Monetary Policyand Growth

Introduction

     RBI has been behind the curve on monetary policy for the past 18 months or so. My forecasts of inflation, on the basis of which I have recommended greater easing of monetary policy(in the TAC on monetary policy till July), have been lower than RBI forecasts, and closer to actual CPI results. (http://dravirmani.blogspot.in/2016/04/growth-inflation-and-monetary-policy.html , http://dravirmani.blogspot.in/2015/04/inflation-monetary-policy-2015-16.html).
     A week before the RBIs February monetary policy(8/2/17) I had said in a long interview, that RBI's MPC should reduce repo rates / loosen monetary policy, but it was very unlikely to do so ( http://www.btvi.in/m/videos/watch/21109/fiscal-prudence-prevails ) . This was because the MPC would focus on global conditions such as world prices and interest rates (possibility of US FED rate rise, forecasts of higher world growth by WB, IMF etc) than on domestic conditions such as the dramatic fall in inflation, slower GDP growth and declining fixed investment. This forecast has unfortunately come true. Worse, the change in guidance from "accommodative" to "neutral" signals an unfortunate tightening of monetary policy.

CPI or Core CPI?

     Now that CPI inflation is down to 3.5%, the inflation target seems to be shifting to "core CPI inflation" which is currently a few tenth of a percent points below 5%. In adopting the "flexible inflation targeting " approach, the RBI had also adopted a single measure of inflation CPI and junked the WPI and sectional CPIs. Further it had adopted CPI rather than core CPI because food is very important part of a Indian budgets, & econometric analysis shows it feeds into core inflation much more quickly & effectively than in the average emerging market or Developed country. Talk of core inflation can therefore send confusing signals.

Effect of Tight policy

    Excessively tight monetary policy has during 2016-17, resulted in a rise in the real interest rate, an appreciation of the real exchange rate (REER), a slower growth of consumer credit and a slower recovery of GDP in 2016-17 H1 (-0.25 to -0.5%). It will have similar negative effect in H2 of 2016-17, compounding the negative effect of demonetization on real estate, housing, automobile & consumer durable purchases.  Given the fragmented Indian financial market, the effect of tightening monetary policy through high real repo rates is primarily through organized/large corporate sector & real estate/durable goods demand. This problem was exacerbated by demonetization & should have been compensated by greater monetary easing than earlier required.

    Going forward ie in H2 of 2016-17, the negative effect of tighter monetary policy will extend to (non-globalised part )corporate investment. In other words the tightening of monetary policy signaled by RBI guidance moving from accommodative to neutral will now begin to effect corporate investment also, given the projected revival in the US and world economy generally. The twin balance sheet problem, though real, is less relevant for the domestically oriented part of the corporate sector, which is not constrained by global excess capacity/less effective demand. Thus the negative effects of monetary tightening, will be felt both in demand for real estate & consumer durables but also for the first time on corporate Investment.

Monetary Transmission

 Historically the monetary transmission rate has been about 40% i.e. 1% point reduction in Repo rate has resulted in a 0.4% reduction in average lending rates. Compared to this benchmark, the current transmission rate is higher despite large NPAs. There is therefore, a puzzling inconsistency in expectations of higher transmission, given the reality of 20% PSB NPAs.

Monetarism post-GFC

     Global Monetrist ideologues have been repeatedly proved wrong during 7 yrs since the Global Financial Crises(GFC), but financial markets still listen to them and follow them respectfully. The fact that they were largely right for several decades before GFC doesn't excuse their failure to understand GFC & post-GFC economy. As I have said many times before, the large success that conventional fiscal-monetary policy had in developed countries, in the second half of the 21st century, is no longer relevant to a post-GFC world.

Growth Forecast (23/2/17)

