There are three different issues involved in this question which need to be addressed and answered separately before putting then together into a single package. The first issue is that of lending external reserves for domestic investment. By definition external reserves have to be kept in safe assets not affected by BOP shocks to the economy as they are held to reduce risks in such an eventuality. The Asian crises showed that external borrowing by domestic banks for the purpose of domestic lending increases systemic risk of crises. “Using” FE reserves for domestic purpose has a similar effect. If reserves are seen as ‘excessive,’ this indicates an implicit judgements that the risks are low and will remain so even with lower reserves. They are two sides of the same coin.
The accumulation of our reserves is the outcome of a BOP & foreign exchange management policy designed to meet external and domestic shocks and promote growth. If this results in “excessive” reserve accumulation the policy needs to be modified. Though the build up of reserves till September this year has roughly halved to what it was last year because of industrial recovery and higher oil and raw material policies there is scope for slowing it further. ICRIER studies have shown the positive effect of the tariff reductions since 1992, on intra-industry trade and specialization, productivity and exports. Reserve accumulation can be efficiently stopped or perhaps reversed by a sharp reduction in tariffs. A reduction in peak tariffs to 10% by 2006 and to 5% by 2008 budget and the lowering the excessively high agricultural tariffs will enhance productivity, increase exports and accelerate industrial growth.
The second issue is that of infrastructure investment and development. Experience with Telecom sector reform has shown that efficient and effective development of infrastructure requires a policy framework that promotes entry and supports competition (particularly with the government supplier). This requires isolation of natural monopoly elements through unbundling and a professional independent regulatory framework to regulate monopoly elements and ensure fair competition with the incumbent. In the case of electricity the so-called ‘Theft & Dacoity’ (T&D) losses would also have to be tackled head on if competitive pricing is to be fair and equitable to honest users. As roads are a classic ‘Public good’ policy reform is not enough and most of the burden has to be borne by the government, policy reform can be helpful high density National highways.
The third issue is that of public investment in infrastructure and its financing. In theory public investment in infrastructure, financed by money creation or by debt can be undertaken as long as the social benefit of the former (in terms of growth/productivity) is greater than the social cost in terms of inflation and/or crowding out. The former depends on the institutional structures for undertaking such expenditures, and institutional reform (of which the National Highway authority is the best example so far) is required to reduce leakage and enhance social productivity. The latter depends on unused capacity in the economy, which was very high from 1998 to 2002, but has tightened since mid-2003. External supply side (e.g. oil) inflationary pressures have also increased over the same period. Thus the conditions for both monetary and debt financing have worsened over the last 18 months. It may therefore not be wise to increase monetary expansion and thus add demand side pressure to supply based inflation nor to crowd out rising private investment with higher government borrowing. Nevertheless, if the social benefit is higher than the social cost, perhaps a financial package can be devised to get round the constraints imposed by the FRBM.
Though the package has been put together as one to “use FE reserves to finance public infrastructure,’ the following restatement/revision would appear to achieve the same objectives more efficiently: Increase government infrastructure investment in concert with, (1) A sharp reduction in tariff rates. Reserve accumulation would slow and perhaps reverse providing greater scope for non-inflationary monetization of the deficit needed to finance infrastructure. (2) A pro-competition infrastructure policy and a professional independent regulatory framework for electricity, railways, ports, airports and dams & canals, (3) Institutional reform of public infrastructure monopolies, like State electricity boards, irrigation departments public works departments (for State highways and village roads). The last two measures would enhance the benefit from increased public investment in infrastructure and thus make the costs of financing them worthwhile.
Notes and Comments on Indian economy, Global economic issues, India's International relations and National Security.
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Tuesday, November 9, 2004
Thursday, October 7, 2004
Planning in a Market Economy
Some people have asserted that the Planning Commission is redundant and should be abolished. To the extent that there is some logic to this assertion, the argument applies to virtually all ministries of the central government barring, defense, home, external affairs and finance. These ministries are not likely to be abolished during my lifetime. The proper question to ask therefore is, ‘What is the appropriate role of the Planning Commission in a market economy? In my view there are four areas that the Planning Commission is best positioned for, among all government institutions:
(1) The Planning Commission is the only institution that has the formal task of interacting with the States in virtually all areas of government functioning. Traditionally it has also had a measure of independence from the Central government and been viewed as an honest broker between the Center and the States. It is therefore uniquely positioned to deal with issues of co-ordination between the Center and the States.
(2) The Central government continues to invest in and spend money on a host of sectors and sub-sectors. The ideas of the fifties that this allocation would be based on comprehensive social benefit-cost calculations remained a gleam in the eye of theoretical economists. The Planning Commission is, however, the only body that can, in principle, objectively determine the optimal allocation of resources among competing uses. This is a difficult and highly challenging job, which would require enormous upgrading.
(3) Large lumpy infrastructure projects require co-ordination. Because different agencies are responsible for different areas (e.g. ports and railways) the Planning commission can ensure that the completion timings are coordinated to maximize the overall benefit-cost ratio.
(4) The Planning Commission can act as a think tank for policies and reforms, either by hiring and empowering internal experts or by sponsoring external research or both. There is great dearth of rigorous empirical research on the effect of different policies and of exogenous shock (e.g. oil prices). The PC can play an important role in promoting intellectual excellence and generating ideas for national development.
(1) The Planning Commission is the only institution that has the formal task of interacting with the States in virtually all areas of government functioning. Traditionally it has also had a measure of independence from the Central government and been viewed as an honest broker between the Center and the States. It is therefore uniquely positioned to deal with issues of co-ordination between the Center and the States.
(2) The Central government continues to invest in and spend money on a host of sectors and sub-sectors. The ideas of the fifties that this allocation would be based on comprehensive social benefit-cost calculations remained a gleam in the eye of theoretical economists. The Planning Commission is, however, the only body that can, in principle, objectively determine the optimal allocation of resources among competing uses. This is a difficult and highly challenging job, which would require enormous upgrading.
(3) Large lumpy infrastructure projects require co-ordination. Because different agencies are responsible for different areas (e.g. ports and railways) the Planning commission can ensure that the completion timings are coordinated to maximize the overall benefit-cost ratio.
(4) The Planning Commission can act as a think tank for policies and reforms, either by hiring and empowering internal experts or by sponsoring external research or both. There is great dearth of rigorous empirical research on the effect of different policies and of exogenous shock (e.g. oil prices). The PC can play an important role in promoting intellectual excellence and generating ideas for national development.
Thursday, September 30, 2004
Prospects for India-Korea Economic Partnership
The process of liberalisation initiated in the new economic policy by India in 1991-92 and South Korea's attempt to look beyond its traditional sources of growth in the last decade gave momentum to the India-Korea economic relationship. Since then, considerable progress has been made in trade and investment between the two countries. The volume of trade expanded from less than $1 billion in 1991 to over $2 billion in 2002-03. Trade between India and Korea witnessed a quantum jump in 2002-2003 registering a growth of 34%. Growth in trade is also characterised by diversification of the trade basket. The export basket for India, though still dominated by low value-added products, has in recent years expanded to cover a wider range of industrial products like machinery and mechanical appliances, iron ore, electrical machinery and equipment and man-made staple fibres. Exports of software and electronics have increased manifold in the last few years. Imports from Korea, on the other hand, continue to be dominated by electronic goods, even though the share of transport equipment is increasing rapidly. Imports of machinery and equipment are set to grow further as several Korean companies are engaged in highways, power plants, chemicals, petrochemicals and metro rail projects in India.
The bilateral economic relationship has, however, not achieved its full potential. In 2002-03 India’s trade with South Korea accounted for less than 2% of its total trade while Korea’s trade with India was less than 1% of its total trade in the year 2002.
Given the economic size and dynamism of the two countries, their civilisational ties and the fact that they are both members of the Bangkok Agreement, the largest PTA in terms of market potential, trade between India and Korea can be expected to double in the next few years. Opportunities for trade expansion and diversification are evident from the as yet unexploited sectoral complementarities between India and Korea. Korea has expertise in manufacturing and financial and international marketing know-how, while India has abundant low-cost and technically-skilled manpower and established strength in science and technology. India and Korea can thus utilise their synergies to boost bilateral trade further.
Sectors like steel, chemicals, pharmaceuticals, automobiles and auto components, textiles, agro-products and gems and jewellery offer scope for expansion in trade. Knowledge-based industries like biotechnology and information technology are the gateways to future trade ties between India and Korea. Korea is fast progressing towards becoming an IT society. Korea’s ratio of internet penetration is the highest in the world and this is where India can make inroads. Korea has world class broadband IT infrastructure, ideal test bed for technology innovation and is a leader in mobile technology. India’s strength lies in its high quality and talented engineering pool, world-class software and services industry and is the world central point for IT outsourcing. Opportunities for joint cooperation and development as well as outsourcing projects for third countries are, therefore, substantial.
