Monday, February 28, 2005

A Reform Budget: Promised Reform have Fructified

The PM and the FM had promised extensive tax reforms in the budget for 2005-6. This transparency raised the possibility of over-expectations and disappointment. The budget has however met the expectations. The surprise element, that could perhaps have transformed this budget from a very good one to an outstanding one, was however lost. There is clearly a trade-off between transparency and pleasant surprises that characterised the two outstanding budgets (current account convertibility and income tax rate reductions).
In the Pre-Budget meeting that the Finance Minister had with economists I had suggested three areas of economic reforms for the 2005-6 budget. These were tax reforms, FDI policy and Infrastructure reforms. As all three areas have been emphasised by the government. it is interesting to see where the budget has fallen short or exceeded these implicit expectations. Taking FDI first, the presentation had emphasised the importance of FDI in raising the growth rate from the 6 to 6.5% level to the 7 to 7.5% level. Research done at ICRIER has shown that FDI has a positive impact on exports, efficiency and productivity of modern sectors where it enters. In contrast to the Interim budget last year this years budget merely talks of a committee to look at FDI in sectors such as mining and distribution. The completion of the FDI reforms promised in the previous budget with respect to Aviation and Telocom and the announcement of considerable liberalisation of FDI in Real Estate (construction development) is however quite encouraging. A paper and a project report by two different ICRIER scholars respectively, have recommended allowing FDI in the retail sector. I expect FDI in the retail sector to be allowed during the next 6 –9 months.
In Infrastructure, the presentation had emphasised the quality of infrastructure investment versus the quantity. The best way to improve infrastructure was to divide it into three different categories that required different emphasis, namely public goods (roads, town & village infrastructure, R&D, knowledge dissemination), quasi-public goods (rural infrastructure) and private goods (urban electricity, airports, ports, railway services). It was recommended that limited government revenues must focus on the first two categories while improving the productivity of these expenditures through institutional reform and innovation. In addition private-public partnerships, subsidy auctions and other innovative mechanisms can play a vital role. Though the budget has still not adopted this three-fold classification, in implementing the agricultural development and rural poverty alleviation objectives of the CMP higher expenditure allocations have sought to be made more effective by channelling them through new and or improved institutional mechanisms. In the case of private goods (infrastructure) the presentation had emphasised the importance of the policy and regulatory framework so as to minimise policy risk. The budget does not spell out these things in detail but one expects the planning commission and the infrastructure committee to do so in the next 3 months.
Tax reform is of course the core of this budget. The income tax and customs duty reforms have met or exceeded expectations, while excise duty reforms have fallen short. The presentation had emphasised the integration of goods and services in a comprehensive CENVAT with a uniform rate of 15-16% and exemptions for food products, medical goods and services and education services. Though the grand design has not been implemented, this can probably be justified the need for caution at the time at which the State Vat is coming into operation. There has also been progress in reducing the excise on PFY & tyres and in exempting some food products. A further rise in the SSI in the SSI exemption from 3 crore to 4 crore is however a retrograde.
On customs duty the presentation had suggested reduction of the peak customs duty to 15% this year and 10% next year along the lines of the Inter-ministerial Group report (Virmani, November 2001). The peak rate reduction will enhance the efficiency and competitiveness of the industrial sector. No steps have been taken to start reducing the very high import duties on some agriculture products and this will act as a drag on the agro-processing sector. Selective reduction of import duties on capital goods to 10% can also be justified in the interest of faster productivity growth.
Income tax reform has three key elements. The elimination of the standard deduction and other exemptions and the consolidation of the saving exemption into one integrated exemption of Rs 1 lakh. The extension of the 10%, 20% and 30% brackets to 1lakh, 1.5 lakh and 2.5 lakh respectively. Our presentation had emphasised the simplification of the system from the perspective of the honest taxpayer and the reform has met this expectation. The long-standing recommendation to bring the corporate tax rate to 30% has also been met, but it has been offset by the imposition of a surcharge and the reduction of the depreciation rate. Along with the MAT credit the effective tax rate is only marginally different.
The SSI reserved list has been further pruned by the removel of 108 items of which 30 are from the textile sector.
The finance minister has successfully balanced tax reform with the need for raising more tax revenue. He has also been reasonable successful in balancing social, agriculture and infrastructure expenditure requirement of the common minimum program against the requirements of fiscal balance imposed by the Fiscal reform and budget management act, even though he has had to suspend the revenue deficit reduction targets for next year. Thus he has neatly balance the political imperatives against the demands of economic rationality and reform.

