Defence modernisation budget rises just 5% each year in real terms - Broadsword by Ajai Shukla - Strategy. Economics. Defence.

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Sunday 10 February 2019

Defence modernisation budget rises just 5% each year in real terms

With customs duties imposed on defence in 2016 and GST in 2017, capex has fallen even more

By Ajai Shukla and Devangshu Datta
Business Standard, 11th Feb 2019

Business Standard analysis of defence capital allocations, the crucial component of the defence budget that buys new weapons and equipment, reveals that it has risen by barely 5 per cent in real terms each year, in the last decade. This is after accounting for inflation and foreign exchange rate variation (FERV). 

Thus, the military’s modernisation budget has trailed far behind growth in the Gross Domestic Product (GDP), which has risen at 6-8 per cent annually for that period.

Twice during this period, in 2012-13 and 2015-16, the adjusted capital budget was lower than the previous year’s allocations. 

There were large hikes of 23.38 per cent (2009-10) and 18.98 per cent (2010-11) in the first two years of the second United Progressive Alliance (UPA-2) government. After those two boosts, the annualised increase over the next eight years amounts to only 1.6 per cent with forex spending up from around $6.97 bn in 2010-11 to $7.73 bn in 2018-19 and domestic capex in constant rupees going from Rs 343 bn (2011-12) to Rs 398 bn (2018-19). 

Business Standard needed to compile allocations scattered across various budget heads and Demands for Grants in order to calculate capital allocations. For example, in the 2019-20 budget, the capital allocations for border road construction is not in the capital budget (Demand No 21), but buried as Demand No 19 under the Ministry of Defence head. It’s similar for the Coast Guard. Until 2016-17, capital allocations for the Defence R&D Organisation and Ordnance Factory Board were also part of the Ministry of Defence budget. These scattered capital allocations have been compiled and included in capex.

Each year’s budget is then adjusted. We have assumed that half of the capital Budget is spent domestically and the rest, abroad in forex. The domestic spending is presented in constant 2011-12 rupees to adjust for inflation, using the deflator given when the Budget is presented. 

The deflator is a ratio of the value at current prices of all the goods and services in the economy in a given year to the value during the base year, which is 2011-12.The capex figures for 2009-10 and 2010-11 have been adjusted “forwards”. The domestic sources of equipment, include the 41 Ordnance Factories (OFs), eight defence public sector undertakings (DPSUs) and Indian private firms. 

The other 50 per cent, which is assumed to be spent in foreign exchange, is adjusted for FERV, using the median US dollar exchange rate of the respective financial year. While some equipment is paid for in Euros, most international defence transactions – even with Russia and Israel – are invoiced in US dollars. 

Comparison over UPA-2 and National Democratic Alliance (NDA) tenures

The UPA-2 increased domestic capital allocations in real terms by about 5.99 per cent annually. The NDA has increased domestic capital spending by about 2.62 per cent annually. The UPA-2 increased FERV-adjusted capital allocations by 8.8 per cent annually, while the NDA government has increased FERV-adjusted capital allocations by 3.46 per cent.

Double whammy: Customs duties and Goods and Service Tax (GST)

Two recent tax measures have cut into these already meagre capital allocations.  In April 2016, customs duty of 10.3 per cent was imposed on defence imports. Since 50 per cent or more of the capital budget is spent on imports, customs duties amount to five per cent of the capital budget. 

An even bigger blow came in July 2017, when Goods and Service Tax (GST) was levied on defence capital purchases. Most military equipment comprises “high end engineering goods” and falls in either the 18 per cent or 28 per cent bracket. As the end-user, the Defence Ministry cannot recover the GST paid out. This has impacted the capital budget in the last two fiscals. 

Ironically, customs duties were imposed for a laudable objective – to provide a level playing field to the private sector vis-à-vis DPSUs, OFs and foreign original equipment manufacturers (FOEMs). Before 2016, DPSUs enjoyed customs duty exemptions, while imports from FOEMs were tax-free. Only private sector firms were liable for customs duties and local taxes. Now everyone pays customs duty.

Before GST, the capital budget paid only the basic cost of domestic defence equipment. The defence firms paid excise duty and value-added tax (VAT), which were reimbursed, on the basis of evidence. But GST is collected before defence equipment is shipped out by a firm. The Defence Ministry doesn’t receive reimbursement for GST. Hence, this is an outflow from the capital budget.

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