With the Union Budget round the corner, many people hope that taxes will be cut to boost private spending and growth. While ordinarily this might be a good idea, there are four main reasons why tax cuts are not prudent now.
First, the strong revenue performance during 2021-22 gives a misleading impression of the government’s fiscal position. Revenues this year have benefitted from some exceptional factors: (i) strong profit growth in the private corporate sector, led mostly by the large firms; (ii) robust collections from the Goods and Services Tax (GST); and (iii) rapid GDP growth. The crucial question to ask is what might happen to these factors in 2022-23. And here we run into some difficulties.
It is risky to assume that corporate profit will continue to grow rapidly going forward. This is because we do not yet fully understand what led to the growth in 2021-22. If we look at the data of listed non-financial, non-oil firms in the private sector, we find that by June 2021, their profit margins were higher than the pre-pandemic period. This could have been the result of an increase in their market share, given that the smaller firms bore the brunt of the pandemic. The larger firms also took emergency measures to cut costs. It is not obvious that as the pandemic recedes, the same trend will continue in 2022-23. If it does not, then corporate tax growth would not be as high as in 2021-22.
In addition, GST growth is likely to slow down. In 2021-22, average monthly collections increased to Rs 1.2 trillion from Rs 0.94 trillion in 2020-21. This increase was mostly on account of resumption of economic activity. GST on imports also played a big role, fuelled by an import boom and higher tariffs. It is unlikely that we will witness a similar import boom next year.
As the recovery period ends and the economy normalizes, GDP growth will slow down too. The main engine of growth for an emerging economy like India is private sector investment, which still shows no signs of acceleration, even as the broader economy recovers. Another engine of growth is exports. While India experienced an export boom in 2021-22, as the developed countries normalise their macro-policies, the global exports boom will diminish, and this will impact India as well. Hence it is not certain where a high GDP growth will come from in the next fiscal year.
All these factors lead to uncertainty about tax revenues.
Second, the fiscal deficit, targeted at 6.8 percent of GDP for 2021-22, continues to be very high. There is little room to cut spending, since demands for social spending such as on NREGA remain high, interest payments continue to be a big component of expenditure, and there is mounting pressure on the government to increase capital expenditure. There is consequently no room to provide tax relief without imposing further pressure on the deficit. Nor is it a good idea to allow the deficit to increase. Government’s total debt has already reached 90 percent of GDP, the highest ever, and there is significant pressure on the bond yields to go up, which would make it costlier for everyone to borrow.
Third, the pandemic has caused supply shortages the world over. In India too we have been experiencing supply chain bottlenecks. In a supply-constrained environment, any attempt to boost demand by increasing households’ after-tax income would lead to inflation. This is exactly what has been happening in the US and other developed economies. In India, CPI inflation has been running at 5-6 percent, close to the upper limit of the RBI’s target band. And already there are pressures for inflation to go up, coming from rising oil and commodity prices. Tax cuts and the resultant increase in spending might push inflation beyond the limit, forcing the RBI into an uncomfortable choice: raise interest rates sharply at a time when the recovery is beginning or allow inflation to tax the country’s poor.
Finally, globally we are entering into a period of macroeconomic uncertainty. The US economy is experiencing its highest inflation in 40 years. The US Fed will consequently raise interest rates this year. When the developed world pulls back their expansionary policies, it is important for emerging economies like India to display strong macroeconomic fundamentals, and for the government to come across as credible.
One of the key reasons India was badly affected by the Taper Tantrum episode of 2013 was because it was doing poorly on macro fundamentals. In a way, the situation now is not very different. Once again, we are running a high fiscal deficit and the real interest rate is negative because inflation is higher than the policy rate. True, inflation is lower than it was in 2013, but the government debt ratio is substantially higher. Hence, the government needs to be somewhat careful about its fiscal math.
With state elections coming up, it might be tempting for the government to slash taxes and win votes. But given its own fiscal limitations and the uncertainty surrounding India’s growth and inflation trajectories in the next fiscal year, this would not be a prudent call.
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