India has also come up as an attractive investment destination for Korean companies. Korean motivation to invest in India is shaped by critical advantages in terms of labour costs and easy access to Chinese, S-E Asian and West Asian markets. South Korea ranks fifth in cumulative investment approved in India. Main sectors that have attracted Korean investment are transportation, largely in the automobiles sector, fuels, electrical equipment (such as computer software and electronics, mobile telephony and consumer goods), metallurgical industry and office and household equipment.
Today, South Korean business groups such as LG, Samsung and Hyundai have become household names in India and are diversifying their businesses into different sectors and also using India as a base for expansion of their global business.
Increased focus on cooperation between our small and medium enterprises is also on the agenda of India Korea bilateral economic relationship. Successful tie-ups in this category would have a beneficial impact on an otherwise technically lagging sector in India.
India and Korea have for long recognised the advantages of regional integration arrangements. India is a founder member of the Bangkok Agreement, signed in 1975 and recently rejuvenated by China's entry. This agreement is the only preferential trading arrangement that provides preferential access to three of the major markets of this region, i.e., India, Republic of Korea and China. This may be an initiative, therefore, where India and Korea can jointly work to broaden the scope of the agreement to deal with non-tariff barriers and trade in services as against its current coverage of tariff concessions on goods only. On the multilateral front also, it would be beneficial for both India and Korea to evolve a consensus on issues of common interest and jointly work for an early resolution of the Doha Development Agenda.
India-Korea economic relationship also offers scope for providing the foundation for a stronger Indian presence in the East-Asian economic zone. India has much to offer as a bridge between East Asia and Central and West Asia. Further, as Asean negotiates free trade agreements with China, Japan, South Korea and India individually, the vision of a larger framework that includes the Asean+3+1 or Asean + 4 is taking shape. The accumulated wealth of Japan and the Republic of Korea and the huge markets of China and India will create fresh opportunities for trade driven growth in the region.
An India-Korea equation with a strong underpinning of economic relations and supported by shared values, religion and culture can make a significant contribution towards the Asean + 4 economic integration process.
Co-authored with Amita Batra
The bilateral economic relationship has, however, not achieved its full potential. In 2002-03 India’s trade with South Korea accounted for less than 2% of its total trade while Korea’s trade with India was less than 1% of its total trade in the year 2002.
Given the economic size and dynamism of the two countries, their civilisational ties and the fact that they are both members of the Bangkok Agreement, the largest PTA in terms of market potential, trade between India and Korea can be expected to double in the next few years. Opportunities for trade expansion and diversification are evident from the as yet unexploited sectoral complementarities between India and Korea. Korea has expertise in manufacturing and financial and international marketing know-how, while India has abundant low-cost and technically-skilled manpower and established strength in science and technology. India and Korea can thus utilise their synergies to boost bilateral trade further.
Sectors like steel, chemicals, pharmaceuticals, automobiles and auto components, textiles, agro-products and gems and jewellery offer scope for expansion in trade. Knowledge-based industries like biotechnology and information technology are the gateways to future trade ties between India and Korea. Korea is fast progressing towards becoming an IT society. Korea’s ratio of internet penetration is the highest in the world and this is where India can make inroads. Korea has world class broadband IT infrastructure, ideal test bed for technology innovation and is a leader in mobile technology. India’s strength lies in its high quality and talented engineering pool, world-class software and services industry and is the world central point for IT outsourcing. Opportunities for joint cooperation and development as well as outsourcing projects for third countries are, therefore, substantial.
India has also come up as an attractive investment destination for Korean companies. Korean motivation to invest in India is shaped by critical advantages in terms of labour costs and easy access to Chinese, S-E Asian and West Asian markets. South Korea ranks fifth in cumulative investment approved in India. Main sectors that have attracted Korean investment are transportation, largely in the automobiles sector, fuels, electrical equipment (such as computer software and electronics, mobile telephony and consumer goods), metallurgical industry and office and household equipment.
Today, South Korean business groups such as LG, Samsung and Hyundai have become household names in India and are diversifying their businesses into different sectors and also using India as a base for expansion of their global business.
Increased focus on cooperation between our small and medium enterprises is also on the agenda of India Korea bilateral economic relationship. Successful tie-ups in this category would have a beneficial impact on an otherwise technically lagging sector in India.
India and Korea have for long recognised the advantages of regional integration arrangements. India is a founder member of the Bangkok Agreement, signed in 1975 and recently rejuvenated by China's entry. This agreement is the only preferential trading arrangement that provides preferential access to three of the major markets of this region, i.e., India, Republic of Korea and China. This may be an initiative, therefore, where India and Korea can jointly work to broaden the scope of the agreement to deal with non-tariff barriers and trade in services as against its current coverage of tariff concessions on goods only. On the multilateral front also, it would be beneficial for both India and Korea to evolve a consensus on issues of common interest and jointly work for an early resolution of the Doha Development Agenda.
India-Korea economic relationship also offers scope for providing the foundation for a stronger Indian presence in the East-Asian economic zone. India has much to offer as a bridge between East Asia and Central and West Asia. Further, as Asean negotiates free trade agreements with China, Japan, South Korea and India individually, the vision of a larger framework that includes the Asean+3+1 or Asean + 4 is taking shape. The accumulated wealth of Japan and the Republic of Korea and the huge markets of China and India will create fresh opportunities for trade driven growth in the region.
An India-Korea equation with a strong underpinning of economic relations and supported by shared values, religion and culture can make a significant contribution towards the Asean + 4 economic integration process.
Co-authored with Amita Batra
Wednesday, August 11, 2004
Inflation and The Way Out
Global oil prices have risen above the OPEC price band over the last 12 months. Because of general elections, the global oil price increase was not passed through into the Indian oil prices. The dismantling of the APM remained purely on paper. The Yukos crises in Russia and the blowing up of Iraqi pipelines has led to a sharp rise in oil prices to $ 45 a barrel. Only a part of global price rise was passed into the Indian market by the new Government in June. As a result of the global rise in oil prices, Indian inflation has increased by about 0.5% point, and is likely to increase further in August. Pressure on this front therefore remains.
In addition to global oil prices, raw materials and minerals prices also increased last year. After a lag of 6 to 9 months, manufactured goods prices of items which have a large component of such minerals in their inputs have tended to increase (e.g. iron ore and iron & steel). These increases were largely due to a tremendous increase in demand from China and from global recovery. Both these sources of growth have abated somewhat and inflation arising from these two sources is likely to moderate. I expect WPI inflation to decline to around 6.5 per cent by December.
The following policy reforms could be helpful in containing inflation (in India): (a) Reduce tariffs on agricultural commodities in which prices are rising sharply; (b) Reintroduce the amendment to the Coal Nationalisation Act to allow private entry in the coal sector so that there is genuine competition for imported oil; (c) Amend the Electricity Act (2003) to make the regulator independent and professional and set up a good regulatory system; (d) Launch a crusade against theft of electricity (35% to 50% of total generation); and (e) Reduce the “peak rate” of tariffs from 20% to 15% (latest by the next budget).
In addition to global oil prices, raw materials and minerals prices also increased last year. After a lag of 6 to 9 months, manufactured goods prices of items which have a large component of such minerals in their inputs have tended to increase (e.g. iron ore and iron & steel). These increases were largely due to a tremendous increase in demand from China and from global recovery. Both these sources of growth have abated somewhat and inflation arising from these two sources is likely to moderate. I expect WPI inflation to decline to around 6.5 per cent by December.
The following policy reforms could be helpful in containing inflation (in India): (a) Reduce tariffs on agricultural commodities in which prices are rising sharply; (b) Reintroduce the amendment to the Coal Nationalisation Act to allow private entry in the coal sector so that there is genuine competition for imported oil; (c) Amend the Electricity Act (2003) to make the regulator independent and professional and set up a good regulatory system; (d) Launch a crusade against theft of electricity (35% to 50% of total generation); and (e) Reduce the “peak rate” of tariffs from 20% to 15% (latest by the next budget).
Wednesday, July 28, 2004
Kelkar Committee Task Force Report
The report of the Task force on FRBM Act 2003 was made public last week. The report discusses the Fiscal challenges and the role of Tax reforms in meeting the Challenges. The latter cover Customs, CENVAT and Income tax and are modified versions of those given in the Kelkar Tax Reform Reports (December 2002). As there is now a large measure of unanimity among tax experts on the broad thrust of tax reform, the article focus on proposals that I disagree with.
