Why Does Economic Survey Not Talk About Subsidy on Stocks?

Arvind_Subrahmaniyam

I know this piece is not going to go down well with a section of readers. Nevertheless, I think this is an important point and needs to be made.

In January 2016, the prime minister Narendra Modi during the course of a speech had said: “Why is it that subsidies going to the well-off are portrayed in a positive manner? Let me give you an example. The total revenue loss from incentives to corporate tax payers was over Rs 62,000 crore… Dividends and long-term capital gains on shares traded in stock exchanges are totally exempt from income tax even though it is not the poor who earn them.”

Not surprisingly, the Economic Survey released on February 26, 2016, under the leadership of Arvind Subramanian, the chief economic adviser, has a chapter titled Bounties for the Well-Off, dedicated to the implicit subsidies on offer to the rich.

The Economic Survey focuses on “seven areas: small savings schemes, kerosene, railways, electricity, LPG, gold, and aviation turbine fuel (ATF),” and calculates the implicit subsidies available to the rich. The total cost of the implicit subsidies works out to Rs 1.03 lakh crore, as per the survey. Now that’s a huge number.

One of the investment avenues that the Economic Survey calculates an implicit subsidy on is the public provident fund(PPF) scheme in which an individual can invest up to Rs 1.5 lakh every year.  While calculating the taxable income, the amount invested in the PPF scheme can be claimed as a deduction. Further, the amount that the investor gets on maturity is also tax-free. This pushes up the effective returns on PPF.

As the Economic Survey points out: “The effective returns to PPF deposits are very high, creating a large implicit subsidy which accrues mostly to taxpayers in the top income brackets. The magnitude of this implicit subsidy is about 6 percentage points – approximately Rs 12,000 crore in fiscal cost terms.

Along similar lines, the subsidy on the cooking gas cylinder is also captured by the rich. As the Survey points out: “LPG consumers receive a subsidy of Rs 238.51 per 14.2 kg cylinder7 (as in January 2016), which amounts to a subsidy rate of 36 per cent (ratio of subsidy amount to the market price). It turns out that 91 per cent of these subsidies are accounted for by the better-off as their share of consumption of LPG in the total consumption is about 91 per cent; while the poor account for only 9 per cent of LPG consumption and hence only 9 per cent of subsidies go to them.”

What Subramanian doesn’t talk about in the Economic Survey, are the issues on which Modi talked about in January i.e. the implicit subsidy on there being no tax on dividends earned through shares as well as no long-term capital gains tax on selling shares. The reason for that is obvious. It was said that prime-minister Modi was wrongly briefed on the issue at that point of time. And that is largely correct.

Companies distributing dividends, do pay a dividend distribution tax(DDT) to the government. Hence, to that extent the dividend is not tax free in the hands of the investor. If there was no DDT, the shareholders would have received a higher dividend. Nevertheless, the tax is just a better way for the government to collect tax, than collecting it from the investors who earn dividends and then hoping that they declare the divided while filing their tax returns and pay a tax on it.

As far as long term capital gains on shares are concerned, currently there are no taxes to be paid, if the investor sells shares, after holding them for a period of one year or more. The government collects a securities transaction tax (STT) every time an investor buys or sells shares, through a stock exchange.

The STT is collected in lieu of there being no long-term capital gains on selling of shares. In 2014-2015, the government collected close to Rs 6,000 crore through the STT. Also, like DDT, STT is just an easier way of collecting tax, in comparison to the long-term capital gains tax.

Nevertheless, it still does not explain why Subramanian did not calculate the implicit subsidy on there being no long-term capital gains tax on selling shares. A calculation would have told us whether the long-term capital gains tax that could have possibly been collected is more than the amount that the government is collecting through STT.

If the difference is substantial, then the government needs to look at taxing long-term capital gains as well, in the years to come. Obviously, this move will not go down well with the rich who benefit from this implicit subsidy. As David Foster Wallace writes inThe Pale King: “We’ve changed the way we think of ourselves as citizens. … We think of ourselves now as eaters of the pie instead of as makers of the pie.”

Also, it needs to be pointed out that many stock market investors do not like the idea of a long-term capital gains tax on stocks. They also justify the short term capital gains tax at 15%. This rate is much lower than the highest rate of 30% that needs to be paid on all other kinds of income.

