governance, political economy, institutional development and economic regulation

Archive for February, 2017

Funding the Republic

tricolour

The tricolour flutters happily at the Peer Makhdum Shah Dargah in Mahim, Maharashtra, hoisted by the peer’s devotees, as a symbol of the Indian Republic being alive and well. 

India is a Republic. But often it feels as though only the Union government must carry the can for doing unpleasant things – like levying tax on those who have the surplus income to add to the national kitty or getting heavy with tax evaders. Of course it is a juggalbandhi. The Union government invariably wants to grand-stand and hang on to financial muscle power so necessary to play “big brother”. State governments are only too keen to accept the federal goodies being thrown at them and thereby avoid the pain of efficiency enhancing structural reform in politics and in government. To be fair, the financial and political firepower of the Union government and individual states is asymmetric in favour of the former. This makes it difficult for a state to chart a lonely, unique, development path. The good news is we may be coming to the limits of this asymmetric sharing of development responsibilities.

The Union lacks funds for its core functions

Consider that rapid infrastructure development and public investment to strengthen competitive markets have become the stepchildren of the annual Union Budget process. This continues a trend, started by the previous government, of shoring up state government finances, at the risk of being stingy on spending in areas of its own core, constitutional mandate.

The Economic Survey 2017 notes that state fiscal deficits reduced sharply from 4.1 per cent to 2.4 per cent of the gross state domestic product (GSDP) over the last 10 years, since state governments adopted the Fiscal Responsibility Act. Enhanced Central transfers to states and reduced interest payments, courtesy debt restructuring, benefited states to the extent of 1.8 per cent of GSDP. To their credit, most states used the additional fiscal space to cover the revenue deficit and lower the fiscal deficit to below the target of three per cent of GSDP.

But how long can the Centre play the role of a responsible elder brother, darning his own clothes, whilst buying new ones for his younger siblings?

India’s poor infrastructure constrains growth. Low spending on infrastructure also limits job creation — something India needs. The Union government expenditure on infrastructure has increased from 0.6 per cent of GDP in 2015-16 to an estimated 0.9 per cent of GDP in 2017-18. But it remains inadequate. Adding the state government and corporate — public and private — expenditure on infrastructure totals less than three per cent of GDP in 2017-18 versus the five per cent of GDP we should be spending.

broken-bridge

Dodgy infrastructure: the bane of the Republic. photo credit: indiamike.com

Repairing the broken system for bank credit and private investment

Bank and corporate finances are the second black hole which the Centre’s Budget was unable to address. Banks have accumulated bad loans to the extent of `12 trillion, or 17 per cent of their assets. The Economic Survey 2017 exhaustively discusses the “twin balance sheet problem” — of banks that must write down at least one half of the bad loans and of large private companies that face bankruptcy, for failing to use the loans productively over the past eight years.

construction

The finance minister has been explicit that the government should not bail out the private companies who made bad decisions. This is well-intentioned but difficult to implement.

There are 13 public sector banks that account for 40 per cent of these bad loans. Merging them with efficient banks can mask the problem for some more time. But such mergers can spread rather than contain the contagion. Selling or closing a failed public bank or enterprise requires courage and conviction. Our inclination is to retain the “crown jewels” no matter how tarnished they get. Air India has got a capital infusion of Rs 1,800 crores in 2017-18 on top of the Rs 5,765 crores over the last two years.

Fifty private companies account for 71 per cent of the bad loans. The public mood is for the government to go for their jugular. This will make it politically difficult for the government to fund write-downs of debt. But vigilantism against corporates can rock the growth story, which we can ill afford.

judge

A fast track quasi-judicial process must distinguish between “wilful” and unintended default, caused by systemic shock. Different rehabilitation regimes should be determined for the two categories of defaulters. Wilful defaulters should be pilloried. The downside is that picking and choosing defaulters, itself can perpetuate what this government abhors — crony capitalism.The finance minister has allocated Rs 10,000 crores in 2017-18 for recapitalising banks. This is a placeholder. All eyes are trained on the additional resources unearthed by demonetisation. The RBI is yet to disclose the value of Rs 500 and Rs 1,000 notes which remain undeposited. This may be around Rs 1 trillion. Transferring the resultant excess sovereign assets, from the RBI to banks, can buy some breathing room.