Let us start with the proposal to convert the CENVAT into a comprehensive VAT. We have argued in several notes and papers since 1998 that the CENVAT should become a full fledged VAT covering all services and goods except those explicitly excluded for efficiency or equity reasons (e.g. Indian Express of July 6, 2004). The new report makes two interesting points: One that the Constitution 88th amendment act (2003) makes it possible to extend the CENVAT up to the retail level. Two that the revenue neutral basic rate of the CENVAT including both goods and services is around 12%. The discussion of how the CENVAT should replace the stamp duty and other imposts on real estate and of how to apply the CENVAT to the financial sector is quite illuminating.
The report also recommends 3 rates (0, 6% and 20%) in addition to the Standard rate of 12%. The negative list of exempted goods (0% rate) is what I have proposed earlier with one important item missing, namely processed food. There is a strong case for including all processed food in the 0% category instead of in a 6% category, because greater employment in agriculture and agro-processing and reduced wastage of agricultural produce would be added benefits. This serves the purpose of equity much better than a separate 6% category with a number of ‘necessities.’ I am also against a separate 20% CENVAT rate for luxury goods: Polyester is the poor man’s fibre not a luxury and it is absurd to classify carbonated drinks as a luxury item in this day and age. Cars, polluting fuels (petrol, diesel) and tobacco (de merit good) should however be subject to an additional special excise/sales tax rate (8%) that cannot be set-off. The recommendations on the treatment of small units are sound (exemption up to Rs. 25 Lac) and pragmatic (choice of 4% sales tax rate up to 1 crore). Monitoring will be much easier in the system proposed by us.
The report also estimates that a revenue neutral standard rate for a State Vat (what I have termed STATVAT) covering goods & services is 8% and proposes three other rates (0%, 4%, 14%) at the State level. It rightly notes that such a state VAT should replace all other taxes on goods and services at the State level. In my view there is no need for a 4% rate and the list of exempted items can be the same as for the CENVAT. Similarly instead of another 14% rate category, a sales tax of 6% could be applied at the retail level on hotels, restaurants, entertainment and betting/gambling, in addition to the standard STATVAT rate.
The Task force proposes a 5%, 8%, 10%, 20% customs duty/tariff rate structure. As acknowledged in the first Kelkar report, the Virmani Committee report of the Department of Revenue (2001) had demonstrated, (a) the negative effect of such a 4-tier structure in terms of effective protection and (b) the advantages of a single uniform rate of 10%. In fact we are now confident, based on a recent ICRIER research paper showing the positive effect on exports and productivity, that tariff rates can be reduced further to a uniform 5% in the next 5 years. Both the Virmani (2001) and Kelkar (2002 & 2004) reports concur that agriculture tariffs have to be dealt with more cautiously. The former however proposed that these tariffs should not be more than 2 or 3 times the standard peak rate (i.e. 20/30% & 10/15%) while the latter recommends an exorbitant rate of 150%.
Turning finally to income tax, the very sound arguments for low marginal tax rates and elimination of exemptions (ineffective & inefficient) are repeated in this report. I do not however agree with the proposal to move to a two rate (20%, 30%) system. The reason why experts have recommended a flat (single rate) income tax is that such a tax would have the lower marginal rate (e.g. Chintan #2, May 1997) than a 2 or 3 rate system. If the 2-rate system is going to have the same marginal rate of 30% as a 3-rate system there is no benefit from the former. On the other hand a gradually rising marginal tax rate of the latter results in a more efficient (lower average marginal rate) system that provides less dis-incentives for honest declaration to both first time tax payers and the ‘missing middle’. Further India has a much higher exemption limit (in PPP terms) then other Asian systems but its tax rapidly exceeds all others. I would therefore recommend the following structure 10% above Rs 60000, 20% above 1.2 (/1.32/1.44) lac and 30% above 3.96 (or 4.2) lacs.
The proposal to eliminate savings exemptions and replace it with an Individual Saving Account is a sound one. However, the EET system proposed for pension savings etc. along with grand-fathering is too complicated. The report has an interesting calculation of the economic depreciation rate, which is calculated as 15%. This needs to be cross-checked. Though the personal and corporate income tax recommendations are consistent, the MAT should be abolished along with exemptions and depreciation rate reduction. Further, in my judgement a system of corporate tax (CIT) credit to all shareholders for CIT paid by the company is preferable to abolition of the income tax on dividends and capital gains on equity. This can be implemented very easily in the proposed Tax Information System. Space limitations do not allow a more detailed analysis.
Let us start with the proposal to convert the CENVAT into a comprehensive VAT. We have argued in several notes and papers since 1998 that the CENVAT should become a full fledged VAT covering all services and goods except those explicitly excluded for efficiency or equity reasons (e.g. Indian Express of July 6, 2004). The new report makes two interesting points: One that the Constitution 88th amendment act (2003) makes it possible to extend the CENVAT up to the retail level. Two that the revenue neutral basic rate of the CENVAT including both goods and services is around 12%. The discussion of how the CENVAT should replace the stamp duty and other imposts on real estate and of how to apply the CENVAT to the financial sector is quite illuminating.
The report also recommends 3 rates (0, 6% and 20%) in addition to the Standard rate of 12%. The negative list of exempted goods (0% rate) is what I have proposed earlier with one important item missing, namely processed food. There is a strong case for including all processed food in the 0% category instead of in a 6% category, because greater employment in agriculture and agro-processing and reduced wastage of agricultural produce would be added benefits. This serves the purpose of equity much better than a separate 6% category with a number of ‘necessities.’ I am also against a separate 20% CENVAT rate for luxury goods: Polyester is the poor man’s fibre not a luxury and it is absurd to classify carbonated drinks as a luxury item in this day and age. Cars, polluting fuels (petrol, diesel) and tobacco (de merit good) should however be subject to an additional special excise/sales tax rate (8%) that cannot be set-off. The recommendations on the treatment of small units are sound (exemption up to Rs. 25 Lac) and pragmatic (choice of 4% sales tax rate up to 1 crore). Monitoring will be much easier in the system proposed by us.
The report also estimates that a revenue neutral standard rate for a State Vat (what I have termed STATVAT) covering goods & services is 8% and proposes three other rates (0%, 4%, 14%) at the State level. It rightly notes that such a state VAT should replace all other taxes on goods and services at the State level. In my view there is no need for a 4% rate and the list of exempted items can be the same as for the CENVAT. Similarly instead of another 14% rate category, a sales tax of 6% could be applied at the retail level on hotels, restaurants, entertainment and betting/gambling, in addition to the standard STATVAT rate.
The Task force proposes a 5%, 8%, 10%, 20% customs duty/tariff rate structure. As acknowledged in the first Kelkar report, the Virmani Committee report of the Department of Revenue (2001) had demonstrated, (a) the negative effect of such a 4-tier structure in terms of effective protection and (b) the advantages of a single uniform rate of 10%. In fact we are now confident, based on a recent ICRIER research paper showing the positive effect on exports and productivity, that tariff rates can be reduced further to a uniform 5% in the next 5 years. Both the Virmani (2001) and Kelkar (2002 & 2004) reports concur that agriculture tariffs have to be dealt with more cautiously. The former however proposed that these tariffs should not be more than 2 or 3 times the standard peak rate (i.e. 20/30% & 10/15%) while the latter recommends an exorbitant rate of 150%.
Turning finally to income tax, the very sound arguments for low marginal tax rates and elimination of exemptions (ineffective & inefficient) are repeated in this report. I do not however agree with the proposal to move to a two rate (20%, 30%) system. The reason why experts have recommended a flat (single rate) income tax is that such a tax would have the lower marginal rate (e.g. Chintan #2, May 1997) than a 2 or 3 rate system. If the 2-rate system is going to have the same marginal rate of 30% as a 3-rate system there is no benefit from the former. On the other hand a gradually rising marginal tax rate of the latter results in a more efficient (lower average marginal rate) system that provides less dis-incentives for honest declaration to both first time tax payers and the ‘missing middle’. Further India has a much higher exemption limit (in PPP terms) then other Asian systems but its tax rapidly exceeds all others. I would therefore recommend the following structure 10% above Rs 60000, 20% above 1.2 (/1.32/1.44) lac and 30% above 3.96 (or 4.2) lacs.
The proposal to eliminate savings exemptions and replace it with an Individual Saving Account is a sound one. However, the EET system proposed for pension savings etc. along with grand-fathering is too complicated. The report has an interesting calculation of the economic depreciation rate, which is calculated as 15%. This needs to be cross-checked. Though the personal and corporate income tax recommendations are consistent, the MAT should be abolished along with exemptions and depreciation rate reduction. Further, in my judgement a system of corporate tax (CIT) credit to all shareholders for CIT paid by the company is preferable to abolition of the income tax on dividends and capital gains on equity. This can be implemented very easily in the proposed Tax Information System. Space limitations do not allow a more detailed analysis.
