governance, political economy, institutional development and economic regulation

Posts tagged ‘Budget 2017’

Funding the Republic

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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.

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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.

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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.

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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.

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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

Fiscal courage needed on Feb 1, 2017

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In a welcome change of national focus, becoming rich is no longer enough unless the poor are taken along. Prime Minister Narendra Modi, who is very au fait with international headwinds, was prescient in his December 31 address. For the first time, it was not the youth, nor non-resident Indians, nor Hindus, that the PM was focusing on. His attention was primarily on the travails of the poor. He donned the mantle, first evoked by Prime Minister Indira Gandhi four and a half decades earlier in 1971, of a pro-poor proselytiser.

Recovering lost ground

Speaking in the shadow of the economic storm unleashed by the demonetisation of 86 per cent of the currency in November and December 2016, Mr Modi extolled the poor for their patience and resilience. They had shown, he said, “…even people trapped in poverty, are willing to… build a glorious India… through persistence, sweat and toil (they), have demonstrated to the world, an unparalleled example of citizen sacrifice.”

The finance minister would do well to gauge which way the wind is blowing when he rises to present the fiscal 2017-18 Budget on February 1. It is not as if the poor were ignored in the earlier three Budgets presented by him. But they only figured tangentially. Growth, macro-economic stability, infrastructure and jobs for the middle-class young, the usual Davos consensus, took pride of place.

A sombre 2017 ahead

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We face a sombre fiscal year ahead. The International Monetary Fund’s economic outlook — a source the finance minister has used previously to highlight India’s outlier growth performance since 2014 — has projected a growth of only 6.6 per cent in 2016 — one percentage point less than the 7.6 per cent estimated pre-demonetisation. Worse, even growth in 2017 at 7.2 per cent will suffer. Even this is dependent on the shock being temporary. The subtext is that if the ongoing jihad against corruption is extended indefinitely and indiscriminately, business sentiment will collapse. Corruption is a curse. But it must be tackled surgically by an army of savvy saints, who are hard to find.

Lower growth in 2017 would reduce tax revenues. Hopefully this can be compensated by taxing some of the Rs 4 trillion, suspected to be dodgy money, deposited in banks during demonetisation.

Sops only for revenue and economic return multipliers

This stash should also encourage the finance minister to take the risk of slashing income-tax rates to boost revenue through better tax compliance and boost demand. The maximum tax rate for an annual income between Rs 25 to Rs 50 lakhs should be 15 per cent (current rate 30 per cent), with suitably lower rates for lower income slabs. The tax on income between Rs 2.5 to Rs 10 lakhs should be broad-banded at five per cent (current rate 10 to 30 per cent). Tax studies show that the revenue dividend is more pronounced by reducing tax in the lower income slabs. This is probably because the proportionate cost of evasion reduces at higher income levels so it is tough to beat. High income wallahs tax arbitrage internationally via corporate earnings. So, they declare domestically only enough to justify their easily verifiable lifestyle and assets.

Lower growth also red flags the fiscal deficit as a percentage of GDP, which acts as a cap on public borrowing to spend. High fiscal deficits can lead to inflation and public indebtedness. But courtesy demonetisation money is cheap. Banks deposits have swelled by Rs 6 trillion since October 28, 2016. This is low-interest money waiting to be used by the government and its assorted entities. Inflation is well below the target five per cent. This presents the option for temporarily breaching the fiscal deficit target of three per cent for 2017-18 to infuse income into the poorest households.

Rich farmers, poor workers

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Sops for agriculture are falsely conflated with poverty-reduction objectives. Admittedly, investing in agricultural growth is an efficient strategy for reducing poverty. Eighty per cent of the poor live in rural areas. But this is too blunt an approach.

