There are three different issues involved in this question which need to be addressed and answered separately before putting then together into a single package. The first issue is that of lending external reserves for domestic investment. By definition external reserves have to be kept in safe assets not affected by BOP shocks to the economy as they are held to reduce risks in such an eventuality. The Asian crises showed that external borrowing by domestic banks for the purpose of domestic lending increases systemic risk of crises. “Using” FE reserves for domestic purpose has a similar effect. If reserves are seen as ‘excessive,’ this indicates an implicit judgements that the risks are low and will remain so even with lower reserves. They are two sides of the same coin.
The accumulation of our reserves is the outcome of a BOP & foreign exchange management policy designed to meet external and domestic shocks and promote growth. If this results in “excessive” reserve accumulation the policy needs to be modified. Though the build up of reserves till September this year has roughly halved to what it was last year because of industrial recovery and higher oil and raw material policies there is scope for slowing it further. ICRIER studies have shown the positive effect of the tariff reductions since 1992, on intra-industry trade and specialization, productivity and exports. Reserve accumulation can be efficiently stopped or perhaps reversed by a sharp reduction in tariffs. A reduction in peak tariffs to 10% by 2006 and to 5% by 2008 budget and the lowering the excessively high agricultural tariffs will enhance productivity, increase exports and accelerate industrial growth.
The second issue is that of infrastructure investment and development. Experience with Telecom sector reform has shown that efficient and effective development of infrastructure requires a policy framework that promotes entry and supports competition (particularly with the government supplier). This requires isolation of natural monopoly elements through unbundling and a professional independent regulatory framework to regulate monopoly elements and ensure fair competition with the incumbent. In the case of electricity the so-called ‘Theft & Dacoity’ (T&D) losses would also have to be tackled head on if competitive pricing is to be fair and equitable to honest users. As roads are a classic ‘Public good’ policy reform is not enough and most of the burden has to be borne by the government, policy reform can be helpful high density National highways.
The third issue is that of public investment in infrastructure and its financing. In theory public investment in infrastructure, financed by money creation or by debt can be undertaken as long as the social benefit of the former (in terms of growth/productivity) is greater than the social cost in terms of inflation and/or crowding out. The former depends on the institutional structures for undertaking such expenditures, and institutional reform (of which the National Highway authority is the best example so far) is required to reduce leakage and enhance social productivity. The latter depends on unused capacity in the economy, which was very high from 1998 to 2002, but has tightened since mid-2003. External supply side (e.g. oil) inflationary pressures have also increased over the same period. Thus the conditions for both monetary and debt financing have worsened over the last 18 months. It may therefore not be wise to increase monetary expansion and thus add demand side pressure to supply based inflation nor to crowd out rising private investment with higher government borrowing. Nevertheless, if the social benefit is higher than the social cost, perhaps a financial package can be devised to get round the constraints imposed by the FRBM.
Though the package has been put together as one to “use FE reserves to finance public infrastructure,’ the following restatement/revision would appear to achieve the same objectives more efficiently: Increase government infrastructure investment in concert with, (1) A sharp reduction in tariff rates. Reserve accumulation would slow and perhaps reverse providing greater scope for non-inflationary monetization of the deficit needed to finance infrastructure. (2) A pro-competition infrastructure policy and a professional independent regulatory framework for electricity, railways, ports, airports and dams & canals, (3) Institutional reform of public infrastructure monopolies, like State electricity boards, irrigation departments public works departments (for State highways and village roads). The last two measures would enhance the benefit from increased public investment in infrastructure and thus make the costs of financing them worthwhile.
Tuesday, November 9, 2004
Thursday, October 7, 2004
Planning in a Market Economy
Some people have asserted that the Planning Commission is redundant and should be abolished. To the extent that there is some logic to this assertion, the argument applies to virtually all ministries of the central government barring, defense, home, external affairs and finance. These ministries are not likely to be abolished during my lifetime. The proper question to ask therefore is, ‘What is the appropriate role of the Planning Commission in a market economy? In my view there are four areas that the Planning Commission is best positioned for, among all government institutions:
(1) The Planning Commission is the only institution that has the formal task of interacting with the States in virtually all areas of government functioning. Traditionally it has also had a measure of independence from the Central government and been viewed as an honest broker between the Center and the States. It is therefore uniquely positioned to deal with issues of co-ordination between the Center and the States.
(2) The Central government continues to invest in and spend money on a host of sectors and sub-sectors. The ideas of the fifties that this allocation would be based on comprehensive social benefit-cost calculations remained a gleam in the eye of theoretical economists. The Planning Commission is, however, the only body that can, in principle, objectively determine the optimal allocation of resources among competing uses. This is a difficult and highly challenging job, which would require enormous upgrading.
