The new government took over in mid-May and will barely have time to settle in before presenting a budget. This is, however, not a serious constraint for an experienced and adept Finance Minister like Mr Chidambaram and a highly knowledgeable Prime Minister like Dr Singh. Though the CMP and the President’s speech have outlined the economic philosophy of the new government, the budget will be the first opportunity to send a clear signal of what it actually intends to do. This article outlines what we can realistically expect from the budget given the economic situation and the approach outlined so far.
Research done at ICRIER shows that the Indian economy has been on a downward growth trend during the past 5 to 7 years. Our research has also shown that this downtrend is the result of a down trend in all three tradable goods sectors, namely agriculture, manufacturing and mining (see presentations & papers on web site). This trend needs to be reversed. There are also signs that the industrial production and domestic investment are emerging from the cyclical down turn that took place in 2002-3. The momentum of recovery needs to be maintained. We also have to put our textile industry in a position to exploit the vast opportunity that is opening in April 2005 with the abolition of Textile quotas. The following reforms are needed to accomplish these objectives:
(a) Continue the tariff reduction process initiated in 1992, by bringing the “peak rate” down to 15% (from 20%) and begin the process of bringing down the dozen or so, mainly agricultural tariffs that exceed the ‘peak rate’. ICRIER research has demonstrated the positive effect of tariff reduction on manufacturing growth and exports (ICRIER WP #135), and this process should be continued till a peak rate of 5% is reached (WP 4/2002-PC, April 2002).
(b) Complete the conversion of the MODVAT (which started in 1986) into a genuine & comprehensive CENVAT that encompasses all goods and services coming within the constitutional ambit of the Central government (MOF 1998 & 1999; ET March 2000; EPW, March 2001). This entails elimination of a number of remaining exemptions while retaining only three (all food products, medicine & medical equipment and tiny units(Rs. 10-20 lacs)).
(c) Phase out SSI reservations over the next 12 months and strengthen technological upgrade and innovations (e.g. credit bureau, credit scoring) to improve access to credit.
(d) Privatise (some) loss-making public sector units and continue the process of dis-investment of profit making ones (i.e. let the “public” hold shares in the “public sector”).
(e) Increase FDI limits in sectors where they are currently constraining growth, such as in Insurance and Telecom.
(f) Initiate the process of comprehensive reform of policies relating to agricultural and agro-processing (Planning Commission WP PC5/2002, December 2001).
Some of these reforms could be stretched out to the next budget in March 2005.
The importance of income tax reform has been emphasised by the Kelkar committee. There are three fundamental issues in income tax reform (Virmani, Public Finance 1988):
(1) The double taxation of corporate income. In theory the shareholders of a company are taxed twice once in the form of corporate tax and then on the dividends and capital gains that they receive. In practice many corporations pay low taxes because of a plethora of exemptions. The first best solution is to abolish these exemptions (along with the MAT) and reduce the tax rate to 30%. Even if this is done, however, high growth companies will not pay much corporate tax. Thus the best way to eliminate double taxation is to give a tax credit to shareholders for all corporate taxes paid (CIT) by the company (on a pro rata basis (n CIT)/N). In this case dividends and real capital gains would be treated as any other income in the hands of the receiver, who can subtract the tax credit from the taxes due and pay the rest. The tax code already allows an adjustment for inflation in calculating real capital gains ( = S – P (1+infl)t , where S is the sale price, P is the original purchase price, infl is the inflation rate and t is the number of years the share was held; t=0 if the share is held for less than one year and no inflation adjustment is made).
(2) The Taxation of Saving: Income is defined as an increase in real wealth. It represents an increase in the command over resources (purchasing power) and forms the basis of the traditional income tax. Modern growth theory, however, shows that taxation of the return on savings puts the economy on a lower growth path and thus reduces the purchasing power of all citizens. Thus it is argued that the return on savings/assts should be completely exempt from income taxation. Note however, that even in this type of tax, investment in assets is not tax deductible, only the returns from such assets (interest, dividend, capital gains, profits on investment) are tax exempt. These efficiency aspects have, however to be balanced against equity concerns. Further the inefficiency arising from high marginal tax rates can be worse. We therefore favour a traditional income tax with all saving exemptions abolished (80L etc) coupled with moderate marginal tax rates. This means that both the 20% rate and the 30% rate should apply at much higher levels of income than currently and there should be no surcharge or cess on the tax. The benchmark should be arithmetic tax neutrality.