The logic is as follows. Stock market investment is risky in comparison to other forms of investing where the amount of money invested is more or less guaranteed. Also, through the stock market entrepreneurs raise capital and investors need to be encouraged to invest in new businesses, and hence, there is no long-term capital gains tax on stocks.

While this may have been valid in the twentieth century, it is worth asking whether this continues to make sense. As the celebrated British economist John Kay writes in Other People’s Money—Masters of the Universe or Servants of the People? : “The first companies to obtain listings on modern markets were companies like railways and breweries, with large requirements for capital for very specific purposes. Building a railway is expensive, and once you have built it the only thing you can do with it is run trains. You cannot use a brewery except to brew beer. Early utilities and manufacturing corporations raised large amounts of money in small packets from private individuals.”

But does that continue to hold good? Do entrepreneurs continue to use the stock market to raise capital for new ventures? As Satyajit Das writes in The Age of Stagnation: “The nature of stock markets has been changed by alternative source of risk capital: the high cost of a stock market listing, particularly increasing compliance costs; increased public disclosure and scrutiny of activities, including management remuneration; and a shift to different forms of business ownership, such as private equity.”

What this means is that more and more entrepreneurs are now raising money through other routes, in the initial stages of their business. This becomes clear in the Indian context from the fact that the number of initial public offerings have come down over the years. But entrepreneurs continue to raise through other routes like private equity, venture capitalists, debentures etc.

The stock market only comes into the picture when these initial investors want to offload their stocks in the firm. As Kay puts it: “Stock market is not a way of putting money into companies, but a means of taking it out.

Hence, all the logic about investors needing to be encouraged to invest in new businesses doesn’t really hold anymore because most of the time, companies now come to the stock market only when they are looking for an exit option for their big initial investors.

In fact, Subramanian and his team could have done some analysis around this issue and told us what portion of the initial public offerings over the last few years raised fresh capital and what portion was investors trying to exit. This is something that the chief economic adviser clearly needs to look at in the next Survey.

And as far as risk of investing in the stock market is concerned. That still remains. But that is the choice that the investor investing in the stock market is making. Why should the government compensate him for it? Beats me.

The column originally appeared in the Vivek Kaul  Diary on February 29, 2016

Economic Survey: Indian Companies Are Trapped In A Chakravyuha

narendra_modi

The Economic Survey released before the budget is brought out by the chief economic adviser to the ministry of finance. Arvind Subramanian is the current chief economic adviser.

In the second chapter of the Economic Survey of 2015-2016, Subramanian makes a very interesting point: “The Charkravyuha legend from the Mahabharata describes the ability to enter but not exit, with seriously adverse consequences. It is a metaphor for the workings of the Indian economy in the 21st century.”

What he means here is that Indian companies continue to operate, irrespective of the fact whether they make money or not. In a free market as firms innovate and grow, they end up pushing out other firms which shut down. But that doesn’t seem to be happening in India.

As the Survey points out: “In principle, productive and innovative firms should expand and grow, forcing out the unproductive ones. So surviving firms should be much larger than new ones…In the US the average 40-year old plant is 8 times larger (in terms of employment) than a new one. Established Mexican firms are twice as large as new firms. But in 2010 India the average 40-year-old plant was only 1.5 times larger than a new one.”

In fact, the situation has deteriorated since the late 1990s. In 1998-99, the ratio of the average 40-year-old plant in comparison to the new ones was 2.5. What this tells us is that “there are not enough big firms and too many firms that are unable to grow, the latter suggesting that there are problems of exit.”

What this basically means is that firms which should be shutdown are not shutting down due to various reasons. Hence, there is an exit problem. A situation that is best expressed by the Hotel California song, sung by The Eagles: “You can check out any time you like, but you can never leave.” As the Survey points out: “India unlike many countries seems to have a disproportionately large share of inefficient firms with very low productivity and with little exit.”

The public sector enterprises lead the pack. The accumulated losses of sick public sector enterprises as of 2013-2014 had stood at Rs 1.04 lakh crore. Then there is the civil aviation sector (read Air India) which has seen losses for seven straight years in a row. In 2013-2014, the losses were at Rs 2,400 crore.

Over and above this there are power distribution companies owned by various state governments with accumulated losses of Rs 2.3 lakh crore. Also, there is the problem of public sector banks, which have seen a fresh infusion of capital of Rs 1.02 lakh crore between 2009-2010 and the first half of this financial year.

