A Budget for Rural Growth

By Knowledge@Wharton | April 20, 2016

The frugal Azim Premji, chairman of Bangalore-based IT giant Wipro, has reason to be annoyed with India’s Union Budget, which was announced last week. The man who switches off the lights when he leaves a room has been hit by a double whammy by finance minister Arun Jaitley. Not only has the surcharge for individuals who earn more than Rs. 1 crore ($149,000) a year been raised to 15% from the existing 12%, an additional tax of 10% — a new dividend distribution tax (DDT) — has been proposed on dividend income of more than Rs. 1 million from domestic companies.

Premji is the top casualty of this new tax. While other well-heeled promoters have increased public holding and set up trusts and foundations to take care of ownership issues, Premji has kept his shareholding close to home. According to Bombay Stock Exchange (BSE) data, the Wipro promoter and promoter group entities held 73.35% of the shares in the company as of December 2015

Union Minister for Finance, Corporate Affairs and Information and Broadcasting Arun Jaitley
arrives at Parliament House to present the General Budget 2016-17.Will the government do a better job with the money it has squeezed out of the rich? Well, certainly not with the $32 million it expects to extract from Premji. Besides, for Premji, it’s loose change. The Hurun India Philanthropy List 2015, published in January this year, names him the “Most Generous Indian” making up 80% of the donations on the list. His total giving during the year is estimated at $4.1 billion, more than 10 times the contribution of former Infosys chief Nandan Nilekani and family ($358.9 million).

Not that the givers are carping about this diversion of their generosity to pay bureaucrats’ salaries; the seventh pay commission has recommended a $15.23 billion bonanza for civil servants, most of which will have to be accommodated in the current Budget.

“On the DDT tax, while I am personally going to be affected, I agree with the government as it is a progressive tax measure,” says Nilekani. “No comment,” says Premji.

Negative Reaction

Is that all one can highlight in a financial roadmap that affects the lives of 1.31 billion Indians? Initially, the response to the Budget was negative. Everyone was waiting for the fine-print which, in the past, has bedeviled the headline announcements. The BSE sensitive index (Sensex) fell to its 52-week low. “The Sensex fell as much as 2.85%, or 659 points, to 22,494 as market participants gave a thumbs down to Jaitley’s announcements, particularly with respect to taxing of dividend income in the hands of high net-worth individuals,” opined business daily Mint. (The markets recovered later to end the day 152 points down.) According to The Times of India, “Jaitley made a strong push to counter the suit-boot ki sarkar [government for the rich] tag conferred on it by [Congress leader] Rahul Gandhi by unveiling a Budget that focused on wooing farmers and the poor while conspicuously soaking the rich.”

The rich may get a bit wet but, frankly, they would welcome a soaking — literally. India has had two bad monsoons in a row; a third would be a disaster. Although agriculture contributes less than 15% to the country’s GDP, the Indian Council for Research on International Economic Relations estimates that some 50% of the workforce is engaged in farming. Rural family sizes are larger than urban ones, which means close to 60% of India’s population is farm-dependent. The rich in their Antillas and Cadillacs get short shrift when farmers are committing suicide after crop failures. (Incidentally, the Budget proposes tax at source at the rate of 1% on purchase of luxury cars exceeding a value of Rs. 1 million.)

The Economic Survey, presented before the Budget, sees more scope for rich pickings; it says, the rich enjoy Rs. 1 trillion annually in “implicit subsidies.” The survey states, “Rectifying some egregious anomalies may be good not only from a fiscal and welfare perspective, but also from a political economy welfare perspective, lending credibility to other market-oriented reforms.”

Does all this imply a return to Nehruvian socialism? No. While big-ticket reforms are missing, there are several green shoots of intentions. The markets feel so, too; the Sensex has galloped some 1600 points in just four days after falling on Budget day.

The pundits have resumed hard-selling equity. “The Budget has been very encouraging for the long-term equity market,” says Sankaran Naren, chief investment officer at ICICI Prudential Asset Management. The problem during the past few months – the Sensex plunged from 30,024 in March 2015 to 22,494 (during Jaitley’s speech this year) — has been a foreign institutional investor (FII) pullout. FIIs sold nearly $2 billion in January 2016, bringing the index to its knees. But, says Naren, an analysis of data for the past 20 years shows that maximum gains are made if you buy when the FIIs flee a market.