(3) Social Exemptions: In a society in which the government provides free health services and is obligated to care for the disabled and old, tax incentives should be provided to encourage health and disability insurance and retirement annuities, so that the burden does not fall on the State. Tax deductions for purchase/premiums on insurance and retirement saving (no withdrawal except health emergency) should remain. Any insurance money received as compensation for destruction of assets or health (and part of life insurance receipts by survivor) merely compensates for a loss and is not taxable income.
The standard deduction should also be simplified to a constant share, as it used to be earlier. All other exemptions should be abolished. If this is accompanied by procedural simplification, tax compliance will increase leading to further rise in income tax-GDP ratio.
Notes and Comments on Indian economy, Global economic issues, India's International relations and National Security.
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Wednesday, June 30, 2004
Sunday, June 27, 2004
The Simple Economics of General Election 2004
The voting in an election depends on a host of economic and social factors (e.g. caste, feudal state machinery, informal terror), as well as political alliances. Many fascinating explanations have been advanced for the surprising results but few based on publicly available data. This article presents a simple explaination: An improvement/worsening of economic conditions can increase/decrease the probability of voting for the party perceived to be responsible for the change.
In a set of papers done at ICRIER we have analysed the linkages between policy, reforms and economic growth (WP #121, #122 & #131), and poverty (forthcoming). Based on these facts we can shed some light on election results.
Before the election it was widely believed that the economy was growing at a rate of 6 to 8%. The media buzz was about 8% growth take-off and India overtaking China. The facts are quite different. The Indian economy grew at a rate of 5.6% per annum during the past five years, a rate, which is not only below the benchmark rate (the average for 24 years) but much less than the 6.1% per year average during 1992-3 to 2003-4. Thus the reality experienced by the average citizen was a GDP growth rate of 5.6% during 1999-2000 to 2003-4 compared to an average growth rate of 6.7% per year in the previous five years (1994-5 to 1998-9).
Campaign slogans tended to raise the benchmark towards the 7-8% range. The educated elite may have convinced themselves of the take-off of the Indian economy, but the reality that the average voter knew from personal experience was a significant slow-down in the growth of the Indian economy since 1996-97. He/she could clearly see the big gap between the “verbal” and the actual growth rate and would be more inclined (i.e. other things equal) to vote against the party in power during these five years (in the Centre or the State).
Incidentally the slower growth rate does not represent the failure of reform. The “verbal reforms” during the five years have been far in excess of the actual reforms. The main areas of real reform have been in Telecom (price reduction and market growth), Insurance (26% FDI), Highways (institutional reform but not policy reform) and the Electricity Act 2003. The first three have been successful sector reforms, while the last is too recent to judge its effect. Though half a dozen companies were privatised (for the first time), the program came to a halt about two years before the election. In other areas new ‘verbal reform’ initiatives have not been followed up by ‘actual reform.’ The question of success or failure of these reforms is therefore moot.
The election results from Rajasthan and Madhya Pradesh, including the preceding State elections, are consistent with our hypothesis. Economic growth in MP declined from an average 5.4% per year during 1994-95 to 1998-99 to an estimated 60% of this level during 1999-2000 to 2003-4. Economic growth in Rajasthan had declined even more sharply from 9.5% per year to an estimated 45% of this rate during the tenure of the incumbent party (Congress). The average voter in each state was therefore more likely to vote against the Congress party in these States. Neither the global reputation of the MP CM as social sector innovator and leader in decentralisation, nor last year efforts of the Rajasthan CM to project good governance could counter the impact of the sharp slow-down in growth.