What this tells us is that many firms which should have been shut down long back are still in operation. In case of public sector enterprises, it is because of the government continuing to bail out these firms. As the Survey points out: “Exit is impeded often through government support of incumbent, mostly inefficient, firms. This support—in the form of explicit subsidies (for example. bailouts) or implicit ones (tariffs, loans from state banks)—represents a cost to the economy.”

What does this mean? It means that the government keeps loss making firms going by bailing them out. The trouble is that every extra rupee that the government spends on the bailout of these firms by taking on their losses, it has to borrow. And for every rupee that the government borrows, there is one rupee less for the private sector to borrow.

This means that the accumulated losses of Rs 1.04 lakh crore of public sector enterprises is money that the private sector could have borrowed. It also means that Rs 1.02 lakh crore spend through the fresh infusion of capital into public sector banks is money that the private sector could have borrowed.

If the government borrows more, it means there is less for the private sector to borrow, and in the process it has to pay a higher rate of interest than it typically would in case of lower borrowing by the government. This essentially leads to “greater interest costs and reduced private sector investment activity”.

Also, in a capital scare country like India, misallocation of capital to keep loss making companies running, is not quite the best thing to do.

It raises the question as to why does the government keep running loss making public sector enterprises? It also raises the question as to why does the government need to own more than twenty-five public sector banks?

Thankfully, the Narendra Modi government has made some effort towards sorting out the mess in the power distribution companies through the UDAY scheme.  Some efforts have also been made towards sorting out the mess in the public sector banking space in the country, though clearly a lot more needs to be done.

But rather ironically the government continues to run loss making public sector enterprises. It continues to own telephone companies, an airline, hotels, a company which makes scooters and a company which used to make bicycles. It also owns a major stake in the country’s biggest cigarette company. How bizarre can it really get?

This also goes totally against the idea of minimum government and maximum governance that Narendra Modi had put forward in the run up to the Lok Sabha elections in 2014, but has since abandoned. One of the main reasons the government has held back in shutting down these companies is that it doesn’t want a run-in with the trade unions, which can get nasty.

Nevertheless, as the Survey points out: “In many cases where public sector firms need to be privatized, the problems of exit arise because of opposition from existing managers or employees’ interests. But in some instances, such action can be converted into opportunities. For example, resources earned from privatization could be earmarked for employee compensation and retraining.”

Also, many public sector enterprises have a large amount of land which can be monetized. This money can go into the government kitty and be used for the development of physical infrastructure. It can also be used to offer the employees an attractive compensation, so that they don’t come in the way of the government shutting down the firms.

As the Economic Survey points out: “Most public sector firms occupy relatively large tracts of land in desirable locations. Parts of this land can be converted into land banks and made into vehicles for promoting the ‘Make in India’ and Smart City campaigns. If the land is in dense urban areas, it could be used to develop eco-systems to nurture start-ups and if located in smaller towns and cities, it could be used to develop sites for industrial clusters.”

This suggestion makes a lot of sense. I hope Narendra Modi has found time to at least read this part of the Economic Survey.

The column originally appeared on Swarajya Mag on February 26, 2016

 

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Economic Survey: There Is A Very Compelling Case For India To Move To Cash Transfer Of Subsidies

narendra_modi

Price subsidies have been a very important part of the Indian government’s plan of trying to bring down poverty in the country. This entails selling commodities like rice, wheat and kerosene, at a price significantly lower than the market price through the public distribution system.

But the question is, do these subsidies work? The Economic Survey for 2014-2015 had said that: “Prima facie, price subsidies do not appear to have had a transformative effect on the living standards of the poor, though they have helped poor households weather inflation and price volatility.”

What are the basic problems with these subsidies? Subsidies are regressive. This basically means that the rich households tend to benefit more from them than the poor for whom the subsidies are meant.

Take the case of cooking gas which the oil marketing companies sell at a loss and are in turn compensated by the government. It turns out that the poorest 50% of the households consume only 25% of the cooking gas.

Further, subsidies don’t reach those who they are meant for. Around 46% of kerosene which has to be distributed through the public distribution system(PDS) is lost as a leakage. This basically means that the kerosene is siphoned off by those running the shops that constitute the PDS and the government functionaries involved. It is then sold in the open market.