   I have made growth forecasts virtually every year for the past 25 yrs. The maximum uncertainty I have had in the past is a + or - 0.5%. Perhaps occasionally an asymmetric 0.75%. This is the first time I am putting a band of 1% point on each side of my mean forecast for the year 2017-18, because there is a huge uncertainty on both the domestic and the global side. This is further magnified by uncertainty about how the monetary policy committee and other policy organizations will react to these sources of risk.
      On the external front multilateral organizations are predicting an increase in World growth by up to 1% point and markets are predicting two upward adjustments in the US FRBs policy rate. On the downside are the political developments in the USA and Europe and the consequent uncertainty on geo-economic front and their consequent negative effect on world growth. Further, forecasts of World growth recovery have proved over optimistic many times since 2009.
  On the domestic front the big uncertainty arises from demonetization and its impact on consumer behavior as well as the related measures that govt has taken and has hinted at taking. In the absence of data and historical experience of such a demonetization. Most initial forecasts have been determined by personal & political biases. Even though I have estimated the  growth loss for 2016-17 at between 0.25% to 1%, the speed of the recovery in 2017-18 remains uncertain. This is because we don not know how pronounced the hysteresis effect will be, after sufficient cash has been injected back into the economy. That is the recovery could be a very sharp V shaped one or it could be U shape with negative effects lingering for a few quarters.
  Therefore my bottom line at this point is a GDP growth forecast for 2017-18 of 7.5% +/- 1% (ie 6.5% to 8.5%). 

Impact of TPP & US-China Trade War?

Q&A with India Today (Ananth Krishnan), January 28-29, 2017

Q1:  Are we heading to a China-US trade war? If Trump goes ahead with 45% (or high) tariffs on Chinese imports, do you think he is in a position to do a lot of damage to the still struggling Chinese economy? 

A1: A selective import tariff on US Imports from China and an equivalent tariff on Chinese imports from US would do much more damage to the Chinese economy than to US economy, because of the asymmetry in current account balance & the ease with which imports can be substituted compared to exports. Such a move would accelerate the crash landing of the Chinese economy. My guess still is that US will find other ways to address China's non-market that don't undermine WTO system.

Q2: Do you think withdrawing from the TPP is really as big a gift to China as many analyses are suggesting? What do you think India's response should be? And what would an increasingly inward looking US (at least on trade) mean for us?

A2: The TPP has been highly over-rated by conventional wisdom (CW) for both its real economic and its geopolitical benefits to members. There is some psychological loss to the members and corresponding psychological gain to China, but this is very minor compared to the general economic & geopolitical uncertainty created by the sceptical approach of the new president towards foreign relations/policy.

Q3: Do you think this is going to speed up the RCEP negotiations or on the other hand allow China to relax and drag its feet? On RCEP, India has been concerned about the services aspect. How do you think we should approach RCEP in this changed climate?

A3: The direct effect would tend to be to speed up RCEP negotiations. On the other hand the greater uncertainty separately created with respect to US-China economic relations,would tend to induce a wait & watch attitude. Net effect is unclear.

Q4: The Chinese have been pushing an FTAAP at the last few APEC Summits (seen by some as a TPP counter). Given China's mercantilism (and the imbalance it enjoys with most countries in the region) do you see this going forward at all? 

A4: Given its mercantilist approach, and its slowing economy, there is little indication that China is willing either to change its economic development model towards genuine openness or make sacrifices for other countries. This constraint to FTAAP remains unchanged.

Income Tax Reform II: A feasible Negative Income tax/Net Income Transfer (NIT)

with Surjit S. Bhalla

    In our Jan 14 article, Towards an Income Tax Revolution, we had outlined what we believe is a major opportunity for the Modi government to bring in a structural reform to our income tax structure. What we suggested, and expand today, is an integrated approach to both taxation and redistribution. The latter can take, and has taken, many forms over the years. Technology (Aadhar), and political will (demonetization) allows India to finally begin to think BIG, and efficiently, in terms of redistributive policies.

But the two are necessary, not sufficient, for successful implementation. There is money involved, and the last thing the Modi government should do is to revert back to the bad old days of “in the name of the poor” corrupt policies like PDS, NREGA, loan waivers, fertilizer subsidies, etc. There is buzz around that the Budget might contain a Basic Income policy. One of us (Surjit) had offered a discussion of how Rs. 1000 per person per month could be transferred to every one in the bottom half of the population, and that the cost would be Rs. 5 lac crore (trillion). As Subhashis Banerjee has correctly pointed out (A Contentious Proposal, Indian Express, Jan 14, 2017), the calculations are incorrect if transfers have to be made to the bottom 50 %; the calculations are correct if transfers are to be made to the bottom 20 %, the percentage poor according to the upwardly adjusted poverty line of Rs. 1525 per person per month. The Tendulkar poverty line for 2016-17 is a lower Rs. 1250 per person per month. The error is unfortunate, and regretted.

