India's Finance Minister Arun Jaitley arrives at parliament to present his budget in New Delhi on July 10, 2014. India's new right-wing government under Prime Minister Narendra Modi unveiled its maiden budget on July 10, promising a new era of fiscal prudence and greater opportunities for foreign investors in key sectors of the economy. AFP PHOTO / RAVEENDRAN (Photo credit should read RAVEENDRAN/AFP/Getty Images)

Arun Jaitley walked into a huge economic mess, unaware of the terrible damage done by 10 years of UPA rule, and which we are still trying to recover from. Here are five things he should do in his third Budget, and five that he shouldn’t.

Budgets do not usually matter. The UPA managed to present 10 pedestrian Budgets and claimed high growth as its fiscal legacy, when the reality is that several things outside the Finance Minister’s control fell into place simultaneously, enabling happy outcomes in most years. Among the favourable winds that pushed the India growth story were the general uptick in global growth, the positive turn in the Indian domestic business cycle that improved India Inc’s appetite for risk and investment, the improving health of Indian banks, the clean-up of power companies’ balance sheets by the Vajpayee government, and the telecom revolution set off by Arun Shourie’s efforts to eliminate cronyism in policy. When the UPA took over, the external current account deficit was good, foreign inflows were beginning to rise, inflation was low and job growth was reviving. They could not have asked for better pitch conditions.

However, what they left behind was a dug-up pitch and legislation intended to ruin growth—a kind of scorched-earth policy where functioning markets were destroyed, inflation was let loose, subsidies went out of control, power companies approached bankruptcy, banks were staggering under loads of bad loans, and business had no appetite left whatsoever to invest. Bad legislation—like the Food Security and the Land Acquisition Acts—were enacted in the name of helping the poor, when the net result was to throw sand in the engine oil of growth. The food and land markets, always heavily distorted by malign government intervention, were just about to seize up.

None of this had much to do with the Budget, except peripherally. Arun Jaitley walked into this mess unaware of the damage done, and that is why we thought his first two Budgets were disasters. His big mistake was to pretend that Budget band aids can cure the underlying cancer, and if his next Budget has become make-or-break, it is because he has to undo the damage done by past Budgets.

The one area where Budgets do matter is in the damage they can avoid doing—intentionally or unintentionally. Pranab Mukherjee, during his stewardship of the Finance Ministry from 2008 to 2012, managed to ruin the climate for foreign direct investment by bringing in retrospective legislation to collect taxes from Vodafone for its purchase of Hutchison’s telecom business in India in the previous decade.

As for sins of omission, there was one major thing both P. Chidambaram and Mukherjee failed to do in their Budgets, especially during UPA2 (2009-14). They failed to force a cut in petroleum subsidies, and thus chalked up a subsidy bill of over Rs 8,30,000 crore during their 10-year economic misrule just on this account. Failure to cut oil subsidies in time cost them the election and the country its growth momentum.

Worse, when it was clear to everybody and the dog at the lamp post that the Indian economy was going downhill from 2012, Chidambaram and Mukherjee cut the wrong costs to rein in the fiscal deficit: they cut productive capital and Plan spending, and let unproductive subsidies run riot. This is like cutting muscle and letting flab accumulate—not a recipe for maintaining good economic health.

The point to underscore is thus simple: Budgets cannot on their own lift growth or improve economic conditions, but they can damage it. Budgets are make-or-break in the sense that doing the wrong things can break the natural rhythm of the economic cycle, and prolong the economic agony; they can make an economy go downhill faster by doing too much.

So the third Arun Jaitley Budget is make-or-break in a very specific context. It does not mean he should not do anything (he should), but primarily that he must avoid the temptation to do things that can damage the recovery. As for the good things he must do, these would essentially fall in the category of greasing the wheels of the economy.

Here is a checklist of five things he can do, and the five things he must not do.

Jaitley’s Five “Do-s” for 2016

First, he must focus on long-term direction, not short-term, year-to-year tinkering with taxation proposals. Simplification of tax compliance rules and reduction of taxation are a continuous process, not a one-time Budget proposal. If you want to protect taxpayers from bracket creep due to inflation, it is simpler to automatically index the tax-free exemption limit according to a formula rather than announce changes every year. If corporate taxes have to be cut, the trajectory must be announced in advance, and so must the proposed withdrawal of exemptions and loopholes. Last year, Jaitley did the first part, and failed to indicate which tax break will end to finance his corporate tax cuts. This kind of suspense is precisely what vitiates the investment climate, as businessmen will wonder where the axe will fall, and will be willing to bribe Finance Ministry officials to know this in advance. Jaitley must start ending the Budget secrecy—something that has remained unchanged from British days.

Second, the Budget must embrace accounting honesty. Budget math is currently a piece of fiction, not because revenue and expenditure estimates go wildly off target, but because the government runs on cash. Cash in the till is considered revenue, and cash not yet spent is not considered expenditure. Any company that ran its business this way would be accused of bad accounting practices, since this would not give an accurate picture of how it has fared in any particular year. The only sensible way to offer transparency on government finance is to adopt the corporate practice of accrual-based accounting, so that all expected revenues and expenditures are accounted for while presenting the Budget. Making this change will prevent Finance Ministers from pretending that “all is well” merely by refusing to recognise expenditure while taking credit for revenues. If Jaitley adopts this system, he will be a true reformer, and not by continuing with the accounting fiction of the UPA years.