Indian Budget 2005-6

There was one expectation and one fear before this budget. The budget fully met the expectation of solid tax reform and belied fears of a politically driven increase in expenditures that would be largely wasted without achieving any social or economic objectives. Given the reputation of the PM and FM as tax reformers and their own statements to this effect tax reform was expected in Customs, Excise and Income tax. This has indeed happened in all three years. The reduction in the peak customs duty rate to 15%, reduction of the excise on PSF and tyres to the general rate of 16%, simplification of the personal income tax and the 30% rate on corporate tax are among the positive features. This does not mean that there are no negative elements in the tax changes only that they are within reasonable bound expected of any government and not so large as to dilute the overall positive impact of the reforms. The reform thrust has been reinforced by removal of another 108 items from the list of SSI reserved items and the reforms of the financial sector.
On the expenditure side, promised increases in expenditure on social sectors (education, health), agricu;lture, rural infrastructure and employment have gone hand in hand with efforts to reduce wastage and improve their effectiveness. This includes efforts to find alternative institutions for channelling these expenditures, improving monitoring and evaluation of the effect of these expenditures and exploration of private-public partnerships.

The Economics and Politics of the Budget

When Dr Manmohan Singh became Prime Minister, the middle class by and large was very happy that an educated professional had become the Prime Minister of India. Still many among his supporters and well wishers wondered whether he had the political savy to be effective in the dog-eat-dog world of politics. The way in which the ‘dream team’ and the finance minister (who has been in politics the longest) have balanced economic rationality against political imperatives has been quite masterful. There are three sets of issues that have been balanced: (a) Tax reform (revenue neutral) and raising tax revenue (tax GDP ratio). (b) Fiscal prudence & revenue deficit reduction and new expenditures mandated by the Common Minimum Program of the government. (c) Broader economic reforms and narrow budget issues (taxes, expenditures) within the purview of the finance ministry. Let us start with the last one first.
Since 1991 most finance ministers have used part A of their speech to send a broader reform message by announcing reforms that do not fall strictly within the purview of the finance ministry. These reforms have often been left unimplemented for many years. For instance three years ago the budget speech promised labour policy reforms, but they could not be implemented by the government in the remaining two years of its tenure. The 2005-6 budget has minimized the announcement of specific non-fiscal/financial reforms that would require action by other ministries. Even in the case of FDI, though the possibility of raising FDI caps has been indicated, there is no specific announcement in contrast to the previous budget. Criticism of the budget by the left has therefore been minimized, while FDI actions including liberalization of FDI in ‘Real Estate’ were announced the previous week and liberalization of FDI in retail is likely to follow after the budget has been passed. Relatively non-controversial financial sector reforms have been carried forward. The SSI reserved list has been rightly pruned further so as to take on the challenge of labour intensive Chinese exports in global markets.
The second set of balances is that between tax reform and raising the tax-GDP ratio so as to finance new expenditures or bring down the revenue/fiscal deficit. Reforms have been carried out in all three areas though to different degrees. The most radical reform is in personal income tax followed by Customs duties and Corporate tax and Excise. The so-called ‘Peak rate’ that applies to all manufacturing and mining has been reduced from 20% to 15%. Though there was scope for reducing the very high agricultural tariffs these have not been touched for political reasons. Duties on capital goods imports have been reduced to 10% in the expectation of greater productivity boost from machinery investment. Excise tax reforms are modest but significant in that PFY duty has finally been brought down to the basic rate along with that on tyres and ACs. The reduction in customs and excise rates on oil products can be justified as a temporary response to high oil prices, though in the long term they should not be given special consideration and must have uniform ad valorem rates. Personal income tax reform has been the most radical with the raising of tax brackets, elimination of the very complex standard deduction and the unification of the savings deductions into a single integrated one of Rs 1 lakh. Corporate tax changes are a mixed bag with a reduction in the rate from 35% to 30%, the imposition of a surcharge of 10% and the reduction in the depreciation rate.
The third set of balances has been that between the social imperatives of the CMP and the requirement of Fiscal Responsibility and Budget Management Act. The CMP asserted the need for raising expenditures on education, employment, health, agriculture/rural and infrastructure sectors. As some of us have pointed, out throwing more public money at these problems will not solve them unless the effectiveness of these expenditures in achieving their objectives is enhanced. Thus higher allocation for the social sectors and rural infrastructure have been balanced by a search for innovative ways of making these expenditures more effective in reaching those who are in greatest need. An output based approach to monitoring and evaluation is promised, in place of the current input/expenditure based approach. Though the FRBM targets have been largely met during the year, they will be held in abeyance during 2005-6. In my view this is better than the alternative of raising effective tax rates under the guise of tax reforms (what I have earlier referred to as ART)
Overall the finance Minister has produced a Very good budget by minimising the opportunity for political criticism while introducing substantial reforms in taxation.

