would help the fiscal targets as well
reduce the inelasticity in imports, helping with the CAD. Immediately after, the government followed
on by pushing for opening up its retail, domestic airline, broadcasting and power exchanges for
foreign investments. It also announced a disinvestment drive to the tune of Rs.15,000 crore to fill the
widening revenue deficit every year. Other measures such as opening up insurance sector for FDI
investments, withholding tax on long term infrastructure bonds, restructuring power distribution
companys liabilities were also announced but some of these still seek parliamentary approval.
The resolution of the prevalent issues is contingent upon the implementation of the major reforms
addressing the fiscal imbalances. Indias rising inflation driven mostly by high food inflation and
supply-side constraints, helped along with minimum support prices and minimum rural wages can
only be addressed by measures aimed at improving agricultural productivity. FDI in multi-brand
should, in theory, help with the inflation by providing lower prices for consumers through better
logistics, competitive shops and expertise, and help reduce fuel subsidies by providing higher prices
for farmers through cutting the middle-men. But, the materialization of these advantages is sharply
dependent on the investment in back-end infrastructure. Similarly, the diesel price hike and the LPG
reforms are only effective to the extent of setting up stage (both together contribute to .1% reduction

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in fiscal deficit) for further reduction in the fuel subsidies which would make the imports much more
elastic, thus reducing the structural nature of trade deficit.
With the global export demand slow and uncertain, attractive investment opportunities are few. Along
with the issues faced by infrastructure sector in terms of stretched balance sheets and resource
availability, the drive for investments is meagre compared to consumption, a part of which is
supported by the continuing uptrend in the rural wages. In this context, many more reforms are
needed to effectively address the twin deficits and other issues listed along with the pending
implementation of a major chunk of the announced reforms. These should form the backdrop for
framing the future budgets.

Analysis of Union Budget 2013-2014

Threat of the ratings downgrade and the spate of reforms announced earlier by Finance Minister Mr P.
Chidambaram had raised the expectations of a fiscally prudent and reform heavy budget. Union
Budget 2013-2014 presented on 28th February 2013, although prudent, targeting a fiscal deficit of
4.8% for FY14 and trimming the fiscal deficit estimate for FY13 to 5.2%, disappointed on many
counts.
Analysis of Budgetary Measures
Taxes
The super-rich individuals and large corporates are more likely to invest and contribute to the
growth than others in a supply-constrained consumption focused current Indian economy. By
imposing additional tax surcharge on these individuals and companies, though higher tax
revenue projections for the fiscal year can be obtained, capital is diverted into inefficient
bureaucracy-riddled government departments, effectively destroying capital and jobs.
The new measures are expected to provide a Rs.13,300 crore revenue gains through direct
taxes and a Rs.4,700 crore revenue gains through indirect taxes helping to bridge the revenue
deficit

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However, the focus should have been on expanding the tax base rather than one-time higher
tax revenues which make the fiscal consolidation in medium term difficult.
Expenditure The decline in the expected budget expenditure by 8.1% in FY14 to that of FY13 helps in the
fiscal consolidation which is very important in boosting the investor confidence and
ultimately attracting and retaining foreign investments
Capital Markets
The reduction in the STT and the extension of RGESS shall improve the participation of retail
investors. This, when combined with the fact that RGESS has a 1year fixed lock-in period and
a 2-year flexible lock-in period allows the focus to shift partially from consumption towards
investment
The move to allow the FIIs in currency derivatives and allowing the usage of bonds as margin
helps increasing the FII flows. However, this still focuses on increasing only the debt flows
while significant incentives for more focus on equity FII flows still lack in the budget.
With the budgeted gross borrowing still standing at a high value, the long term rates are likely
to stay higher. Even if with the projected lower inflation, monetary easing is viable thus
reducing the short term rates, higher long term rates prevent an effective move towards
investment
Infrastructure
First time home buyers can get loans for lesser interest
Savings
As the inflation expectations remain high in the minds of Indian investors, they gradually
moved towards investing in gold and other alternative non-capital investments instead of
investing in paper that might prove to be worthless. The introduction of the inflation-indexed