Thursday, July 8, 2004
Economic Reforms and The Budget
The CMP and the statements of some of the coalition partners had lead to a lot speculation in the media and many fears. The PM’s address to the Nation and the budget have progressively elaborated the concept of “Reforms with a human Face,” that was first mentioned in the CMP. In the process they have also dispelled the notion that focusing on the “common man” the poor, the farmer and the unemployed will mean huge subsidies fiscal irresponsibility and large deficits. The government has made very clear that they intend to meet the targets of the FRBM (with a delay of one year). The counterpart of this on the expenditure side is a careful and cautious refocusing of the emphasis of the expenditure side of the budget, particularly the plan expenditure on agriculture & rural development and social sectors. Though plan allocations have been increased allocation to specific programs will follow a thorough review by the planning commission.
Several reform steps also confirm that in the view of the government reforms are consistent with the social objectives of employment growth and poverty reduction. At the same time exaggerated fears stimulated earlier have been laid to rest. Among the reform actions in the budget are:
1) A rise in FDI limits in Telecom to 74% (from 49%), in insurance to 49% (from 26%) and in Civil Aviation to 49% (from 40%). This follows the earlier cabinet decision to proceed with private entry into the development & management of the Delhi and Mumbai airports with 49% FDI.
2) SSI de-reservation of 85 items.
3) Board of Restructuring to carry forward the disinvestment/closure/sale/revival of PSEs.
4) Proposal to convert the CENVAT into a goods and service tax. The first step of modifying the service tax to allow off-set for both goods and service taxes paid is a good first step.
5) A comprehensive law for SEZs to devolve administrative and financial responsibility. This had been deadlocked between the MOF, MOC etc.
6) Reduction in customs duty on steel to a rate closer to that on other metals like aluminum & copper and a reversal of the February distortion (to 8%) in CENVAT rate.
As in every budget there are also actions that are either anti-reform such as the removal of Textiles from CENVAT. Controversial moves include (a) the tax changes relating to removal/reduction of capital gains on securities and its replacement by a turnover tax on securities transactions and (b) the manner of reducing income tax on individuals with taxable income less than Rs. 1 lakh. Both these are likely to have unpleasant long term consequences even if they appear successful in the short run. I hope that the FM will correct these as part of the broader tax reform he is likely to undertake in his next budget.
Several reform steps also confirm that in the view of the government reforms are consistent with the social objectives of employment growth and poverty reduction. At the same time exaggerated fears stimulated earlier have been laid to rest. Among the reform actions in the budget are:
1) A rise in FDI limits in Telecom to 74% (from 49%), in insurance to 49% (from 26%) and in Civil Aviation to 49% (from 40%). This follows the earlier cabinet decision to proceed with private entry into the development & management of the Delhi and Mumbai airports with 49% FDI.
2) SSI de-reservation of 85 items.
3) Board of Restructuring to carry forward the disinvestment/closure/sale/revival of PSEs.
4) Proposal to convert the CENVAT into a goods and service tax. The first step of modifying the service tax to allow off-set for both goods and service taxes paid is a good first step.
5) A comprehensive law for SEZs to devolve administrative and financial responsibility. This had been deadlocked between the MOF, MOC etc.
6) Reduction in customs duty on steel to a rate closer to that on other metals like aluminum & copper and a reversal of the February distortion (to 8%) in CENVAT rate.
As in every budget there are also actions that are either anti-reform such as the removal of Textiles from CENVAT. Controversial moves include (a) the tax changes relating to removal/reduction of capital gains on securities and its replacement by a turnover tax on securities transactions and (b) the manner of reducing income tax on individuals with taxable income less than Rs. 1 lakh. Both these are likely to have unpleasant long term consequences even if they appear successful in the short run. I hope that the FM will correct these as part of the broader tax reform he is likely to undertake in his next budget.
Exaggerated Fears, Exaggerated Hopes
When the UPA government came to power about 40 days ago, there were exaggerated fears about the negative role of the left and of some of the coalition allies with respect to the reform process. These stemmed partly from selective reading of the Common Minimum Programme and but were enhanced by statements made by members of some of these parties. It was asserted by many observers that the reforms undertaken by the previous NDA government would be reversed and the overall pace of reform would slacken with negative consequences on economic growth. After the PM and FM took charge and a new Deputy Chairmen of the Planning commission was appointed these fears gave way to exaggerated hopes of a “dream budget.’ Both these have been laid to rest by the budget.
Two of the reforms about which there was great doubt were Foreign Direct investment and dis-investment. This happened despite the fact that there was no clear statement against FDI and a number of statements about stimulating investment and supporting growth. Similarly while the CMP clearly ruled out privatization of profit making units, this was not ruled out for loss making ones. Dis-investment in all PSUs was also an open question. The cabinet decision on setting up public-private partnership in Delhi and Mumbai airports with 49% FDI and 26% government ownership was a pre-cursor. The budget takes the investment message forward unambiguously by proposing to raise the FDI limit to 49% in Airlines (from 40%) and Insurance (from 26%) and to 74% in Telecom.
Given the example of West Bengal fears on the dis-investment side were also clearly exaggerated. The finance minister in his budget speech has taken a leaf out of the book already written by this Left front government by announcing the setting up of a Board for Restructuring of Public Sector Enterprises (PSEs). As stated by the FM this Board will evaluate the PSEs and make recommendations accordingly. This could involve closure, sale or disinvestment. The plans of one profit making PSE to raise funds through sale of the shares to the public has also been supported in the budget and credit taken for Rs 4000 crore of dis-investment receipts.
A third are of even greater concern was the fiscal balance. Frightening estimates of the cost of the CMP were published some by reputed research institutions. The question was repeatedly asked how the tax revenues to fund these programs would be raised and would this not involve a large increase in the tax rates. Stock market intermediaries and fiscal conservatives unambiguously outlined their concerns about the fisc. The first indication that these concerns were exaggerated came when the FFRBM along with the rules for its implementation were notified a week before the budget. This indicated how seriously the government took the responsibilities embodied in the FRBM. These concerns have been considerably dampened by the careful and cautious way in which the CMP promises on social sectors, employment and rural/ agriculture have been spelt out. A clear road map has been given for rural and agricultural reform, with the Planning commissions forthcoming mid-term review charged with spelling out concrete changes and re-allocation of resources that are necessary for an implementation of this strategy. A number of well targeted social schemes have also been picked up for greater emphasis and future expansion, to promote the social objectives of the government. At the same time the budget by containing the fiscal deficit proportion and reducing the revenue deficit at the same time has confirmed this responsible approach.
Other reform actions for improving competitiveness and growth prospects are SSI de-reservation and the start of merger/integration of service tax with CENVAT. The de-reservation of 85 SSI items clearly signals the governments understanding that such economic reforms that promote employment growth will go forward.. Any number of committees have argued for complete abolition of SSI reservation. More recently the labour intensive exports and employment generated in China in the sectors in which SSI reservation exists in India, and has limited exploitation of economies of scale, has added to the urgency of de-reservation.
The move to give a set-off to service tax payers across goods and services and vice versa is an important new reform. It is the first significant step in the direction of integration of goods and services in the Central Value added tax (CENVAT).
As with virtually every budget, there are also some anti-reform steps and a few that are ambiguous. The former includes the abandonment of CENVAT for the textiles sector. This will limit exploitation of the great opportunities that are opening up with the expire of the Multi-fibre agreement next year. The abolition of the long term capital gains tax the reduction of short term capital gains tax to 20% and its replacement by a turnover tax for securities does not appeal to fiscal purist like me who worked on tax evasion issues well before they became popular. The same reservations apply to the new method of reducing tax rates up to Rs. 1 lakh through a rebate. In my experience such theoretically unsound ideas always lead to problems in the long run even though they may be successful in the short term.
Two of the reforms about which there was great doubt were Foreign Direct investment and dis-investment. This happened despite the fact that there was no clear statement against FDI and a number of statements about stimulating investment and supporting growth. Similarly while the CMP clearly ruled out privatization of profit making units, this was not ruled out for loss making ones. Dis-investment in all PSUs was also an open question. The cabinet decision on setting up public-private partnership in Delhi and Mumbai airports with 49% FDI and 26% government ownership was a pre-cursor. The budget takes the investment message forward unambiguously by proposing to raise the FDI limit to 49% in Airlines (from 40%) and Insurance (from 26%) and to 74% in Telecom.
Given the example of West Bengal fears on the dis-investment side were also clearly exaggerated. The finance minister in his budget speech has taken a leaf out of the book already written by this Left front government by announcing the setting up of a Board for Restructuring of Public Sector Enterprises (PSEs). As stated by the FM this Board will evaluate the PSEs and make recommendations accordingly. This could involve closure, sale or disinvestment. The plans of one profit making PSE to raise funds through sale of the shares to the public has also been supported in the budget and credit taken for Rs 4000 crore of dis-investment receipts.
