Fiscal consolidation is critical for lowering India's debt-to-GDP ratio-Crisil Research

In fiscal correction quest, the best bet's GST 

The BJP-led National Democratic Alliance won the 2014 election on two planks – reviving growth and lowering inflation. To achieve both simultaneously, the new government will have to boost expenditure in growth-critical areas such as infrastructure, and reduce unproductive spending such as subsidies. In other words, there is scope for expenditure switching but there is little room to lower overall expenditure. That being the case, to sustainably reduce fiscal deficit from current levels, the government will have to rely on raising revenues as a share of GDP. 

To raise tax rates at this juncture is not prudent because it will severely hurt growth. Instead, the government has to implement structural tax reforms such as the goods and services tax (GST), which will lift tax revenues, lower the cost of doing business and boost growth. 

How GST helps 

The impact of GST on tax revenues will be two-fold. By eliminating the cascading effect of multiple central and state taxes, GST will reduce the cost of doing business and increase profitability, which, in turn, will attract investments and ultimately help GDP growth. Lower taxation and filing costs will also improve the price competitiveness of Indian goods abroad, boosting exports. Second, by simplifying the tax regime, GST can significantly improve tax compliance and increase tax revenues. 

Fiscal deficit will remain high 

However, implementation of GST in this financial year is unlikely. Therefore, we forecast fiscal deficit to stay high at 4.3% of GDP in the current year. That too, after assuming higher non-tax revenues and a significant increase in disinvestments as compared to last fiscal. This is because, sans GST, upside to tax revenues will be limited. Yet the government will have to accommodate large rollover of subsidies from the last fiscal – estimated at Rs 650 billion or 25% of the recognised subsidies in fiscal 2014 – as well as raise capital expenditure or spend productively to bolster growth. 

If monsoons are below normal, GDP growth could slip to 5.5% in fiscal 2015 instead of our base case forecast of 6.0%. However, we do not expect this to materially change our forecast for fiscal deficit, as lower agriculture growth is unlikely to have a significant impact on tax collections. We also believe that any increase in expenditures due to relief packages etc will be rationalised with cutbacks or savings in spending elsewhere. 

Partial GST rollout most likely 

In the next financial year, GST implementation will facilitate a much-needed correction in the fiscal deficit. But despite its myriad advantages, we do not foresee a full-scale implementation of GST in its current form. Instead, we believe, the most likely outcome is a partial rollout of GST - one that excludes petroleum goods - given its large impact on state revenues. Even so, fiscal deficit is forecast to correct to 3.3% of GDP by 2017. On the downside, a failure to implement GST will crank up the fiscal deficit to 4-4.2% in 2016 and 2017. 

Fiscal consolidation key for lowering India's debt ratio 

Fiscal consolidation is also critical for lowering India's debt-to-GDP ratio. Central government's internal debt has stabilised at 48% of GDP in the last two years after declining steadily since fiscal 2005, when it peaked at 60% of GDP. Including external liabilities, the centre's debt burden is higher at 51% of GDP and the debt burden of centre+ states is even higher at 65% of GDP! 

Furthermore, the declining trend of the centre's debt ratio post fiscal 2009 has been driven more by high inflation rather than lower fiscal deficit or faster GDP growth – as is desirable. Had inflation not risen so sharply, the central government's internal liabilities-to-GDP ratio would have started rising by now and stood at 55% in fiscal 2014 instead of 48%. 

Going ahead, with inflation expected to moderate and upside to growth limited, a strong commitment to fiscal consolidation is an imperative to lower India's debt-to-GDP ratio. With a partial GST implementation, we forecast that India's debt-to-GDP ratio (internal liabilities as a % of GDP) will decline to 45% by fiscal 2017. 

The task of fiscal consolidation for this government will not be easy. There is very little scope to cut overall expenditure, as it has already been trimmed sharply in the last two years. The government must instead focus on switching expenditure from unproductive subsidies toward spending on sectors such as health, education and infrastructure. The only way to reduce fiscal deficit, therefore, is to raise revenues as a share of GDP. To do so, the government must implement structural tax reforms such as GST, improve tax compliance and widen the tax coverage. 

The scope to lower fiscal deficit in fiscal 2015 is limited given large roll-over of subsidies from last fiscal and little possibility of implementation of GST within this year. Beyond that, however, implementation of GST could facilitate a much needed correction in fiscal deficit. In the base case, we believe that partial GST - one that excludes petroleum goods - is most likely. Even with this, fiscal deficit could correct to 3.3% of GDP by fiscal 2017. On the downside, a complete failure to implement GST would result in the fiscal deficit being higher at around 4-4.2% in fiscals 2016-2017. 

Fiscal consolidation is also critical for lowering India's debt-to-GDP ratio, which has stabilised in the last two years, after declining steadily since fiscal 2005. From fiscal 2009, however, high inflation has been the primary driver of India's declining debt-to-GDP ratio. Had inflation not risen so sharply, India's debt ratio would have started rising by now. Going ahead, as inflation is expected to moderate and the upside to growth will be limited, a strong commitment to fiscal consolidation will be key to lowering India's debt-to-GDP ratio.