The conventional wisdom on Bihar’s growth performance under Shri Lalu Yadav is that it has been performing very poorly. The average rate of growth of Bihar’s GDP during the last five years (1999-2000 to 2003-4) is about 60% higher than it was in the previous five years (4.8% per annum). The average Bihar voter would therefore be more likely to vote for the ruling party in election 2004 than in the previous general election. That is why contrary to all forecasts the RJD improved its performance.
What about Andhra Pradesh and Orissa? Everyone thought that Andhra has been shining under Shri Naidu while Mr Patnaik had botched the electricity privatisation in Orissa! In both these States the growth rate during the past five years is approximately the same as in the previous five years. The high profile Mr. Naidu raised the benchmark against which Andhra voters judged him, while the low key Mr Patnaik lowered the benchmark against which Orissa voters judged him. Another difference was that Mr Naidu had served two terms as CM while Mr Patnaik had served only one. As a consequence the former was found by the average voter to be under-performing while the latter was perceived to be performing at an acceptable level.
These results have little to do with rich-poor divide or the India-Bharat divide. There is no data to determine (a) whether the change in poor citizens voting behaviour was different from the change in middle class voter behaviour, (b) That any group (poor, middle-class, rural, urban) voted for or against reforms.
Available data does, however, allow us to delve a little deeper into a sector on which rural voters are relatively more (but not solely) dependent, the agricultural sector. The average agriculture growth declined sharply from 3.5% per year during 1994-5 to 1998-9 to 2.3% per year during 1999-2000 to 2003-4. This is however the average national situation and rainfall variations have a strong regional dimension. States such as Andhra Pradesh have been particularly affected by poor rainfall and drought conditions in the last 3-5 years and the data for Andhra Pradesh confirms the slowdown. Thus the average person/voter (nationally & in AP) dependent primarily on agriculture income is likely to have concluded that progress has slowed and would be more likely, ipso facto to vote against the party in power at the State level responsible for the poorer agricultural growth performance.
The second important explanatory factor is the widening gap between individual income and the private goods purchased with this income (e.g. food, clothing durable goods) and the public & quasi-public goods provided by the government. While the former has increased in line with GDP, this is not necessarily true of the latter (police protection, roads, drinking water, sanitation & sewerage, public health, primary education, agriculture R&D and extension). The ICRIER working papers have shown that there has been a slow but steady decline (over the past 4 decades) in the quality and efficiency of government institutions. The quality and average quantity of public services provided by the government to its citizens has therefore deteriorated. Deterioration in the quality of private goods supplied by government monopolies such as electricity boards has accentuated the citizens’ negative experience of government performance (as private purchase from a competitor is not allowed). This deterioration in governance is an important underlying economic factor underlying the so-called ‘anti-incumbency’ vote observed by political analysts over the last 3&1/2 decades. It has also been argued (Virmani, EPW, June 2002) that the deterioration in governance has ‘reduced the ability of the government to do good relative to its ability to do harm to the economy/its citizens.’ Unless an incumbent government takes an active interest in improving the supply of public services, benign neglect will inevitably lead to a gradual deterioration.
Though we do not have detailed information on the quality and quantity of public goods and services provided by States, there is wide agreement among analysts that the Ms. Dixit’s government in Delhi has beaten the anti-incumbency factor through better governance and sincerity of purpose. Mr Naidu and Mr Digvijay Singh seem to have done it in their first re-election bid 4-5 years ago but could not sustain it in the second re-election bid in 2003/2004. Mr Patnaik has also managed it in his first re-election bid. The voters are perhaps more willing to give credit for good intentions and sincere effort in the first re-election bid, than they are in the second and subsequent re-election bids (when they judge by actual improvement). The credibility of the challenger is clearly important when the voters’ judgement is based not on actual performance but on potential.
