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FM Jaitley, aim for the sweet spot

Manmohan Jaitley

Former Prime Minister Manmohan Singh, recently released a book titled India Transformed — 25 years of Economic Reform, edited by Rakesh Mohan, at the appropriately historic Nehru Memorial Library. After the obligatory photo-op, Dr Singh turned to finance minister Arun Jaitley and with a beatific smile, handed the book over to him, as if, symbolically, he was satisfied that he could hand over trusteeship of the economy, to the three-year-old NDA government, and walked off, disregarding the speech he was scheduled to deliver.

The reform baton passes on

It was indeed a poignant moment and well chosen, for the economic baton to be handed over. The high-decibel criticism by Left-oriented, liberal public intellectuals of the economic vacuity of the BJP government’s economic policies continues. But the fact is that we are now at a cusp, an inflexion point. In all likelihood, we shall do substantially better on inclusive growth. This may sound incredulous at a time when growth, industrial investment and exports have fallen from the earlier upward looking trend line. But a dip in the industrial investment and growth rate are natural short-term consequences of the BJP having finally walked the talk on corruption.

Pressing the economic accelerator is not enough

Over the first three years, the NDA merely pressed the accelerator harder on the positive legacy of the UPA — rural unemployment support, fast-forwarding Aadhar, digitisation of commerce and banking, financial inclusion, space technology competitiveness, making electricity surplus, making access to telecommunications even more affordable, better transport and urban infrastructure, disinvestment of minority shares of state-owned entities, ensuring fiscal stability and progressively higher financial devolution to sub-national governments, including local governments.

Burying past negativities is good but not enough

It also did very well to bury the negative legacy of the UPA. The biggest achievement is in fast forwarding of expenditure programmes without the viral outbreak of corruption scandals seen earlier. More positively a three-pronged action plan is in place to make public systems resilient to corruption.

GST – the corruption buster

First, getting the GST is the biggest legislative and operational achievement to dampen corruption and enhance value addition by integrating the national market. Glitches remain due to poor drafting of rules which burden the small, honest taxpayer. Many such are the obsessive dedication to maximising revenue, even at the expense of simplicity. As usual the pain is being most felt by those least able to bear it — ragpickers — at the bottom of the urban food chain – their daily income have halved because the “kabadis” (junk yards) they sell plastics and glass to, are playing safe on the likely new tax liabilities. Small individual consultants or homeowners,  who live in one state but get work or rent from another, re similarly caught in a bewildering tax reporting spaghetti.

Bankruptcy & NPA resolution – The crony capitalism killer app

Second, is the frontal attack on crony capitalism — identifying the borrowers who have defaulted on Rs 12 trillion owed to banks, getting the Bankruptcy Act operational and signaling public sector banks that there will be no more “Mundra scam (1950s)” type telephone calls from the government. Reaffirming that sensible lending shall be rewarded and inept or corrupt lending punished.

Big brother must watch use smart analytics

Big data

Third, the proposed use of “big data”, including data from social media, to zoom in on potential tax evasion and crime. Taken together, these actions lay the systemic capacity for reducing corruption.

Aim for the sweet spot

cricket sweet spot

Whilst perfecting its drive at real sector reforms, here are the four “tests” the government must pass.

Defang the trade Unions

First, the unleashing of genuine privatisation (offloading of majority shares in a state-owned entity) as proposed in the long-delayed case of Air India is the winner. It sends the signal that India is open to efficiency enhancing financial restructuring. That it intends to free up existing public capital to create new public goods — jobs, physical infrastructure, improved social services, like health and education, whilst fresh private capital gets infused into the commercially viable supply of private goods — air and rail travel, steel, metals, petroleum and electricity. The Labour Unions are up in arms. This is where privatisation flagged in 2003 under Minister Arun Jaitley and Prime Minister A.B. Vajpayee. Can the Modi-Jaitley team de-fang the inward looking, protectionist, labour “aristocracy” comprising the Trade Unions – the bedrock of the moribund CPI(M)?

TU

Grow private banking rapidly

Second, financial sector restructuring to make state-owned banks commercially viable. Uday Kotak, of the Kotak Mahindra Bank, surely over-stretches when he advocates the  wholesale exit of loss making public banks and their substitution by private banks. But clearly, the strategy of incremental privatisation, as done earlier to enhance telecom, aviation or electricity generation, will pressure state-owned banks to become competitive. This should also circumscribe the ability of the government to use banks like ATMs for populist goodies.