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bonds and National Security Certificates is targeted towards providing the investors higher
inflation adjusted returns. This might help in diverting some of the current flows into gold
into these securities helping partially address the issue of capital flight. However, the utility
from these instruments might prove to be limited.
Though this move would improve household savings, it would not do much in addressing the
key decline in the private corporate sector savings which forms the major issue
Analysis of Budgetary Assumptions
The budgeted fiscal deficit of 4.8% for FY14 looks prudent and shows the right intent of the
government to consolidate its finances. However, we need to critically examine the assumptions made
in the budget regarding expenditure, revenue growth and planned asset sales, given the tendency of
the government to consistently miss the budgeted target in the recent years
The budget envisages a tax revenue growth of 19.10% for FY14 assuming a nominal GDP growth of
13.4% in FY14 (real GDP growth of 6.1% - 6.7%). This looks optimistic when we look at the
corresponding numbers for FY13 (tax revenue growth of 16.7% and a revised nominal GDP estimate
of 11.7%) Budget assumes a high tax buoyancy of 1.4 even though there have not been any
substantial changes in the tax rates. Tax buoyancy has been 0.8 on an average over the past 5 years.
The disinvestment target of INR 55,000 crore looks difficult to achieve given the fact that the
government was able to raise only INR 24,000 crore against a target of INR 30,000 crore in FY13.
The budgeted spectrum sale target of INR 40,000 crore also looks challenging in the light of
disappointing response to these auctions in FY13. (Give some more details here)
The expenditure assumptions, though reasonable on some counts, does not give the government any
leeway to cut expenditures to meet the fiscal deficit targets as was done in FY13.Planned expenditures
are budgeted at 29.4% for FY14.
The fiscal deficit target of FY13 was achieved through a combination of real expenditure cuts and
delay in payment of subsidies to government companies and lower income tax refunds. These rolled

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over payments would add to the financial burden in FY14. Further, the Food Subsidy Bill would add
to the subsidy burden and the budgeted reduction in fuel and fertilizer subsidies is contingent on
sustained hike in diesel prices and raising urea prices in FY14. This is easier said than done given
elections in five state in 2013 and General elections scheduled for May 2014. The three major
subsidies of food, fuel and fertilizer are capped at Rs.2.2 lakh crore. Food subsidies, after
incorporating a INR 10,000 crore allocation for the food security bill, moved to a INR 90,000 crore
from INR 85,000 crore of FY13. With a possible increase of fertilizer and fuel prices, the production
and transportation costs are expected to move to a higher number bringing the expected baggage to
INR 90,000 crore without even considering the impact of the food security bill, in light of which, the
estimates of the subsidy expenditure look rather dubious.

Shadow budget
Potential Reforms
To sum up the analysis so far, it is evident that India is not lacking in growth potential with huge
latent demand and low per capita consumption; it is the supply-side constraints that cannot keep up
pace with the growth of demand. Any moves to spurt demand without addressing the structural nature
of the deficits will only lead to a higher inflation. Keeping this context at the head of analysis, the
following broad reforms might prove to deliver the highest promise in the medium to long term.

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Item

Measure

Term

Revenue
Expand the tax base

Medium

Reduce the complexity of the current tax regime

Medium

Set concrete disinvestment targets

Medium

Focus on efficiency of tax collection system

Short

Reduce the subsidies

Medium

Eliminate the minimum support prices

Long

Prevent leakages direct cash transfer (mention its

Medium

Expenditure

shortcomings)
Trade deficit
Reduce the inelastic nature of imports

Medium

Increase exports

Medium

Focus on raising the productivity of agricultural sector

Medium

Eliminate the minimum support prices

Long

Creation of a strong cold-chain infrastructure for agriculture

Medium

Inflation

Increase private sector participation

Investments
Shift the focus from consumption to investment

Short

Transparency in the land procurement process and

Medium

environmental clearances
Power sector reforms

Medium

Faster approval of projects

Short

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Remove infrastructure bottlenecks

