India’s Money Challenge

Business Week wonders how India’s coalition government will fund the promises it is making:

So far, the government hasn’t answered the biggest question: Where will the money come from? Federal and state governments are staggering under fiscal deficits equal to 9% of gross domestic product, one of the highest levels of government debt in the world. Yet Congress already has ruled out two obvious sources of new revenue: major sell-offs of state assets, which last year netted $3.5 billion, and tax increases. Protectionism is out, too. “In today’s environment, one can’t increase taxes or hike import tariffs or close the doors to foreign direct investment,” says Jairam Ramesh, the party’s economic adviser. What’s more, with interest rates and oil prices rising and investor sentiment for emerging markets on the wane, the global climate isn’t as friendly to India as it was in 2003.

This is why analysts anxiously await the budget that Chidambaram, who helped put India on firmer footing during a previous stint as Finance Minister in the mid-1990s, is to unveil in July. So far, Congress officials have released few details about how they will finance greater social spending. Observers aren’t expecting miracles. India has lived with high budget deficits for 15 years, and neither the BJP nor Congress before it made much headway in reducing them. “The problem with the budget is hard to fix because it’s structural and has a lot to do with the political dynamics of India,” says Gregory Fager, Asia/Pacific director at Institute of International Finance Inc., a Washington think tank for the banking industry.

New Delhi can do many things to whittle that problem down, though, if Congress has the political will. For example, it could trim generous food and fertilizer subsidies, slash overstaffed bureaucracies, and use federal fund transfers to coax spendthrift states to do the same. The government also could find ways to get more companies to pay taxes without chilling investment. Despite a maximum 35% rate for corporations and 30% for personal income, India collects just 14% of GDP in taxes, a skimpy rate by world standards. That’s because most farmers, small businesses, and rapidly growing service companies pay little or nothing, thanks to exemptions or evasion. As a result, the heaviest burden falls on salaried employees at big companies and on manufacturers. The government is starting to tax information technology companies on domestic earnings and will soon tax exports. But to get more companies on the rolls, it must overcome powerful lobbies and implement better systems to monitor small businesses.

New Delhi could make a bigger impact if it introduced a value-added tax, which imposes levies on the production and distribution of goods and services. In Europe the VAT raises more revenue than would sales taxes. A tax-reform commission headed by Finance Ministry official Vijay L. Kelkar in 2002 endorsed the VAT.

Deficit hawks are more worried about profligate state governments. A day after the election victory, Y.S. Rajasekhara Reddy, the new Congress chief minister for the southern state of Andhra Pradesh, promised free electricity to farmers. Economists estimate that would boost power subsidies by 20%, to $475 million. Politicians in neighboring Tamil Nadu then hiked power subsidies by one-third.

There are some bright spots. The Congress coalition inherited a strong economy with $114 billion in foreign reserves, up from $40 billion three years ago. India has a relatively high savings rate of 23%. And last year, low interest rates helped states retire $14.2 billion in loans owed the central government. This trimmed the deficit a bit. And although India’s public debt load is high at 82% of GDP, it has been able to finance it through local institutions, rather than rely on foreign markets. “The banks are flush with liquidity,” reasons Standard & Poor’s sovereign ratings analyst Joydeep Mukherji. “So there’s no risk of a crisis.”

Chidambaram is likely to present the Budget in the first week of July.

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Rajesh Jain

An Entrepreneur based in Mumbai, India.