Nail large. serial loan defaulters as criminals 

Modi nail

Third, the strong action proposed for making collusive default on bank loans a criminal act is commendable. It brandishes a big stick for potential defaulters. The intention is virtuous. But experience shows that criminals, especially rich ones, find it easier to evade the law than poor innocents. To avoid this perverse outcome, criminal powers should not be delegated outside the judiciary. The record of tax tribunals and quasi-judicial agencies is not sanguine enough to empower them with criminal powers in addition to their economic mandates.

There is no option except to reform the judiciary through incentives and structural changes in judicial governance. This is a tough nut to crack, but shortcuts will give rise to the miscarriage of justice, vigilantism, and massive public resentment — specially in the middle class, which will be the most impacted in cases related to property and small business.

Remain a classic, fiscal fundamentalist

Lastly, the finance minister’s determination to maintain macro-economic stability has been amply demonstrated. This resolve must not weaken even during the run up to the 2019 general election. This will be the biggest economic win,lo if achieved. The report of the N.K. Singh Fiscal Responsibility and Budget Management Committee 2017 embeds too much flexibility to provide credible guidance for the future. Fiscal fundamentalism is better.

cricket defense

Good politics must also be good economics. There is an appetite now amongst voters for hard reform. This, by itself, is a tribute to the credibility of the NDA government. A populist pre-election budget would be seen by the voters as an early admission of defeat. That is not the winner’s way.

Adapted from the author’s article in The Asian Age, August 9, 2017 http://www.asianage.com/opinion/columnists/090817/hard-reforms-vital-nda-needs-to-shun-populism.html

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banking, BJP, corruption, CPI (M), Economy, India, Law and regulation, Tax

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Rooting out perverse incentives in GST

Hasmukh Adhia Masterclass

Muscular tactics are paying-off in the Income Tax system. The number of assesses went up by an astounding 25 percent from 37 million in March 2016 to 46 million, by March 2017 and to 63 million by mid-July 2017. The linking of Aadhar-PAN card to bank accounts; the campaign against cash and now the GST, together create desirable institutional incentives for individuals and business to bank their transactions. This provides the “push” factor for enlarging the income tax base of potential assesses.

Transformative GST  

The GST is even better designed to provide desirable incentives for enlarging the indirect tax base. Unlike, Income Tax where “push” factors compel assesses to pay tax on the income revealed via bank transactions, the GST uniquely also has “pull” factors for better tax compliance. The biggest being the facility to set-off GST paid on purchases against GST payable on sale, which reduces the net tax payable. This induces both buyers and sellers to bank their transactions – which is also good for income tax collections.

Transformative, as the GST is, glitches have inadvertently crept in, which go against the grain of positive incentives to prefer banked to cash transactions; increase value addition and boost tax revenues.

But design glitches remain

One such, relates to small service providers with annual revenues of up to Rs 2 million. Those providing services within the state are exempt from both registration and payment of GST up to this limit. But the moment they provide a service across the state borders or to a client abroad, they are compelled to get a GST registration; submit the mandatory three returns per month and much worse, pay GST on their entire revenue stream.

Killing the small cross-border service provider

Individual IT professionals writing code or designing websites routinely get contracted over the internet to provide services to overseas clients or to clients across state borders. Each contract may be as low as Rs 20,000. But all these professionals will need to get registered and incur the transaction cost on submitting monthly GST returns. For these small service providers, the price points are highly competitive. It is unlikely that clients will be willing to part with the 18 percent GST for out of state providers. They will be pushed to get registered and pay the GST themselves or absorb the tax in the price they charge with the GST paid on the purchase by the client.

The net result will be that out- of-state small service providers will become uncompetitive and may stop seeking work outside their states, reducing competition. GST which was meant to create a Pan Indian national market will instead, end up creating intra-state silos for small service providers.

The negative impact is fiscally marginal but it rankles

This design flaw will also impact income tax revenue. Service providers whose annual billing reaches Rs 1.6 million within a state, will refuse out-of-state work of less than Rs 0.5 million because, by increasing their out-of-state billing by up to Rs 0.4 million they end up paying the entire incremental amount as GST.

If 2 million small service providers, ranging from civil contractors, designers to business consultants, refuse additional work due to this reason, the government loses Rs 18 billion as income tax. This calculation assumes a tax rate of 20 percent and the underlying taxable income lost at one half of the amount of work refused.

Protection for local service providers breeds inefficiency

The “infant industry” proposition can be used to justify discouraging cross border services and thereby encouraging small local service providers to ramp up their capacity and fill the gap. This may well be true. But it rankles against the pan-Indian tax framework objective of promoting efficiency and competition. It is also, against the logic of digital India which is meant to enable seamless work across state and international borders.