(3) Large lumpy infrastructure projects require co-ordination. Because different agencies are responsible for different areas (e.g. ports and railways) the Planning commission can ensure that the completion timings are coordinated to maximize the overall benefit-cost ratio.
(4) The Planning Commission can act as a think tank for policies and reforms, either by hiring and empowering internal experts or by sponsoring external research or both. There is great dearth of rigorous empirical research on the effect of different policies and of exogenous shock (e.g. oil prices). The PC can play an important role in promoting intellectual excellence and generating ideas for national development.
(1) The Planning Commission is the only institution that has the formal task of interacting with the States in virtually all areas of government functioning. Traditionally it has also had a measure of independence from the Central government and been viewed as an honest broker between the Center and the States. It is therefore uniquely positioned to deal with issues of co-ordination between the Center and the States.
(2) The Central government continues to invest in and spend money on a host of sectors and sub-sectors. The ideas of the fifties that this allocation would be based on comprehensive social benefit-cost calculations remained a gleam in the eye of theoretical economists. The Planning Commission is, however, the only body that can, in principle, objectively determine the optimal allocation of resources among competing uses. This is a difficult and highly challenging job, which would require enormous upgrading.
(3) Large lumpy infrastructure projects require co-ordination. Because different agencies are responsible for different areas (e.g. ports and railways) the Planning commission can ensure that the completion timings are coordinated to maximize the overall benefit-cost ratio.
(4) The Planning Commission can act as a think tank for policies and reforms, either by hiring and empowering internal experts or by sponsoring external research or both. There is great dearth of rigorous empirical research on the effect of different policies and of exogenous shock (e.g. oil prices). The PC can play an important role in promoting intellectual excellence and generating ideas for national development.
Thursday, September 30, 2004
Prospects for India-Korea Economic Partnership
The process of liberalisation initiated in the new economic policy by India in 1991-92 and South Korea's attempt to look beyond its traditional sources of growth in the last decade gave momentum to the India-Korea economic relationship. Since then, considerable progress has been made in trade and investment between the two countries. The volume of trade expanded from less than $1 billion in 1991 to over $2 billion in 2002-03. Trade between India and Korea witnessed a quantum jump in 2002-2003 registering a growth of 34%. Growth in trade is also characterised by diversification of the trade basket. The export basket for India, though still dominated by low value-added products, has in recent years expanded to cover a wider range of industrial products like machinery and mechanical appliances, iron ore, electrical machinery and equipment and man-made staple fibres. Exports of software and electronics have increased manifold in the last few years. Imports from Korea, on the other hand, continue to be dominated by electronic goods, even though the share of transport equipment is increasing rapidly. Imports of machinery and equipment are set to grow further as several Korean companies are engaged in highways, power plants, chemicals, petrochemicals and metro rail projects in India.
The bilateral economic relationship has, however, not achieved its full potential. In 2002-03 India’s trade with South Korea accounted for less than 2% of its total trade while Korea’s trade with India was less than 1% of its total trade in the year 2002.
Given the economic size and dynamism of the two countries, their civilisational ties and the fact that they are both members of the Bangkok Agreement, the largest PTA in terms of market potential, trade between India and Korea can be expected to double in the next few years. Opportunities for trade expansion and diversification are evident from the as yet unexploited sectoral complementarities between India and Korea. Korea has expertise in manufacturing and financial and international marketing know-how, while India has abundant low-cost and technically-skilled manpower and established strength in science and technology. India and Korea can thus utilise their synergies to boost bilateral trade further.
Sectors like steel, chemicals, pharmaceuticals, automobiles and auto components, textiles, agro-products and gems and jewellery offer scope for expansion in trade. Knowledge-based industries like biotechnology and information technology are the gateways to future trade ties between India and Korea. Korea is fast progressing towards becoming an IT society. Korea’s ratio of internet penetration is the highest in the world and this is where India can make inroads. Korea has world class broadband IT infrastructure, ideal test bed for technology innovation and is a leader in mobile technology. India’s strength lies in its high quality and talented engineering pool, world-class software and services industry and is the world central point for IT outsourcing. Opportunities for joint cooperation and development as well as outsourcing projects for third countries are, therefore, substantial.
India has also come up as an attractive investment destination for Korean companies. Korean motivation to invest in India is shaped by critical advantages in terms of labour costs and easy access to Chinese, S-E Asian and West Asian markets. South Korea ranks fifth in cumulative investment approved in India. Main sectors that have attracted Korean investment are transportation, largely in the automobiles sector, fuels, electrical equipment (such as computer software and electronics, mobile telephony and consumer goods), metallurgical industry and office and household equipment.
Today, South Korean business groups such as LG, Samsung and Hyundai have become household names in India and are diversifying their businesses into different sectors and also using India as a base for expansion of their global business.
