The Interim Budget on February 16 and subsequent developments have helped unravel the fiscal conundrum to a considerable extent. The Interim Budget has confirmed the fact that the deficit situation is far from comfortable, if not alarming, and there is very little room for manoeuvring fiscal policy to provide additional stimulus to the economy.

The revised estimate of expenditure for 2008-09 in the Interim Budget is higher than the Budget estimate by almost 20 per cent and if the off-Budget liabilities are included, it is higher by 32.8 per cent. The two supplementary demands for grants have made a provision of Rs 292,891 crore (Rs 2,928.91 billion) including off-Budget liabilities, which is higher than the Budget estimate by 39 per cent.

Thus, actual government expenditure could go up by another Rs 44,800 crore (Rs 448 billion) and the actual deficit would be substantially higher than even the revised estimates reported in the Interim Budget.

I have argued in these columns that much of the additional expenditure was made necessary mainly because of under-provision for subsidies, pay revision, loan waiver and NREGP in the 2008-09 Budget. This was partly deliberate -- to show conformity with the FRBMA even as, in actual practice, there has been a slippage.

In addition, the government decided to enhance outlays for flagship schemes. Whatever be the cause, two things are clear. First, be it by design or otherwise, additional expenditures will provide stimulus. Even the fertiliser and oil subsidies provide stimulus for fertiliser and oil companies, in the absence of which they will have to borrow from the banking system to keep up their activities. Second, additional expenditures and tax cuts have considerably added to the fiscal deficit in the country. 

Barely a week after the presentation of the Interim Budget, the government came out with the third fiscal stimulus package in which further tax cuts costing Rs 29,100 crore (Rs 291 billion) or about 0.5 per cent of GDP were announced. The service tax was cut by two points from the prevailing level of 12 per cent and excise duty was reduced by a similar magnitude for items presently subject to 10 per cent.

The reduction in the tax rates a few days after the Interim Budget raises curious questions. If, indeed, the government thinks that this was necessary, why was it not announced in the Budget? If, on the other hand, it was a question of propriety, then how is it appropriate now? Perhaps, the government decided to cut the rates after the Opposition and media criticised it for not doing enough in the Budget. Now that it has been done, the Opposition cannot criticise the measure.

There are questions on the appropriateness of the measure in the already strained fiscal scenario. The effectiveness of cuts in excise duty and service tax in providing a demand stimulus is doubtful -- first, the tax cuts should result in price cuts and then, these should translate into higher demand in the situation of falling incomes. Furthermore, there will always be dissatisfaction when the tax cuts are reversed.

Many, in fact, believe that fiscal stimulus is better served by expenditure increase rather than tax cuts not only because the impact is direct but also because it can be better targeted. Hopefully, the reduction in excise duty and service tax rates will facilitate the unification of the two taxes for levying the GST at a reasonable rate when implemented. In any case, the entire episode of announcing tax cuts just after a week of presenting the Interim Budget points to the government's lack of clarity in combating the slowdown.

The market is clearly worried about the size of the deficit as well. It is not just the pressure on interest rates and financial crowding-out that the massive borrowings entail. Today's deficit also implies taxes tomorrow. The tax cuts are estimated to reduce the revenue by 0.5 per cent of GDP and that will increase the central government's cash deficit to 6.5 per cent of GDP for the current year.

In addition, the off-Budget liabilities will add another 2.5 per cent and the deficit of the central government alone could be close to 9 per cent. With the additional accommodation of 0.5 per cent of GSDP in states' fiscal deficit, the consolidated deficit including off-Budget liabilities could be an all-time high of 12 per cent. Not surprisingly, Standard & Poor's has revised its outlook on India to 'negative.'

The decision to transfer Rs 45,000 crore (Rs 450 billion) from RBI's MSS cash account to government cash account by March 31 this year, besides increasing government's debt, will monetise the deficit by that amount. The government is expected to go to the market with an additional market borrowing of Rs 91,000 crore (Rs 910 billion) and that will put further pressure on the interest rates. 

The simple point is that there is no room for providing fiscal stimulus and any further stimulus will only add to the woes of the private sector and make it that much more difficult for its revival. With the household sector having a financial saving of just about 11 per cent of GDP; with government borrowing at more than that amount; and with government saving declining sharply, the private sector is made to fend for itself as far as credit availability is concerned. How can one reasonably expect the interest rates on corporate borrowings to decline in such an environment?

Unlike in the OECD countries, where the stimulus strategy will have to be led by fiscal policy, in India monetary policy will have to lead the revival. There is still some room for reducing the CRR and repo and reverse repo rates, but the RBI has to act decisively in whatever measure it takes.

The RBI has been far too hesitant and missed an opportunity in the third quarter monetary policy announcement. Merely stating that it will act at the appropriate time will not improve market sentiments. Besides, monetary policy has a longer time lag before it impacts on the economic system, particularly when the sentiment is far from comfortable.

With the third quarter GDP growing at a much slower rate, the outlook is much worse than what was officially acknowledged. This is the appropriate time for the RBI to act and hopefully, it will.