Whence the pan-Indian market and digital India?

Admittedly lost income tax revenue of Rs 18 billion is small change, in an income tax kitty of around Rs 4 trillion. But it is personally frustrating for small service providers who can see the cross-border opportunity to expand their business but are blocked by the “deadweight” amount of Rs 0.4 million of billing, which equals the GST they would pay by increasing their billing to Rs 2 million, if some part of it coming from cross border contracts.

Have a common GST exemption limit irrespective of location of the client

Is there a way of getting away from this flawed design? Yes, there is. The first option is to extend a common GST exemption limit to all service provision, irrespective of whether it is within state, across state borders or overseas. This immediately removes the “deadweight” of GST becoming payable, the moment a cross border transaction, no matter how small, is made.

Tax only the incremental revenue above the GST exemption limit

However, this still leaves the problem of expanding billing above Rs 2 million and thereby losing the exemption from GST on the initial Rs 2 million. Adopting the principle of taxing only the incremental amount, as used in the Income Tax, can effectively avoid the perverse incentive for opting for cash based transactions to avoid losing the tax exemption above a billing of Rs 2 million, till billing expands substantially beyond Rs 2.4 million, at which point it would neutralize the additional GST paid and yield a net income increase for the supplier.

Harmonise tax exemptions under IT and GST to reduce reduce the compliance cost 

The best option is to harmonize the exemption limits under GST and income tax. The current income tax regime presumes taxable income at 50 percent of billing, unless shown otherwise. A billing of Rs 0.5 million corresponds to a net taxable income of Rs 0.25 million which is also the maximum limit for income exempt from income tax. Hence the exemption limit for GST could be reduced to Rs 0.5 million from the existing limit of Rs 2 million. But rolling back exemptions is tough. Alternatively, the exemption limit in Income Tax could be increased to Rs 1 million. Enhancing the income tax exemption limit is the preferred option.

The number of income tax assesses increased by 25 percent in 2016-17 over the previous year. In comparison the revenue from Income Tax increased by 18.4 percent. Tax yields are lagging increase in assesses. Efficient tax collection practices would point towards focusing on high value targets rather than cluttering up the system with marginal yield assesses until tax filing systems are vastly more simplified and easy to follow for the average citizen.

This article is also available at http://blogs.timesofindia.indiatimes.com/opinion-india/end-perverse-incentives-for-small-service-providers-in-gst/

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Digital connectedness, Economy, India, Tax

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Fix the “market” for political power

Indian army

Citizens expect governments to intervene when the markets fail. The market for Diplomacy failed last month at Doklam. If the Chinese Army is to be stopped well north of the tri-junction between India, Bhutan and Tibet/China, then only the Indian forces, funded by taxes, can do the job. This is a satisfactory arrangement for all Indian and Bhutanese citizens, who otherwise may be hard-pressed to secure their territory.

When State failure fails to fix the underlying market failure

But not all government actions have an obvious rationale. Demonetisation was unleashed in November 2016 to end black money. Few believe that this objective has been achieved. Black money is not an outcome of market failure. It is an outcome of governmental failure to tax income effectively; control corruption or control crime. Poor governance only encourages the generation of black money, which then requires another intervention to root out black money. Economist Shanta Devarajan of the World Bank, in New Delhi last week for the NCAER annual India Policy Forum <http://www.ncaer.org/event_details.php?EID=184>  believes such iterative interventions are ineffective in improving the quality of governance, and can reduce the legitimacy of governments. Far better instead to rethink how to deal with the underlying market failure – in this case the “market” for political power.

Poor tax administration

So why do governments tax ineffectively? Most commonly, multiple objectives in the tax policy are to blame. The sale of loose groundnuts — the ordinary person’s food — may be tax-free but packed groundnuts, even if unprocessed, are taxed. This creates a five per cent tax differential for arbitrage between the two categories, which are difficult to administer separately. A single rate of tax levied on a non-evadable tax base is the most effective. But consider that this would be akin to the colonial “poll or head tax” — levied on each person uniformly. Effective, but terribly inequitable.

The killer “app” for instant equity – Universal Basic Income- how effective?

Admittedly, mechanisms like transfer of a basic income to the poor can neutralise such an inequity. But transfer of a similar amount of cash, to each poor person, itself creates huge inequities, even among the 40 per cent population vulnerable to poverty. Transferring differential amounts, depending on need, attracts the same inefficiencies as trying to administer progressive tax rates fairly.