Second, the incremental tax collection from demonetised “black money” deposited in banks, can fund infrastructure development or recapitalise banks, as it dribbles in over the next two years. This windfall was to be distributed to the poor as cash support. But recapitalising publicly-owned banks, albeit with more vigorous oversight and more transparent and intrusive stress tests, has a higher priority. More credit for corporates translates into more investments, more jobs and higher economic growth. These are the fundamentals that must accompany fiscal stability.

More “give” rather than just “take”, needed from States

We are in the middle of an incipient financial emergency, which can be triggered by a shock. The RBI cautions against thinking that inflation has been tamed. Other than food and oil, where prices remain low, inflation hovers just below the red flag of five per cent. This limits the headroom available to overshoot the fiscal deficit red flag of three per cent of GDP.

The Centre needs considerable fiscal slack to fund infrastructure development and recapitalise the banks. State governments can help by enhancing their own tax resources. Imposing income tax on agricultural income and vigorously collecting property tax are low hanging fruit available to them. These measures can add around one per cent of GSDP to their resources. This will enable the Union government to scale back the long list of Central sector schemes for human development and social protection and use the funds instead for its core mandate — developing infrastructure, markets and a competitive private sector.

gst

The Goods and Services Tax Council meets: State’s follow the take rather than give strategy. 

States may well ask why they should bother, since they were never partners in the illicit gains from mega crony capitalism. But this would be short-sighted. Faltering economic growth adversely affects all boats. An increase of six per cent in economic growth boosts state government tax revenue by one percentage of GDSP with more jobs in tow. But above all, cooperative federalism must have some give — along with the take. This is the time for states to give to the Republic, as equal partners in national development.

Adapted from the author’s article in the Asian Age, February 14, 2017 http://www.asianage.com/opinion/oped/140217/to-raise-resources-give-and-take-needed.html

Red flags for FM Jaitley

Finance Minister Arun Jaitley

The embattled Finance Minister Arun Jaitley – clearly aware that the knives are out for him

 

Finance minister Arun Jaitley will be fighting from a tight corner on February 1, 2017, boxed in by low domestic demand and the approaching international headwinds of a protectionist United States.

Fighting on the backfoot is new to this government, which had it easy over the first two years. The windfall from falling oil and commodity prices created fiscal space over the last two years to check the right boxes on fiscal deficit and inflation. High interest rates kept the rupee strong. Deft footwork also boosted GDP numbers since 2014 to signal a new age of high economic performance.

Here are six red flags, which track if the finance minister’s courtroom fighting abilities are still intact as he presents Budget 2017-18.

red-flagDoes the growth estimate triangulate?

The estimate for growth during the current year 2016-17 and 2017-18 will show whether the government recognises that it has a problem. Assumptions of unrealistically high growth have a domino effect. They reduce the credibility of the tax revenue projections and the size of the fiscal deficit both of which track GDP growth. GDP growth estimates above 10 per cent in current prices (corresponding to six per cent in constant prices) or a number higher than Rs 149.5 trillion for 2016-17 and above 10.5 per cent in current prices (corresponding to 6.5 per cent constant prices), for 2017-18 is a red flag showing the government is burying its head in the sand.

red-flagDo the tax revenue estimates sound real?

An estimate for gross tax receipts, including the share of the states in Centrally-levied taxes, higher than the 10.8 per cent of GDP budgeted for in 2016-17 is unrealistic. Sticking to this level may be termed not aggressive enough in the context of the hyped-up expectations from the attack on black money. But note that this level was previously last achieved seven years ago, in 2007-08 before the financial crisis. Now, with fresh uncertainties in demand and corporate profitability, it remains an aggressive target. Anything higher is dodgy.