Monday, February 21, 2005

What Should The SEZ Law Do?

China’s success in attracting export related FDI and its success in labour intensive exports contrasts sharply with that of India. Many of the policy reforms that are politically difficult in India were equally difficult in China. China however was able to introduce these reforms on an experimental basis in their Special Export Zones and then use the demonstrated success of these reforms to make them deeper and wider. This is an example worth emulating.
A number of surveys have shown that the key problems with respect to FDI are Bureaucratic red tape, Labour laws, rules & procedures and Private infrastructure policy and regulatory systems (“Foreign Direct Investment Reform,” Arvind Virmani, Occasional Policy Paper, ICRIER, April 2004; http://www.icrier.org/FDIsgpc03.pdf). Though the first best solution would be to improve these across the country, this could take decades. The Central and State SEZ laws should cover industrial, labour, environmental, infrastructure and administrative issues, with a view to simplifying and promoting investment and production in the SEZs. Though tax neutrality is an objective, the purpose is not to give sops and incentives that distort the system and are not sustainable .
Though it will take a decade or more to improve infrastructure services across the country, infrastructure availability and quality can be brought to global standards in the Special Economic Zones (SEZs) within a couple of years. The effect of a weak highway and railway system can be minimised by locating SEZs in the coastal regions as was done by China and many other countries in S. E. Asia. Among the measures needed for accelerated development of Infrastructure in and exports from SEZs are;
a. Power generation and distribution for the SEZ needs to be isolated from the crumbling SEBs to the extent possible. As size limitations make electricity generation for the SEZ (alone) non-optimal, the private electricity generator for the SEZ should be allowed to sell excess power to parties outside the SEZ subject to transparent wheeling charges and cross tax-subsidy arrangement.
b. There should be free entry and exit of Telecom service providers into the SEZ without any service or USO charges, subject only to the condition that the spectrum would be auctioned if and only if it ceases to be a “free good” within the SEZ. Inter-connectivity with other countries (ILD) should be free and unrestricted (subject only to the condition that this cannot be used as a conduit for provision of unregulated telecom services into the DTA). Automatic 100 per cent FDI should be allowed.
c. Private parties would also be free to set up a private airport or port to service the SEZs with automatic 100% FDI. If an unused harbour is not available nearby, the requisite number of berths in the closest port should be made available to private parties for the purpose of servicing the SEZ. These parties (or another developer) should be given the authority to set up toll highway connecting the port to the SEZ.
d. A law should be passed by the State governments under which 100% privately owned townships can be set and run by private developers as private municipalities. Private SEZs should be designated as private municipalities under this law and road, electricity transmission & other linkages provided by State/Central govt.

