The Daily Reckoning

Why private equity cannot rescue real estate

3D chrome Dollar symbolRegular readers of The Daily Reckoning would know that I have been bearish on the real estate sector for a while now. There is no way that the current price level in real estate is sustainable. It has gone way beyond what most people can afford and hence needs to fall. That’s the basic logic I offer in almost all the columns that I write on real estate.

In response to these columns I get different kind of feedback. Some people agree with me totally. Some grudgingly. Some are coming around to the idea. And some don’t agree at all and ask me to revisit everything that I have been saying on real estate up until now.

The latest reason offered to me on why real estate prices will not crash is that the private equity firms are now investing in real estate. This will help real estate companies get the money they need. And in the process they won’t cut prices.

This logic doesn’t hold on multiple counts. But before I get into explaining why, let me first talk about a term called “availability heuristic” from behavioural economics. As Jason Zweig writes in The Devil’s Finance Dictionary: “Availability [is] essentially a mental shortcut, or HEURISTIC, that leads people to judge the frequency or probability of events by how easily examples spring to mind. The vividness of rare events can make them seem more common and likely to recur than they are.”

Initial public offerings of companies in stock markets are a good example. As Zweig writes: “The vast majority of initial public offerings (IPOs) fail to outperform the market, but it takes only a few spectacular successes like Google to create the illusion that investing in IPOs is the road to riches.”

Further, the availability heuristic leads to people making confident conclusions. As Dan Gardner writes in Future Babble—Why Expert Predictions Fail and Why We Believe Them Anyway: “The availability heuristic is a tool of the unconscious mind. It churns out conclusions automatically, without conscious effort. We experience these conclusions as intuitions. We don’t know where they come from and we don’t know how they are produced, they just feel right. Whether they are right is another matter.”

Hence, how did the availability heuristic evolve is a question worth asking? As Gardner writes: “The availability heuristic is the product of the ancient environment in which our brains evolved. It worked well there. When your ancestor approached the watering hole, he may have thought, “Should I worry about crocodiles? Without any conscious effort, he would search his memory for examples of crocodiles eating people. If one came to mind easily, it made sense to conclude that, yes, he should watch out for crocodiles.”

Nevertheless, the world has changed since then. But looks like our minds haven’t and the availability heuristic instead of helping us, continues to trick us.
Getting back to the topic at hand, people who believe that the private equity money coming into real estate will lead to real estate prices not falling, have essentially become victims of the availability heuristic. These people, the smart lot, read business newspapers religiously every day. And in these newspapers they read that a lot of private equity money is being invested in Indian real estate companies. This leads them to conclude that the money problems of all Indian real estate companies are over and hence, real estate prices will not fall. Their “unconscious mind churns out conclusions automatically, without conscious effort.”

Those who believe real estate prices will not fall because of private equity money can easily recall examples of private equity investment in real estate companies. These examples are very easy to recall given that the smart lot reads business newspapers regularly. But the business newspapers only report the news of real estate companies getting investment from private equity firms.

No newspaper talks about those real estate companies which have not received any private equity money and the situation that they are in. And that’s simply because there is no news in it for them. The situation is similar to newspapers and the media talking about airplane crashes though no newspaper or media talks about the thousands of safe airplane landings that happen all over the world every day. This leads people to conclude that airplane travel is unsafe, though it is not.

Along similar lines, the examples of real estate companies getting investment from private equity firms are fairly easy to recall. The opposite is not. The availability heuristic is at work. Hence, the idea that private equity firms are investing in real estate companies seems more common than it actually is.

Now the question is how many Indian real estate companies have actually seen investments from private equity firms? The real estate lobby the Confederation of Real Estate Developers’ Associations of India (CREDAI) claims to have 11,500 real estate developers from 156 cities across 23 states as its members. Only a very small portion of these real estate companies have seen private equity investment.  And those that have seen investments operate largely in the bigger cities.

So that was one part of the analysis. Now let’s get to the second part with some numbers. Crisil has carried out an analysis of India’s top 25 listed real estate companies which make up for 95% of the market capitalization of India’s real estate sector. The analysis is titled The realty reality.