This story plays out across other commodities distributed through the PDS as well. Nearly 54% of the wheat meant to be distributed through PDS is lost as a leakage. Around 48% of the sugar and 15% of rice meant to be distributed through the public distribution system is lost as a leakage.

Fertilisers also face a similar leakage problem. As the Economic Survey of 2015-2016 released a few hours back points out: “The government budgeted Rs 73,000 crore—about 0.5 per cent of GDP—on fertiliser subsidies in 2015-16. Nearly 70 percent of this amount was allocated to urea, the most commonly used fertiliser, making it the largest subsidy after food.”

Subsidised urea has three kinds of leakages. As the Survey points out: “(i) 24 per cent is spent on inefficient urea producers (ii) of the remaining,4 1 per cent is diverted to non-agricultural uses and abroad; (ii) of the remaining, 24 per cent is consumed by larger—presumably richer—farmers.”

These are huge leakages which cost the government a lot of money. So what can be done about this? As the Economic Survey points out: “Cash transfers can directly improve the economic lives of India’s poor, and raise economic efficiency by reducing leakages and market distortions.”

The current model of distribution of subsidies is essentially very leaky. This has led to a situation where only 35% or Rs 17,500 crore of the total urea subsidy of Rs 50,300 crore reaches the small and marginal farmers, the intended beneficiaries.

It is estimated that 75% subsidy on agricultural urea has essentially managed to create a thriving black market in the Bangladesh and Nepal. As the Economic Survey points out: “Comparing urea allocation data with estimates of actual use from the Cost of Cultivation Survey 2012-13, we estimate that 41 per cent of urea is diverted to industry or smuggled across borders.”

Further, there is a huge black market for urea within India as well. “It is estimated that about 51 per cent of Indian farmers buy urea at above-MRP. In the three eastern states bordering Bangladesh, 100 per cent of farmers had to buy urea at above MRP in the black market. Similarly, in Uttar Pradesh, which borders Nepal, 67 per cent of farmers had to buy urea in the black market at above the stipulated MRP,” the Survey points out.
The simple answer to prevent this leakage would have been better policing. Nevertheless, as World Bank chief economist Kaushik Basu writes in An Economist in the Real World—The Art of Policymaking in India: “Trying to police such a large system by creating another layer of police and bureaucracy will come with its own problems of corruption and bureaucracy.” It also leads to the proverbial question of who will police the police?

The answer lies in coming up with a better design in order to deliver food grains, fertiliser and kerosene to the poor. Essentially, the role of the PDS shop owner needs to be cut down. The Economic Survey for 2014-2015 as well as the Economic Survey for 2015-2016 talk about direct cash transfers to beneficiaries of these subsidised commodities, instead of distributing them through the PDS.

Instead of distributing food grains, fertiliser and kerosene through the PDS shops, the intended beneficiaries need to be given money through cash transfers and be allowed to buy commodities from wherever they want to.

As the Survey for 2014-2015 pointed out: “Recent experimental evidence documents that unconditional cash transfers – if targeted well – can boost household consumption and asset ownership and reduce food security problems for the ultra poor.”

In fact, Basu explains this in some detail in his book through the concept of food coupons, which are again nothing but cash transfers. He envisages a system where the poor get food coupons or cash transfers and they then use that money to buy kerosene, fertiliser and food grains from any shop instead of just the PDS shop in their neighbourhood.

As he writes: “Note that since the stores get full price from the poor and, more importantly, the same price from the poor and the rich, they will have little incentive to turn away the poor away. Further, the incentive to adulterate will also be greatly reduced since the poor will have the right to go to any store with their coupons [or cash for that matter].”

This means that the PDS shops are also likely to sell good stuff, instead of trying to adulterate the commodities. Further, the siphoning of the food grains, fertiliser and kerosene will also come down.

The fear here is that the poor will use their coupons or cash for something else. But that risk is anyway there in the current system as well. The poor can sell the grain or the kerosene that they get and do something else with that money.

Also, as Basu puts it: “If they choose not to take the benefit in the form of food and buy something else, it is not nearly so counterproductive as the benefit going to owners of PDS stores as often happens in the current system.” The chances of that money being spent and benefitting the economy are higher.