Increased focus on cooperation between our small and medium enterprises is also on the agenda of India Korea bilateral economic relationship. Successful tie-ups in this category would have a beneficial impact on an otherwise technically lagging sector in India.
India and Korea have for long recognised the advantages of regional integration arrangements. India is a founder member of the Bangkok Agreement, signed in 1975 and recently rejuvenated by China's entry. This agreement is the only preferential trading arrangement that provides preferential access to three of the major markets of this region, i.e., India, Republic of Korea and China. This may be an initiative, therefore, where India and Korea can jointly work to broaden the scope of the agreement to deal with non-tariff barriers and trade in services as against its current coverage of tariff concessions on goods only. On the multilateral front also, it would be beneficial for both India and Korea to evolve a consensus on issues of common interest and jointly work for an early resolution of the Doha Development Agenda.
India-Korea economic relationship also offers scope for providing the foundation for a stronger Indian presence in the East-Asian economic zone. India has much to offer as a bridge between East Asia and Central and West Asia. Further, as Asean negotiates free trade agreements with China, Japan, South Korea and India individually, the vision of a larger framework that includes the Asean+3+1 or Asean + 4 is taking shape. The accumulated wealth of Japan and the Republic of Korea and the huge markets of China and India will create fresh opportunities for trade driven growth in the region.
An India-Korea equation with a strong underpinning of economic relations and supported by shared values, religion and culture can make a significant contribution towards the Asean + 4 economic integration process.
Co-authored with Amita Batra
The bilateral economic relationship has, however, not achieved its full potential. In 2002-03 India’s trade with South Korea accounted for less than 2% of its total trade while Korea’s trade with India was less than 1% of its total trade in the year 2002.
Given the economic size and dynamism of the two countries, their civilisational ties and the fact that they are both members of the Bangkok Agreement, the largest PTA in terms of market potential, trade between India and Korea can be expected to double in the next few years. Opportunities for trade expansion and diversification are evident from the as yet unexploited sectoral complementarities between India and Korea. Korea has expertise in manufacturing and financial and international marketing know-how, while India has abundant low-cost and technically-skilled manpower and established strength in science and technology. India and Korea can thus utilise their synergies to boost bilateral trade further.
Sectors like steel, chemicals, pharmaceuticals, automobiles and auto components, textiles, agro-products and gems and jewellery offer scope for expansion in trade. Knowledge-based industries like biotechnology and information technology are the gateways to future trade ties between India and Korea. Korea is fast progressing towards becoming an IT society. Korea’s ratio of internet penetration is the highest in the world and this is where India can make inroads. Korea has world class broadband IT infrastructure, ideal test bed for technology innovation and is a leader in mobile technology. India’s strength lies in its high quality and talented engineering pool, world-class software and services industry and is the world central point for IT outsourcing. Opportunities for joint cooperation and development as well as outsourcing projects for third countries are, therefore, substantial.
India has also come up as an attractive investment destination for Korean companies. Korean motivation to invest in India is shaped by critical advantages in terms of labour costs and easy access to Chinese, S-E Asian and West Asian markets. South Korea ranks fifth in cumulative investment approved in India. Main sectors that have attracted Korean investment are transportation, largely in the automobiles sector, fuels, electrical equipment (such as computer software and electronics, mobile telephony and consumer goods), metallurgical industry and office and household equipment.
Today, South Korean business groups such as LG, Samsung and Hyundai have become household names in India and are diversifying their businesses into different sectors and also using India as a base for expansion of their global business.
Increased focus on cooperation between our small and medium enterprises is also on the agenda of India Korea bilateral economic relationship. Successful tie-ups in this category would have a beneficial impact on an otherwise technically lagging sector in India.
India and Korea have for long recognised the advantages of regional integration arrangements. India is a founder member of the Bangkok Agreement, signed in 1975 and recently rejuvenated by China's entry. This agreement is the only preferential trading arrangement that provides preferential access to three of the major markets of this region, i.e., India, Republic of Korea and China. This may be an initiative, therefore, where India and Korea can jointly work to broaden the scope of the agreement to deal with non-tariff barriers and trade in services as against its current coverage of tariff concessions on goods only. On the multilateral front also, it would be beneficial for both India and Korea to evolve a consensus on issues of common interest and jointly work for an early resolution of the Doha Development Agenda.
India-Korea economic relationship also offers scope for providing the foundation for a stronger Indian presence in the East-Asian economic zone. India has much to offer as a bridge between East Asia and Central and West Asia. Further, as Asean negotiates free trade agreements with China, Japan, South Korea and India individually, the vision of a larger framework that includes the Asean+3+1 or Asean + 4 is taking shape. The accumulated wealth of Japan and the Republic of Korea and the huge markets of China and India will create fresh opportunities for trade driven growth in the region.
