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India's watershed election has laid the foundation for economic reforms – but now the real test begins.
On Thursday, the new government led by Narendra Modi will present its first budget, faced with the challenge of balancing its pro-growth agenda with the need for fiscal consolidation.
"The backdrop of weak growth makes it pertinent for the new government to come up with a holistic road map to improve the growth outlook. We believe the government needs to cut back on less effective redistributive polices and implement reforms that will boost productive investment and job growth," Morgan Stanley economists led by Chetan Ahya wrote in recent report.
Asia's third-largest economy is stuck in a rut with weaker consumption and stalled investments hindering growth. The economy expanded 4.7 percent in the fiscal year that ended March 31, with growth stuck below 5 percent for a second consecutive year.
It also faces persistently high fiscal deficits in part due to a large population and low per capita income levels, which limits the government's tax revenue base while increasing pressure to boost spending on subsidies.
Since coming into to power in late-May, Modi has lived up to his reputation as an effective administrator – recently hiking railway fares to improve the financial health of the state-run national rail operator, for example.
As a result, expectations that the government will deliver critical reform initiatives are high.
"We remain optimistic on the direction for fiscal consolidation. Tough decisions are likely to be made to prune unproductive and populist expenditure over the next few years. This will mark an important shift away from entitlement based consumption growth towards more private sector-led investment growth," Radhika Rao, economist at DBS Group Research.
Reforms to watch out for
While investors have a long wish list for the budget, there are four reforms that would demonstrate the government's commitment to improving the country's long-term economic outlook, according to economists.
First, a timeline for the roll out of a goods and services tax (GST) and steps to ensure states' cooperation and compliance. The implementation of a GST is critical to improving revenues in the medium to long-run.
"One of the critical policy reforms that need to be taken up soon is the implementation of the GST Act. We believe this will help accelerate productivity growth in the manufacturing sector. Implementing the GST is likely to accelerate growth, boost exports and improve tax Collections," said Ahya.
India's tax revenue declined in recent years as a result of sluggish growth. Gross tax revenue declined from a peak of 11.9 percent of gross domestic product (GDP) in fiscal 2008 to 10 percent of GDP in 2014, according to Morgan Stanley.
Second, an aggressive target for the divestment of public sector enterprises – the proceeds from which can be channeled towards more productive investments.
"The favorable market environment provides a suitable backdrop for pursuing divestment of public sector enterprises. Stake sales in Coal India, Hindustan Zinc, Bharat Aluminium Company, Steel Authority of India, Rural Electrification Corporation, among others, are likely in the pipeline this year," said Rao.
Thirdly, a reduction in subsidies to bring down the budget deficit. Despite recent policies aimed at reducing fertilizer and fuel subsidies, India's subsidy bill has increased significantly over the past decade. Spending on subsidies rose to 16 percent of the budget in the fiscal year ended March 2013, up from 9 percent in 2004.
Finally, a more systematic and time-bound process to approve infrastructure projects to address supply-side concerns – an important factor in unleashing the country's growth potential.
"We believe that the government could announce the setting up of infrastructure funds, which would help in raising capital to meet the infrastructure needs," said Ahya.