In this analysis Crisil points out that “Rs.35,000 crores or 50 per cent of their residential debt will continue to remain at high refinancing risk.” “With the demand pick-up expected to remain tepid in the near term, developers are heavily dependent on refinancing their existing debt given their highly leveraged balance sheets.”

What does this mean? It means that real estate companies that Crisil studied need to repay Rs 35,000 crore to banks soon. With real estate companies not being able to sell enough homes they are not earning enough to be able to repay these loans. Hence, they need to refinance these loans i.e. borrow more to repay these loans.

The question is with their highly stretched balance sheets will the banks be interested in lending more to developers? The monthly sectoral deployment of credit data released by the Reserve Bank of India (RBI) points out that the total bank lending to commercial real estate grew by a minuscule 2% between September 19, 2014 and September 18, 2015. This, when the overall lending by banks grew by 8.4%.

Now compare this to how things were in September 2014. Bank lending to commercial real estate between September 20, 2013 and September 19, 2014, had grown by a massive 20%. The overall bank lending by banks had grown by a similar 8.6%.

This clearly shows that the lending by banks to real estate companies has slowed down dramatically. Between September 2013 and September 2014 banks lent Rs 26,958 crore to real estate companies. This has crashed to Rs 3,157 crore between September 2014 and September 2015.

In fact, the overall lending to real estate companies by banks is down by 1% during the course of this financial year (actually between March 20, 2015 and September 2015, to be very precise).

And this is clearly reason for worry for real estate companies. As Crisil points out: “Traditionally, bank loans have been the primary source of funding, meeting ~90% of the requirements of India’s top 25 developers. The net exposure of banks to the real estate sector declined 1% in the first half of the current fiscal…However, going forward, incremental bank funding is expected to decline ~5%.”

What this clearly tells us is the banks are not really gung-ho about lending to real estate companies anymore. (As can be seen from the accompanying table).

So what happens from here on? The slowdown in lending from banks explains why real estate companies have been looking at alternative sources of finance through non-convertible debentures and private equity. Data from Crisil points out that the issuances of non-convertible debentures have grown at the rate of 68% per year over the last four years and reached Rs 8,500 crore in 2014-2015. The private equity investments in real estate have also jumped at a very fast rate of 32% per year from Rs 6,600 crore in 2012 to Rs 15,600 crore in 2015.

Over and above this, the recent government moves on foreign direct investment in real estate is also expected to help bring in money into the sector. Earlier foreign direct investment could come into real estate only if the project size was a minimum 20,000 square meters with a minimum capital of $5million.

Further, it was required that foreign investors bring in money within six months. This requirement has also been done away with.

All this is good news for some cash-strapped real estate companies. But can we conclude from all this that with the money flowing back into the sector again, real-estate companies will not cut prices? The first point I would like to make here is that only a small portion of the builders have received money from the alternative routes. The second point is that the alternative routes of raising money come with a very high cost of funding.

As Crisil points out: “The cost of alternative funding has increased over the last two years as pressure on developers financial position intensified. About one-third of the non-convertible debentures issuances last fiscal yielded an internal rate of return of more than 20%, compared with no issuances of similar yields in 2012.”

The same stands true for private equity firms as well. As Crisil points out: “As for private equity [firms], the higher return expectation will increase the refinancing risk for the realtors over the longer term, unless the demand picks up substantially. CRISIL estimates payout for private equity funds for the sector as a whole at Rs 85,000 crore, assuming a return of 20% over a 5 year period. Hence, alternative funding sources such as non-convertible debentures and private equity [firms] are expected to continue providing some respite in the short term only.”

What does this mean in simple English? The real estate companies are essentially kicking the can down the road. The money being brought in through the alternative route will also have to be returned. And where will that money come from is a question worth asking?

My guess here is that the money being brought in through non-convertible debentures and private equity firms is being used to pay-off the bank loans of real estate companies that are falling due (It would be great if any Daily Reckoning readers in know of this trend can confirm it by commenting on this column or writing to me at [email protected]). This has allowed the real estate companies to not cut prices. If this money hadn’t come in then the real estate companies would have had to cut prices in order to sell unsold homes to repay their bank loans.