An India-Korea equation with a strong underpinning of economic relations and supported by shared values, religion and culture can make a significant contribution towards the Asean + 4 economic integration process.
Co-authored with Amita Batra
Wednesday, August 11, 2004
Inflation and The Way Out
Global oil prices have risen above the OPEC price band over the last 12 months. Because of general elections, the global oil price increase was not passed through into the Indian oil prices. The dismantling of the APM remained purely on paper. The Yukos crises in Russia and the blowing up of Iraqi pipelines has led to a sharp rise in oil prices to $ 45 a barrel. Only a part of global price rise was passed into the Indian market by the new Government in June. As a result of the global rise in oil prices, Indian inflation has increased by about 0.5% point, and is likely to increase further in August. Pressure on this front therefore remains.
In addition to global oil prices, raw materials and minerals prices also increased last year. After a lag of 6 to 9 months, manufactured goods prices of items which have a large component of such minerals in their inputs have tended to increase (e.g. iron ore and iron & steel). These increases were largely due to a tremendous increase in demand from China and from global recovery. Both these sources of growth have abated somewhat and inflation arising from these two sources is likely to moderate. I expect WPI inflation to decline to around 6.5 per cent by December.
The following policy reforms could be helpful in containing inflation (in India): (a) Reduce tariffs on agricultural commodities in which prices are rising sharply; (b) Reintroduce the amendment to the Coal Nationalisation Act to allow private entry in the coal sector so that there is genuine competition for imported oil; (c) Amend the Electricity Act (2003) to make the regulator independent and professional and set up a good regulatory system; (d) Launch a crusade against theft of electricity (35% to 50% of total generation); and (e) Reduce the “peak rate” of tariffs from 20% to 15% (latest by the next budget).
In addition to global oil prices, raw materials and minerals prices also increased last year. After a lag of 6 to 9 months, manufactured goods prices of items which have a large component of such minerals in their inputs have tended to increase (e.g. iron ore and iron & steel). These increases were largely due to a tremendous increase in demand from China and from global recovery. Both these sources of growth have abated somewhat and inflation arising from these two sources is likely to moderate. I expect WPI inflation to decline to around 6.5 per cent by December.
The following policy reforms could be helpful in containing inflation (in India): (a) Reduce tariffs on agricultural commodities in which prices are rising sharply; (b) Reintroduce the amendment to the Coal Nationalisation Act to allow private entry in the coal sector so that there is genuine competition for imported oil; (c) Amend the Electricity Act (2003) to make the regulator independent and professional and set up a good regulatory system; (d) Launch a crusade against theft of electricity (35% to 50% of total generation); and (e) Reduce the “peak rate” of tariffs from 20% to 15% (latest by the next budget).
Wednesday, July 28, 2004
Kelkar Committee Task Force Report
The report of the Task force on FRBM Act 2003 was made public last week. The report discusses the Fiscal challenges and the role of Tax reforms in meeting the Challenges. The latter cover Customs, CENVAT and Income tax and are modified versions of those given in the Kelkar Tax Reform Reports (December 2002). As there is now a large measure of unanimity among tax experts on the broad thrust of tax reform, the article focus on proposals that I disagree with.
Let us start with the proposal to convert the CENVAT into a comprehensive VAT. We have argued in several notes and papers since 1998 that the CENVAT should become a full fledged VAT covering all services and goods except those explicitly excluded for efficiency or equity reasons (e.g. Indian Express of July 6, 2004). The new report makes two interesting points: One that the Constitution 88th amendment act (2003) makes it possible to extend the CENVAT up to the retail level. Two that the revenue neutral basic rate of the CENVAT including both goods and services is around 12%. The discussion of how the CENVAT should replace the stamp duty and other imposts on real estate and of how to apply the CENVAT to the financial sector is quite illuminating.
The report also recommends 3 rates (0, 6% and 20%) in addition to the Standard rate of 12%. The negative list of exempted goods (0% rate) is what I have proposed earlier with one important item missing, namely processed food. There is a strong case for including all processed food in the 0% category instead of in a 6% category, because greater employment in agriculture and agro-processing and reduced wastage of agricultural produce would be added benefits. This serves the purpose of equity much better than a separate 6% category with a number of ‘necessities.’ I am also against a separate 20% CENVAT rate for luxury goods: Polyester is the poor man’s fibre not a luxury and it is absurd to classify carbonated drinks as a luxury item in this day and age. Cars, polluting fuels (petrol, diesel) and tobacco (de merit good) should however be subject to an additional special excise/sales tax rate (8%) that cannot be set-off. The recommendations on the treatment of small units are sound (exemption up to Rs. 25 Lac) and pragmatic (choice of 4% sales tax rate up to 1 crore). Monitoring will be much easier in the system proposed by us.
