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).
Wednesday, August 11, 2004
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.
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