A third are of even greater concern was the fiscal balance. Frightening estimates of the cost of the CMP were published some by reputed research institutions. The question was repeatedly asked how the tax revenues to fund these programs would be raised and would this not involve a large increase in the tax rates. Stock market intermediaries and fiscal conservatives unambiguously outlined their concerns about the fisc. The first indication that these concerns were exaggerated came when the FFRBM along with the rules for its implementation were notified a week before the budget. This indicated how seriously the government took the responsibilities embodied in the FRBM. These concerns have been considerably dampened by the careful and cautious way in which the CMP promises on social sectors, employment and rural/ agriculture have been spelt out. A clear road map has been given for rural and agricultural reform, with the Planning commissions forthcoming mid-term review charged with spelling out concrete changes and re-allocation of resources that are necessary for an implementation of this strategy. A number of well targeted social schemes have also been picked up for greater emphasis and future expansion, to promote the social objectives of the government. At the same time the budget by containing the fiscal deficit proportion and reducing the revenue deficit at the same time has confirmed this responsible approach.
Other reform actions for improving competitiveness and growth prospects are SSI de-reservation and the start of merger/integration of service tax with CENVAT. The de-reservation of 85 SSI items clearly signals the governments understanding that such economic reforms that promote employment growth will go forward.. Any number of committees have argued for complete abolition of SSI reservation. More recently the labour intensive exports and employment generated in China in the sectors in which SSI reservation exists in India, and has limited exploitation of economies of scale, has added to the urgency of de-reservation.
The move to give a set-off to service tax payers across goods and services and vice versa is an important new reform. It is the first significant step in the direction of integration of goods and services in the Central Value added tax (CENVAT).
As with virtually every budget, there are also some anti-reform steps and a few that are ambiguous. The former includes the abandonment of CENVAT for the textiles sector. This will limit exploitation of the great opportunities that are opening up with the expire of the Multi-fibre agreement next year. The abolition of the long term capital gains tax the reduction of short term capital gains tax to 20% and its replacement by a turnover tax for securities does not appeal to fiscal purist like me who worked on tax evasion issues well before they became popular. The same reservations apply to the new method of reducing tax rates up to Rs. 1 lakh through a rebate. In my experience such theoretically unsound ideas always lead to problems in the long run even though they may be successful in the short term.
Budget for the Masses
Before discussing the budget it is useful to recall that the new government has in power for a little over one month. A new government takes time to find its feet. This is even more so for a coalition government in which the coalition is coming to power for the first time. In this background the most likely outcome (as we wrote and said to the media) was some general reforms to promote growth and some actions to implement the new emphasis in the CMP on the poor, agriculture, employment and social issues. The Central government budget covers three aspects. Further all budgets since 1991 have had a mix of continuity with some change. This is what we have in fact got. The government will take perhaps 3 to 6 months to fully find its feet after which we can expect greater changes. The FM has in fact promised more tax reform in his next budget.
The budget consists of three parts; General policy reform, expenditures and revenues including tax revenues and taxation issue. Most areas that The CMP highlights as constituting the “human face “ of its reform strategy (agriculture, social sectors) largely fall within the constitutional purview of the State governments. The central government can influence outcome by laying out a road map or vision and through the allocation of plan expenditures and persuasive powers of the Planning Commission. This is what the budget tries to do. There are also some policy reforms that come under the purview of the Central government (essential commodities act, food Act, food regulator) and these have not been touched yet. The budget focuses on areas of critical importance to agriculture such as Water, technology, connectivity, credit, agro-industry and crop diversification and tries to integrate, modify and fine tune programs to give them a new direction. It carries out a similar exercise for the social sectors such as basic education and health, and socially disadvantaged persons. It has also increased overall plan allocation and promised further programmatic reform after the planning commission carries out a thorough review. Though the proof of the pudding will be in the eating, we expect more purposeful action to follow after the this review by the new Planning Commission, given the Prime Minister’s emphasis on governance issues and efficiency of expenditure.
The budget also gives clear reform signals aimed at fostering investment and growth. Sceptics have been silenced by the unambiguous proposal to raise FDI limits in Telecom from 49% to 74%, in Civil Aviation from 40% to 49% and in insurance from 26% to 49%. This follows the earlier cabinet proposal to move ahead with respect to private entry into up gradation and management of the Delhi and Mumbai airports with FDI up to 49%. Decisive implementation of this prior decision is more important the futile quibbling over limits. Removal of 85 items from the list of goods reserved for SSI also gives a clear signal that economic reforms and employment generation are not incompatible. This has been proved by China becoming the factory of the world (for labour intensive manufacturing) in precisely those item that had for so long been reserved in India. Another reform step that lays to rest to a great extent earlier fears about a collapse of the dis-investment program is the setting up of a Board for restructuring of Public sector enterprises. This board will consider all aspects objectively including the possibility of sale, closure and dis-investment.
On the Tax side the picture and the signals are mixed. Tax reform message is given by the bold move to a true CENVAT that integrates goods and services. The first step has been taken to convert the service tax, which is a turnover tax into a VAT type tax by allowing offset for taxes paid across both goods and services. The FM has also taken on the Steel producers lobby that had successfully kept the customs duty rate on steel way above the customs duty on all other metals such as aluminium, copper, nickel and tin, by reducing the import duty to 10% and related duties to 15%. The distortion introduced last February by reducing CENVAT from 16% to 8% has also been partially corrected.
On the other side of the balance sheet are the removal of the textile sector from CENVAT, the changes with respect to capital gains and turnover on securities, the method of reducing personal income tax for those with income below Rs. 1 lakh. Even if these are successful in the short term they will come back to haunt the FM in the long term, though he retains the option of correcting them in the next budget or the subsequent ones.
The budget consists of three parts; General policy reform, expenditures and revenues including tax revenues and taxation issue. Most areas that The CMP highlights as constituting the “human face “ of its reform strategy (agriculture, social sectors) largely fall within the constitutional purview of the State governments. The central government can influence outcome by laying out a road map or vision and through the allocation of plan expenditures and persuasive powers of the Planning Commission. This is what the budget tries to do. There are also some policy reforms that come under the purview of the Central government (essential commodities act, food Act, food regulator) and these have not been touched yet. The budget focuses on areas of critical importance to agriculture such as Water, technology, connectivity, credit, agro-industry and crop diversification and tries to integrate, modify and fine tune programs to give them a new direction. It carries out a similar exercise for the social sectors such as basic education and health, and socially disadvantaged persons. It has also increased overall plan allocation and promised further programmatic reform after the planning commission carries out a thorough review. Though the proof of the pudding will be in the eating, we expect more purposeful action to follow after the this review by the new Planning Commission, given the Prime Minister’s emphasis on governance issues and efficiency of expenditure.
The budget also gives clear reform signals aimed at fostering investment and growth. Sceptics have been silenced by the unambiguous proposal to raise FDI limits in Telecom from 49% to 74%, in Civil Aviation from 40% to 49% and in insurance from 26% to 49%. This follows the earlier cabinet proposal to move ahead with respect to private entry into up gradation and management of the Delhi and Mumbai airports with FDI up to 49%. Decisive implementation of this prior decision is more important the futile quibbling over limits. Removal of 85 items from the list of goods reserved for SSI also gives a clear signal that economic reforms and employment generation are not incompatible. This has been proved by China becoming the factory of the world (for labour intensive manufacturing) in precisely those item that had for so long been reserved in India. Another reform step that lays to rest to a great extent earlier fears about a collapse of the dis-investment program is the setting up of a Board for restructuring of Public sector enterprises. This board will consider all aspects objectively including the possibility of sale, closure and dis-investment.
On the Tax side the picture and the signals are mixed. Tax reform message is given by the bold move to a true CENVAT that integrates goods and services. The first step has been taken to convert the service tax, which is a turnover tax into a VAT type tax by allowing offset for taxes paid across both goods and services. The FM has also taken on the Steel producers lobby that had successfully kept the customs duty rate on steel way above the customs duty on all other metals such as aluminium, copper, nickel and tin, by reducing the import duty to 10% and related duties to 15%. The distortion introduced last February by reducing CENVAT from 16% to 8% has also been partially corrected.
On the other side of the balance sheet are the removal of the textile sector from CENVAT, the changes with respect to capital gains and turnover on securities, the method of reducing personal income tax for those with income below Rs. 1 lakh. Even if these are successful in the short term they will come back to haunt the FM in the long term, though he retains the option of correcting them in the next budget or the subsequent ones.