The report also estimates that a revenue neutral standard rate for a State Vat (what I have termed STATVAT) covering goods & services is 8% and proposes three other rates (0%, 4%, 14%) at the State level. It rightly notes that such a state VAT should replace all other taxes on goods and services at the State level. In my view there is no need for a 4% rate and the list of exempted items can be the same as for the CENVAT. Similarly instead of another 14% rate category, a sales tax of 6% could be applied at the retail level on hotels, restaurants, entertainment and betting/gambling, in addition to the standard STATVAT rate.
The Task force proposes a 5%, 8%, 10%, 20% customs duty/tariff rate structure. As acknowledged in the first Kelkar report, the Virmani Committee report of the Department of Revenue (2001) had demonstrated, (a) the negative effect of such a 4-tier structure in terms of effective protection and (b) the advantages of a single uniform rate of 10%. In fact we are now confident, based on a recent ICRIER research paper showing the positive effect on exports and productivity, that tariff rates can be reduced further to a uniform 5% in the next 5 years. Both the Virmani (2001) and Kelkar (2002 & 2004) reports concur that agriculture tariffs have to be dealt with more cautiously. The former however proposed that these tariffs should not be more than 2 or 3 times the standard peak rate (i.e. 20/30% & 10/15%) while the latter recommends an exorbitant rate of 150%.
Turning finally to income tax, the very sound arguments for low marginal tax rates and elimination of exemptions (ineffective & inefficient) are repeated in this report. I do not however agree with the proposal to move to a two rate (20%, 30%) system. The reason why experts have recommended a flat (single rate) income tax is that such a tax would have the lower marginal rate (e.g. Chintan #2, May 1997) than a 2 or 3 rate system. If the 2-rate system is going to have the same marginal rate of 30% as a 3-rate system there is no benefit from the former. On the other hand a gradually rising marginal tax rate of the latter results in a more efficient (lower average marginal rate) system that provides less dis-incentives for honest declaration to both first time tax payers and the ‘missing middle’. Further India has a much higher exemption limit (in PPP terms) then other Asian systems but its tax rapidly exceeds all others. I would therefore recommend the following structure 10% above Rs 60000, 20% above 1.2 (/1.32/1.44) lac and 30% above 3.96 (or 4.2) lacs.
The proposal to eliminate savings exemptions and replace it with an Individual Saving Account is a sound one. However, the EET system proposed for pension savings etc. along with grand-fathering is too complicated. The report has an interesting calculation of the economic depreciation rate, which is calculated as 15%. This needs to be cross-checked. Though the personal and corporate income tax recommendations are consistent, the MAT should be abolished along with exemptions and depreciation rate reduction. Further, in my judgement a system of corporate tax (CIT) credit to all shareholders for CIT paid by the company is preferable to abolition of the income tax on dividends and capital gains on equity. This can be implemented very easily in the proposed Tax Information System. Space limitations do not allow a more detailed analysis.
Let us start with the proposal to convert the CENVAT into a comprehensive VAT. We have argued in several notes and papers since 1998 that the CENVAT should become a full fledged VAT covering all services and goods except those explicitly excluded for efficiency or equity reasons (e.g. Indian Express of July 6, 2004). The new report makes two interesting points: One that the Constitution 88th amendment act (2003) makes it possible to extend the CENVAT up to the retail level. Two that the revenue neutral basic rate of the CENVAT including both goods and services is around 12%. The discussion of how the CENVAT should replace the stamp duty and other imposts on real estate and of how to apply the CENVAT to the financial sector is quite illuminating.
The report also recommends 3 rates (0, 6% and 20%) in addition to the Standard rate of 12%. The negative list of exempted goods (0% rate) is what I have proposed earlier with one important item missing, namely processed food. There is a strong case for including all processed food in the 0% category instead of in a 6% category, because greater employment in agriculture and agro-processing and reduced wastage of agricultural produce would be added benefits. This serves the purpose of equity much better than a separate 6% category with a number of ‘necessities.’ I am also against a separate 20% CENVAT rate for luxury goods: Polyester is the poor man’s fibre not a luxury and it is absurd to classify carbonated drinks as a luxury item in this day and age. Cars, polluting fuels (petrol, diesel) and tobacco (de merit good) should however be subject to an additional special excise/sales tax rate (8%) that cannot be set-off. The recommendations on the treatment of small units are sound (exemption up to Rs. 25 Lac) and pragmatic (choice of 4% sales tax rate up to 1 crore). Monitoring will be much easier in the system proposed by us.