A number of other legal and bureaucratic changes can also be introduced much more quickly in the SEZs than is possible in the country in general. The applicable laws, rules, regulations and procedures in the SEZs should be made as attractive as in China’s coastal regions & other competing destinations. This requires,
a. Elimination of all price controls & distribution controls (e.g. on Power, Rents),
b. Removal of all investment restrictions (e.g. SSI reservation, foreign equity limits & bans, public sector reservation) for production and supply within the zone or for export. This would include removal of State & local restrictions (eg. Urban land ceiling, retail trade, real estate).
c. Removal of all capital account restrictions/controls/prior permissions for businesses operating within the SEZ (reporting requirements and regulations relating to inflow of Foreign exchange debt etc. into DTZ would remain).
d. International standard financial regulations for financial institutions operating within the zone with our unique Indian “controls” eliminated. Thus the FDI limits on Banking, Insurance, NBFCs would not apply, directed credit & SLR would be eliminated and CRR brought down to internationally comparable levels.
e. Customs, Excise & Service tax laws to be modified so that all transactions within the SEZ are exempt and transaction of DTA with the SEZ can be treated as if with a foreign country. Normal excise (& customs) rules would no longer apply for transactions within the SEZs. Customs and Additional duty (equal to CENVAT/Excise) would apply to all sales to DTA. SAD should not apply as state sales and other taxes would apply on DTA sale. State sales tax law should also be modified, so that within the SEZ only sales to resident consumers (not producers/traders) are taxed. No excise/CST/ST/Octroi would be charged for sales from DTA to SEZs.
f. Normal personal and corporate income taxes would apply, but not the surcharges, cesses, MAT or any other temporary/special imposts. The depreciation rate should be globally competitive.
g. A new labour law incorporating a work ethic. Abolition of Contract Labour restrictions. Freedom for multiple and night shift for workers of both sexes. Designation of Development Commissioner as Labour Commissioner.
h. An integrated unified industrial regulator (i.e. only one inspector for all continuing industrial regulations including pollution, labour safety).
i. Designation of the Development Commissioner as the Commissioner under all the relevant laws (industrial, environmental etc.) within the SEZ.
j. A modernised judicial sub-structure for SEZs that deals with cases in a time bound manner.
In fact we should experiment with an even bolder model of a market economy with no controls and restrictions complemented by a modern regulatory system based on trust that punishes violators quickly and effectively like the traffic light approach. For some regulations, self-certification may be adequate while for others outside (private) certification eg. by an accredited professional or certification agency) may be required.
A special marketing effort is needed for export oriented FDI. For instance, Taiwanese and other exporters in East and S.E. Asia can be targeted for this purpose. Our missions in OECD and other FDI source countries should be fully briefed on the comparative advantages of SEZs in India and distribute the required literature.

Monday, February 14, 2005

It’s the economy stupid

Though we are not in the business of forecasting elections, what this article attempts to do is to relate standard economic analysis of consumer utility to voting behavior. It goes on to authenticate (not test) the results against the results of recent elections but at this stage, it remains a hypothesis, perhaps a useful starting point for more refined and perhaps even much better models of voter behaviour.
A short article is not the place to give detailed specifications of the model (for the full text, visit icrier.res.in/wp138.pdf), but broadly speaking, the model assumes an improvement/worsening of economic conditions can increase/decrease the probability of voting for the party perceived to be responsible for the change, that voters vote for the incumbent if they are happy with the quality/supply of public goods, that they tend to vote in favour of parties that lower tax rates, among others.

Since income taxes or transfers (like subsidies) received by the voter are generally a very small fraction of a voter’s total income, the change in income growth will usually have a far more significant impact on voter behaviour. While voting behaviour is influenced by the quality of public services like electricity, but when these are privatised and still continue to remain poor, voters tend to blame the private firms and not the government.
While the economy grew at 5.6 per cent annually during the National Democratic Alliance’s (NDA) tenure, this was lower than the 6.7 per cent in the previous five years. In terms of per capita income, the NDA clocked 3.8 per cent versus 4.7 per cent of the previous five years. Not only was the NDA’s economic performance poorer than the United Front’s, the India Shining campaign served to highlight to the voter the gap between what was being projected and what had actually been achieved. Not surprisingly, the NDA was voted out in the elections.
Election results in Rajasthan, Madhya Pradesh, and Punjab are all in keeping with what the model suggests. Economic growth during Digvijay Singh’s last tenure fell to around 60 per cent of the 5.4 per cent achieved during the 1994-95 to 1998-99 period (per capita income growth fell from 3.1 per cent to 0.5 per cent per year), and so Singh lost the assembly elections. Since GDP performance slowed in Rajasthan (per capita collapsed from 6.7 per cent in 1994-95 to 1998-99 to 0.5 per cent between 1999-00 to 2003-04), the government there fell as well.
What of Bihar? Surprise, Surprise! Bihar’s economic performance has actually improved under Lalu Prasad Yadav’s last tenure. While GDP grew by 4.8 per cent per annum during the 1994-95 to 1998-99 period it grew by 7.7 per cent during the 1999-00 to 2003-04 period and per capita income galloped from 1.9 per cent to 5.4 per cent. Indeed, even agricultural growth in Lalu’s last tenure in Bihar was much higher than in the previous five years, and this was a reason for why voters voted for him once again.
While the ‘simple’ economic analysis fails in Delhi since Sheila Dikshit won the election despite economic growth falling (per capita growth fell from 5.5 per cent to 4.2 per cent)? A more ‘complicated’ analysis could be that growth in Delhi was still among the highest in India and comparable to the best in the world and that ‘the relatively better educated/informed electorate in Delhi were also convinced that the incumbent (Dikshit) was sincerely trying to improve governance, including through privatisation of electricity distribution.
While there was only a marginal fall in Andhra’s GDP growth, and none in per capita income growth during the two periods, Chandrababu Naidu’s defeat is explained by the high expectations that Chandrababu had aroused. Naveen Patnaik’s win in Orissa despite virtually no change in growth, on the other hand, can be explained away by the argument that his low key style lowered expectations and so he came out smelling of roses. The Godhra riots, helped the BJP win the Gujarat assembly elections despite the sharp slowdown in economic growth (GDP growth fell from 7.4 per cent per annum to 3.1 per cent between the two periods), but within a year of Narendra Modi coming back to power the NDA lost the election at the centre since people realized the impact of Godhra on investment and so in the general elections the growth factor seems to have re-asserted itself.
The purpose of the paper is not to do forecasting in the manner that psephologists do, but to explain the role played by economic factors.