Fifty-four out of 180 million rural households (30 per cent) own no land and survive on manual labour. Benefits from agricultural growth are indirect for the poor. Scheduled Castes, Tribes and Muslims are overrepresented in this group. They need instant relief. Consumption loans of Rs 20,000 for each household, deposited into bank accounts, repayable by labour in village improvement schemes, can combine the advantages of a direct benefits strategy, coupled with the self-selecting benefits of the National Rural Employment Guarantee Act programme. This requires an allocation of Rs 1 trillion — three times the NREGA allocation. This would be a fit use for the demonetisation windfall.

Neo-middle class vulnerable to sliding back into poverty

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But income support is a short-term mechanism to reduce poverty. The World Bank assesses that the Indian growth strategy, whilst effective in pulling people out of poverty, is less effective in keeping them out of poverty. By 2012 poverty levels were down to 22 per cent, from 45 per cent in 1994. But an astonishingly high 41 per cent in the neo-middle class were vulnerable to sliding back into poverty. Even in the go-go years (2005 to 2012) around seven per cent of the neo-middle class slid back into poverty. Sudden economic stress, like the loss of jobs, can significantly increase this proportion.

Reduce multidimensional poverty through better services 

Vulnerability to sliding back into poverty can be fixed if the poor get steady jobs, which are more likely if they are educated. Shocks to household budgets can be mitigated by access to healthcare. Nutrition can be improved through clean water supply and sanitation. Lower tax on low-income earners reduces the effective cost of labour versus capital, making labour competitive in the formal sector. Public services, which reduce the multidimensional index of poverty, can be ramped up by the private sector, if the government provides viability gap funding.

Junk low economic return schemes & protect the poor from shocks

India can be on track, to meet the interim sustainable development goal of reducing the level of extreme poverty to nine per cent by 2020, if we safeguard growth and cocoon the poor from shocks by providing access to better public services. The finance minister must identify the allocations specifically for the core objectives and discard the chaff generated by the testosterone of high growth.

Adapted from the authors article in Asian Age January 20, 2015 http://www.asianage.com/opinion/columnists/200117/safeguard-poor-bring-india-back-on-track.html

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Budget 2017 “pull in” black money

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Photo credit: Kundan Srivastava

A month has passed. Opinion is unanimous that demonetisation has failed as an instrument to end terror or black money. Brazen terror strikes continue. The shadow industry for converting black into white has perversely got a boost from a new business vertical — converting “old black” into “new black”. Worse still, the economy has taken a severe hit in the process. The good news is that committing mistakes is a sign of executive action. Mistakes fade from public memory if the government learns from them and takes corrective action. So what is the learning?

Too much black

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First, black money is too pervasive to be substantively reduced either via anti-corruption legislation; strong-arm tactics like “raids” or moral persuasion. We dont know the proportion of black money creaed out of crime – this is the most difficult to eradicate – and the proportion created due to the evasion of tax – either because the owner considers that she does not get enough for what she pays to government or because she is a congenital free rider. Post colonial democratic economies have this problem. Even after independence citizens continue to remain aleinated from the State. Free riding is the natural consequence of alienation.

Rationalise the tax regime

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Things become worse if the marginal rate is ficed very high mimicking what happens in other countries without considering the underlying social compact. India is one such economy. We tax at high rates from a narrow base and end up with a paltry tax to GDP ratio of around 20% (center and states included). High rates provide an incentive to evade tax. Our strategy has been to dilute the high marginal rate of tax by offering a slew of deductions if investments are channeled into government entities. Such tax avoidance options must be rationalised and reduced. Tax exemptions are a non-transparent way of providing a subsidy to either an individual or a business. They are difficult to target narrowly ato achieve the intended objectives and generate perverse, unintended outcomes. The real estate boom and subsequent bust happened because of tax incentives to but multiple houses by leveraging savings with bank debt pushing housing demand into purely speculative territory. Black money, which always looks for supranormal financial returns to defray the risk it carries, boosted the process.