The report also estimates that a revenue neutral standard rate for a State Vat (what I have termed STATVAT) covering goods & services is 8% and proposes three other rates (0%, 4%, 14%) at the State level. It rightly notes that such a state VAT should replace all other taxes on goods and services at the State level. In my view there is no need for a 4% rate and the list of exempted items can be the same as for the CENVAT. Similarly instead of another 14% rate category, a sales tax of 6% could be applied at the retail level on hotels, restaurants, entertainment and betting/gambling, in addition to the standard STATVAT rate.
The Task force proposes a 5%, 8%, 10%, 20% customs duty/tariff rate structure. As acknowledged in the first Kelkar report, the Virmani Committee report of the Department of Revenue (2001) had demonstrated, (a) the negative effect of such a 4-tier structure in terms of effective protection and (b) the advantages of a single uniform rate of 10%. In fact we are now confident, based on a recent ICRIER research paper showing the positive effect on exports and productivity, that tariff rates can be reduced further to a uniform 5% in the next 5 years. Both the Virmani (2001) and Kelkar (2002 & 2004) reports concur that agriculture tariffs have to be dealt with more cautiously. The former however proposed that these tariffs should not be more than 2 or 3 times the standard peak rate (i.e. 20/30% & 10/15%) while the latter recommends an exorbitant rate of 150%.
Turning finally to income tax, the very sound arguments for low marginal tax rates and elimination of exemptions (ineffective & inefficient) are repeated in this report. I do not however agree with the proposal to move to a two rate (20%, 30%) system. The reason why experts have recommended a flat (single rate) income tax is that such a tax would have the lower marginal rate (e.g. Chintan #2, May 1997) than a 2 or 3 rate system. If the 2-rate system is going to have the same marginal rate of 30% as a 3-rate system there is no benefit from the former. On the other hand a gradually rising marginal tax rate of the latter results in a more efficient (lower average marginal rate) system that provides less dis-incentives for honest declaration to both first time tax payers and the ‘missing middle’. Further India has a much higher exemption limit (in PPP terms) then other Asian systems but its tax rapidly exceeds all others. I would therefore recommend the following structure 10% above Rs 60000, 20% above 1.2 (/1.32/1.44) lac and 30% above 3.96 (or 4.2) lacs.
The proposal to eliminate savings exemptions and replace it with an Individual Saving Account is a sound one. However, the EET system proposed for pension savings etc. along with grand-fathering is too complicated. The report has an interesting calculation of the economic depreciation rate, which is calculated as 15%. This needs to be cross-checked. Though the personal and corporate income tax recommendations are consistent, the MAT should be abolished along with exemptions and depreciation rate reduction. Further, in my judgement a system of corporate tax (CIT) credit to all shareholders for CIT paid by the company is preferable to abolition of the income tax on dividends and capital gains on equity. This can be implemented very easily in the proposed Tax Information System. Space limitations do not allow a more detailed analysis.
Thursday, July 8, 2004
Economic Reforms and The Budget
The CMP and the statements of some of the coalition partners had lead to a lot speculation in the media and many fears. The PM’s address to the Nation and the budget have progressively elaborated the concept of “Reforms with a human Face,” that was first mentioned in the CMP. In the process they have also dispelled the notion that focusing on the “common man” the poor, the farmer and the unemployed will mean huge subsidies fiscal irresponsibility and large deficits. The government has made very clear that they intend to meet the targets of the FRBM (with a delay of one year). The counterpart of this on the expenditure side is a careful and cautious refocusing of the emphasis of the expenditure side of the budget, particularly the plan expenditure on agriculture & rural development and social sectors. Though plan allocations have been increased allocation to specific programs will follow a thorough review by the planning commission.
Several reform steps also confirm that in the view of the government reforms are consistent with the social objectives of employment growth and poverty reduction. At the same time exaggerated fears stimulated earlier have been laid to rest. Among the reform actions in the budget are:
1) A rise in FDI limits in Telecom to 74% (from 49%), in insurance to 49% (from 26%) and in Civil Aviation to 49% (from 40%). This follows the earlier cabinet decision to proceed with private entry into the development & management of the Delhi and Mumbai airports with 49% FDI.
2) SSI de-reservation of 85 items.
3) Board of Restructuring to carry forward the disinvestment/closure/sale/revival of PSEs.
4) Proposal to convert the CENVAT into a goods and service tax. The first step of modifying the service tax to allow off-set for both goods and service taxes paid is a good first step.
5) A comprehensive law for SEZs to devolve administrative and financial responsibility. This had been deadlocked between the MOF, MOC etc.
6) Reduction in customs duty on steel to a rate closer to that on other metals like aluminum & copper and a reversal of the February distortion (to 8%) in CENVAT rate.