Third, the old distinction between “Plan” and “non-Plan” Budgets makes no sense when the Planning Commission has been abolished. In a market-based economy, five-year plans are passe, even though it is useful to have a long-term vision for where the investments are needed, and where they are not. The only sensible way to draw up Budgets is to distinguish capital expenditure from consumption (revenue) expenditure. One creates assets, and the other consumes the seedcorn. Consumption Budgets are important, for we still need to run the government, but capital Budgets are more important for future growth.

This categorization will also enable the government to focus on the real deficits—revenue deficits, and not the fiscal deficit, which is the net amount the government needs to borrow to close the gap between revenues and receipts and expenses. Money borrowed to build infrastructure is different from money paid out as subsidies or salaries as the former creates opportunities for growth, while the latter saps them. Howsoever important it is to build safety nets for the poor and employ staff to run various government functions, it is even more important to ensure that these services are delivered efficiently. The government’s revenue expenses cannot be financed from borrowings, as they have been in most of the years. No company borrows only to pay its employees; it borrows to create future revenue streams, to invest.

Apart from segregating capital and revenue expenditures, it would also be useful for Jaitley to allocate a specific proportion of revenues for subsidies—and not make them open-ended. A subsidy cap of, say, 2 percent of GDP, is more than adequate to provide safety nets to the poor.

The real deficit to monitor is the revenue deficit, and not the fiscal deficit, as investments in viable physical and social infrastructure will generate future incomes for both citizens and the government. The revenue deficit target should be zero in three to five years. The red line in sand should be drawn on revenue deficits, and not the overall fiscal deficit, which could have productivity and growth-enhancing expenditures embedded in them.

Fourth, barring long-term direct and indirect taxes, all other forms of taxation must be self-terminating. For example, the Swachh Bharat cess may be a good way of raising money for toilets and garbage disposal in cities, but if this is going to be a permanent tax in the system, it would be far better to raise the income tax rate by, say, 1 percent than to keep adding to cesses to existing taxes and complicating the tax filing and collection process.

We already have an education cess to fund education, and we have a cess on petro-fuels to finance road-building. And now we have the Swachh Bharat cess. Jaitley must avoid this needless building of cesses on top of existing taxes and instead make the tax system itself simple and transparent.

Fifth, if the previous four “do-s” are fairly non-partisan ideas that all finance ministers must embrace, the last “do” is ideological. Jaitley must simply make it clear what the NDA’s approach is to the role of government in economic life. All future Budget and non-Budget measures must emanate from this statement of ideology. This must be something the Prime Minister himself believes in and will help develop the political will for prosecuting policy, with or without legislation.

Being pro-poor is not a directional statement, for no government will say it is anti-poor or pro-rich; so making statements like these do not define the ideological position of the government. What does is its attitude to running commercial enterprises, its belief in how subsidies should be delivered (physically or in cash), or its attitude to competition and regulation, etc. While these points can be articulated even outside the Budget speech, since all ideologies are finally financed through the Budget, it is worth making the thinking in government clear. This, unfortunately, has not been the case with the Modi government. It’s time to make it clear to the world, or else “minimum government, maximum governance” is a meaningless phrase.

Five Don’ts for Jaitley

And now the don’ts. This is a fairly simple list, and needs no elaboration.

One, the Budget speech must be short. If it is largely about policy direction and most elements are discussed well before Budget Day, last-minute tax surprises can be ruled out. Length militates against focus and clarity in approach. Budget secrecy needs to be eliminated.

Two, there should be no retrospective proposals—ever. This builds credibility about intent, and avoids capriciousness. Even if it is assumed that some rogue corporations may have used loopholes in the law to avoid tax, it is the loophole that needs closing, not business certainty. Any tax or methodological changes in its calculation should always be prospective. Predictability is the key to building trust with business, not vicarious changes intended to correct past carelessness with the drafting of the law.

Three, draconian laws are no substitutes for a sensible compliance system that encourages proper reporting of incomes and tax dues—both for companies and individuals—and penalizes only aberrant behaviour and tax evasion, not honest mistakes. Tax laws based on bad economics will not be complied with merely by making punishments harder. Harsh punishments actually make it more difficult for the crooks to come clean. Similarly, black money in real estate—the Gangotri of Indian corruption—cannot be eliminated through harsh laws alone, but through more sensible taxation of real estate transactions, building a digitised database of land and property ownership, and lower stamp duties.

Four, Jaitley has to avoid treating the sale of public sector assets as part of annual revenues. Any non-recurrent source of receipts ought not to be seen as an income. They should be treated as one-off extraordinary receipts that should be shown separately and possibly used to reduce debt or for creating a corpus for generating long-term incomes with which to finance unavoidable subsidies.

Spectrum revenues ought not to be shown as one-time incomes, but amortised over the span of the spectrum licence.

Five, Budget extravaganzas ought not to become a source of false expectations. The reason why Jaitley’s third Budget is make-or-break is not because he can do much to turn the tide through his Budget proposals, but because the long-term build-up of expectations over Budgets has made Finance Ministers being pushed to “do something” or at least “announce something” in order to satisfy media requirements. Constant changes can—and do—create a new source of instability for policies. The best Finance Minister is the one who steadily de-emphasizes the importance of Budgets.

The “make” part of Budgets is about making good policy and directional choices, and the “break” part is about not doing anything to fix something that ain’t broke, or messing around with market forces that are working.

Get Swarajya in your inbox everyday. Subscribe here.