Monday, July 5, 2004
Budget, Policy Reform and Growth
As most readers know, the budget consists of two parts: The revenue and expenditure accounts of the government (the ‘fisc’) and policy reform issues falling under the purview of the finance ministry. The latter includes tax reform and financial reform (capital market, banking, insurance, pensions). Since 1991 broader macro (growth and poverty reduction) policies have also featured in the budget speech. The shape of the budget will be determined by the economic and political back-drop.
With a new government, there is bound to be a change in socio-political emphasis, while the underlying themes will remain unchanged as they have since 1991. The Congress party manifesto, the CMP, the President’s address to Parliament and the PM’s speech have progressively sharpened the focus and the budget will give it concrete shape. We distil two messages from these signals: One that faster economic growth is essential for meeting the national objectives, but policy reforms must firmly focus on the growth of incomes of the bottom 50% of the population. There is therefore increased hope that the much talked about agriculture and allied policy reforms will be translated into concrete actions. Second, public services such as drinking water, sewage, sanitation, public health & basic education depend critically on governance factors and delivery mechanisms and these must be improved in tandem with increased allocation of funds. One hopes that the improvement in governance that Dr Singh brought about from 1991 to 1996 in the finance ministry, banks etc. would now be replicated through out the central government. This could have a measurable impact on the welfare of the poor.
On the economic front, growth has slowed during the last five years to 5.6% per annum from 6.7% per annum in the previous five years. This has both a trend component and a cyclical component. The underlying growth trend in the manufacturing, agriculture and mining sectors has been downward for the past 7 years. Consequently GDP growth has also been on a downtrend contrary to the conventional wisdom prevailing in 2003-4. There is an urgent need to reverse this trend if the CMP objective of sustained 7% to 8% growth and employment for all is to be realised. The cyclical component, driven in the last 3 years by rainfall variations, contributed to the poor performance. The 8% growth rate last year represented mostly a monsoon led recovery of agriculture from the very poor rainfall of 2002-3. There are clearer signs of a cyclical recovery in 2004. A recovery in domestic investment, which has been low in the past three years, is presaged by the sustained higher growth rate of capital goods production. The cyclical recovery in industry needs to be sustained and strengthened. Both these require reforms that will improve the environment for investment and the generation of productive jobs and stimulate higher productivity growth.
The forthcoming budget is likely to make a start in addressing these issues. In our view, the following reforms will fulfil the objectives and constraints discussed above:
1. Reduce the peak tariff rate to 15% and above peak rates to 60%. A department of revenue committee (Virmani, 2001) had recommended limiting above peak rates to twice (3 times for liquor) the ‘peak rate’. Alternatively, announce that the peak rate will go down to 10% by 2006-7 and a uniform 5% import duty will come into being by 2008-9 thus converting India’s tariff rates from the highest in the world to the lowest. An ICRIER study (WP 135) has estimated the positive impact on exports and productivity.
2. Make the CENVAT into a genuine central VAT by including services within its ambit, eliminating all exemptions besides food, medical, education and tiny industry (Rs 10-20 lac) and reducing the rate to 15%. This is a better alternative to the Service tax (WP 4/2002-PC, April 2002).
3. Simplify the personal income tax by eliminating all exemptions (80L, 88 etc), having one rate for the standard deduction and sharply raising the income levels at which the 20% and 30% rates become applicable. This should be tax neutral for the average tax payer, make tax filing/payment easier, reduce tax evasion and increase revenues over time.
4. Phase out SSI reservation over the next year or so.
Agriculture deserves special attention because (a) its growth rate has declined sharply to 2.1% per year during 1998-9 to 2003-4 compared to 3.6% per annum in the previous five years. (b) Repeated droughts in some rain fed areas have been particularly harsh on those dependent solely on agriculture. (c) A large proportion of the poor reside in rural areas. Reform of agriculture and the food economy requires action by Central and State governments. The following are under the purview of the Centre:
5. Introduce a food debit/credit card (smart card) that entitles the poor to obtain food rations from any registered shop at specified rates. This would have to be supplemented by food stamps in areas where credit card systems have not reached and by co-operative channels of distribution in remote areas where the PDS is non-existent (WP 5/2002PC, December 2001).
6. Repeal the Essential Commodity act and replace it with an act that can be used only in an emergency in a specified area for a limited duration.
7. Introduce a unified food act and a single food regulator to deal with all food regulations.
8. Comprehensive reform of the agriculture research system to make it more autonomous (free of red tape & bureaucratic interference) and accountable for research (peer review of defined output) and dissemination. Encourage private-public partnership in the interest of the farmer.
9. Remove ceiling restrictions on FDI (in telecom, banks, insurance, retail trade, real estate development) that is exclusively directed either at the agriculture sector or at rural inhabitants/areas.
On the expenditure side, budget allocations for agriculture, irrigation, water, health and education sectors and employment (guarantee scheme) are likely to increase. Governance and social service delivery system reform will probably take shape over the next 6-9 months.
With a new government, there is bound to be a change in socio-political emphasis, while the underlying themes will remain unchanged as they have since 1991. The Congress party manifesto, the CMP, the President’s address to Parliament and the PM’s speech have progressively sharpened the focus and the budget will give it concrete shape. We distil two messages from these signals: One that faster economic growth is essential for meeting the national objectives, but policy reforms must firmly focus on the growth of incomes of the bottom 50% of the population. There is therefore increased hope that the much talked about agriculture and allied policy reforms will be translated into concrete actions. Second, public services such as drinking water, sewage, sanitation, public health & basic education depend critically on governance factors and delivery mechanisms and these must be improved in tandem with increased allocation of funds. One hopes that the improvement in governance that Dr Singh brought about from 1991 to 1996 in the finance ministry, banks etc. would now be replicated through out the central government. This could have a measurable impact on the welfare of the poor.
On the economic front, growth has slowed during the last five years to 5.6% per annum from 6.7% per annum in the previous five years. This has both a trend component and a cyclical component. The underlying growth trend in the manufacturing, agriculture and mining sectors has been downward for the past 7 years. Consequently GDP growth has also been on a downtrend contrary to the conventional wisdom prevailing in 2003-4. There is an urgent need to reverse this trend if the CMP objective of sustained 7% to 8% growth and employment for all is to be realised. The cyclical component, driven in the last 3 years by rainfall variations, contributed to the poor performance. The 8% growth rate last year represented mostly a monsoon led recovery of agriculture from the very poor rainfall of 2002-3. There are clearer signs of a cyclical recovery in 2004. A recovery in domestic investment, which has been low in the past three years, is presaged by the sustained higher growth rate of capital goods production. The cyclical recovery in industry needs to be sustained and strengthened. Both these require reforms that will improve the environment for investment and the generation of productive jobs and stimulate higher productivity growth.
The forthcoming budget is likely to make a start in addressing these issues. In our view, the following reforms will fulfil the objectives and constraints discussed above:
1. Reduce the peak tariff rate to 15% and above peak rates to 60%. A department of revenue committee (Virmani, 2001) had recommended limiting above peak rates to twice (3 times for liquor) the ‘peak rate’. Alternatively, announce that the peak rate will go down to 10% by 2006-7 and a uniform 5% import duty will come into being by 2008-9 thus converting India’s tariff rates from the highest in the world to the lowest. An ICRIER study (WP 135) has estimated the positive impact on exports and productivity.
2. Make the CENVAT into a genuine central VAT by including services within its ambit, eliminating all exemptions besides food, medical, education and tiny industry (Rs 10-20 lac) and reducing the rate to 15%. This is a better alternative to the Service tax (WP 4/2002-PC, April 2002).
3. Simplify the personal income tax by eliminating all exemptions (80L, 88 etc), having one rate for the standard deduction and sharply raising the income levels at which the 20% and 30% rates become applicable. This should be tax neutral for the average tax payer, make tax filing/payment easier, reduce tax evasion and increase revenues over time.
4. Phase out SSI reservation over the next year or so.
Agriculture deserves special attention because (a) its growth rate has declined sharply to 2.1% per year during 1998-9 to 2003-4 compared to 3.6% per annum in the previous five years. (b) Repeated droughts in some rain fed areas have been particularly harsh on those dependent solely on agriculture. (c) A large proportion of the poor reside in rural areas. Reform of agriculture and the food economy requires action by Central and State governments. The following are under the purview of the Centre:
5. Introduce a food debit/credit card (smart card) that entitles the poor to obtain food rations from any registered shop at specified rates. This would have to be supplemented by food stamps in areas where credit card systems have not reached and by co-operative channels of distribution in remote areas where the PDS is non-existent (WP 5/2002PC, December 2001).
6. Repeal the Essential Commodity act and replace it with an act that can be used only in an emergency in a specified area for a limited duration.