For this system to work the government needs to be able to link the Aadhaar number to an active bank account, in which it can transfer money. As of January 2016, around 970 million Indians have Aadhaar numbers. In fact, linking Aadhaar numbers to bank accounts has worked very well in case of subsidised cooking gas cylinders where black marketing has come down. “The use of Aadhaar has made black marketing harder, and LPG leakages have reduced by about 24 per cent with limited exclusion of genuine beneficiaries.”

As the Survey points out:A number of states, like Andhra Pradesh and Gujarat, with high Aadhaar penetration and POS devices in rural areas might be good candidates to start pilots based on this model.” 
Let’s hope this happens on a larger scale than it currently is, sooner rather than later.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Huffington Post India on February 26, 2016

Railway Budget Shows that India is Not Growing at 7.6%

suresh prabhuSuresh Prabhu, the minister of railways, presented the railways budget yesterday. During the course of the budget speech Prabhu said: “The freight basket of Indian Railways is dominated by 10 bulk commodities which enjoy a share of around 88%.”

The accompanying table shows the total amount of some of these commodities moved by the Railways along with the revenue earned during the course of the current financial year. What the table clearly tells us is that the projections that the railways minister made when he presented the last budget in February 2015, have turned out to be extremely overoptimistic.

Commodity2014-2015 (actuals)2015-2016 (projected)2015-2016 (revised)2016-2017 (projected)
Coal
Tonnage (in million tonnes)545.81585555.63577.8
Earnings(in Rs crore)47,937.5150,398.5952,054.8353,684.72
Pig Iron and Finished Steel
Tonnage (in million tonnes)42.8443.541.6444.8
Earnings(in Rs crore)6,544.447,108.415,814.556,302.15
Iron Ore
Tonnage (in million tonnes)112.77125117.81125.7
Earnings(in Rs crore)7,892.869,767.236,593.276,966.95
Cement
Tonnage (in million tonnes)109.8120.5105.36111
Earnings(in Rs crore)8,378.1810,813.569,397.799,901.88
Petroleum
Tonnage (in million tonnes)41.143.2542.4843.5
Earnings(in Rs crore)5,515.665,787.895,907.266,040.06
Fertilizers
Tonnage (in million tonnes)47.4149.554.8356
Earnings(in Rs crore)5,152.065,317.356,147.566,286.7
Food
Tonnage (in million tonnes)55.476244.1346
Earnings(in Rs crore)8,138.3310,153.587,731.158,084.96
Total freight
Tonnage (in million tonnes)1095.261186.2511071157
Earnings(in Rs crore)1,05,791.3412,14231,11,852.721,17,932.75
Source: Indian Railways

 

Prabhu had assumed that the total freight moved by the Indian Railways in 2015-2016 would stand at a total of 1186.25 million tonnes, a jump of 8.3% in comparison to the actual freight moved in 2014-2015. The actual increase in freight moved is now expected to be only a minor 1.07% to 1107 million tonnes. In fact, between April 2015 and January 2016, the Indian Railways moved 914.8 million tonnes of freight, an increase of just 0.9%, the lowest it has been in years.

This minor jump in freight movement led to earnings jump of 5.7% to Rs 1,11,853 crore. Prabhu had projected that the earnings will jump by 14.7% to Rs 1,21,423 crore. Given this, the earnings have fallen considerably short by around Rs 10,000 crore of what had been projected.

The jump in earnings primarily came from the fact that Prabhu had increased the freight rates for the movement of various commodities in his last budget. The freight rate for coal, which forms around half of the total freight that Indian Railways moves, was increased by 6.3%, and seems to have saved the day for the Railways. The rate for cement was increased by 2.7% and that of urea, pulses and grains by 10%.

The inability to meet the projected earnings could be possibly because of two reasons. First, there is the perpetual reason of the Indian Railways losing out to the road transport sector. As Prabhu said during the course of his speech: “Historically declining modal share of Indian Railways, which dropped from 62% in 1980 to 36% in 2012, is continuing to exert pressure on the institution.”

Further, as the White Paper released by the Indian Railways last year pointed out: “Railway expenditure as percentage of transport sector expenditure used to be about 56% in 7th Plan (1985-90). It has reduced to 30% in 11th Plan (2007-12). IR in last two decades has remained under-invested whereas the road sector has witnessed a surge in investments. The share of IR in overall GDP has been static at 1% and has, in fact, gone down to 0.9% in 2012-13.”

Nevertheless, the difference between the projected freight earnings and the actual freight earnings, is too huge. Hence, the difference cannot wholly be because of transportation of commodities moving from Indian Railways to the road transport sector.