Medium

Focus on reducing the long term rates

Short

Open more areas to FDI investments; raise FDI limits in key

Short

areas
Savings
Shift the focus of savings from physical assets such as gold

Short

into financial assets

Increase the corporate savings

Short

Promote the development of a corporate debt market

Medium

Promote deficit financing through domestic debt

Medium

Promote FII flows in debt and equity markets

Short

Capital markets

The moves outlined in the table above are categorized into three terms Short, Medium and Long.
The short term activities need decisive actions outlined in the budget, the medium term ones require a
concrete measure in the budget to stress upon the governments drive to achieve the target and the
long term reforms need to be communicated by having measures indicative of these reforms. Keeping
this analysis as a guiding principle, a shadow budget has been presented in the next section.
Revenue Taxes
Goods & Service Tax:
o

Definitive road map for single Goods & Services tax of 20% on the value add created
at various stages in the importing producing distributing value chain of the taxapplicable products.

This tax would replace all the indirect taxes levied such as VAT, CST along with
other indirect taxes. This would make the tax system much simpler and tracking

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easier. Tax burden would be equitably shared between manufacturing and services.
Tax rates shall be reduced and tax base would be widened helping the buoyancy. In
the current taxation method, inter-state state sales were avoided by sending the
finished goods to the depots in the state where sales would be made to save the CST,
thereby creating a large number of inefficient small depots. GST would thereby
increase supply-chain efficiency by keeping the taxation independent of the supply
chain route.
Direct tax code:
o

Definitive road map for the implementation of the Direct tax code. The DTC should
remove most categories of exempted income other than Educational loans. Tax
regime should be simplified by unifying the tax brackets and exemptions across the
country.

A concrete plan for recovering Rs.50,000 crores in the Rs.4 lakh crore currently
under the tax disputes.

Revenue Non tax receipts

Set disinvestment targets of reducing the stakes of Government in major Public Sector Units
to 50% by 2018.
Divestment through fund creation and offer exchange traded funds.
Expenditure Subsidies
Reduce the food subsidy allocations in the budget to Rs. 50,000 crore stressing on the
removal of the minimum support prices.
Reduce the fuel subsidy allocations to Rs.40,000 crore by increasing the diesel prices and
placing a cap on other subsidies.
Reduce the fertilizer subsidies to Rs.40,000 crore while focusing on measures to increase the
agricultural productivity.

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Rs.61,000 crore of the freed up expenditure from the deduction of subsidies shall be utilized
in building infrastructure for increasing agricultural productivity. The remaining Rs.30,000
crore shall be distributed through direct cash transfer mechanism.
Expenditure Leakages
Stress the importance of increasing the momentum in issuing Aadhar cards and set a target of
issuing 40 crore UID cards by the end of FY14
Start a separate mechanism to issue bank accounts for the Aadhar holders and link these
accounts to UID on a fast track basis. Set a target of 30 crore account by the close of FY14
Rs.30,000 crore shall be distributed through direct cash transfers to these accounts

The main issue for the implementation of this would be the absence of banks in a large
number of villages. Banking industry should be incentivized to open branches in the rural
areas with diffused reach. RBIs supervisory power should be increased to accelerate the
issuance of licenses to the rural non-banking entities to increase the rural penetration of the
banking system. Provisions should be laid down to increase the number of rural branches for
the regular banking organizations.
Direct cash transfer system should be implemented in the areas with banking facilities. For
other regions, regular subsidy flows shall continue till 2018 while steadily reducing these
areas.
As the tax base and tax buoyancy increases and non-tax revenues gathered, while at the same time
subsidies reduced along with plugging the leakage holes in the subsidy delivery system, the fiscal
deficit decreases and fiscal consolidation shall no longer be a distant dream.
Current Account Deficit
Large current account deficits are financed by large capital inflows in India.
With the reduction in fuel subsidies, the structural nature of the imports shall be reduced and
market forces automatically reduce the amount of imports.

