corporate tax

Explained: Why the Govt is Misleading Us on High Fuel Prices and Oil Bonds

The reason why doesn’t matter. The only thing that matters is controlling the narrative – Fabian Nicieza in Suburban Dicks.

Over the last few years, several government ministers have blamed the oil bonds issued during the era of the previous United Progressive Alliance (UPA) government, for the high petrol and diesel prices, which have prevailed for a while now.

The then oil minister Dharmendra Pradhan had tweeted in 2018 that: “The country and our OMCs [oil marketing companies} are also yet to recover from the shock of Oil Bonds worth Rs 1.4 Lakh Crores issued during the UPA regime.”

The finance minister Nirmala Sitharaman rblamed the oil bonds for the high prices of petrol and diesel, in a recent statement.  This is not true. I have explained this issue in great detail on earlier occasions. Nevertheless, I will try and offer a broader summary here, before getting on to the new points I want to make. 

Oil bonds were largely issued by the previous UPA government. This was done in order to compensate oil marketing companies, like Indian Oil, Bharat Petroleum and Hindustan Petroleum, for selling petrol, diesel, kerosene and domestic cooking gas, at a price which wasn’t monetarily feasible for them.

The argument offered by the National Democratic Alliance (NDA) government is that since interest has to be paid on these bonds and that these bonds have to be repaid, the government needs to charge a high excise duty on petrol and diesel. This leads to high petrol and diesel prices.

In that sense, the NDA government and you and me are paying for the sins of the UPA government. This argument is never made in as clear words as I am making it here. Things are left vague enough for people to fill in the gaps and make their own WhatsApp forwards.

As of March 2014, before the NDA government came to power, the total oil bonds outstanding stood at Rs 1,34,423 crore. By March 2015, this had come down to Rs 1,30,923 crore, which is where it has stayed up until March 2021.

This means that between end March 2015 and end March 2021, no oil bonds matured and hence, the NDA government didn’t need to repay a single rupee of oil bonds. Of course, interest had to be paid on these bonds. An interest of Rs 9,990 crore has to be paid on these bonds every year. This means, over a period of six years, between end March 2015 and end March 2021, the government has paid Rs 59,940 crore as interest on these bonds.

During the same period, it earned Rs 14,60,036 crore as excise duty on petroleum products. As the government told the Lok Sabha in early August this year: “Central excise duty is contributed largely by Petrol and Diesel.” So, excise duty earned on the sale of petrol and diesel makes up for a bulk of the excise duty earned on sale of petroleum products.

In total, during this period, 4.1% of the excise duty collected on petroleum products has gone towards paying interest on oil bonds. In 2020-21, this stood at just 2.7% (Rs 9,990 crore of interest against excise duty of Rs 3,71,726 crore earned on petroleum products).

In fact, if were to look at excise duty collected on just petrol and diesel, between end March 2015 and end March 2021, it amounts to around Rs 13.7 lakh crore. The interest paid on oil bonds amounts to 4.4% of this amount.

In 2021-22, the current financial year, Rs 10,000 crore worth of oil bonds are maturing and hence, need to be repaid. The interest that needs to be paid on the oil bonds during the year should amount to around Rs 9,500 crore. So, during 2020-21, around Rs 19,500 crore will be needed by the government to service these bonds.

In an answer provided to the Lok Sabha recently, the government had said that the total excise duty earned on petrol and diesel, between April and June this year, had stood at Rs 94,181 crore.

Given that, the second Covid wave was on during this period, and that it would have negatively impacted the consumption of petrol and diesel to some extent, it is safe to say that if excise duty on petrol and diesel continue to be where they are, the total collections this year can easily touch Rs 4 lakh crore. Of course, the collections on petroleum products will be even greater.

Rs 19,500 crore works to around 4.9% of Rs 4 lakh crore. So, the government is likely to spend one-twentieth of the excise duty earned on petrol and diesel, in servicing the oil bonds (both repaying maturing bonds and paying interest on the outstanding bonds).

The remaining bonds worth Rs 1,20,923 crore (Rs 1,30,923 crore minus Rs 10,000 crore worth of bonds maturing this year), will mature between November 2023 and March 2026.