7. Introduce a unified food act and a single food regulator to deal with all food regulations.
8. Comprehensive reform of the agriculture research system to make it more autonomous (free of red tape & bureaucratic interference) and accountable for research (peer review of defined output) and dissemination. Encourage private-public partnership in the interest of the farmer.
9. Remove ceiling restrictions on FDI (in telecom, banks, insurance, retail trade, real estate development) that is exclusively directed either at the agriculture sector or at rural inhabitants/areas.
On the expenditure side, budget allocations for agriculture, irrigation, water, health and education sectors and employment (guarantee scheme) are likely to increase. Governance and social service delivery system reform will probably take shape over the next 6-9 months.
Wednesday, June 30, 2004
Pre-Budget Ruminations: 2004-5
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.
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.
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.
Friday, May 21, 2004
Elections 2004 And Economic Reforms
The PM designate (of India) has in his statement outlined the objectives of his government. At the risk of simplification we can say that there are two objectives. One is the emphasis on the income and welfare of the poor, the farmers and workers. The other is to make this to make India a prominent power so as the 21st century is an “Indian century.” To put it in economics lingo, the objective is to accelerate Growth, employment generation and poverty reduction. The PM designate has also emphasised that neither he nor his party have an ideological approach to meeting these objectives. In other words the method adopted for achieving these objectives will be pragmatic. Whatever works (policy, programs) to achieve these objectives will be adopted, whatever is ineffective or inefficient in meeting these objectives will be abandoned. In a way this can be read as the common mans definition of reforms.
The markets have been worried about what will happen to economic reforms generally and in particular to “Privatisation” and “ Labour reforms” under a Congress led government. Let us start with the facts. On privatisation the Congress party manifesto is quite explicit about not privatising profit making PSUs. It is pertinent to ask how many such units were privatised in the past 5 years. The answer is about five. About two years ago it looked like privatisation of PSUs was about to take off. Within a couple of months thereafter the exercise had crashed under the determined opposition of Shri Ram Naik, the SJM, the RSS and others. In the most negative scenario in which no profit making PSUs are privatised in the next five years a change from five to zero is not earth shaking. Further, won’t privatisation of 6-10 loss-making PSUs be as good for the economy as that of 5 profit making ones? In any case much of the action in the last few months of 2003-4, which had enthused the equity market, was in terms of sale of shares of profit making companies to the public. There does not seem to be any convincing reason why the public should not hold more shares in public sector units managed by the government.
A few years ago the Finance Minister’s budget speech talked about reforming the labour laws to impart greater flexibility to the labour market. Despite sporadic discussion and a number of GOMs on the issue no central laws, rule or regulation has been changed pursuant to this announcement. Thus even in the most negative scenario in which no further action is taken for labour reform, the actual policy change will be ‘no less than’ it was during the last 5 years.
What about reforms more generally? With Dr. Manmohan Singh as the (likely) Finance Minister, the quality of reforms is likely to improve. What do we mean by the quality of reform? As shown in a recent ICRIER paper (WP #121) on the link between policy reform and institutional reform successful policy reform requires good analysis to identify the critical bottlenecks to higher growth and poverty reduction, innovative design of policy taking account of socio-political constraints and supportive institutional changes. These steps improve the efficiency and sustainability of reforms. This is what one would expect to happen under the experienced economic leadership of Dr Manmohan Singh fully supported by the Prime Minister. The experience of a breakthrough in the growth of manufacturing sector during 1994-5 to 1996-7 (ICRIER WP #122) also gives room for optimism that it can both be recreated and sustained given the accumulated experience.
Expectations play a very important role in the modern economy. This situation is quite different from what it was twenty years ago and is radically different from what it was 50 years ago. By the nature of capital (stream of output for many years in the future) investment has to be forward looking. Therefore an entrepreneur or investor has to gaze into the future and form expectations about what will happen to the market for its product etc. As the financial sector intermediates between savers and investors it is the fulcrum around which these expectations operate. With the widening of markets for saving, investment and the growth of the financial sector, and the increasing diversity of markets and products, the importance of expectations has increased over time. Both domestic and global politics influence expectations about the economy. There is therefore a link between political developments and financial markets through expectations. In a period of transition from one government to another, such as the present, when hard facts about the new government are scarce, speculation plays a much greater role than at normal times. Thus great care needs to be exercised in making statements about policy and programs that will effect investment decisions. These speculative elements will gradually die down as the new government ministers take charge and the policy of the new government gets defined. Reform actions will then have a greater role in determining expectations and financial market developments. I have no doubt that reforms will continue (at least) at a pace that maintains the 5.8% per annum growth rate that has prevailed for the last 24 years, the 8th highest in the World (ICRIER WP #122). This has reduced the poverty rate from about 55% of the population (end-1970s) to 26% (1999-2000). Faster growth and poverty reduction may, however, require accelerated reform.
The markets have been worried about what will happen to economic reforms generally and in particular to “Privatisation” and “ Labour reforms” under a Congress led government. Let us start with the facts. On privatisation the Congress party manifesto is quite explicit about not privatising profit making PSUs. It is pertinent to ask how many such units were privatised in the past 5 years. The answer is about five. About two years ago it looked like privatisation of PSUs was about to take off. Within a couple of months thereafter the exercise had crashed under the determined opposition of Shri Ram Naik, the SJM, the RSS and others. In the most negative scenario in which no profit making PSUs are privatised in the next five years a change from five to zero is not earth shaking. Further, won’t privatisation of 6-10 loss-making PSUs be as good for the economy as that of 5 profit making ones? In any case much of the action in the last few months of 2003-4, which had enthused the equity market, was in terms of sale of shares of profit making companies to the public. There does not seem to be any convincing reason why the public should not hold more shares in public sector units managed by the government.
A few years ago the Finance Minister’s budget speech talked about reforming the labour laws to impart greater flexibility to the labour market. Despite sporadic discussion and a number of GOMs on the issue no central laws, rule or regulation has been changed pursuant to this announcement. Thus even in the most negative scenario in which no further action is taken for labour reform, the actual policy change will be ‘no less than’ it was during the last 5 years.
What about reforms more generally? With Dr. Manmohan Singh as the (likely) Finance Minister, the quality of reforms is likely to improve. What do we mean by the quality of reform? As shown in a recent ICRIER paper (WP #121) on the link between policy reform and institutional reform successful policy reform requires good analysis to identify the critical bottlenecks to higher growth and poverty reduction, innovative design of policy taking account of socio-political constraints and supportive institutional changes. These steps improve the efficiency and sustainability of reforms. This is what one would expect to happen under the experienced economic leadership of Dr Manmohan Singh fully supported by the Prime Minister. The experience of a breakthrough in the growth of manufacturing sector during 1994-5 to 1996-7 (ICRIER WP #122) also gives room for optimism that it can both be recreated and sustained given the accumulated experience.
Expectations play a very important role in the modern economy. This situation is quite different from what it was twenty years ago and is radically different from what it was 50 years ago. By the nature of capital (stream of output for many years in the future) investment has to be forward looking. Therefore an entrepreneur or investor has to gaze into the future and form expectations about what will happen to the market for its product etc. As the financial sector intermediates between savers and investors it is the fulcrum around which these expectations operate. With the widening of markets for saving, investment and the growth of the financial sector, and the increasing diversity of markets and products, the importance of expectations has increased over time. Both domestic and global politics influence expectations about the economy. There is therefore a link between political developments and financial markets through expectations. In a period of transition from one government to another, such as the present, when hard facts about the new government are scarce, speculation plays a much greater role than at normal times. Thus great care needs to be exercised in making statements about policy and programs that will effect investment decisions. These speculative elements will gradually die down as the new government ministers take charge and the policy of the new government gets defined. Reform actions will then have a greater role in determining expectations and financial market developments. I have no doubt that reforms will continue (at least) at a pace that maintains the 5.8% per annum growth rate that has prevailed for the last 24 years, the 8th highest in the World (ICRIER WP #122). This has reduced the poverty rate from about 55% of the population (end-1970s) to 26% (1999-2000). Faster growth and poverty reduction may, however, require accelerated reform.
Saturday, February 28, 2004
The 2003-04 Budget: Commentary
In listening to the budget live, as one special group after another received specially tailored exemptions, I was gradually transported back a decade and a half in time, when budgets used about giving and withdrawing concessions. My fear that the budget would be shaped and driven by the forthcoming elections was moderated by the Finance minister’s inherent conservatism. Even when he gave income tax concessions to government servants, retirees, pensioners, the sick, these were far from extravagant. The sectoral give-aways though equally modest were more clearly ART (against the reform trend) as they represented a return to industry specific customs duty exemptions, that every body had agreed were bad for the economy. As expected only the administrative reform recommendations of the Kelkar committees were accepted while the reform elements were junked after a bow. Even the forecast removal of the surcharge was partial, the dividend tax was replaced by the old dividend distribution tax and the long-term capital gains tax on shares eliminated for a year.
