The Budget for 2008-09 is being formulated in the background of a reasonably sound economy despite a downward revision in the growth prospects, particularly the deceleration in the manufacturing sector. Moderation in growth is seen from the slowdown in non-food credit from over 30 per cent last year to about 20 per cent so far this year. The infrastructure sector recorded a lower growth rate of 6 per cent during April-November this year from 8.9 per cent a year ago.

Nevertheless, the economy is expected to grow at over 8.5 per cent in 2007-08. The price situation is within the comfort zone though, as stated by the Reserve Bank, the non-revision of administered prices artificially suppresses it. The burden of not revising administered prices is on the fiscal deficit and in the case of petroleum products, off budget liabilities.

The major concern last year was the increasing prices of food items and these prices have stabilised. Increased domestic production and the import of food grains have eased the prices of food grains and edible oils.

There are, however, formidable external and domestic policy challenges and although not all of them can be met in the Budget, it is a signalling device. The international situation is far from being comfortable. The recessionary environment in the United States will pose problems.

Despite the attempt to diversify, the United States still continues to be a predominant source of export demands for many countries and naturally, whenever the United States sneezes, other countries catch cold.

Inflationary concerns have prevailed upon the Reserve Bank to maintain the status quo with regard to the interest rate and as the Federal Reserve has reduced the rate by 75 basis points, arbitrage opportunities have increased. With a further reduction by the Federal Reserve by another 50 basis points, there will be a flood in capital inflows. Managing external flows, pegging the exchange rate at the appropriate level and monetary management will continue to pose serious policy challenges.

On the fiscal deficit front, the Union government is well on course to achieving the FRBM target, though it is doubtful whether the target of phasing out the revenue deficit can be achieved. Indeed, there are concerns from significant off budget liabilities. If electoral consideration overwhelms the Budget formulation, the situation could worsen. There will be significant increase in expenditure liabilities from pay revision and with pressure to significantly increase allocation to various schemes.

An unplanned expansion of schemes for electoral reasons is a real risk. So far, despite much pressure, the finance minister has been able to contain the situation, thanks largely to the highly buoyant income tax revenues. The gross revenue from Central taxes increased by over 3.6 percentage points of GDP in 2007-08 over 2001-02 and even after devolving 0.7 points more to the state governments, this has helped to reduce the revenue deficit of the Centre by 2.8 percentage points.

Indeed much of the increase in income tax revenue during the last few years did not come about by changing the structure of the tax but by strengthening the information system. Therefore, there is no need to make large-scale changes in the structure of taxation.

Similar initiatives of strengthening the information system in Customs and excise duties and information sharing between the tax departments can go a long way in improving tax compliance. This would require that the task should be entrusted to a competent agency. When we have set the objective of moving over to the GST in April 2010, the possibility of pegging the rate of GST at a reasonable level depends on expanding the tax base and this requires that the scope for tax evasion be minimised.

This, however, does not mean that there is no scope for discretionary measures in this Budget. Indeed, electoral considerations may prompt changes in the tax structure and pattern of expenditure allocation.

Although there are speculations, the abolition of the earmarked surcharge is unlikely because the government will have to continue providing funds for education or highways. Similarly, personal income and corporate tax rates may also be expected to continue.

Indeed, one area where there is large-scale tax avoidance is in the tax treatment of charitable institutions and trusts. While genuine charities and research organisations deserve tax exemption, this provision has been thoroughly misused. One way to deal with this is to restrict tax exemption to the expenditures incurred on charity or research by these institutions. The economic environment provides scope for rationalising and reducing the peak import duty rates further.

The Budget for 2008-09 provides an opportunity to initiate preparatory steps for introducing the GST, which are long overdue. This involves rationalising excise duties and services taxes.

The most important measure that the Budget should take is to extend service taxation to all services and unify the rate with excise duty. Simultaneously, it could reduce the general rate of excise duty by two percentage points to 14 per cent. Extending the tax to all services will do away with discrimination between services and special interest group politics to keep some services out of the tax net, simplify administration and significantly reduce litigation.

A general taxation of services would require that only the "service" should be defined and not each of the taxed services, which, in the past, has provided enormous scope for litigation. Indeed, the expansion of excise duty exemption to the small-scale sector provided last year was retrograde from the viewpoint of keeping the GST base broad and any change in that direction this year may stir the hornet's nest.

Similarly, in the interest of keeping the tax base broad and minimising distortions, it is desirable to do away with various tax preferences, but that is not likely to happen.

The preparatory step for GST also includes rationalising excise duty rates. Unifying the tax rates is necessary. This entails that except for sumptuary items the tax rates should be unified at 14 per cent. In the case of sumptuary items such as cigarettes, the rate should have a GST component at a regular rate and a sumptuary component, which may be specific.

This would also provide an opportunity to convert specific duties on items such as cement to ad valorem rates. The seriousness of the government in introducing the GST in 2010 should be seen in the preparatory measures that the forthcoming Budget will initiate.

The author is Director, NIPFP.