Nevertheless, the non-convertible debentures as well as private equity firms will also have to be repaid in the years to come. As mentioned earlier the returns expected by those providing the alternative sources of finances are very high. They will also have to be eventually be repaid.

And how will that happen? The only way real estate companies can do that is by selling homes. Homes will only sell if they are reasonably priced. At current prices the demand will continue to remain muted. As a recent 99acres’ Insite report points out in the context of the Mumbai real estate market: “The market is witnessing demand in the affordable and mid-range segments (Rs 25 lakh to Rs 60 lakh), while supply is in the bracket of Rs 1 crore or more.” So there is clearly good demand at lower prices.

Further, as Crisil puts it: “demand recovery and deleveraging are the only sustainable solutions to the problems staring at the real estate developer community.”

And that ain’t happening without prices falling.

The column originally appeared on The Daily Reckoning on November 20, 2015

More reasons on why Swacch Bharat cess is a bad idea

narendra_modi
In the November 16 edition of The Daily Reckoning I had written a column on the recently implemented Swacch Bharat cess. In this column I had talked about how the Swacch Bharat cess is an example of maximum government.

In today’s column I want to make give more reasons on why the Swacch Bharat cess is a bad idea. Just to recount for readers who hadn’t read the earlier column, on November 6, the Narendra Modi government decided to implement a Swacch Bharat cess. The cess amounts to 0.5% on all services, and has pushed up the effective rate of service tax to 14.5%, from the earlier 14%. The cess has come into effect from November 15, 2015.

Any tax that the central government collects needs to be shared with the state governments. But that isn’t the case with cesses as well as surcharges that it collects. The money raised through cesses as well as surcharges is not shared with the state governments.

In fact, take a look at the accompanying table. In 2013-2014, the cesses and the surcharges collected by the central government amounted to Rs 71,713.7 crore. This formed 8.79% of the total tax revenue remaining with the central government after handing over the share of the state governments.

 

Cesses and surcharges (in Rs crore)2013-20142014-20152015-2016
Total cesses and surcharges71713.7102859.4117460.5
Total tax revenue remaining with central govt after sharing with states815854.2908462.8919842.3
Cesses and surcharges as a percentage of total tax revenue remaining with central govt8.79%11.32%12.77%
Source: www.indiabudget.nic.in

In 2014-2015, the cesses and surcharges collected by the central government jumped by a huge 43.4% to Rs 1,02,859.4 crore. They formed 11.32% of the total tax revenue remaining with the central government after handing over the share of state governments. In 2015-2016, this number is projected to further jump to 12.77%. That’s a jump of close to 400 basis points (one basis point is one hundredth of a percentage) between 2013-2014 and now.

What does this tell us? Since the Narendra Modi government has come to power a greater proportion of the central government’s tax revenue is coming from cesses and surcharges. Take a look at the following table. Look at the last two entries which are in bold (The entries before that are exactly the same as in the earlier table).

Cess and surcharge (in Rs crore)2013-20142014-20152015-2016
Total cess and surcharges71713.68102859.4117460.5
Total tax revenue remaining with central govt after sharing with states815854.2908462.8919842.3
Cess and surcharges as a percentage of total tax revenue remaining with central govt8.79%11.32%12.77%
Total tax revenue of the central govt113873412513911449491
Cess and surcharges as a percentage of total tax revenue 6.30%8.22%8.10%
Source: www.indiabudget.nic.in

In 2013-2014, cesses and surcharges formed around 6.30% of the total tax revenue earned by the central government. After the Modi government took over, the number has jumped to more than 8%.

This has been made possible through several things. In the budget presented in February earlier this year, the finance minister Arun Jaitley had subsumed the education cess and the secondary and higher education cess in central excise duty. “In effect, the general rate of Central Excise Duty of 12.36% including the cesses is being rounded off to 12.5%,” Jaitley had said during his budget speech. The clean energy cess was hiked from Rs 100 to Rs 200 per metric tonne of coal. The existing excise duty on petrol and diesel to the extent of Rs 4 per litre was converted into a road cess. And there was an enabling provision for the Swacch Bharat cess as well.