The other argument that is being made is that the government needs to save money in order to repay these bonds in the years to come. It is worth clarifying here that the government meets the expenditure of a given year from the revenue earned during that year. Hence, bonds maturing in 2023, 2024, 2025 and 2026, will be repaid using taxes earned during that year. This nullifies the argument about the government having to save in order to repay these bonds.

Hence, the entire argument that the oil bonds have led to a situation where the government has had to charge a high excise duty on petrol and diesel, is totally wrong. In fact, as I have explained earlier, the reason for this lies in the fall of corporate tax collections.

In 2018-19, the total corporate tax or the income tax paid by corporates had stood at Rs 6.64 lakh crore. This fell to Rs 5.57 lakh crore in 2019-20. It fell further to Rs 4.57 lakh crore in 2020-21.

This fall was on account of the base rate of corporate tax being cut from 30% to 22% in September 2019. It can also be argued that Covid must have led to lower profits for corporates in 2020-21 and hence, lower corporate tax collections for the government.  

Data from the Centre for Monitoring Indian Economy tells us that in 2020-21, the net profit of listed corporates (more than 5,000 companies) increased by 120.3% in comparison to 2019-20. So, Covid didn’t impact profits among the listed corporates. While net profit went up by 120.3%, the corporate tax paid by these companies went up just 13.9%. 

Covid has negatively impacted smaller businesses and that must have impacted corporate tax collections to a certain extent. But a bulk of the fall in corporate tax collections seems to have come from a lower rate of tax. This has been compensated through higher excise duty on petrol and diesel.

In 2018-19, excise duty earned on petroleum products by the central government brought in Rs 2.14 lakh crore. This jumped to Rs 3.72 lakh crore in 2020-21, thanks to a higher excise duty on petrol and diesel.

The corporate tax cut was supposed to boost consumption and lead to an increase in corporate investment. But that hasn’t really happened. Expecting consumption to increase thanks to lower corporate taxes was kite-flying at its very best.

Consumption increases when people see the prospect of earning more money, not when corporate taxes go down. Investment, for a whole host of reasons, has been down in the dumps for close to a decade now,. I shall not go into these reasons in detail here, having dealt with this issue on multiple occasions in the past.

This has created a communication problem around high petrol and diesel prices for a government obsessed with managing the narrative.

In their book Nudge—The Final Edition, Richard Thaler and Cass Sunstein talk about the publicity principle, originally elucidated by the philosopher John Rawls. As Thaler and Sunstein write: “If a firm or government adopts a policy that it could not easily defend publicly, it stands to face considerable embarrassment, and perhaps much worse, if the policy and its grounds are disclosed [emphasis added].”

This is precisely the problem with the entire messaging around the issue of high petrol and diesel prices. The only reason for this is the high excise duty on petrol and diesel, in order to compensate for lower corporate tax collections.

The excise duty on petrol has gone up from Rs 9.48 per litre in October 2014 to Rs 32.90 per litre currently, a jump of close to 250%. A bulk of this increase of around Rs 10 per litre has happened in the last one year. A similar story has played out with diesel, with excise duty going up from Rs 3.56 per litre in October 2014 to Rs 31.80 per litre currently, a jump of close to 800%. (I would like to thank Chintan Patel for providing this information by using the central government notifications on excise duty on petrol and diesel).

Of course, this is not something that a narrative obsessed government can admit to. This would mean telling the world at large that the common man is being made to pay for lower corporate taxes. This has led to the entire narrative around oil bonds and they having to be repaid and interest having to be paid on them, and that leading to a higher excise duty on petrol and diesel, and hence, higher pump prices of fuel.

This is a narrative that can be easily sold on WhatsApp, given that most people don’t have the time to check the facts of any argument and buy anything that is sent to them over the world’s newest and the most happening university.

As Thomas Sowell writes in Knowledge and Decisions: 

“To exhort the individual citizen to make investments in knowledge comparable to those of lobbyists and political crusaders (both of whom have much lower costs per unit of personal benefit) is to urge him to behaviour that is irrational, if not physically impossible in a twenty-four hour day.”

