Explained: How the Union Budget is prepared

Udit Misra
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Finance minister Nirmala Sitharaman along with MoS Anurag Thakur at the halwa ceremony ahead of the Union Budget (File/ Twitter/ Ministry of Finance)

On February 1, Finance Minister Nirmala Sitharaman will rise in the Lok Sabha to present the Union Budget for the next financial year (2020-21). The Budget comes at a crucial time because the Indian economy has been steadily losing its growth momentum, and as such, the exercise of making the Budget is not easy.

That’s because the FM is looking at the entire spectrum of competing choices before her.

Some believe the Budget should focus on increasing government expenditure to spur economic growth. Others opine the exact opposite and point towards the rising fiscal deficit to assert that the government has already been spending too much. Still others point to the increasing gap in actual revenues accruing to the government, thus severely constraining its ability to spend.

There is also a growing concern about the credibility of Budget numbers and many argue that the first thing to do is to reduce the gap between the numbers projected in a Budget and what actually happens.

So how does an FM go about deciding what to do in the Budget? Raise taxes or lower them, raise government expenditure or lower it?

The starting point for a better understanding of what the FM can and should do is to understand how exactly a Budget is made. In other words, what are variables an FM has and what are the constraints she faces as she goes about preparing the Budget.

What is the starting point of a Union Budget?

N R Bhanumurthy, Professor at the National Institute of Public Finance and Policy (NIPFP), explains that the nominal gross domestic product (GDP) is the most fundamental building block of a Budget. [The nominal GDP is nothing but the value of all goods and services produced in the country at current market prices.]

“I always call nominal GDP the Lord Ganesh of the Budget, “ says Bhanumurthy. That’s because without knowing the absolute amount of nominal GDP for the current year, there is no way one can make the Budget for the next year.

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The FM is looking at the entire spectrum of competing choices before her. (File Photo)

“The Budget is the financial plan of the Union government for the next financial year. Essentially, it is an exercise in determining how far can the government exceed its expenditure over its revenues, given that the government is required to meet a fiscal deficit target that is provided by the Fiscal Responsibility and Budget Management Act (FRBM) Act,” says Bhanumurthy.

The fiscal deficit is the level of borrowing that a government does in a year. Targets for the fiscal deficit are set in terms of “percentage of nominal GDP”. In other words, if the nominal GDP is higher, the government can borrow more money (in absolute terms) from the market to fund its expenditure.

But without knowing the nominal GDP for the current year, the government cannot project what the nominal GDP is likely to be in the next financial year. Without clarity about the absolute level of nominal GDP, the government can neither estimate the absolute amount of fiscal deficit it must not breach nor can it estimate how much revenues it will get in the coming year. And without knowing the absolute revenues it is likely to get, it cannot promise or decide how much it should spend and on which scheme. Here's what former FM P Chidambaram has to say on Union Budget 2020

So the first thing to understand is the importance of nominal GDP. It is the nominal GDP growth that an FM targets, not the real GDP growth.

But isn’t the “real GDP” the most important variable? After all, everyone quotes the growth rates of real GDP, rarely the nominal GDP.

It is true that real GDP is the variable that is used for comparing the economic growth of countries most of the time. And there is a good reason for it. The real GDP growth is derived by subtracting the inflation rate (that is the rate at which prices are increasing in an economy) from the nominal GDP growth rate. By doing this, real GDP growth provides a better picture of economic growth between countries that may have differing levels of inflation.

Suppose in an economy that only produces apples, the total number of apples do not increase from Year 1 to Year 2. However, the prices of apples in this economy grow by 10%. In such a case, nominal GDP growth would be 10% but all of it would be due to the rise in prices, not actual production. Real GDP growth (in this case, 0%) would show this lack of production growth as it would remove the effect of inflated prices from nominal GDP.

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But contrary to public perception, no one targets the real GDP growth rate. Bhanumurthy explains: “The real GDP is a derived number. The government, through its fiscal policy, targets nominal GDP and the RBI, through its monetary policy, targets inflation rate. The interplay of these two variables provides real GDP growth”.

For the purposes of the budget-making, it is the nominal GDP number that is the actual observed data. It is with this data as the foundation that the whole edifice of the next year’s Budget is constructed.

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The customary halwa ceremony ahead of the Budget

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So, what are the key steps of Budget-making?

Step 1: The Finance Ministry has to first ascertain the nominal GDP of the current financial year.

Step 2: Then it has to take this number and “project” the likely nominal GDP for the coming year.

In the “Budget at a Glance” document that is supplied at the time of the Budget presentation, the government mentions this calculation.

For instance, in the Budget for 2019-20, that was presented in July, the government stated, “GDP for BE 2019-2020 has been projected at Rs 2,11,00,607 crore assuming 12.0 % growth over the estimated GDP of Rs 1,88,40,731 crore for 2018-2019 (RE)”.

In other words, the nominal GDP (the market value of all goods and services produced within the domestic boundaries of India) to be Rs 1,88,40,731 crore in 2018-19.

The Finance Ministry then assumed that this nominal GDP would grow by 12% in 2019-20 and as such arrived at the nominal GDP figure of Rs 2,11,00,607 crore for 2019-20, which is the current financial year.

Step 3: Given the nominal GDP, the government can look at the FRBM Act target and figure out the absolute level of fiscal deficit (or borrowings or the difference between the expenditure and revenues) that it can have.

Step 4: After having a sense of how the overall economy will do in the coming year, the next logical step for a government making the Budget is to figure out how much money would it get in terms of revenues.

The absolute amount of revenues that the government will get is calculated by looking at revenue buoyancy. A tax buoyancy of 1 means that if the nominal GDP increases by 12% in the next year, the tax revenues would also increase by 12%.

Step 5: By now, the government knows what its revenues are likely to be and maximum allowable fiscal deficit. Now it is the turn of determining the level of expenditure. The idea is to contain the level of total expenditure in such a matter that fiscal deficit is not breached.

Step 6: Once the government has the fix on the total expenditure, it can go about allocating the absolute amount of money it intends to spend on different schemes.

In the next article of this series, we will explain how a government “projects” the next year’s nominal GDP, how it calculates the tax buoyancies and why the Indian Budget numbers are increasingly being questioned.

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