As in every budget there are also actions that are either anti-reform such as the removal of Textiles from CENVAT. Controversial moves include (a) the tax changes relating to removal/reduction of capital gains on securities and its replacement by a turnover tax on securities transactions and (b) the manner of reducing income tax on individuals with taxable income less than Rs. 1 lakh. Both these are likely to have unpleasant long term consequences even if they appear successful in the short run. I hope that the FM will correct these as part of the broader tax reform he is likely to undertake in his next budget.
Several reform steps also confirm that in the view of the government reforms are consistent with the social objectives of employment growth and poverty reduction. At the same time exaggerated fears stimulated earlier have been laid to rest. Among the reform actions in the budget are:
1) A rise in FDI limits in Telecom to 74% (from 49%), in insurance to 49% (from 26%) and in Civil Aviation to 49% (from 40%). This follows the earlier cabinet decision to proceed with private entry into the development & management of the Delhi and Mumbai airports with 49% FDI.
2) SSI de-reservation of 85 items.
3) Board of Restructuring to carry forward the disinvestment/closure/sale/revival of PSEs.
4) Proposal to convert the CENVAT into a goods and service tax. The first step of modifying the service tax to allow off-set for both goods and service taxes paid is a good first step.
5) A comprehensive law for SEZs to devolve administrative and financial responsibility. This had been deadlocked between the MOF, MOC etc.
6) Reduction in customs duty on steel to a rate closer to that on other metals like aluminum & copper and a reversal of the February distortion (to 8%) in CENVAT rate.
As in every budget there are also actions that are either anti-reform such as the removal of Textiles from CENVAT. Controversial moves include (a) the tax changes relating to removal/reduction of capital gains on securities and its replacement by a turnover tax on securities transactions and (b) the manner of reducing income tax on individuals with taxable income less than Rs. 1 lakh. Both these are likely to have unpleasant long term consequences even if they appear successful in the short run. I hope that the FM will correct these as part of the broader tax reform he is likely to undertake in his next budget.
Exaggerated Fears, Exaggerated Hopes
When the UPA government came to power about 40 days ago, there were exaggerated fears about the negative role of the left and of some of the coalition allies with respect to the reform process. These stemmed partly from selective reading of the Common Minimum Programme and but were enhanced by statements made by members of some of these parties. It was asserted by many observers that the reforms undertaken by the previous NDA government would be reversed and the overall pace of reform would slacken with negative consequences on economic growth. After the PM and FM took charge and a new Deputy Chairmen of the Planning commission was appointed these fears gave way to exaggerated hopes of a “dream budget.’ Both these have been laid to rest by the budget.
Two of the reforms about which there was great doubt were Foreign Direct investment and dis-investment. This happened despite the fact that there was no clear statement against FDI and a number of statements about stimulating investment and supporting growth. Similarly while the CMP clearly ruled out privatization of profit making units, this was not ruled out for loss making ones. Dis-investment in all PSUs was also an open question. The cabinet decision on setting up public-private partnership in Delhi and Mumbai airports with 49% FDI and 26% government ownership was a pre-cursor. The budget takes the investment message forward unambiguously by proposing to raise the FDI limit to 49% in Airlines (from 40%) and Insurance (from 26%) and to 74% in Telecom.
Given the example of West Bengal fears on the dis-investment side were also clearly exaggerated. The finance minister in his budget speech has taken a leaf out of the book already written by this Left front government by announcing the setting up of a Board for Restructuring of Public Sector Enterprises (PSEs). As stated by the FM this Board will evaluate the PSEs and make recommendations accordingly. This could involve closure, sale or disinvestment. The plans of one profit making PSE to raise funds through sale of the shares to the public has also been supported in the budget and credit taken for Rs 4000 crore of dis-investment receipts.
A third are of even greater concern was the fiscal balance. Frightening estimates of the cost of the CMP were published some by reputed research institutions. The question was repeatedly asked how the tax revenues to fund these programs would be raised and would this not involve a large increase in the tax rates. Stock market intermediaries and fiscal conservatives unambiguously outlined their concerns about the fisc. The first indication that these concerns were exaggerated came when the FFRBM along with the rules for its implementation were notified a week before the budget. This indicated how seriously the government took the responsibilities embodied in the FRBM. These concerns have been considerably dampened by the careful and cautious way in which the CMP promises on social sectors, employment and rural/ agriculture have been spelt out. A clear road map has been given for rural and agricultural reform, with the Planning commissions forthcoming mid-term review charged with spelling out concrete changes and re-allocation of resources that are necessary for an implementation of this strategy. A number of well targeted social schemes have also been picked up for greater emphasis and future expansion, to promote the social objectives of the government. At the same time the budget by containing the fiscal deficit proportion and reducing the revenue deficit at the same time has confirmed this responsible approach.