This is something that the current government is making use of and projecting a narrative that wrongly blames the past government for high fuel prices.

As Thaler and Sunstein write: “Organizations of all forms should respect people, and if they adopt policies that they could not and would not defend in public, they fail to show that respect. Instead, they treat citizens as tools for their own use or manipulation [emphasis added].”

This is precisely what is happening.

The interesting thing is that the government has given the more or less the right reason behind high fuel prices in an answer to a question raised in the Lok Sabha. As it said: “The excise duty rates on petroleum products are calibrated from time to time with the objective of generating resources for infrastructure and other developmental items of expenditure, taking into account all relevant factors and keeping in view the prevailing fiscal situation.”

Every government has the right to tax the citizens in different ways. This answer tells us precisely that. Of course, explaining the rationale behind the tax is not always that straightforward.

Petrol and Diesel Prices are High Due to Lower Corporate Taxes, Not Because of Oil Bonds

Life is what happens between WhatsApp forwards.

Yesterday evening, a friend from school WhatsApped a doubt he had. He wanted to know if petrol and diesel prices were high because the Narendra Modi government had to repay oil bonds, which had been issued by United Progressive Alliance (UPA) government more than a decade back.

To repay these oil bonds, money is needed. This has led to significantly higher central government taxes on petrol and diesel, which has in turn led to higher pump prices.

However convincing the argument may sound, it’s wrong. 100% wrong. And I have been saying this for a few years now.

Of course, my saying this hardly makes a difference, given that every time petrol and diesel prices rise, WhatsApp starts buzzing all over again with forwards blaming oil bonds issued by the UPA for high petrol and diesel prices. Currently, the price of petrol is more than Rs 100 per litre in several parts of the country.

This high price is on account of a higher excise duty collected by the central government in order to compensate for a fall in corporate tax collections. In that sense, you and I are bearing the cost of lower corporate taxes, in the form of a higher price of petrol and diesel. 

Let’s try and understand the issue of high petrol and diesel prices, and why things are the way they are, in some detail.

1) Crude oil prices have risen between last year and now. In June 2020, the average price of the Indian basket of crude oil was at $40.63 per barrel. As of June 16, 2021, the price was at $73.18 per barrel. Clearly, this is one reason behind the rise in petrol and diesel prices, but this isn’t the only reason, and not even the main one.

2) Before getting into any other detail, let’s understand what oil bonds are. These bonds were issued by the UPA government to the oil marketing companies (Indian Oil, Bharat Petroleum, Hindustan Petroleum), for the under-recoveries (the difference between the administrative price and the cost) they suffered when selling petrol, diesel, kerosene and domestic cooking gas, below their cost. This happened up until 2009-2010. Officially, these bonds are referred to as special securities issued to oil marketing companies in lieu of cash subsidy.

Instead of compensating companies immediately for the subsidy offered by them, by giving them money, the government gave them oil bonds, which would pay annual interest and mature a few years down the line. By doing this, the government expenditure during those years didn’t go up. This helped control the fiscal deficit in those years, when oil bonds were issued. Fiscal deficit is the difference between what a government earns and what it spends.

3) Of course, these bonds would mature over the years and the government of the day would have to repay them. And that would need money.
So what is the value of these bonds which the government still needs to repay?  In a question raised in the Rajya Sabha in December 2018, the government had said: “The current outstanding balance on account of Government of India (GoI) Special Bonds issued to the Public Sector Oil Marketing Companies (OMCs) in lieu of cash subsidy is about Rs 1.30 lakh crore.”

So, two and a half years back, the value of the outstanding oil bonds had stood at around Rs 1.30 lakh crore. What’s the latest number? Take a look at the following table. It has been sourced from the latest government budget. It lists out the different oil bonds that are still to be repaid, with their maturity dates.

Source: https://www.indiabudget.gov.in/doc/rec/allrec.pdf

What does this table tell us? It tells us that as of March 2021, the total outstanding oil bonds issued by the government stood at Rs 1,30,923 crore. Or the same as what the government had told the Rajya Sabha in December 2018.