The big 2Cs – Corruption and Crime

Why is corruption or crime so hard to control in India? If citizens feel that political power can be acquired by subverting the “popular” vote, it reduces their faith in the power of their vote. It also delegitimises the government and undermines its ability to rule, in the eyes of those who voted against the government. Bihar faced this conundrum for two decades.

It does not help that, in India, governments can be formed even with a minority of the total votes cast in elections, so long as each elected member of the ruling party gets more votes than the next candidate. This first-past-the-post system fractionalises politics. It encourages parties to form coalition governments, which are unable to discipline errant behaviour by their constituents. This “coalition dharma” fosters crime and corruption.

Are laws aligned with context?

An alternative explanation for pervasive crime or corruption is that laws are out of sync with local customs. And not enough has been done to change social behaviour beyond legislating transformative rights and duties. Ending open defecation — a prime driver to reduce the vulnerability of women to crime — is one such example. The benefits from ending open defecation are dependent on collective action. One reason why we did not do more earlier could be that the political incentives are perverse. They favour exaggerating, rather than bridging, the social cleavages of caste and religion, which inhibit collective, progressive decision making.

Feudal governance patterns breed poor accountability

Low public accountability and lackadaisical collective action can also be traced to the continuation of feudal traditions of governance and poorly distributed income growth. Richer citizens are more resilient to State encroachment of their rights and less dependent on State largesse. Luckily, over the past three decades, we have become less poor, better educated and more aware of our rights versus the State.

But the extent of inequality remains significant as does the infrastructure deficit across rich and poor areas. The privileged crust is thinner than a hand-tossed Neapolitan pizza — possibly just 10 per cent of the population. The rest seethe in forlorn frustration. Can we get away from this low-level equilibrium? Yes, we can by fixing the market for political power.

End the perverse incentives in our political architecture 

Our political architecture is riddled with perverse incentives which  constrain the will to reform. Here are four changes which are overdue – deepening decentralisation; enhancing state government autonomy; enhancing the representativeness of the legislatures and regulating political parties better.

First, bridge the trust deficit and distance between citizens and the State. Empower state governments versus the Union government and local government versus state governments. Hopefully, the 15th Finance Commission will carry forward the trend of forcing the Centre to devolve functions and Central taxes to states and directly to local governments based on performance criteria.

Second, cut the colonial fat; abolish the titular but unedifying position of state governors. These are unelected nominees of the Union government exercising oversight over elected state governments. Transfer this role to the President, who is elected. This will level the playing field between states and the Centre versus the presidency.

Third, make Parliament and state Assemblies more representative. Sharply reduce the size of constituencies. Only directly-elected members should be eligible to become Prime Minister or chief minister. A candidate should be able to contest an election for only one seat at a time. The winner must secure a simple majority of the available votes and two-thirds of the votes cast. Municipalities must be headed by elected mayors.

Fourth, the functioning and finances of recognised political parties must be made transparent. Inner-party elections must conform to common but effective guidelines. The Election Commission must be empowered to determine constituency boundaries and diversified beyond the administration, to include citizen representatives and the judiciary with the chief election commissioner chosen specifically.

Use the GST process of risk-free consensual decision making

GST became a reality as a process of cooperative federalism was followed led by the finance minister. Reforming the market for political power could benefit from a similar approach.

Adapted from the author’s article in The Asian Age, July 19, 2017 http://www.asianage.com/opinion/columnists/190717/power-structure-needs-reform.html

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corruption, Democracy, elections, India, Law and regulation, Tax

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Can GST make Hasmukh Adhia smile?

Hasmukh

Hasmukh Adhia, India’s revenue secretary, is finance minister Arun Jaitley’s chief aide for rolling out the Goods and Services Tax. Contrary to his first name, he never smiles, at least not in public. But even he can now take a break and smile. The GST juggernaut is careening ahead. In just over a week, India would have leapfrogged into the league of economies which have walked the talk on rationalising indirect taxes.

Noose tightens on black money generation

card pay

Photo credit: Imagesbazar.com

So what will Mr Jaitley and the GST Council have achieved on July 1, 2017? First, this collegial team of finance ministers, across the Central and state governments, would have fired the first, potent salvo against black money. Demonetisation; tax raids; getting back overseas black money caches — all pale in significance, compared to the institutional impact of GST. Consider, that the most vocal protests against GST have come from dry fruit traders, cloth merchants and jewellery makers. These businesses have been traditionally cash heavy. Of course, the intrepid evader will still have tax leak holes left open. Agriculture, food items and the business in booze remain yawning gaps in the tax revenue security architecture. But the message is loud and clear: the rope is shortening. So watch out!