Putting indirect and direct tax together, the incidence of tax in India at the highest level is around 43 per cent on an income of just Rs 83,000 ($1,220) a month if the entire amount left over after paying income-tax is spent on purchasing services or goods. In the United States, the federal income tax rate of 33 per cent is attracted by an income of $75,000 per year. The US is nine times wealthier than India. Factoring in the income differential, the comparable income level in India would be $8,300 per year (Rs 5.6 lakhs per year or Rs 47,000 per month). At this income level, the marginal rate in India is just 20 per cent. This is understandable, purely on considerations of equity, since the income tax base is narrow, unlike in the US and targets only that tiny sliver of the population earning more than Rs 2.5 lakh ($ 3600)a year, other than in agriculture. Just around 3 percent feel compelled to file a tax return.

Plug revenue leaks 

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Numerous deductions reduce the effective incidence of tax by a further 10 percentage points. Loan repayment and interest payments for house building, fixed income investments in postal savings, public sector enterprises and infrastructure, capital gains re-invested in specified government bonds, capital gains on equity held for a paltry one year — all qualify for a tax rebate.

These exemptions distort the fixed income market for attracting savings into banking and private business entities. They also do nothing to “pull in” new taxpayers. On the contrary, these exemptions serve as avenues for parking black money through substitution. Instances abound of the entire salary being deposited in such investments with living expenses met from “other” undisclosed sources.

End deductions & reduce income tax

The finance minister proposed, last year, a lower rate of corporate tax of 25 per cent for new assesses if no tax deductions were availed. A similar strategy of reducing the marginal income-tax rate should be followed in Budget 2017 to widen the tax base. Reducing the marginal rate from 30 to 20 per cent can “pull in” new taxpayers. A simultaneous declaration of an intention to reduce the rate further to 15 per cent, depending on the revenue surge, would provide the much-needed assurance of medium-term stability in the tax architecture. The incentives being provided for digital payments and selective targeting of high-profile tax evasion could provide the “push” factor towards better tax compliance. The lesson here is that in a democratic, open economy, incentives work better than directives.

Institutions matter – preserve or build judiciously

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The second lesson is that whilst politics always drives government policy, the consequences of ignoring well-honed governance principles are severe. Institutions matter for sustainable results. Why are 32,290 gazetted tax officers powerless to perform? Are we aware that 36 per cent of available Grade A tax positions are vacant? Is it appropriate that the academic requirements for becoming a tax officer do not mandate having either a masters in commerce or economics or being a chartered accountant? Nor are candidates tested psychologically for their motivations or their ability to put the public interest first. All these red flags show that tax collection has never been a priority. We tend to focus overly instead on the spending departments.

The ability to tax and to punish citizens as per the law is the best metric of sovereignty. To build institutional support for targeting black money we should take a leaf from the British Raj. During the colonial period, the district collectors were the flag-bearers of the Raj. Today, their successors — the Indian Administrative Service — occupy the same high status. But they do everything except collect tax. Those who collect tax — the Central Board of Direct Taxes and the Central Board of Excise and Customs — are condemned to be second-class bureaucrats, perpetually subservient to a revenue secretary from the IAS. The IAS is an elite because it is treated as such by the government. It attracts the best. It trains and gives its members the opportunity to be leaders. If collecting tax is a national priority, we must give the tax officers the privilege of being an elite and leading the tax effort. This will mould them, over time, into being leaders rather than mere camp followers.

A boost for tax collectors 

A healthy parallel is the possible formation of a tri-services command, in the defence ministry, to establish a direct link between the defence minister and the armed forces. This architecture must be replicated in the department of revenue. Create a “Supreme Tax Council” of secretary-level officers, expert in direct and indirect tax, led by a chairperson in the rank of a minister of state, reporting directly to the finance minister. Consequential changes in the method of recruitment, training, functions, powers and upgrade in the service conditions of the tax services can follow.

Targeting black money is a medium-term task. No government has had the gumption or the political capital to sustain the process. The personal charisma and overwhelming public support that Prime Minister Narendra Modi enjoys places the buck for tax reform squarely at his door.

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Adapted from the authors article in Asian Age , December 10, 2016. http://www.asianage.com/opinion/columnists/101216/next-use-budget-to-target-black-money.html

 

 

 

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