4) In fact, the amount of outstanding oil bonds has barely changed during Modi government’s tenure. Look at the following tabled sourced from the 2014-15 budget, presented in July 2014, after Narendra Modi became prime minister.

Source: https://www.indiabudget.gov.in/budget2014-2015/ub2014-15/rec/annex6e.pdf

As of March 2014, the total outstanding oil bonds stood at Rs 1,34,423 crore. Two different oil bonds with maturity amounts of Rs 1,750 crore each, matured in 2014-15, on March 7, 2015, and March 23, 2015, respectively. This brought down to the total outstanding oil bonds to Rs 1,30,923 crore, and which is the current outstanding amount as well.  

The point being that the government hasn’t had to repay any outstanding oil bonds since March 2015. Of course, it has had to pay an interest on these oil bonds, like it does on all other bonds.

How much is this interest? As the government told the Rajya Sabha in December 2018: “The annual aggregated amount of Rs 9,989.96 crore was paid every year during 2015-16 to 2017-18 and the similar amount is required to be paid in the current financial year.”

Given that, the outstanding amount of oil bonds didn’t change through 2018-19, 2019-20 and 2020-21, the government would have paid the same amount as interest in each of these years, as it did during 2015-16 to 2017-18.

How does the situation look in 2021-22, the current financial year? As can be seen from both the tables (I know the tables are not very clear. If you really want to verify the data, the source of the tables is available just below them. All you need to do is click), Rs 5,000 crore of bonds are due to be repaid on October 16 and November 28, respectively, later this year. This amounts to Rs 10,000 crore in total.

Over and above this, interest needs to be repaid on the outstanding bonds. Given that Rs 10,000 crore worth of bonds of the total Rs 1,30,923 crore of oil bonds, will be repaid during this financial year, the interest to be paid on the remaining bonds will be less than Rs 9,989.96 crore that the government has been paying year on year. A back of the envelope calculation tells us that the interest to be paid this year should amount to around Rs 9,500 crore.

Hence, in total, the government needs Rs 19,500 crore to repay oil bonds as well as pay interest on them during 2021-22. When it comes to government finances, this is small change.

5) If we look at the excise duty collected on petroleum products over the years, data from Petroleum Planning and Analysis Cell tells us that it stood at Rs 99,068 crore in 2014-15, the financial year in which Narendra Modi was sworn in as prime minister.

The number reached Rs 2,23,057 crore in 2019-20. It touched Rs 2,35,811 crore between April and December 2020, the first nine months of 2020-21. Given this, it would have crossed Rs 3,00,000 crore during 2020-21.

In 2021-22, the central government expects to collect more than Rs 3,00,000 crore through excise duties on petroleum products. A look at this year’s budget tells us that the government hopes to collect Rs 74,350 crore on special additional duty of excise on motor spirit(petrol) and Rs 1,98,000 crore through duty of excise on motor spirit and high-speed diesel oil (road and infrastructure cess). Just this adds to close to Rs 2.75 lakh crore.

Over and above this, one needs to pay a basic excise duty on every litre of petrol and diesel purchased, and there is an agriculture infrastructure and development cess to be paid as well. Clearly, this year, the government will earn more than Rs 3 lakh crore from different kinds of excise duties on petroleum products.

From February 2, 2021, the total excise duty on petrol and diesel has stood at Rs 32.90 per litre and Rs 31.80 per litre, respectively. The total central excise duties on petrol and diesel have been rising since 2014. They had stood at Rs 10.38 per litre and Rs 4.52 per litre in March 2014.

In fact, even in April 2020, they had stood at Rs 22.98 per litre and Rs 18.83 per litre, respectively.

Between April last year and now, the petrol price is higher by close to Rs 10 per litre just because of higher central government taxes on it. When it comes to diesel, it is higher by close to Rs 13 per litre because of this.

6) There is another small reason for higher prices as well. The state government taxes on petrol and diesel are ad valorem, that is they are a certain percentage of the price charged to dealers plus the excise duty of the central government plus the dealer commission on every litre of petrol and diesel sold.

