Pareto Optimal Budget Scenario: FE 1st March 2008

The Budget resembles a Pareto optimal situation, where no one is worse-off while some people are better-off. And yet, after all these displays of benevolence, the numbers read very well with a lower fiscal deficit number in absolute terms as well as a ratio of gross domestic product (GDP). This sounds just too good.
If tax rates are being cut almost across the board, and only a few irritants have been ushered in by the finance minister—like the hiking of short-term capital gains tax in the capital market and introduction of a commodities transaction tax along the lines of the securities transactions tax introduced earlier—they should not really matter if the big picture looks good. The FM has based his approach on the one used last year, when a buoyant Economy helped push up tax revenue on both the direct and indirect taxes fronts to ultimately bring down the fiscal deficit to 3.1% of GDP.
In fact, P Chidambaram has reiterated that a simple tax structure with better administration and compliance can deliver good results. Now, the big question is whether or not the good growth numbers witnessed today will be the same in 2008-09.
By the FM’s own admission, there is a slowdown in industry, and since this will be the fulcrum for future growth, there is a big gamble being taken. The approach appears to be based on the tenets of the famous Laffer Theory, where lower taxes and more incentives lead to higher tax collections based on buoyancy.
But, can we be sure of this?
Evidently, this is a wager being taken, as the FM has not been parsimonious with his expenses and there have been liberal doses of expenditure that have been doled out to poorer sections, which is welcome, of course.
It appears to be a case of the FM chalking out his expenditure and then assuming collections based on an optimistic growth scenario. Given that this was the last Budget before general elections, there appeared to be no other way out.
It may be pointed out that these principles of supply-side economics have worked well in the past, albeit only periodically. It cannot be a continuous policy, though, as has been witnessed in the past. In fact, even in the US and UK, where this theory first originated in the early 1980s, it was not found to be sustainable.
So, what do we see here? First, individuals are... happy because they pay less tax. Corporates should not be unhappy, as their rates have not been affected, even though they were hoping for the surcharge to be removed. In fact, some industries have got the benefits of customs and excise cuts. Some minor FBT cuts have been announced to placate them. The capital market will be ambivalent—but then, it is always so, since it has become a habit. The corporate bond market is to be given a boost, which will be good, especially with currency futures also getting the government’s nod, with equal emphasis on credit derivatives and bond Markets. This means that the old cliché of a moribund debt market may no longer hold.
On the other side, Indian farmers must be happy that their loans are being written off and they can still get new loans. There are enormous allocations for education, health, rural infrastructure, etcetera, which if implemented well can only have positive results. A new PDS system is being experimented within a couple of states, which if successful will set benchmarks for others. The focus is completely on financial inclusion, which is a handy slogan that can be taken to the pulpits next year with these Budget numbers. The threshold for taxing the smaller services has been raised, which keeps another group out of the tax net.
Let us see who can be affected adversely on account of the Budget. The banks are still not sure if the Rs 60,000-crore loan waivers will push them back (the sum is certainly quite large), but the immediate sentiment has been negative. The nascent commodity Markets would receive a setback because of the new transaction tax, which, combined with service tax, will push them back a few years and probably lead to the grey market flourishing.
Now, while the economic survey had spoken a lot about controlling inflation, which was presented as a downside risk, the Budget has actually skirted the issue, probably because it is more in the domain of monetary policy. But the high unbridled growth assumed by the finance minister here is likely to be accompanied by significant inflationary pressures, and given that our investment rate too is expected to be over 36%, one can see a demand-pull spiral being triggered. If this happens, it could have an unintended impact on interest rates. The RBI will have to stay on high alert