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To counter the regularly rising gold imports, place a surcharge on gold imports.
To improve the exports, policy and infrastructure barriers have to be removed and
manufacturing sector has to be incentivized.
Investments and Infrastructure
Land Acquisition:
In India, 48% of land is dedicated to agriculture which is abnormally huge while in China it is
limited to 15%. Financial return on Indian agriculture is very low at 3-4%. Iconic projects like
Tata Nano have suffered due to the lack of a harmonious process for the transfer of land from
agriculture to industry. The Land Acquisition Rehabilitation and Resettlement (LARR) bill in
the parliament should be championed with all the government behind it. To make the process
of land acquisition fair, the following measures have to be taken.
o

A portion of the mining profits should (Mining tax) should be used for developing
the local community

Instead of upfront payments to the farmers, annuity payments should be made for
acquisition of lands

Proper ownership entitlements to land have to be documented. To this extent, all the
land in India should be surveyed in the next 3 years and the absolute ownership rights
should be digitized.

Mining reform:
o

Mines and Minerals bill has to be passed at all cost. This bill categorizes the mines
and sets appropriate standards for awarding licenses and compensations for the
displaced.

Power sector reforms:

o

Adequate power should be made available to the industry usage.

Once land acquisition and Mining reforms are in place, many power projects would
be fast tracked and industries would have access to more power.

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o

A coal regulatory authority has to be set up to create a well-defined structure to

regulate the coal prices and to make the auctions competitive. The dependence on
imported coal should be reduced and fuel linkages have to be assured to this extent to
the state electricity boards.

Manufacturing:
o

Provide a 25% accelerated depreciation allowance for industries with the highest
export growth potential.

Targets should be set to increase the manufacturing sectors contribution to GDP,

20% by 2018 and 7 crore jobs have to be added in the manufacturing sector.

Agriculture:
o

Private sector participation in the agricultural sector should be encouraged to boost

productivity

Rs.61,000 crore saved from subsidies should be invested in developing cold chain
infrastructure

FDI:
o

More sectors have to be opened up for FDI investments

A commission has to be set up to track the FDI inflows and identify illegal FDI
inflows from black money

FDI limits in multi-brand retail, insurance and aviation sectors have to be increased

Cost of doing business in India should be reduced by way of reducing corruption

Project clearance:
o

A national investment board has to be set up on a fast track basis to accelerate the
clearances for projects greater than Rs.500 crores

Financial sector:
o

Corporate bond market has to be developed to address the Indian infrastructure needs.

Pension systems should be opened up to private firms

Voting rights in private banks have to be increased.

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o

Inflation indexed instruments should be provided to both household sector and

corporate sector to incentivize savings.

Labor market:
o

Flexible labour laws aimed at achieving economies of scale should be incorporated

Minimum wage support should be stopped to reduce the rural demand for
consumption. Instead, labour markets should be allowed to clear automatically.

Corruption:
o

One time window for a period of six months should be opened for the corrupt to
surrender their corrupt wealth anonymously. A one-time tax shall be levied on this.

After the window is closed, strict measures have to be taken to curb corruption. The
first step would be curb corruption at the lower levels. Cost of doing business in
China is low despite high corruption levels primarily due to its centralized corruption
model.

Incentivize the lower level corrupt to surrender the corrupt money by waging
relentless rides on these.

Give a break after a while and open the black money surrender window during which
the corrupt tax of 40% would be levied.

The big sharks of corruption would not object to this as their black money is safe.

This would change the model into a centralized model

Once the window closes, focus on the corrupt in the middle and higher levels.
Identify ways to locate the accounts in tax havens.

Shadow budget 2013-14