Take a look at the following table, which has the detail for petrol sold in Delhi.

Source: https://www.bharatpetroleum.com/pdf/MS_Webupload_16.06.2021.pdf.

The price of petrol charged to dealers in Delhi by Bharat Petroleum was at Rs 37.68 per litre as on June 16. On this there was an excise duty charged by the central government of Rs 32.90 per litre along with a dealer commission of Rs 3.80 per litre. This adds up to Rs 74.38 per litre.

On this, the Delhi government charges a value added tax of 30%, which amounts to Rs 22.32 per litre. This leads to a retail selling price of Rs 96.70 per litre (Rs 74.38 plus Rs 22.32) in Delhi.

Like, the Delhi government, other state governments also charge a value added tax or a sales tax on petrol and diesel sold in their respective territories. The 30% tax charged by the Delhi government is ad valorem. Hence, if the petrol price charged to dealers goes up as oil price goes up, the tax collected by the Delhi government also goes up.

Over and above this, when the central government increases the excise duty on petrol, the tax collected by the Delhi government (and all other governments) goes up because the state government charges a value added tax on dealer price plus excise duty plus dealer commission.

Hence, every time you and I buy petrol or diesel, we are paying a tax on tax. This is an anomaly that needs to be set right. And state governments need to charge a sales tax just on the dealer price and commission, and not on the central government excise duty as well.

7) A major reason for the central government implementing a high excise duty on petrol and diesel, lies in the fact that the government’s tax revenues as a proportion of the size of the Indian economy, measured by the gross domestic product (GDP), has been falling over the years.

Look at the following chart. It plots the ratio of gross tax revenue earned by the central government as a proportion of the GDP.


Source: Centre for Monitoring Indian Economy and Controller General of Accounts.

What does this chart show? It shows that the gross tax revenue as a percentage of the GDP reached an all-time high of 12.11% in 2007-08. The gross tax revenue was at 11.22% of the GDP in 2017-18 and fell to 10.25% of the GDP in 2020-21.

The recent fall has been more because of a fall in corporate tax collections. In 2017-18, the corporate tax collections amounted to a total of 3.34% of the GDP and fell to 2.32% of the GDP in 2020-21. This was despite the listed companies registering bumper profits during the financial year.

Corporate taxes have come down primarily on account of the base tax rate being cut from 30% to 22% in September 2019 and to 15% from the earlier 25% for new manufacturing companies.

In absolute terms, the total corporate tax collected in 2019-20 had stood at Rs 5.57 lakh crore. It fell to Rs 4.57 lakh crore in 2020-21, thanks to lower tax rates. The collections of the goods and services tax have also not gone along expected lines.

To compensate for this to some extent, the government has had to increase the excise duty on petroleum products. Hence, it is only fair to say that the cost of lower corporate tax rates for the government, is being borne by citizens in the form of higher petrol and diesel prices. There is no free lunch, as I keep reminding.

To conclude, while the revenue earned by the government can vary, its expenditure doesn’t. It usually goes up year on year. In 2017-18, the total expenditure to GDP ratio stood at 12.53%. This jumped to 17.47% in 2020-21. Of course, 2020-21, could very well be an anomaly given that the size of the economy (GDP) contracted.

Nevertheless, the expenditure in 2019-20 had also stood at a higher 13.20% of the GDP, while the gross tax collections fell. And someone had to pay for this. 

Personal income tax comes to Narendra Modi govt’s rescue as corporate tax falls

Earlier this week, the government released some interesting data on direct taxes which essentially are composed of corporate taxes, personal income tax. They also include tax collected through the income tax amnesty schemes launched by the governments over the years.

How have these taxes done over the years? Has the Narendra Modi government managed to collect more direct taxes than the earlier government’s (as is often said)? The recently released data provides the answers.

Take a look at Figure 1. It basically plots the direct taxes to the GDP ratio over the years.

Figure 1:

Tax to GDP

Source: http://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf

 

What does Figure 1 tell us? It tells us very clearly that the direct taxes collection as a proportion of the GDP, has remained flat over the last few years, including the three years of the Modi government. It also tells us very clearly that whenever a politician talks about the collection of direct taxes (or for that matter any other tax) going up, it should be in the context of the size of the economy (i.e. the GDP).