Within this overall picture of lack of clear economic direction there are a few nuggets that are positive. As expected the ‘peak’ customs duty was reduced to 25% (from 30%). To my surprise the administered interest rate on Government Provident fund and related schemes was reduced by 1% point. SSI reservation was also eliminated on 75 more items, and the expenditure tax eliminated. These steps could have a modest positive effect on investment expectations if followed up by other reform steps in the EXIM and Credit policies in the next two months.
Within this overall picture of lack of clear economic direction there are a few nuggets that are positive. As expected the ‘peak’ customs duty was reduced to 25% (from 30%). To my surprise the administered interest rate on Government Provident fund and related schemes was reduced by 1% point. SSI reservation was also eliminated on 75 more items, and the expenditure tax eliminated. These steps could have a modest positive effect on investment expectations if followed up by other reform steps in the EXIM and Credit policies in the next two months.
Wednesday, February 4, 2004
Interim Budget/Vote on Account : Mini-budget for 2004-5
Many people made the mistake of seeing the actions so called ‘election sops’ announced earlier as being distinct actions, that gave an indication of more to come in the (Indian) Mini-budget. It was actually a three act play, where the more provocative and surprising actions were taken pre-budget and the budget itself was more moderate and mild so as to ensure quick passage in parliament and minimise any potential hitch in dissolving parliament on February 6th. From an economic reform perspective, it is therefore more fruitfull to take all the measures together. These can be divided into three parts:
(a) Genuine reform measures include the reduction of the peak import duty rate from 25% to 20% and the corresponding reduction baggage import duties along with a rise in the free allowance and the elimination of the SAD. Research at ICRIER has shown that these measures will stimulate the efficiency and productivity of the manufacturing sector.
(b) Anti-reform actions: Include a number of new end-use exemptions in the customs act, and exemptions in the CENVAT something that tax reformers like myself have been struggling for the past decade and a half to eliminate. Zero duty excise rates on food, drug and medical items improve equity. All others increase inefficiency. Every customs duty exemption hurts another industry and leads to a string of input exemptions that complicate the system often leading to negative protection. That is why the Virmani(2001) committee of the revenue department recommended a uniform tariff rate. Other negative changes relate to the sugar industry and the merging of 50% of DA with salary for central govt employees. The solution to the former is complete de-control of the sugar industry. The latter will result in further pressure on the fiscal situation of the Centre and the States.
(c) There are also a number of measures, that are taken in every budget to provide some benefit to each group. As long as there is no major negative impact on the fic these are the normal socio-economic actions that every government has to take. Some of them pan out (eg. The Antodya scheme, the Kisan Credit Card), while others fail (DRI scheme, the subsidised interest scheme for loans below Rs 2 lakh, now raised to Rs 10 lakh).
Overall I would say it is moderate budget and more appropriate to the circumstances than I had expected.
(a) Genuine reform measures include the reduction of the peak import duty rate from 25% to 20% and the corresponding reduction baggage import duties along with a rise in the free allowance and the elimination of the SAD. Research at ICRIER has shown that these measures will stimulate the efficiency and productivity of the manufacturing sector.
(b) Anti-reform actions: Include a number of new end-use exemptions in the customs act, and exemptions in the CENVAT something that tax reformers like myself have been struggling for the past decade and a half to eliminate. Zero duty excise rates on food, drug and medical items improve equity. All others increase inefficiency. Every customs duty exemption hurts another industry and leads to a string of input exemptions that complicate the system often leading to negative protection. That is why the Virmani(2001) committee of the revenue department recommended a uniform tariff rate. Other negative changes relate to the sugar industry and the merging of 50% of DA with salary for central govt employees. The solution to the former is complete de-control of the sugar industry. The latter will result in further pressure on the fiscal situation of the Centre and the States.
(c) There are also a number of measures, that are taken in every budget to provide some benefit to each group. As long as there is no major negative impact on the fic these are the normal socio-economic actions that every government has to take. Some of them pan out (eg. The Antodya scheme, the Kisan Credit Card), while others fail (DRI scheme, the subsidised interest scheme for loans below Rs 2 lakh, now raised to Rs 10 lakh).
Overall I would say it is moderate budget and more appropriate to the circumstances than I had expected.
Tuesday, February 3, 2004
Interim Budget/ Vote on Account 2004-5
Many people were dis-appointed by the Mini Budget. Neverthless many people, particularly stock market investors and salary earners, hoped that they would be favoured by an election eve Bonanza through reduction in their income tax liability. The Finance Minister, quite wisely, decided not to stir the hornet’s nest in the Lok Sabha by announcing income tax changes that could not be implemented as parliament could not pass such a finance bill under the vote-on account.
So what is the balance sheet of this Mini-budget. From a reform perspective, there are two significant plus points and two minus points. First the announcement of a halving of the central Stamp duty, even though implementation must await a change in the stamp act is a positive signal. The stamp duty is a highly inefficient and outdated tax. The reduction in rates may not even reduce revenues as evasion is likely to decline as more people follow regular registration procedure. The second positive signal is the setting up of the non-lapsable Defence fund. As major defence purchases have to be forward looking because the fast pace of technological development and consequent obsolescence, and the procurement procedures are unduly drawn out dilatory, defence planning suffers. This fund will make it possible to plan and procure major weapons systems more efficiently. The two negative factors are to (a) continue the license-subsidy Raj in the sugar industry, and (b) to merge 50% of DA with salary for central government servants. The latter will not only increase the revenue and fiscal deficit of the central government on a continuing basis but also have a negative effect on State governments’ finances.
So what is the balance sheet of this Mini-budget. From a reform perspective, there are two significant plus points and two minus points. First the announcement of a halving of the central Stamp duty, even though implementation must await a change in the stamp act is a positive signal. The stamp duty is a highly inefficient and outdated tax. The reduction in rates may not even reduce revenues as evasion is likely to decline as more people follow regular registration procedure. The second positive signal is the setting up of the non-lapsable Defence fund. As major defence purchases have to be forward looking because the fast pace of technological development and consequent obsolescence, and the procurement procedures are unduly drawn out dilatory, defence planning suffers. This fund will make it possible to plan and procure major weapons systems more efficiently. The two negative factors are to (a) continue the license-subsidy Raj in the sugar industry, and (b) to merge 50% of DA with salary for central government servants. The latter will not only increase the revenue and fiscal deficit of the central government on a continuing basis but also have a negative effect on State governments’ finances.
Has the interim budget achieved anything?
Many people were dis-appointed by the Mini Budget. Neverthless many people, particularly stock market investors and salary earners, hoped that they would be favoured by an election eve Bonanza through reduction in their income tax liability. The Finance Minister, quite wisely, decided not to stir the hornet’s nest in the Lok Sabha by announcing income tax changes that could not be implemented as parliament could not pass such a finance bill under the vote-on account.
So what is the balance sheet of this Mini-budget. From a reform perspective, there are two significant plus points and two minus points. First the announcement of a halving of the central Stamp duty, even though implementation must await a change in the stamp act is a positive signal. The stamp duty is a highly inefficient and outdated tax. The reduction in rates may not even reduce revenues as evasion is likely to decline as more people follow regular registration procedure. The second positive signal is the setting up of the non-lapsable Defence fund. As major defence purchases have to be forward looking because the fast pace of technological development and consequent obsolescence, and the procurement procedures are unduly drawn out dilatory, defence planning suffers. This fund will make it possible to plan and procure major weapons systems more efficiently. The two negative factors are to (a) continue the license-subsidy Raj in the sugar industry, and (b) to merge 50% of DA with salary for central government servants. The latter will not only increase the revenue and fiscal deficit of the central government on a continuing basis but also have a negative effect on State governments’ finances.
So what is the balance sheet of this Mini-budget. From a reform perspective, there are two significant plus points and two minus points. First the announcement of a halving of the central Stamp duty, even though implementation must await a change in the stamp act is a positive signal. The stamp duty is a highly inefficient and outdated tax. The reduction in rates may not even reduce revenues as evasion is likely to decline as more people follow regular registration procedure. The second positive signal is the setting up of the non-lapsable Defence fund. As major defence purchases have to be forward looking because the fast pace of technological development and consequent obsolescence, and the procurement procedures are unduly drawn out dilatory, defence planning suffers. This fund will make it possible to plan and procure major weapons systems more efficiently. The two negative factors are to (a) continue the license-subsidy Raj in the sugar industry, and (b) to merge 50% of DA with salary for central government servants. The latter will not only increase the revenue and fiscal deficit of the central government on a continuing basis but also have a negative effect on State governments’ finances.