Delhi's Budget Bets on Growth

Against the backdrop of worldwide anxiety about the state of public finances, India's Finance Minister Pranab Mukherjee will present the annual budget to parliament Friday. India's budgetary situation has deteriorated substantially in the last two years. The overall government deficit is now in double-digit territory and government debt exceeds 80 percent of GDP. Whether urgency and dramatic progress will mark this budget remains the question.

First, there is little pressure for immediate corrective action. Public finances may be well into the red, but not so the overall economy. At an expected 7.5 percent growth rate for the year ending March this year, the economy has bounced back strongly, surviving both the global financial crisis and shrugging off the effects of a weak monsoon and poor harvest last year. And although inflation remains high, economic growth seems to be heading inexorably toward dizzy precrisis levels. The mood remains buoyant, especially because of the contrast with the performance of the industrial economies.

Second, policymakers have limited ability to take action now. Unlike in most other countries, India's worsening fiscal situation had more to do with political promises than the financial crisis and recent economic downturn. Well before the crisis began, the combination of a rural employment guarantee program and oil- and fertilizer-related subsidies that ballooned with global price increases contributed to a soaring budget deficit. The crisis-related stimulus, which took the form of indirect tax cuts, was modest-accounting for only about a quarter of the overall worsening of the fiscal deficit.

There are some bright spots. In the coming year, the uptick in economic activity will boost tax revenues. Pending tax reform may also help boost compliance. The budget will also benefit from the fact that arrears to civil servants resulting from wage increases in 2008 have been paid off in the previous two years. (But defense-related expenditures are likely to increase.) Together, all these factors will lower the deficit by a little more than one percentage point. Privatization sales could also relieve some of the pressure on the government's need to borrow.

But the budget will need to make headway in addressing the basic vulnerability of India's public finances. Compared to Brazil, Russia, and China, India's ratio of government debt-to-GDP is the highest. Amongst a wider group of emerging-market countries, its fiscal performance has been relatively weak in recent years. During the global boom years, when the economy was growing at 9 percent and revenues were buoyant, India squandered a golden opportunity to set its fiscal house in permanent order.

There are signs that the Congress Party-led government wants to rectify this mistake. The government may announce a path for medium-term fiscal adjustment that would take the deficit down to about 3 percent of GDP. Achieving this target will require spending restraint and implementing the new broad-based value added tax, which commands wide support across the political spectrum and across the Indian states. The government expects the new tax could generate additional annual revenues of about 1.5 percent of GDP. The government has also sent signals about tackling subsidies: for example, some fertilizer subsidies have been reduced, and subsidies on gasoline and diesel fuel could be eliminated once inflation subsides.

But fiscal populism will remain a temptation, especially if the betting is that strong growth in the future will outstrip spending promises. Resisting that temptation, especially by tackling wasteful subsidies that do not directly benefit the poor, could be the strongest signal yet that India is committed to putting its fiscal house in permanent order.