The difference is also because of the broader slowdown in economic growth. And if the Railways has not moved the total amount of commodities that it expected to, it means that there has been a considerable slowdown in industrial demand.

This is something I have written about it in the past. And the railway budget numbers, only provide more evidence of the same. The numbers along with the slow growth in passenger revenue (which I shall discuss later in this piece) also clearly tell us that the Indian economic growth cannot possibly be 7.6% during 2015-2016. If the freight revenues have gone up by a nominal 5.7%(not adjusted for inflation) there is no way, the economy can be growing at a real 7.6%(adjusted for inflation). 

The basic problem here is that the freight trains are slow as well as expensive in comparison to road transport. In this scenario, the Railways has to be a little more dynamic in its handling of freight. As Prabhu said during the budget speech: “Indian Railways typically has focused on increasing revenues through tariff hikes. We want to change that and challenge our conventional thinking on freight policies to win back our share in the transportation sector.” This means that Railways will perhaps look at cutting the freight rates during the course of the year and expanding its business beyond the ten commodities that it mainly moves.

Prabhu also talked about “time tabled freight trains with credible service commitments,” by 2020. This is one way forward in order to take on competition from the road transport sector.

Passenger revenue of the Indian Railways during the course of this financial year is expected to be lower than what had been projected. The overall revenue expected from passengers was Rs 50,175 crore. The actual revenue earned came in 9.5% lower at Rs 45,376 crore. The revenue that was expected to be earned from second class passengers was at Rs 35,101 crore. It came in 12.5% lower at Rs 30,709 crore. This is another good data point which shows the slowdown in consumer demand in rural and semi-urban India, where Railways are still a major form of transportation.

The revenue that was expected to earned from upper class passengers was projected at Rs 15,074 crore. It came in 2.7% lower at Rs 14,667 crore.

In total, the passenger revenues had been assumed to grow by 18.9% to Rs 50,175 crore in 2015-2016, in comparison to 2014-2015. The passenger revenues will grow at 7.6% to Rs 45,376 crore in 2015-2016.

It needs to be pointed out here that a passenger seat that is not booked in Indian Railways is essentially wasted. And given this, the Railways should look at more forms of dynamic pricing, instead of just trying to maximise revenues through the Tatkal ticketing system.

Given the fact that the revenue projections of Indian Railways went wrong the operating ratio of the Railways came in at 90% against the projected 88.5%. This essentially means that in order to earn Rs 100, the Railways ended up spending Rs 90, instead of the projected Rs 88.5. The operating ratio projected for next year is a high 92%, given that the recommendations of the seventh finance commission will have to implemented.

This will push up the salary and more importantly the pension bill of the Indian Railways. Also, the projections made by Prabhu for 2016-2017 are also optimistic, though not as optimistic as the ones he made in the last budget. He expects the freight revenue collections to go up by 5.4% to Rs 1,17,933 crore.

This is more or less similar to the increase in freight revenue during the course of this financial year. But it is worth remembering that the increase came on the back of an increase in freight rates, which is something that Prabhu has rightly resisted from this time around.

Prabhu also assumed a jump of 12.4% to Rs 51,012 crore in passenger revenues in 2016-2017. This comes after

a slow growth in passenger revenues of 7.6% against the assumed 18.9%, and hence, is a little difficult to explain.
Not surprisingly, economist Bibek Debroy who also happens to be a member of the NITI Ayog told CNBC TV 18: “the projections last year were not very good and the projections this year are also somewhat optimistic.”

I agree with Debroy.

 (This was a take on the finances of the Indian Railways, which is what a budget is essentially all about. I will write another piece next week discussing the future plans of the Indian Railways)

The column originally appeared on February 26, 2016 in the Vivek Kaul Diary.

Here’s One Thing Modi Govt Should Do in Its Remaining Budgets

narendra_modi

The annual budget of the Narendra Modi government will be presented by the finance minister Arun Jaitley on February 29, the last day of this month.

Given this, it is a season where everyone has been advising Jaitley on how to go about the entire thing. Some economists have said that the government should increase the public investment, in order to get the economy growing at a faster pace. Others have said that it is important that the government maintain the fiscal deficit target that it has set for itself and not spend more in the process of increasing public investment. Fiscal deficit is the difference between what a government earns and what it spends.