If that is not the case, then he or she is clearly bluffing or does not understand how taxes are reported. As I said earlier, the direct taxes are comprised of personal income tax, corporate tax and other direct taxes. First and foremost, let’s take a look at how things look if we ignore the other direct taxes. This is important for the year 2016-2017, when the government managed to collect a significant amount of tax, through two income-tax amnesty schemes, one launched before demonetisation, and one after it.

Figure 2:

Net direct tax

Source: Author calculations based on data taken from http://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf

Unlike Figure 1, which curves up at the end, Figure 2 is more flattish, once we adjust for the other direct tax. This matters in a year like 2016-2017, when the government collected Rs 15,624 crore as other direct tax, much of which was collected from income tax amnesty schemes. Once adjusted for this, the direct taxes to GDP ratio in 2016-2017 falls to 5.49 percent. In 2015-2016, it was at 5.46 percent of the GDP. This is much lower than the 6.30 percent achieved in 2007-2008. Hence, the direct taxes to GDP ratio has fallen over the years.

It is important to take a look at how does the situation look for corporate tax and personal income tax, as a proportion of the GDP, the two most important constituents of direct taxes. Let’s take a look at Figure 3, which plots the corporate income tax as a proportion of GDP.

Figure 3:

Corp tax

Source: Author calculations based on data taken from http://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf

Figure 3 tell us very clearly that corporate income tax to GDP ratio has been falling over the years. It has fallen from a peak of 3.88 percent of the GDP in 2007-2008 to 3.19 percent in 2016-2017. One reason for this has been the slow growth in corporate earnings over the last few years. Finance Minister Arun Jaitley has talked about lowering corporate income tax rates, but that hasn’t really happened. Whether lower taxes lead to higher collections remains to be seen.

Now let’s take a look at Figure 4, which plots to the personal income tax to GDP ratio.

Figure 4:

personal tax

Source: Author Calculations based on data taken from http://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf

Figure 4 makes for an interesting reading. While, personal income tax to GDP ratio like the corporate tax to GDP ratio also fell, it has managed to recover over the years. Basically, the loss of income tax from the corporates has been covered by getting individuals to pay more income tax, on the whole. One reason for this lies in the fact that the number of individual assessees have risen at a much faster rate over the years, than the number of corporate assessees. And this jump has basically ensured that the tax collections of the Narendra Modi government have continued to remain flat. They would have fallen otherwise.

The column originally appeared on Firstpost on December 21, 2017.

Point blank: 7th Pay Commission recommendations will hit govt finances hard

rupee
The Seventh Pay Commission has recommended a 23.6% increase in salaries of central government employees, as well as pensions of retired central government employees. This largesse will cost the government Rs 1,02,100 crore in 2016-2017, the report estimates.

The report estimates that this increase will work out to 0.65% of the gross domestic product (GDP) in 2016-2017.  In comparison, the awards of the Sixth Pay Commission had worked out to 0.77% of the GDP.

The report points out that “while projecting the GDP for 2016-17, we assumed that the real growth rate of GDP will be 7.5 percent and inflation will be 4 percent in 2016-17.” This is perhaps a little overoptimistic, but let me not nit-pick.

Also, the 0.65% of the GDP number may be lower than what the number might eventually turn out to be because it does not take into account the impact of recommending one rank one pension for central government employees as well as para-military personnel.

Further, the trouble with expressing amounts as a percentage of the GDP is that it does not always show the correct picture. It is important to understand what will be the impact of the ‘extra’ Rs 1,02,100 crore on government finances.

In 2005-2006, the total government expenditure had stood at Rs 5,06,123 crore. A decade later in 2015-2016, the total government expenditure is projected to be at Rs 17,77,477 crore. This means an increase in expenditure at around 13.4% per year.

In 2005-2006, the total receipts of the government (less its borrowings) or what it earned, stood at Rs 3,59,688 crore. Ten years later in 2015-2016, the total receipts of the government(less its borrowing) is expected to be at Rs 12,21,828 crore. This means an increase in earnings at around 13% per year.