Lower net indirect tax, lower prices to spur demand

shopping

Photo credit: Imagesbazar.com 

Second, the massive discounts being offered on pre-GST clearance of the stock of consumer durables suggests that prices of these goods will reduce. An entity, empowered to investigate and ensure that net tax reduction benefits are passed on by manufacturers and dealers to consumers, is in the offing. The history of such clunky, intrusive executive action is not encouraging. Due to information asymmetry, determining the cost breakdown of products externally, is invariably inefficient. Either the enforcement agents get compromised or they end up harassing manufacturers and suppliers for trifling results.

But in truth, it really doesn’t matter. Inflation levels are at historic lows — below three per cent per annum; the monsoon is progressing well and global demand remains damp. Babus and their counterparts in the public sector — around 18 million households — have all either been given or will soon get pay revisions. They are itching to spend the windfall.

Clunky “inspector raj” to check price rise – a bad idea

Even if the entire tax rationalisation bonanza is retained by manufacturers and dealers, it will still generate surpluses for private investment — in debt servicing, realty and equity markets. Improving the revenue steam of corporate India is vital for getting over the gargantuan NPA problem, which is bad cholesterol for growth. The good news is that most product markets are competitive. Digital marketers have cut retail margins to the bone. Even the market for services is hyper competitive — think telecom. This makes it tough for corporates to retain extra normal profits.

SMEs & Trade pay the price for becoming accountable – high compliance cost

Also, undeniably, tax rationalisation has come at a cost. The actual transaction cost, for business, to comply with digital GST processes is unknown. But GST provides a huge opportunity to India’s IT developers to innovate low-cost compliance and oversight options — particularly for value segments produced by small and medium industries. These could be perfected at home and marketed worldwide as context-specific solutions for developing countries. In 2013, at a conference in Washington, the World Bank president asked Nandan Nilekani why he wasn’t rolling out Aadhaar across the globe? Mr Nilekani responded that he was too busy at home and had no time left for solving the problems of the world. This single statement projected India’s enormous domestic, digital market potential far better than the glossies, which international consultants and governments routinely produce touting themselves. These digital opportunities have multiplied by several degrees with GST.

Multiple rates align with multiple objectives 

Third, the agreed-upon somewhat clunky architecture for GST reflects compromises made to achieve the twin overriding concerns — protecting the poor and ensuring fiscal neutrality for all governments. In the absence of a direct cash transfer framework, continuing tax exemptions on mass consumption goods and services is a reasonable policy option. Given the federal structure and the plurality of our polity, there never was an option to the consensual approach adopted by the GST Council. Meeting the revenue concerns of state governments has inevitably led to six GST rates. The highest rate of 28 per cent is designed to be used for neutralising any revenue loss for state governments.

Multiple rates result in efficiency loss due to tax leakage from misclassification of goods to a lower tax rate. A good example is the amorphous classification of a storage battery as a computer peripheral (lower tax rate) versus use for backup lighting needs (higher tax rate). Multiple rates also increase the accounting load for keeping track of tax credits and debits. But the economic benefits from early implementation of a less than perfect solution far outweigh the opportunity lost from a prolonged wait for the BJP to come to power in all the states, thereby enabling a best practice single rate template to be imposed from above, China style.

Fourth, GST is good for jobs. It gives a boost to “Make in India” by withdrawing the tax advantage for imported manufacturers. Importers pay Central state tax at four per cent as special additional customs duty. But domestic products are taxed at the rates of state sales tax, which are generally higher. This disadvantage for domestic production will vanish with GST. Imports, in addition to customs duty, will pay additional customs duty at the GST rate applicable for domestic products.

Flexible implementation arrangements – to muddle through the knots

Finally, the finance minister has consistently adopted a firm but nuanced, practical stance on the implementation schedule. Recognising that small-scale industry and traders are lagging in preparations, he has agreed to defer the filing of returns by two months. Assurances have also been given that the GST rates could be adjusted if the net tax burden gets distorted or gets unbearable. A government that is open to negotiating beneficial outcomes for all stakeholders and still retains the will to keep the national interest foremost is quite clearly operating at the tax-related good governance frontier. Smile, please.

Adapted from the author’s article in the Asian Age , June 23, 2017 http://www.asianage.com/opinion/columnists/230617/its-time-to-smile-gst-to-usher-in-a-new-era.html

Jaitley black money

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bureaucracy, corruption, Economy, India, Tax

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