Negative Income Tax: We are proposing, in lieu of basic income for all or even for a targeted population, that each non-farmer worker (hereafter just worker) receive a transfer upto a maximum of Rs. 15000 a year. The negative income tax is obtained according to the formula 15000 – 0.05*income of worker (upto an income of Rs. 3 lacs). In the aggregate, for about 240 million workers (72.7 % of the worker population) the total outgo for NIT is Rs. 1.70 lakh crores or an average of Rs. 7100 per earner recipient of NIT.

The Tendulkar poverty line, for a family of five, in 2016-17 prices, is Rs. 75000 a year. According to NSS data, the average number of earners in a poor family are close to 3.1; even for a two earner household, the transfer will be equal to an average of Rs. 16000  (Rs. 8000 per earner). The average earnings for the bottom 25 % of earners is Rs. 90,000. Thus for these 25 %, the take home post NIT income is 2*(90000+8000) or Rs. 196,000 a year – i.e. well above the five person poverty level income of Rs. 75000.

Proposed Income Tax system: In several comments received over our previous proposal [Towards an Income Tax Revolution, January 14], the one overwhelming response was that while the flat tax rate of 12 % was appreciated, most felt that it was politically unrealistic in the Indian context. Hence, we now propose a new revenue neutral system. This will be a two rate structure, 10 and 20 %. For the income range Rs. 3 to Rs. 6 lacs, the tax rate is 10 %; for those above Rs. 6 lacs, the tax rate is 20 %. Details are presented in the Table. Note that there is a loss of Rs. 1181 billion in the new system with compliance unchanged. What is noteworthy about tax compliance in India in 2013-14 is that while tax compliance for those earning less than Rs. 10 lacs was close to 30 %, the rate for those earning more than Rs. 10 lacs is as low as 20 %. As the PM had mentioned, in 2013-14, there were only 2.4 million earners with income above Rs. 10 lacs – our NSS distribution for 2016-17 suggests that the number of workers in this category is around 12 million.

Why should our numbers/estimates be believed? For two reasons: the mean income of our constructed distribution matches the mean income as obtained from national accounts (this is by construction!). Second, and more importantly, official tax receipts for each of the years 2011/12 to 2015/16 broadly matches (within 10 percent)  the receipts obtained via our synthetic distribution. Note that compliance rates are estimated via the number of official taxpayers (MOF data, 2013/14) and the taxpayers as per the constructed distribution.

There are significant gains for all workers in the new system. A person earning Rs. 4 lacs has her tax liability reduced by 35 %; for those earning Rs. 8 lacs, the tax liability is reduced by 20 %, and for those earning Rs. 16 lacs, the reduction is 27 %. A minimum set of compliance changes assumed by us are as follows: all compliance in the new tax regime is estimated to be 40 percent.

With this change in compliance, the new system will still entail a loss of Rs. 640 billion. This will still mean that only 4 out of 10 workers actually pay taxes in India. In the US, 85 of every 100 people pay taxes. We will still have a very long way to go – but we can begin to get there!

This loss can be made up either by another few percentage points increase in compliance (even with the reduced tax rates, we are assuming only a 40 % compliance rate) or by removing all budgeted tax incentives. In 2015-16, total incentives for tax payers was Rs. 550 billion, with Section 80C (mutual fund investments for rich taxpayers!) accounting for a fat Rs. 450 billion. There is no need for this payment to the rich in the new system – hence, removal of this exemption, is able to reduce the tax loss in the new system to practically zero; actually, a small loss of 90 billion.

What remains is the financing of the NIT. As outlined above, the cost of NIT is Rs. 1.7 lakh crores. If NIT is part of official tax policy, then there seems to be precious little need for anti-poverty programs like PDS or NREGA. These programs are not only costly, but also involve a lot of corruption -as most analysts (and us), and politicians, have pointed out over the years. Starting with Rajiv Gandhi, who in 1985 stated that only 15 % of the money meant for the poor actually reached the poor! Currently, total expenditure on these two wasteful programs is Rs. 1.75 lakh crores. If the government decides to eliminate other in the name of the poor (but not benefitting the poor) programs, then the net income transfer (NIT), per worker, can be increased.

With the adoption of this new thinking, and new anti-poverty policies, absolute poverty will be zero in India, and according to a much higher poverty line. And with no extra cost. The only assumption we are making in the tax reform is that tax compliance rates have to increase to 40 percent. The de-monetization policy has provided the stick for increased tax compliance – our proposed policy provides a much needed carrot.