Sunday, February 13, 2005

Uniform Customs Duty

It can be shown that a single uniform import tariff implies that the effective protection for all producers is also equal to this single uniform tariff (‘Towards a Competitive Economy: VAT and Customs Duty Reform’, Arvind Virmani, Planning Commission Working Paper No. 4/2002-PC, April 2002). Thus all producers and all uses of capital and labour are equally protected. Such a system also eliminates the possibility of negative protection as well as arbitrarily high rates of protection. Such a system is neutral and equal for all value added by domestic producers, promotes efficiency and competitiveness and eliminates all administrative hassles and legal disputes about classification.
A single uniform rate of customs duty on all imports has many attractive features. It ensures that the nominal protection for all imports is the same thus eliminating all classification problems and disputes, resulting in substantial saving in administrative and legal costs. It also makes it much easier to administer the duty free import regime for exporters. As a single rate applies to all imports only a total value of imports needs to be specified in any advance license, making actual import 100% flexible. Similarly any draw back or refund only needs to have the value of imports used in export production. Most imports can in principle be on self-declaration basis with customs staff focusing their time and energy on checking smuggling (mis/non-declaration of quantity) and chronic misstatement of price. If in addition this rate is reasonably low the incentive for smuggling will be minimised and make the administrative problem of checking it, manageable.
There is much greater economic justification for a neutral customs duty regime than there is for a single uniform rate VAT (or CENVAT) with no exemptions, special excises or sales taxes. Such a regime will eliminate the continuous lobbying by special interest groups that now takes place and the special benefits to the rich and powerful that inevitably result from such lobbying. This is so because the benefit-cost ratio for an individual person/company is greater the larger its market share. The ability of Public sector units, whether in steel, oil or other sectors, to lobby for special protection through their administrative ministry and to thus distort the structure of customs duties has been amply demonstrated. As the cost of such lobbying is even less than for large private firms, the distortions can be even greater. This too would be eliminated.
The country should aim to achieve internationally comparable rates of import duty during the next 3-4 years and therefore recommend that a single uniform rate of basic customs duty of 5% be applied to all imported goods by 2008-9. All end-use exemptions should be abolished when this rate is achieved. At this point all anomalies would be removed with the exception of those arising from international agreements.
The ‘peak rate’ should be reduced to 15% in 2005-6. A schedule of rate reductions should also be announced. The minimum duty on exempt items should be raised to 5% by 2006-7. The high rate exceptions to the peak rate should be specified in multiples of the peak rate and brought down in line with the peak rate till 2008-9. Thereafter the import duty on these items should be phased down to 5%.
The uniform rate of 5% will have the additional benefit of reducing our simple average tariff rates below those prevailing in neighbouring countries and in Vietnam & Thailand. Our economic interests will then become much more closely aligned with theirs. Indian industry and agriculture will have much less to fear from special free trade arrangements with our neighbours than is the case today. Similarly India would have a much better case for closer economic integration with ASEAN than it has today. We can then sign FTA agreements with any country without much danger of distorting bilateral and regional trade through trade diversion.
The ‘peak’ rate of duty, which is currently 20%, applies to manufactured goods, minerals and some agricultural goods. In addition many agricultural goods have rates that are higher than the peak rate. Overall, these rates are still among the highest in the world.