Regular readers of the Diary will know that I am in the government trying to maintain its fiscal deficit camp. Having said that I am not against the government ramping up public investment as long as it can find the money to do so without increasing the fiscal deficit and borrowing more in the process.

As World Bank chief economist Kaushik Basu writes in his new book An Economist in the Real World—The Art of Policymaking in India: A fiscal stimulus is like an antibiotic. It is very effective when used for a short period of time. But if used repeatedly and over long stretches of time, the side effects tend to outstrip the benefits. In India’s case a large deficit is likely to fuel the inflation rate.”

Given this, it is very important as to how the government goes about increasing public investment. As Basu writes: “Choices have to be made very carefully. The first task to which more effort needs to be directed is raising tax revenue.”

Take a look at the accompanying table. Between 2010-11 and this financial year, the taxes as a proportion of gross domestic product have more or less been similar, and have varied within a narrow range. Interestingly, the taxes as a proportion of GDP have fallen since 2007-08.

 

YearDirect taxes as a % of GDPIndirect taxes as a % of GDPTaxes as a % of GDP
2004-054.15.269.36
2005-064.475.49.87
2006-075.365.6210.98
2007-086.265.611.86
2008-095.934.7910.72
2009-105.833.769.59
2010-115.724.410.12
2011-125.594.4310.02
2012-135.594.7510.34
2013-145.634.3710
2014-155.634.319.94
2015-165.664.5810.24
Source: Reserve Bank of IndiaAverage10.25

 

One possible explanation for this lies in the fact that both the stock market as well as real estate prices rallied between 2002-03 and 2007-08. This meant that investors would have made a lot of capital gains, on which they would have paid capital gains tax. This would have pushed the total amount of income tax collected by the government.

In 2001-02, the direct taxes amounted to around 2.94% of the GDP. By 2007-08, they had jumped up to 6.26% of the GDP. Another possible explanation for this lies in the fact that the salaried class got very good increments during the period. Also, the wealth effect was at play as well. With stock prices and real estate prices going up, people felt wealthy and in the process indulged in greater consumption. This led to the collection of higher indirect taxes. The collection of indirect taxes fell dramatically after 2007-08. In 2009-10, indirect taxes collected were at 3.76% of the GDP.

Since 2010-11, the collection of direct as well as indirect taxes as a proportion of GDP has been more or less flat. What this means is that the same set of people are essentially financing the Indian government and there seems to have been no effort made to expand the tax base. As Basu puts it: “Not only is India’s tax-to-GDP ratio low, it went down over the last seven years. Global comparison suggests that India can do much better.”

How does India fair in comparison to other countries when it comes to the tax to GDP ratio? A study titled Tax Revenue Mobilisation In Developing Countries: Issues and Challenges points out: “In comparative perspective, developing countries raise substantially less revenue than advanced economies. The ratio of tax to GDP in low-income countries is between 10% and 20% whereas for OECD economies [or developed economies] it is in the range of 30- 40%.”

What this clearly tells us is that India is at the lower end of the spectrum when it comes to collecting taxes and hence, there is tremendous scope to improve. As Basu puts it: “India should aim to reach a tax revenue-to-GDP ratio of 15 percent within two or three years, and then set an even higher target of, for instance, 20 percent over the medium term.

This does not mean that the government has to raise tax rates. As Basu writes: “This can be done almost entirely through plugging of loopholes and prevention of tax evasion, and the implementation of a more rational tax code, without having to raise taxes.”

Interestingly, along with the budget every year, the government releases the statement of revenue foregone. As the statement released with the last budget pointed out: “The aggregate revenue impact of incentives available in respect of direct and indirect taxes (levied by the Central Government) is Rs 5,49,984.1 crore for 2013-14 and is projected to be Rs 5,89,285.2 crore for 2014-15.” The point being if the tax laws did not have a significant number of exemptions, the government would have collected more tax.

As the statement further points out: “The estimates and projections are intended to indicate the potential revenue gain that would be realised by removing exemptions, deductions, weighted deductions and similar measures.”

Hence, there is a lot to gain for the government if it goes about plugging these loopholes. But then that would mean side-lining corporate lobbies and big business, which finance political parties. Can the Modi government afford to do that?

On that your guess is as good as mine!

The column was originally published in Vivek Kaul’s Diary on February 25, 2016