Revenue Neutral - a Two (10 & 20 %) Income Tax Policy
Range	Existing Tax	New Tax	Reduction in Tax Paid	Number of Workers	Revenue Loss
					Average	Total	With Greater Compliance
(in lacs)	(At upper end of range)		(in per cent)	(in million)	(per worker)	(in billions)	(in billions)
3 - 4	15450	10000	35.3	7.8	5150	40	30
4 - 8	87600	70000	20.1	10.4	15000	156	117
8 - 16	316000	230000	27.2	7.0	95000	665	333
> 16	790000	470000	40.5	1	320000	320	160
Total				26.2	45083	1181	640
Note: Proposed Tax Rates : 0-3 lacs : No Tax; 3-6 lacs: 10%; and above 6 lacs: 20%; average income >16 lacs estimated to be Rs. 28 lacs 1. Reduction = 100 x ("Existing Tax" - "New Tax")/"Existing Tax" 2. Total Loss = Number of Workers x Average Loss per worker 3. Tax revenue loss with greater compliance has been calculated with compliance increase of 10 % points for ranges 3-4 lacs and 4-8 lacs, while a compliance increase of 20 % points for the range 8 -16 lacs and 16 lacs & above.

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A version of this article appeared in the  Indian Express, of  January 19, 2017 under the banner, " Taxing your way to popularity."

Income Taxt Reform I: A Benchmark Flat tax cum Transfer System

with Surjit S. Bhalla

 In his December 31^st speech, Prime Minister Modi made a pointed reference to the fact that in 2013-14, as per official Ministry of Finance data, there were only 2.4 million individuals declaring incomes above Rs. 10 lacs. As many have pointed out, no matter what the indicator used (number of big houses, luxury cars, yachts, private planes etc.) this is too small a number for an economy the size, and richness, of India. What this means is that there is a considerable amount of tax evasion– a rough estimate of the order of magnitude is around Rs. 6 to Rs. 9 lakh crores. Maybe a strange coincidence but this number corresponds closely to our estimates of black cash in the Indian economy in 2016-17, or as of November 8^th, 2016.

The battle against black income has been an ongoing one. It was included in the manifesto of the BJP government and has been on the agenda since it came to power in May 2014. Besides the Government and its supporters, opposition parties in Parliament have demanded that black money held abroad be identified and brought back. Even the Supreme Court came into the picture with the setting up of a Special Investigation Team (SIT) on black money under its oversight/supervision. A number of acts have been passed by parliament to tighten the screws and to make it more difficult to hold undeclared assets. And then there was demonetization on November 8^th.

As the history of the License Permit Quota Raj shows, that unless the economic incentive favor voluntary tax compliance and less political, bureaucratic and police corruption, any benefits are soon frittered away and negative effects multiply over time.  Consequently institutional reforms for minimizing corruption and policy reforms for encouraging voluntary compliance are very important. Something we outline below.

In the US, the IRS has been conducting an annual exercise since 2006, an exercise which attempts to identify the tax losses which arise from income tax evasion. For personal income tax (PIT), the concern of this article, the IRS estimates that of every $100 the US government does collect, about $ 20 is missed. One of the authors (Surjit) had conducted a detailed exercise on tax compliance in India in 2002; this report was conducted for the Ministry of Finance under the supervision of Mr. Vijay Kelkar (Task Force on Direct and Indirect Taxes). The report found that income tax compliance in India, while varying across income groups, was in the broad range of 10 to 30 %. 

Updating the method to the 2013-14 data (the same as used by PM Modi), we find that there should be approximately 10 million taxpayers earning above Rs. 10 lacs i.e. the compliance rate is only 25 %. For all taxpayers, and an estimate comparable to the IRS, we obtain the result that for every Rs. 100 obtained in PIT in India, Rs. 300 goes missing; on a very conservative basis, Rs. 200 goes missing. Whether this is the largest in the world, we do not know – but it has to be close to the top (one area where India is tops!).

This also puts into perspective PM Modi’s anti-black money (or black income) drive. We have consistently argued that the largest low hanging fruit in the Indian economy is the level of tax compliance.  And that one of the goals of demonetization has to be a change in the tax regime, a change that brings out an increase in tax compliance. 

The Union Budget for 2017-18 will be presented on February 1^st. We believe that de-monetization has provided the government with the courage, and the vision, of a major reform in direct income taxes. As shown below, one version of this reform is a move to a flat income tax rate of 12 %. Yes, that is the rate the average taxpayer actually paid in 2013-14! 