Other reform actions for improving competitiveness and growth prospects are SSI de-reservation and the start of merger/integration of service tax with CENVAT. The de-reservation of 85 SSI items clearly signals the governments understanding that such economic reforms that promote employment growth will go forward.. Any number of committees have argued for complete abolition of SSI reservation. More recently the labour intensive exports and employment generated in China in the sectors in which SSI reservation exists in India, and has limited exploitation of economies of scale, has added to the urgency of de-reservation.
The move to give a set-off to service tax payers across goods and services and vice versa is an important new reform. It is the first significant step in the direction of integration of goods and services in the Central Value added tax (CENVAT).
As with virtually every budget, there are also some anti-reform steps and a few that are ambiguous. The former includes the abandonment of CENVAT for the textiles sector. This will limit exploitation of the great opportunities that are opening up with the expire of the Multi-fibre agreement next year. The abolition of the long term capital gains tax the reduction of short term capital gains tax to 20% and its replacement by a turnover tax for securities does not appeal to fiscal purist like me who worked on tax evasion issues well before they became popular. The same reservations apply to the new method of reducing tax rates up to Rs. 1 lakh through a rebate. In my experience such theoretically unsound ideas always lead to problems in the long run even though they may be successful in the short term.
Two of the reforms about which there was great doubt were Foreign Direct investment and dis-investment. This happened despite the fact that there was no clear statement against FDI and a number of statements about stimulating investment and supporting growth. Similarly while the CMP clearly ruled out privatization of profit making units, this was not ruled out for loss making ones. Dis-investment in all PSUs was also an open question. The cabinet decision on setting up public-private partnership in Delhi and Mumbai airports with 49% FDI and 26% government ownership was a pre-cursor. The budget takes the investment message forward unambiguously by proposing to raise the FDI limit to 49% in Airlines (from 40%) and Insurance (from 26%) and to 74% in Telecom.
Given the example of West Bengal fears on the dis-investment side were also clearly exaggerated. The finance minister in his budget speech has taken a leaf out of the book already written by this Left front government by announcing the setting up of a Board for Restructuring of Public Sector Enterprises (PSEs). As stated by the FM this Board will evaluate the PSEs and make recommendations accordingly. This could involve closure, sale or disinvestment. The plans of one profit making PSE to raise funds through sale of the shares to the public has also been supported in the budget and credit taken for Rs 4000 crore of dis-investment receipts.
A third are of even greater concern was the fiscal balance. Frightening estimates of the cost of the CMP were published some by reputed research institutions. The question was repeatedly asked how the tax revenues to fund these programs would be raised and would this not involve a large increase in the tax rates. Stock market intermediaries and fiscal conservatives unambiguously outlined their concerns about the fisc. The first indication that these concerns were exaggerated came when the FFRBM along with the rules for its implementation were notified a week before the budget. This indicated how seriously the government took the responsibilities embodied in the FRBM. These concerns have been considerably dampened by the careful and cautious way in which the CMP promises on social sectors, employment and rural/ agriculture have been spelt out. A clear road map has been given for rural and agricultural reform, with the Planning commissions forthcoming mid-term review charged with spelling out concrete changes and re-allocation of resources that are necessary for an implementation of this strategy. A number of well targeted social schemes have also been picked up for greater emphasis and future expansion, to promote the social objectives of the government. At the same time the budget by containing the fiscal deficit proportion and reducing the revenue deficit at the same time has confirmed this responsible approach.
Other reform actions for improving competitiveness and growth prospects are SSI de-reservation and the start of merger/integration of service tax with CENVAT. The de-reservation of 85 SSI items clearly signals the governments understanding that such economic reforms that promote employment growth will go forward.. Any number of committees have argued for complete abolition of SSI reservation. More recently the labour intensive exports and employment generated in China in the sectors in which SSI reservation exists in India, and has limited exploitation of economies of scale, has added to the urgency of de-reservation.
The move to give a set-off to service tax payers across goods and services and vice versa is an important new reform. It is the first significant step in the direction of integration of goods and services in the Central Value added tax (CENVAT).
As with virtually every budget, there are also some anti-reform steps and a few that are ambiguous. The former includes the abandonment of CENVAT for the textiles sector. This will limit exploitation of the great opportunities that are opening up with the expire of the Multi-fibre agreement next year. The abolition of the long term capital gains tax the reduction of short term capital gains tax to 20% and its replacement by a turnover tax for securities does not appeal to fiscal purist like me who worked on tax evasion issues well before they became popular. The same reservations apply to the new method of reducing tax rates up to Rs. 1 lakh through a rebate. In my experience such theoretically unsound ideas always lead to problems in the long run even though they may be successful in the short term.
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