Indian Finance Minister Nirmala Sitharaman arrives at Parliament House to present the 2019-20 federal budget, in New Delhi on July 5, 2019. Photo: PIB

When Indian Finance Minister Nirmala Sitharaman last Friday announced some big-ticket tax relief to boost the sagging economy, the stock market experienced a record-breaking rally that was widely reported by the Indian media.

However, what remained underreported on the same day was that the bond market, too, had staged a rally on speculation that the government might have to borrow more to meet its spending needs.

The Finance Minister later asserted that neither would the government revise its fiscal deficit target in the near future nor was it planning any spending cuts at this stage.

Also read: Indian govt says no plan to cut spending

However, various rating agencies have forecast that the fiscal deficit will rise and the latest to do so is Fitch Ratings. It has said that with the latest tax sops India’s combined fiscal gap, including deficits of states, is seen widening to the highest level in about eight years.

It sees the government deficit at 7.5% of the gross domestic product in this financial year. This is the highest since March 2012, when the combined deficit was around 8%.

Earlier S&P Global had said that India’s move to cut corporate tax rates was a “credit-negative development,” despite potentially boosting the economy, as it would widen the fiscal deficit.

Moody’s said this move would narrow the government’s fiscal room for maneuver. However, it described the rate reduction as credit-positive for companies because it would enable them to generate higher after-tax incomes.

The Narendra Modi government’s latest decision to cut taxes on companies is a departure from its conservative budget in July, when it targeted narrowing the federal government’s fiscal gap to 3.3% of gross domestic product from 3.4%. This flip flop has led to a speculation of missing deficit targets.

With the latest round of tax cuts, it expects a tax revenue shortfall of 1.45 trillion rupees (US$20 billion) but hopes that the new tax rates will spur private investment and boost tax collection in the long run.

Even before this announcement was made the government was expecting a revenue shortfall of 1 trillion rupees ($14 billion) in income tax and goods and services tax collection. A further shortfall could worsen the fiscal deficit situation further.

After the gross domestic product for the April-June quarter slipped to a six-year low of 5%, the government was under pressure to stimulate private investment. Reserve Bank governor Shaktikanta Das had admitted that the gross domestic product numbers had come as a surprise.

The slowdown in investment and consumer demand had derailed manufacturing, which grew just 0.6%. The farm sector also posted a meager 2% rise, and this added to the demand slowdown.

The Indian auto industry is passing through the worst slowdown seen in the past two decades. Domestic inventory piles range between 45-60 days across vehicle categories and exports are contracting on the back of a global slowdown.

But critics argue that mere tax cuts to corporations will do little to slow the economic downturn. They point out that the current slowdown is mainly due to weak consumer demand.

If consumers are not spending due to falling income or unemployment, the demand will continue to remain low and the companies will be reluctant to increase production or expand capacity.

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