But what about progressivity in the tax system? Shouldn’t the rich be taxed more? We strongly believe that questions of ethics, and philosophy, and false morality should be kept out of the taxation system. Indeed, those who argue for higher tax rates are often those who have a vested interest in keeping tax rates high in order that their own personal (black) incomes increase – if you think we are hinting at the Income Tax Authority, you are right.

This Budget should be, and we hope will be, about reform of direct taxes. In previous budgets government has proposed reforms of the Corporate Income  Tax (CIT). These reforms are in the right direction, but have been carried out too slowly and must be accelerated.  The government is on track to introduce the  GST by August 2017, given that the Constitutional Amendment has been passed – we hope administrative matters will soon be sorted out.  Less attention has been focused on reform of the personal income tax and import-export tariffs and duties. 

We do believe that the rich, the well-off, should pay more in tax. Hence, this proposal focuses on reform of the personal income tax and the related issue of Direct Cash Transfers (DCT)/Net Income Transfers or Negative Income Tax (NIT). Note that an NIT policy was first outlined by Milton Friedman in the late 1950s.   

The Table  summarizes the important parameters of income tax compliance and revenue collection based on detailed Ministry of Finance data for 2013-14 (available at www.incometaxindia.gov.in) and uses these data to make projections for 2016-17. We want to be as close to revenue neutral as possible, and also provide for NIT. 

Some basic facts about income tax in India. In 2016-17, it is estimated that  sixty-two percent of the non-cultivator workforce in India earns below Rs. 2.5 lakhs a year. That is 205 million earners.  Our design of NIT is such that each worker earning below Rs. 2.5 lakhs will obtain some income transfer. A person with no income will receive Rs. 30,000 and one who earns Rs. 2.5 lakhs, will receive zero income transfer. The bill for NIT, for 2016-17, is estimated to be Rs. 2.92 lakh crores. Where will this money come from ?

From a minimum increase in tax compliance, which presently stands at 25 %. The flat tax rate we propose is 12 %, the rate actually observed in 2013-14, and very likely the tax rate estimated by the Ministry of Finance in making its revenue projections for 2016-17! [Note that this average rate includes surcharge and cess]. 

A flat tax rate of 12 %, even for a tax shy Indian, should be very appealing. We estimate that the compliance rate will increase by 8 percentage points to 33 percent. This increase in compliance will compensate for the extra revenue needed for the NIT proposal – i.e. 2.9 lakh crores. Incidentally, the tax revenue data for post demonetization November and December does suggest that an increase in tax compliance is taking place.

So will the Union Budget transform India into a moderately tax compliant economy? The Union Budget provides an opportunity for the Modi government to unleash a Big Bang reform in personal income taxation. The economy provides scope, and the demonetization the rationale, for a  flat income tax rate  and a negative income tax for the poor and the needy. Let not the de-monetization pain be in vain.

Table: Direct Taxes in India and Proposed NIT structure
	2013-14	2016-17#
Actual Revenue Data
Revenue (Total) (in lakh crore)	1.89	3.4
No. of Tax Payers (in millions)	22.8	31.5
Average Tax (in lakh crore)	82900	108000
Average Income of Tax Payers (in rupees)	693000	900000
Implicit Rate of Taxation (in per cent)	12	12*
Non Cultivator workers in economy, with incomes>2.5 lakhs (in million)**	91	126
Personal Income Tax Compliance Numbers (in per cent)	25	25
Proposed Tax Rate (in per cent)	12	12
Revenue Increase due to raising compliance from 25% to 33% (in lakh crores)		2.9
Net Income Transfer (NIT) / Direct Cash Transfer (DCT)
Tax rates (t per cent)	15	12
Constant (in rupees)	30000	30000
Max income receiving NIT/DCT (in lakh)	2.0	2.5
Cost (in lakh crore)	3.77	2.92
Source: Author's calculations based on Direct Taxes data from - http://www.incometaxindia.gov.in/Pages/Direct-Taxes-Data.aspx Note: *Taken from 2013-14 value # Using 2013/14 actual MOF data to make projections with the same characteristics e.g. compliance etc. **Source - NSS Survey 1. Implicit Rate of Taxation = 100*(Average Tax / Average Income Tax Payers) 2. Compliance Numbers = 100* (No. of taxpayers / Workers in the economy with incomes>2.5 lacs) 3. NIT / DCT = Constant - tY ; where 't' is the tax rate and 'Y' is the income

A version of this article appeared in the Indian Express, on January 14, 2017 under the banner "Towards an Income Tax Revolution"