The upcoming Budget will be the first test of the Narendra Modi government's determination to get to grips with the fiscal situation, which is a serious stress point for the economy. Finance Minister Arun Jaitley needs to send a very strong signal about his commitment to fiscal discipline. Effectively done, this will buy the government the space to flesh out a longer-term strategy, which can be rolled out by the 2015-16 Budget next February. Here are some things that he must do in next month's exercise. A timetable for deficit reduction must be laid out, as if the government were operating under a fiscal rule, such as the Fiscal Responsibility and Budget Management (FRBM) Act. A revival of this law, with explicit limits on revenue deficits, fiscal deficits and, very importantly, on the overall subsidy bill, will constitute a significant fiscal reform. Until that happens, the government could suo motu build these limits into its Budget estimates.
A looming threat to the consolidation process is the likely recommendations of the Seventh Central Pay Commission, which would come into effect from January 2016. Precedent suggests a hit of full one per cent of gross domestic product (GDP) to government finances. This should be warded off by combining meaningful pay increases with significant rationalisation across categories, though it may be politically unpalatable. A second imperative is to enhance resources allocated to infrastructure. Former prime minister Atal Bihari Vajpayee's emphasis on highways could well be matched by Mr Modi's priority on railways, a national backbone that has been tragically depleted. A short-term source of funds for this could be an investment surcharge on rail fares; clearly, a decade of static fares has hugely reduced them in real terms and there should be little political resistance to a partial correction, particularly if it is visibly going into improving the system. Another urgent challenge is to revamp the state of the defence system. That Mr Jaitley has been asked to head the defence and finance ministries simultaneously is a rare opportunity to rationalise the system itself while finding the resources to modernise it. There is promising talk of private, including foreign, investment in defence equipment. Given the increasing technology intensity of everything defence-related, even food supplies, it is high time that the public monopoly in this domain was done away with.
On the tax front, even as the goods and services tax (GST) is being put through the constitutional amendment process, the Budget can get the process started by introducing a single-rate framework, just as a GST would have done. This will send a strong signal of commitment to that very important reform. Mr Jaitley should also begin talking about compensation to states as an inducement to get them to make the final push. Properly managed, the GST could become a reality in 2015-16, which would be a huge feather in this government's cap. A politically attractive personal tax measure would be to index the income tax threshold level to, for example, consumer inflation. The revenue loss can be mitigated by a small increase in the tax rate on incomes above, say, the ~50 lakh level. A reasonable long-term capital gains tax could also be considered. Finally, for so many years, the direct tax framework has incentivised capital intensity of production. It is time labour-intensive production was incentivised, perhaps through an employment tax credit.
