# **Box 2: Assumptions Underlying Debt/Deficit Projections**

The **initial level of general government debt** is 86 percent of GDP, its level at the end of 2002/03 plus 0.8 percent of GDP proposed for bailouts in connection with UTI, IDBI and IFCI.

The **primary deficit** of the general government stays at 3.5 percent of GDP in the _base case_ , a little below its average level over the past six years.<sup>57</sup> In the _reform scenario_ , the primary deficit goes down linearly from 3.5 percent of GDP to 0.2 percent by the last year. This comes from raising central government revenue by 1.7 percentage points and state revenues by 0.7 percentage points by the terminal year; eliminating the petroleum subsidy of 0.4 percent of GDP; and eliminating the portion of the power subsidy already included in the state government budgets (0.5 percent of GDP out of a total of 1.5 percent of GDP, see below). It is assumed that taxes rise as a result of eliminating exemptions, widening the tax net to include services and implementing the state VAT.

**Food and fertilizer subsidies** amount to about 1.4 percent of GDP.  Under reforms, 0.5 percent of GDP is maintained as a minimum social safety net; the balance of 0.9 percent is phased out while productivity-enhancing investments in agriculture, such as rural infrastructure and agricultural R&E, increase by the same amount.  There is no change in the _base case_ .

**SEB losses** (portion not included in budget) remain 1 percent of GDP in the _base case_ and go linearly to zero by the terminal year as a result of aggressive power sector reforms in the _reform scenario_ .

**Divestment receipts** remain 0.5 percent of GDP in both scenarios.

**Guarantees** (contingent liabilities, CL) accumulated as of end 2002/03 devolve at the rate of 1 percent of GDP per year in both scenarios.

**Growth, real interest rates** and **inflation** **_based on the GDP deflator_** (percent) are as follows<sup>58</sup> :

||2003/04|2004/05|2005/06|2006/07|
|---|---|---|---|---|
|Growth (base)<sup>59</sup>|5.5|5.0|5.0|5.0|
|Growth (reform)|5.5|7.0|7.5|8.0|
|Real interest rate (both)|6.3|6.2|6.3|6.4|
|Inflation(both)|2.0|2.0|2.0|2.0|

A comment is in order on the real interest projection, which is common to both scenarios. The real interest rate which emerges will depend upon the nominal interest rate and inflation. The nominal interest rate will be determined by a weighted average of the interest rate on the preexisting debt stock and that on new borrowings. The implied nominal interest rate paid by the government was 8.6 percent in 2002/03.<sup>60</sup> We assume that the marginal nominal interest rates are 7, 8, 9 and 9 percent respectively for the remaining four years of the Tenth Plan period and that 15 percent of the debt stock matures every year. Given the strong influence of the global interest rate cycle on Indian interest rates, there is no good reason to assume that one scenario will have dramatically different interest rates from the other over the next few years; further, the higher demand on the credit market for financing the much larger deficit in the base case will be offset to some extent by rising private credit demand in the reforms case as growth picks up. Similarly,

> 57 The primary deficit incorporates seigniorage in the form of RBI profits and dividends, which enter non-tax revenue. 58 The 8 percent Tenth Plan target would imply a growth rate of 8.9 percent per year over the remaining years of the Tenth Plan period, which seems unattainable at this point.  The base case assumes a compound average growth rate of 5 percent during the Tenth Plan period and the reform scenario, 6.5 percent, reaching 8 percent in the terminal year.

> 59 We also report results with a 6.5 percent growth rate assumption for 2003/04, given the present upbeat mood. 60 This is obtained by adding the real growth rate to the implied difference between the real interest rate and growth rate shown in Figure 2 and then inflating by the implicit GDP deflator for 2002/03.

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