Pitch Report | Markets want Budget to spend more, leave capital gains tax alone

The Union Budget team faces the need for faster fiscal consolidation over the medium term

In a month’s time, the government will present its budget for 2023-24, outlining measures that it will take to support the economy, markets and consumption. India’s equity markets have been the outperformer this year, riding on the hope that the economy would continue to weather the global turmoil and show resilience.

It is no surprise then that markets have a lot of expectations for the upcoming budget that will set the tone for next year’s performance. As such, the government’s spending intentions are critical for the private sector to gauge the demand in the economy.

In this regard, market participants have just four simple asks from the budget. They want the government to spend more on targeted high-multiplier sectors such as infrastructure, announce steps to boost rural demand and consumption, bring down the fiscal deficit to a manageable level and avoid tinkering with taxes that may hurt the market.

For Indian markets, the current fiscal year may have been choppy but compared with global peers, their performance has been resilient, even robust at times. Benchmark indices Sensex and the Nifty 50 have gained nearly 3 percent even as the S&P has lost a whopping 21 percent so far in FY23. Most other emerging markets, from Hong Kong to Brazil, have also lost heavily during the year and may end it on a weak note.

Challenges such as liquidity tightening by central banks, stubbornly high inflation globally and a grim outlook for growth amid fears of a recession in developed countries have kept investors worried. But India has been a bright spot, mostly driven by hopes of robust growth that will trump the rest of the world in the next year as well.

“We do not expect the developed world phenomenon of rising rates impacting growth through a slowdown in housing & corp spending to happen in India,” wrote analysts at Jefferies India Pvt Ltd in their outlook note. “Corporate sector leverage is at a cyclical low & corp spending will likely rise. India's GDP growth should, at best, witness a marginal slowdown due to rising rates,” the note said.

For the market, the main expectation remains that as monetary policy tightens, fiscal policy would do the heavy lifting. With the wounds of the pandemic now healed, the government’s job is to help the economy get back to a sustained growth rate of 6-8 percent. For this, the private capex cycle must turn upwards. While the initial signs such as a surge in credit growth and capacity utilisation reaching three-year high are encouraging, the government needs to increase capital expenditure to boost animal spirits in the economy.

For 2022-23, the Centre had set a record capex target of Rs 7.5 lakh crore, up 35 percent from the budget estimate for 2021-22. Market participants would want this increased to Rs 10 lakh crore for the next year. “What is very interesting about the way we are going about capex is that one, the allocations are obviously increasing over time, and they are staggered. The general bias to allocate more and build up capacity to spend is going to be there,” Rahul Bajoria, chief India economist at Barclays said in an interview last month.

Indian companies may not be enthused to build factories and increase capex if they are unsure about demand. Rural demand has been fumbling, evident through the volume growth deceleration seen by fast-moving consumer goods (FMCG) companies this year. The surge in inflation has hurt rural spending power more owing to stagnant wages. Rural distress is also evident from the fact that the government has spent more than budgeted on its flagship rural employment scheme for the past three years.

The rural employment guarantee scheme had seen a drop in demand as 8.05 crore households asked for jobs in 2021-22, roughly 6 percent lower than the previous year. Even in 2022-23 so far, demand has been from 6.24 households, lower than the corresponding period last year. That said, the demand for jobs is still higher than pre-pandemic levels, indicating that the wounds are deep.

The market clearly wants the government to continue to support the consumption story. One way is to increase direct benefit transfers that ensure money in the hands of the rural consumer. Another way could be tweaking direct taxes, but this is far trickier.

Much as the market wants the government to spend, it also wants it to keep a close eye on its fiscal deficit. Here, the tax buoyancy seen in goods and services tax (GST) collections offers considerable comfort to the government. Most economists believe that the government would be able to target a lower fiscal deficit of 5.8-6.0 percent of GDP for FY24. To achieve the same could be tricky given that tax collections have surged also due to inflation. In the next financial year, inflation is likely to moderate and GST collection growth could be more modest owing to this as well as this year’s high base. Compared with the current year’s budgeted 18 percent growth in taxes, expectations for next year’s are likely to be more modest, around 12 percent. Economists at Kotak Institutional Equities expect tax revenues to moderate next year and gross tax collections to grow 8 percent. “We expect tax revenue growth to moderate as nominal GDP growth slows to 10-11% (from 15-16% in FY2023E),” they wrote in a January 2 note.

Therefore, the government needs to give a glide path to show conviction on its fiscal prudence commitment. The fiscal responsibility and budget management act requires the government to bring down the deficit to 4.5 percent by FY26 and the government has time and again reiterated its commitment to the same.

On expenditure, the government’s latest move to stop the pandemic era additional free food subsidy would prune its outgo considerably. “The government should save ~0.15% of GDP in the last quarter of FY23, or ~0.6-0.7% of GDP (annualized) owing to the discontinued programme, while incurring around 0.04% of GDP in FY24 in terms of lost revenues,” economists at Nomura wrote in a December 27 note.

Markets loathe taxes as they eat into individual returns and earnings of companies. Tax tweaks or even sweeping changes have historically triggered unpleasant reactions from the markets. While it may look unfair expecting the government to increase spending without seeking additional income, the markets do not want any changes in the current tax policy. Specifically, investors want tax on capital gains to be left alone amid fears that the buoyancy in Indian markets post pandemic may encourage the taxmen to come after them for a share.

Tax consultants point out that the government’s tweaks or big changes in the past have been driven largely by the compulsion to incentivise investment in a particular financial product. Currently, bank deposits have fallen out of favour due to their negative real interest return amid inflation. Any measure from the government to incentivise investment flow towards bank deposits by increasing the tax burden on capital market instruments may not be taken well by the markets. “There is enough uncertainty in the market and though we have seen better performance than other global markets, it is better for the government to leave any tax changes for now. Increasing the tax burden for the markets on an immediate basis will kill the sentiment,” said an equity fund manager, requesting anonymity.

Markets fear that the government may change the holding period of equity to three years from the current one year for gains to qualify as long-term capital gains. What this may do is bring gains of up to three years under short-term capital gains tax which is a flat rate of 20 percent. Another measure that may spook markets is making long-term capital gains tax in line with personal income tax rates. This could increase tax outgo for investors.