On Budget day, of course, it was all very different. “Austerity by tokenism,” said a report by Emkay, a financial services company. “Overall, the Budget is heavily oriented towards addressing rural and agri-sector distress, boosting demand and the imperatives of upcoming state elections.” Four states and one union territory go to the polls in April-May.

Jaitley Knew Limitations

Jewellers protest against the one percent excise duty proposed by Finance Minister Arun Jaitley
in the 2016-17 national budget outside Jaitley’s residence in New Delhi.But Jaitley was aware of these limitations. “The financial years 2015-16 and 2016-17 have been and will be extremely challenging for government expenditure,” he said in his Budget speech. “The next financial year 2016-17 will cast an additional burden on account of the recommendations of the Seventh pay commission…. The government, therefore, has to prioritize its expenditure. We wish to enhance expenditure in the farm and rural sector, the social sector, the infrastructure sector and provide for recapitalization of the banks. This will address those sectors which need immediate attention.”

Jaitley could have done more. His options were to stick to the fiscal deficit target or bypass it and loosen purse strings. He opted to retain the fiscal deficit in the estimates for 2015-16 and 2016-17 at 3.9% and 3.5% of GDP, respectively.

“Given anemic conditions and broken balance sheets, higher spend is unlikely to have kick started growth and instead increased vulnerability to global vagaries,” says Nandan Chakraborty, managing director of institutional equity research at Axis Capital. “The arithmetic [of the Budget] is realistic.” Adds a report by Crisil, a Standard & Poor’s company: “The fiscal math mostly ties up. The government has done a fine balancing act and maintained its credibility by sticking to the target of bringing down fiscal deficit to 3.5% of GDP in fiscal 2017 after having met the 3.9% target for fiscal 2016.”

Two Conflicting Goals

“The government seeks to reconcile two often conflicting goals – induce growth and restrain spending,” says Ravi Aron, professor at the Johns Hopkins Carey Business School. “Given the constraints that it faces, the government cannot run a larger deficit. It is important to note that, this year, international investors have already pulled over $2 billion from the Indian equity markets and have driven the rupee down by nearly 4%. Private investment too is at near its lowest point, given the debt levels of private corporations coupled with low earnings. As many Indian companies have dollar-denominated debt, private investment is unlikely to rise quickly in the short term. The government has been realistic in the face of these constraints.”

“Three factors — globally weak aggregate demand, bank rates becoming negative in Japan and near zero in most developed countries, and subdued inflation in India — make the monetary policy space much wider. The fiscal policy space is limited,” says Jayanta Nath Mukhopadhyaya, director of the department of management at the J.D. Birla Institute. “Sticking to fiscal discipline sends a strong signal to the RBI (Reserve Bank of India) to lower rates.”

“Keeping the fiscal deficit at 3.5% along with lower government borrowings will work well for the bond, currency and eventually the equity markets,” notes S. Raghunath, professor of corporate strategy and policy at the Indian Institute of Management, Bangalore. “Fiscal discipline is required in order to maximize confidence and boost macroeconomic performance. This is a well-balanced Budget. There are credible initiatives relating to agriculture reforms, social sector spending and rural electrification.”

“It is a pragmatic approach,” says an analysis by Anand Rathi Financial Services. “We approached the crucial 2016-17 Budget presentation with a fair slice of skepticism. There was talk of the long-term capital gains tax tenure being increased to three years and introduction of higher service tax rates. That would have been construed as negative. Given the backdrop of negative expectations, we reckon that the Budget should be looked at positively.”

Should the absence of bad news be interpreted as good news? No, but it leaves the talking heads with nothing to talk about on TV. This perhaps explains why the fresh taxes on the rich (they aren’t complaining) should be hogging so much headline space.

But Jaitley, like prime minister Narendra Modi, is excellent at packaging. His speech unveiled “nine distinct pillars” to transform India. (Modi’s plan for Digital India has nine pillars, too.) The pillars, as set out by the FM are: Agriculture and farmers’ welfare – “Farmers’ income will be doubled in five years”; Rural sector; Social sector including health care; Education, skills and job creation; Infrastructure and investment; Financial sector reforms; Governance and ease of doing business; Fiscal discipline; and Tax reforms.