Only Mr Lalu Yadav in Bihar and the Left front in W. Bengal have beaten the anti-incumbency/governance twice to win a third consecutive term. Out migration from Bihar and remittances from these migrants seem to have played a role in accelerating the growth of the Bihar economy. Such migrants may also incidentally have voted with their feet (because of caste/party bias in terms of jobs, personal safety etc.) and therefore reduce the anti-incumbency vote. The deterioration in personal safety (kidnapping, dacoty) can be directed at groups who do not vote for the ruling party. The rents can be extracted from such opponent groups and channelled to supporting groups to ensure re-election (as against self-aggrandisement). Thus any deterioration in the former’s economic well being has no effect on the ruling party vote. Shekhar Gupta has written that the use of coercion and fear (in both Bihar and W Bengal) also helps keep the ruling party vote bank intact during elections. This is a possible explanation for Bihar and W Bengal beating anti-incumbency in the second re-election bid.
Our analysis of available data shows that the change in the economic growth rate during the tenure of the incumbent, the governance factor and the benchmark set by the incumbent provide a good explanation for a change in the likelihood (swing) of voting for the incumbent.
In a set of papers done at ICRIER we have analysed the linkages between policy, reforms and economic growth (WP #121, #122 & #131), and poverty (forthcoming). Based on these facts we can shed some light on election results.
Before the election it was widely believed that the economy was growing at a rate of 6 to 8%. The media buzz was about 8% growth take-off and India overtaking China. The facts are quite different. The Indian economy grew at a rate of 5.6% per annum during the past five years, a rate, which is not only below the benchmark rate (the average for 24 years) but much less than the 6.1% per year average during 1992-3 to 2003-4. Thus the reality experienced by the average citizen was a GDP growth rate of 5.6% during 1999-2000 to 2003-4 compared to an average growth rate of 6.7% per year in the previous five years (1994-5 to 1998-9).
Campaign slogans tended to raise the benchmark towards the 7-8% range. The educated elite may have convinced themselves of the take-off of the Indian economy, but the reality that the average voter knew from personal experience was a significant slow-down in the growth of the Indian economy since 1996-97. He/she could clearly see the big gap between the “verbal” and the actual growth rate and would be more inclined (i.e. other things equal) to vote against the party in power during these five years (in the Centre or the State).
Incidentally the slower growth rate does not represent the failure of reform. The “verbal reforms” during the five years have been far in excess of the actual reforms. The main areas of real reform have been in Telecom (price reduction and market growth), Insurance (26% FDI), Highways (institutional reform but not policy reform) and the Electricity Act 2003. The first three have been successful sector reforms, while the last is too recent to judge its effect. Though half a dozen companies were privatised (for the first time), the program came to a halt about two years before the election. In other areas new ‘verbal reform’ initiatives have not been followed up by ‘actual reform.’ The question of success or failure of these reforms is therefore moot.
The election results from Rajasthan and Madhya Pradesh, including the preceding State elections, are consistent with our hypothesis. Economic growth in MP declined from an average 5.4% per year during 1994-95 to 1998-99 to an estimated 60% of this level during 1999-2000 to 2003-4. Economic growth in Rajasthan had declined even more sharply from 9.5% per year to an estimated 45% of this rate during the tenure of the incumbent party (Congress). The average voter in each state was therefore more likely to vote against the Congress party in these States. Neither the global reputation of the MP CM as social sector innovator and leader in decentralisation, nor last year efforts of the Rajasthan CM to project good governance could counter the impact of the sharp slow-down in growth.
The conventional wisdom on Bihar’s growth performance under Shri Lalu Yadav is that it has been performing very poorly. The average rate of growth of Bihar’s GDP during the last five years (1999-2000 to 2003-4) is about 60% higher than it was in the previous five years (4.8% per annum). The average Bihar voter would therefore be more likely to vote for the ruling party in election 2004 than in the previous general election. That is why contrary to all forecasts the RJD improved its performance.
What about Andhra Pradesh and Orissa? Everyone thought that Andhra has been shining under Shri Naidu while Mr Patnaik had botched the electricity privatisation in Orissa! In both these States the growth rate during the past five years is approximately the same as in the previous five years. The high profile Mr. Naidu raised the benchmark against which Andhra voters judged him, while the low key Mr Patnaik lowered the benchmark against which Orissa voters judged him. Another difference was that Mr Naidu had served two terms as CM while Mr Patnaik had served only one. As a consequence the former was found by the average voter to be under-performing while the latter was perceived to be performing at an acceptable level.