Any incentives for tax compliance?

red-flagAssuming higher average revenue from increased indirect tax rates, when the Goods and Services Tax rates have still to be negotiated with the states, give the wrong signals for growth, business and private consumption. On direct tax, some fiscal courage is required. Dilute the disincentive to evade tax, inherent in high tax rates — currently between 10 to 30 per cent — for middle-income earners up to an annual income of Rs 24 lakhs. It is reasonable to expect that better compliance will compensate for the hit taken on lower tax rates. Not doing so flags low confidence in the responsiveness of the tax machine to broaden the tax base. Challenging the machine to do better can work. Try it.

red-flagAre there band aids for the victims of demonitisation? 

Economic shocks affect the poor the most. Eighty per cent of the poor live in rural areas. The bottom 40 per cent of the population are either poor — a constantly changing group averaging around 22 per cent of the population — or are non-poor but vulnerable to fall into poverty due to personal or systemic shocks.

The allocation for rural poverty alleviation in 2016-17 is Rs 0.6 trillion across four schemes. The ongoing National Rural Employment Guarantee Act (NREGA) is a second best but a practical, quick-start option to scale up income transfer to the poor to insulate them for the twin economic shocks.

NREGA operates in all the 707 districts of India. This is politically sensible but wasteful. Out of the 29 states there are nine states in which the proportion of the poor exceeds the national average of 22 per cent. These “stressed states” should be specifically targeted. Separately, the government should target 40 per cent of the poorest districts, using the “poverty gap/person equivalent” metric to ensure that there is an incentive to first transfer income to the poorest of the poor. Anything less than an enhanced outlay of Rs 1 trillion for poverty alleviation red flags an irresponsible development strategy.

red-flagHas the fiscal deficit become an unreal holy grail?

Mr Jaitley has been steadfast in lowering the fiscal deficit from the level of 4.3 per cent in 2013-14 — the terminal year of the previous government. He courageously embraced the daunting target of 4.1 per cent, naughtily left for him to deal with by P. Chidambaram in the interim Budget for 2014-15.

He succeeded in meeting the target against all expectations. But he was subsequently, practical enough, to retain a target of 3.5 per cent of GDP for 2016-17 instead of the planned three per cent. Inflation is currently low, at well under five per cent per year — the target level determined in the monetary policy framework. The US generated economic shocks to world trade; to growth and to world demand will keep commodity prices low.

It is good to recollect that the fiscal deficit peaked at 6.5 per cent in 2009-10 soon after the financial crisis of 2008. We are yet again in a perfect storm of domestic and external shocks. The need of the hour is to be practical not foolhardy. If the finance minister chooses valour over vision and sticks to a fiscal deficit target of three per cent for 2017-18, the red flag of fiscal cowardice should go up. The brave accept challenges and fight them openly.

red-flagHas public investment been provided for?

Sluggish private investment requires that the slack be met by public investment. Banks are to be recapitalised, infrastructure developed and armaments upgraded. 2016-17 targeted 1.6 per cent of GDP for Central government investment expenditure. Budget allocations have always trailed actual investment expenditure so there is room for some bravado here. The investment red flag must be raised if targeted investment in 2017-18 is below two per cent of GDP.

To navigate the dragnet of stagnant tax income, lower growth and low demand, the finance minister must avoid raising any of the six red flags. To do so, he must systematically cut waste and pork to balance the Budget transparently.

green-flagPushing for doubling revenues from privatisation to a never-achieved estimate of Rs 1 trillion is one button he should press for increasing the fiscal leeway available to him. This will also signal that the reform process is alive and well. There is nothing like a resource constraint to separate the winners from the also ran.

Adapted from the author’s artcile in Asian Age, February 1, 2017 http://www.asianage.com/opinion/columnists/010217/red-flags-that-finance-minister-must-not-ignore.html

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