The budget says nothing about a Goods and Services Tax (GST) timeline. The GST is a key reform that has widespread support. But, while in the opposition, the now-ruling Bharatiya Janata Party had successfully prevented it from being passed. Now the Congress has so far done the same thing.

The budge had some incentives for foreign investors — 100% foreign direct investment (FDI) will be allowed in marketing of food products produced and manufactured in India. But whether that will attract the Walmarts of the world, who have been lobbying intensely for FDI in multi-brand retail, remains to be seen.

Dealing with Defaulters

In another initiative, Jaitley invited alleged tax defaulters like Vodafone and Cairn to buy peace, proposing that they settle their tax arrears, waiving interest and penalty. There have been no takers so far.

Jaitley’s Budget thus has the broad-brush strokes of the big picture but is weak on specifics. On bank recapitalization, he has provided $40 billion, but that will not be enough. “The market expected $60 billion,” says Mukhopadhyaya. “It looks more sensible to have a stressed asset fund rather than bad banks.” Says Jaitley: “We will find the money.”

Traders track the national budget 2016-17 at Bombay Stock Exchange in Mumbai.

Where will he find the money (and growth)? India is actually in a ‘sweet spot.’ The Economic Survey projects the GDP growth rate at 7% to 7.5% in 2016-17. But the numbers have a lot of assumptions behind them. “On the domestic side, two factors could boost consumption,” says the Economic Survey. The first is increased spending from higher wages and allowances of government workers, courtesy the pay commission largesse. “If, in addition, the monsoon returns to normal, agricultural incomes will improve, with attendant gains for rural consumption.”

There are other grey areas. The Indian corporate sector is adept at finding ways to avoid taxes. One instance is the new DDT, which comes into effect from April 1, 2016. The Economic Times did a back-of-the-envelope calculation and arrived at a figure of $1.2 billion in additional tax. But hundreds of companies are rushing to pay interim dividends before April 1, so those expectations may not be met. When accused of tax avoidance (not evasion), companies argue that the tax is ethically objectionable. The same income is being taxed three times. First, the company pays tax on the profits it makes. Second, it pays a DDT. Now, the dividend recipient has to pay DDT also.

This may be peanuts in the overall Budget numbers, but there are other targets that cause more concern. “While the tax revenue arithmetic is realistic, the risk of undershooting resides in non-tax revenues specifically the ambitious divestment target of $8.4 billion,” says Crisil chief economist Dharmakirti Joshi. “If this risk materializes, the government may have to axe capital spending in its zeal to meet the deficit target. This will dent India’s growth potential. To avoid this, it important for the government to frontload its divestment program.”

“There is only one source of funds that the government can count on without adding to the already high debt,” says Aron. “It must divest its holdings in the ’public sector’ corporations. The government has missed its divestment targets every year for the past five years. Divestment has three benefits. First, it brings critically needed revenues for investment in infrastructure, education and public health, all of which are very important for growth.

“Second, it will produce substantial savings in the government’s huge and recurring salary bill – about $16 billion starting 2016 will be paid towards the salaries and pensions of the 10 million or so employees and retirees. Third, it will reduce by some measure the graft and corruption involved in running these firms. For decades, they have been chronic underperformers as they have been managed as private fiefdoms by ministers who extracted rents from them, aided and abetted by a pliant bureaucracy. There can be no justification for the government owning stakes in companies as varied as hotels, machine tools, airlines, electronics and telecom service providers. These are of no strategic value and nor do they safeguard scarce national resources. There is no public interest in the public sector holdings of the Indian government. It is time that these enterprises were divested and the capital used where it is vitally needed — in investing in India’s future.”

Bright Future

Last year, India overtook China to become the fastest-growing large economy in the world. The IMF expects it to stay that way. The future, everyone agrees, is bright. “In addition to lower oil prices, the Indian economy needs another dose of good luck from monsoons and interest rate cuts to support the nascent recovery,” says Joshi.

Rate cuts are in the hands of RBI governor Raghuram Rajan who has thus far disappointed both government and industry by giving priority to fighting inflation. As long as the price-rise ogre is knocking at the door (governments in India have fallen because onions turned costlier), Rajan is unlikely to relent in any substantial manner. The rest may be up to the rain gods.