These results have little to do with rich-poor divide or the India-Bharat divide. There is no data to determine (a) whether the change in poor citizens voting behaviour was different from the change in middle class voter behaviour, (b) That any group (poor, middle-class, rural, urban) voted for or against reforms.
Available data does, however, allow us to delve a little deeper into a sector on which rural voters are relatively more (but not solely) dependent, the agricultural sector. The average agriculture growth declined sharply from 3.5% per year during 1994-5 to 1998-9 to 2.3% per year during 1999-2000 to 2003-4. This is however the average national situation and rainfall variations have a strong regional dimension. States such as Andhra Pradesh have been particularly affected by poor rainfall and drought conditions in the last 3-5 years and the data for Andhra Pradesh confirms the slowdown. Thus the average person/voter (nationally & in AP) dependent primarily on agriculture income is likely to have concluded that progress has slowed and would be more likely, ipso facto to vote against the party in power at the State level responsible for the poorer agricultural growth performance.
The second important explanatory factor is the widening gap between individual income and the private goods purchased with this income (e.g. food, clothing durable goods) and the public & quasi-public goods provided by the government. While the former has increased in line with GDP, this is not necessarily true of the latter (police protection, roads, drinking water, sanitation & sewerage, public health, primary education, agriculture R&D and extension). The ICRIER working papers have shown that there has been a slow but steady decline (over the past 4 decades) in the quality and efficiency of government institutions. The quality and average quantity of public services provided by the government to its citizens has therefore deteriorated. Deterioration in the quality of private goods supplied by government monopolies such as electricity boards has accentuated the citizens’ negative experience of government performance (as private purchase from a competitor is not allowed). This deterioration in governance is an important underlying economic factor underlying the so-called ‘anti-incumbency’ vote observed by political analysts over the last 3&1/2 decades. It has also been argued (Virmani, EPW, June 2002) that the deterioration in governance has ‘reduced the ability of the government to do good relative to its ability to do harm to the economy/its citizens.’ Unless an incumbent government takes an active interest in improving the supply of public services, benign neglect will inevitably lead to a gradual deterioration.
Though we do not have detailed information on the quality and quantity of public goods and services provided by States, there is wide agreement among analysts that the Ms. Dixit’s government in Delhi has beaten the anti-incumbency factor through better governance and sincerity of purpose. Mr Naidu and Mr Digvijay Singh seem to have done it in their first re-election bid 4-5 years ago but could not sustain it in the second re-election bid in 2003/2004. Mr Patnaik has also managed it in his first re-election bid. The voters are perhaps more willing to give credit for good intentions and sincere effort in the first re-election bid, than they are in the second and subsequent re-election bids (when they judge by actual improvement). The credibility of the challenger is clearly important when the voters’ judgement is based not on actual performance but on potential.
Only Mr Lalu Yadav in Bihar and the Left front in W. Bengal have beaten the anti-incumbency/governance twice to win a third consecutive term. Out migration from Bihar and remittances from these migrants seem to have played a role in accelerating the growth of the Bihar economy. Such migrants may also incidentally have voted with their feet (because of caste/party bias in terms of jobs, personal safety etc.) and therefore reduce the anti-incumbency vote. The deterioration in personal safety (kidnapping, dacoty) can be directed at groups who do not vote for the ruling party. The rents can be extracted from such opponent groups and channelled to supporting groups to ensure re-election (as against self-aggrandisement). Thus any deterioration in the former’s economic well being has no effect on the ruling party vote. Shekhar Gupta has written that the use of coercion and fear (in both Bihar and W Bengal) also helps keep the ruling party vote bank intact during elections. This is a possible explanation for Bihar and W Bengal beating anti-incumbency in the second re-election bid.
Our analysis of available data shows that the change in the economic growth rate during the tenure of the incumbent, the governance factor and the benchmark set by the incumbent provide a good explanation for a change in the likelihood (swing) of voting for the incumbent.