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Nirmala Sitharaman has to be complimented for two of the main building blocks of her fourth budget as finance minister.

First, she has budgeted for a modest reduction in the fiscal deficit when the recovery in domestic demand is still uneven. A sharp reduction in the fiscal deficit, even as the Reserve Bank of India (RBI) is expected to tighten monetary policy to quell rising inflationary pressures, could have put the economic recovery at risk. The aim to reduce the fiscal gap from 6.9% of gross domestic product (GDP) in 2021-22 to 6.4% of GDP in 2022-23 also means that the fiscal correction in the subsequent three years will be more severe, if India is to meet its medium-term fiscal deficit target of below 4.5% of GDP in 2025-26. Remember, there is a general election scheduled in the middle of all this. Whether the Narendra Modi government can avoid the usual demands of the Indian political business cycle will be an acid test. Bond yields surged soon after the size of the borrowing programme was announced.

Two, the budget has been built on reasonable assumptions. The finance minister has generally stuck to this strategy during her tenure, and also made budgeting more transparent than before. At 17.6%, nominal GDP growth was off the charts in 2021-22, thanks to the economic recovery as well as rise in consumer and wholesale prices. There is an overwhelming consensus that nominal GDP growth will be much lower next year. The budget has been built on the assumption that the Indian economy will grow at 11.1% in nominal terms, which seems out of line with the estimates of real growth that economists in the finance ministry announced on Monday, as well as most inflation forecasts. The conservative assumption on nominal GDP growth next year is an inbuilt buffer in the new budget.

Tax collections this year have been stellar, partly because the economic recovery has favoured large enterprises as well as people with higher incomes. The fact that net tax revenue is likely to be ₹2.20 trillion more than what the budget had announced last year ensured that the government will be able to almost stick to its fiscal deficit target, despite the ₹2.99 trillion supplementary demand tabled in parliament in December to pay for an increase in food and fertilizer subsidies. Growth in tax revenues in 2022-23 is expected to be slower than growth in the underlying economy, which is a safe assumption.

The Indian fiscal response to the covid shock had two elements. The intervention to protect the supply side of the economy was skewed towards ‘below-the-line’ measures such as credit guarantees rather than direct income support. The extra spending to support aggregate demand focused on capital rather than revenue spending, because of the higher fiscal multipliers for the former. This strategy continues in the new budget as well, even though the supply shock has now morphed into stress on the demand side. For example, the Emergency Credit Line Guarantee Scheme has been extended for another year. The budget for the national rural employment scheme has been cut significantly—implicitly assuming a jobs revival—while the subsidy bill for food and fertilizers has also been reduced sharply, even as funding for drinking-water, sanitation and roads programmes has been increased. The inability of government departments to spend on new projects—as a recent report from the Controller General of Accounts showed—raises questions about state capacity to deliver on such a strategy.

There is a shadow looming over the new budget. As a result of the borrowing needed to support the economy in the worst months of the pandemic, public debt is now nearly 90% of GDP, the highest in many decades and nearly 20 percentage points higher than its pre-pandemic level. The interest burden of this higher debt is evident in the finances of the government. For example, the total spending of the Union government has increased by ₹12.47 trillion in two years of the pandemic while interest payments have gone up by ₹3.16 trillion. Also, interest payments will suck up 48.6% of the net tax collections of the Union government in 2022-23, compared to 37.9% in 2019-20, which was the last fiscal year before the covid pandemic struck.

The dynamics of public debt are complex, but India has usually brought down its public debt as a percentage of GDP when nominal economic growth is far higher than the borrowing costs of the government. In 2021-22, the gap between nominal growth and the interest rate was the highest in a decade. It will narrow next year as nominal growth comes down while RBI increases interest rates. The narrower the gap, the sharper the fiscal correction will have to be, to meaningfully reduce the burden of public debt over the next decade. The International Monetary Fund has estimated that the primary deficit needed to stabilize India’s debt/GDP ratio is 2.9% of GDP, which is close to what has been budgeted.

The pandemic has left behind deep scars on the Indian economy. The overarching strategic theme of Budget 2022 seems to be continuity rather than any sudden changes in tax laws or severe expenditure compression. There has been the usual tinkering with tax rates, and creeping protectionism is a worry. Much now depends on whether the economic recovery can sustain itself given the international economic situation, higher domestic interest rates and a gradual withdrawal of fiscal support.

This article was originally published in Mint on Feb 2, 2022.

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