I am calculating these numbers so as to be make a rough projection for the receipts as well as the expenditure of the government in 2016-2017, the next financial year. Looking at the long-term trend we will assumethat for 2016-2017, the receipts of the government will go up by 13%, whereas its expenditure will go up by 13.4%. While the chances of things playing out exactly like this are low, but please indulge me, in order to understand the broader point I am trying to make.

Hence, the government receipts for the year 2016-2017 are likely to be at Rs 13,80,666 crore (1.13 times Rs 12,21,828 crore, the projected receipts for 2015-2016). The government expenditure for the year is likely to be around Rs 20,15,389 crore (1.134 times Rs 17,774,77 crore, the projected expenditure for 2015-2016).

This expenditure for 2016-2017 does not include the Rs 1,02,100 crore cost of the recommendations of the Seventh Pay Commission. We need to add this.

Hence, the total expenditure is likely to be at Rs 21,17,489 crore. Against this, the government will earn Rs 13,80,666 crore as receipts.

This means that the government will run a fiscal deficit of around Rs 7,36,823 crore. Fiscal deficit is the difference between what a government earns and what it spends. In 2015-2016, the fiscal deficit is projected to be around Rs 5,55,649 crore or 3.9% of the GDP. So what will the fiscal deficit work out to be in 2016-2017 as a proportion of the GDP?

For 2015-2016, the nominal GDP(i.e. not adjusted for inflation) is assumed to be at Rs 14,108,945 crore. The Seventh Pay Commission assumed a real GDP growth of 7.5 percent and an inflation of 4 percent in 2016-17. We will stick to the same numbers and hence assume a nominal GDP growth of 11.5% (7.5% real GDP growth plus 4% inflation).

This would mean the nominal GDP in 2016-2017 would be Rs 15,731,474 crore (1.115 times Rs 14,108,945 crore, the GDP projected for 2015-2016). Hence, the fiscal deficit as a proportion of GDP for 2016-2017 would work out at 4.7% (Rs 7,36,823 crore expressed as a proportion of Rs 15,731,474 crore).

This means the Seventh Pay Commission recommendations if accepted, will push up the fiscal deficit to 4.7% of the GDP from this year’s 3.9%. And this isn’t a good thing, given that the government is trying to achieve a fiscal deficit of 3.5% of the GDP by 2016-2017 and 3% of the GDP by 2017-2018.

The broader lesson here is that if things continue in the way they are now the Seventh Pay Commission recommendations are likely to screw up the government finances big time by pushing up the fiscal deficit.

The way to avoid this situation is by increasing receipts or cutting down on expenditure. If salary expenditure goes up, then other productive expenditure like capital expenditure may have to be cut. And that can’t be good news for the economy.

Further, if the government believes in good economics it needs to shut down loss-making public sector enterprises, but that is unlikely to happen.

On the receipt side the option to raise income tax rates is always there. But that will be a very unpopular move. The finance minister Arun Jaitley in his last budget speech had said: “I, therefore, propose to reduce the rate of Corporate Tax from 30% to 25% over the next 4 years.” So if corporate tax rate is likely to be brought down, that doesn’t leave the government with many options in order to increase its receipts. Perhaps, we may see the service tax rate being raised further in the next budget.

We may also see the government resorting to more standalone surcharges and cesses, like it already has in the form of Swacch Bharat cess. The government will also have to fasten the pace of disinvestment, something most governments haven’t shown interest in doing up until now.

Also, this year the government benefitted substantially from lower oil prices. It captured a major part of the gains by raising excise duty and not passing on the gain to consumers. Next year, any incremental help from falling oil prices may not be available.

All in all, the recommendations of the Seventh Pay Commission, if accepted, will not work out well for the government finances, unless it chooses to change the current way of doing things. Further, it is best that the government instead of accepting an increase of 23.6%, settles at a lower number between 12-15%, to control the damage on its finances.

The government as expected remains optimistic. As the finance secretary Ratan Watal put it: “We will handle this.” I really hope it does.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost.com on Nov 20, 2015