What is the problem here? The Modi government made a lot of song and dance about increasing the share of state governments in the tax revenues collected by the central government from 32% to 42%. After having done that, it has also managed to increase the amount of money collected through cesses and surcharges which it does not need to share with the state governments.

This goes against the entire idea of cooperative federalism which Narendra Modi had passionately espoused after coming to power. In fact,  the 14th finance commission report released earlier this year had pointed out: “Almost all States have argued that cess and surcharges should form part of the divisible pool, with some suggesting that this should be done if cess and surcharges continue for more than three years.”

The education cess which brings in a bulk of the money collected under cesses, has been around for a very long time. In fact, the Comptroller and Auditor General in a recent report had pointed out that not all the money collected through the education cess went towards education.

As a news-report in The Economic Times points out: “The CAG report said that against the total collection of Rs 130,599 crore as primary education cess, only Rs 119,197 crore was transferred to the Prarambhik Shiksha Kosh in public account from 2004-05 to 2013-14, resulting in a short transfer of Rs 11,402 crore in the Prarambhik Shiksha Kosh.”

The cess on education as well as the new Swacch Bharat cess which will be used for improving sanitation, raises a very important question. If cesses have to be collected for things as important as education and sanitation, what is the government doing with all the actual tax revenue that it is raising? The tax revenue is essentially being used to finance what we can safely call maximum government. While Narendra Modi had promised to change that, up until now he has operated more or less similarly like the Congress governments before him.

For a cess to be effective it is important that it be ring fenced properly. Take the case of the cess on diesel implemented by the Atal Bihari Vajpayee government to finance the national highway development programme. It was a proper ring-fenced cess where there was total clarity of what the money collected under the cess will be used for.

In comparison, the definition of the Swacch Bharat programme remains very vague and given that it will be very difficult to ring-fence it properly. Also, it needs to be asked how effective can a central government be in implementing a cleanliness and sanitation programme at the local level throughout the country. And given that wouldn’t it make more sense in sharing the money raised with state governments?

To conclude, in order to woo foreign investors to invest in India, the finance minister Arun Jaitley has been talking about a fair and predictable tax regime. In fact, at the 11th Indo-US Economic Summit in September earlier this year he had said: “We can evolve into fairest and predictable taxation regime in India.”

How about offering a fair and predictable tax regime to the Indian tax payer as well, Mr Jaitley?

The column was originally published on The Daily Reckoning on Nov 19, 2015

Why oil prices have fallen by 63% and petrol prices by only 17%

light-diesel-oil-250x250One good news for the Indian economy during this financial year has been the huge increase in indirect tax collections. Customs duty, excise duty and service tax together form the indirect taxes collected by the central government.

Data released by the ministry of finance earlier this month showed that indirect taxes as a whole have grown by close to 36%, during the course of this financial year (April to October 2015). The accompanying table provides a breakup of the different kinds of indirect taxes collected during the course of this financial year.

Indirect Tax Collection:  April- October 2015

(Rs. in crores)

Tax Head

 

 

B.E.

2015-16

For OctoberUp-to October% of BE achievement
2014-152015-16% Growth2014-152015-16% Growth
 Customs208336

 

168001899813.110483112244816.858.8
Central Excise*228157

 

135692255066.28758814768568.664.7
Service Tax209774

 

125281714336.88937911272726.153.7
 

Total

 

646267

 

 

42897

 

58691

 

36.8

 

281798

 

382860

 

35.9

 

59.2

*Exclusive of cess administered by other departments.

What is interesting is that customs duty, central excise duty as well as service tax collected have grown at very good rates. The increase in the collection of indirect taxes between the end of 2013-2014 and the end of 2014-2015 had been just 9.1%. Also, the government failed to meet the indirect tax target of Rs 6,24,902 crore in 2014-2015. It managed to collect only Rs 5,42,325 crore.

Also, the indirect taxes collected during the course of this year up until now indicate that the government seems all set to meet its target of Rs 6,48,418 crore. This target is an increase of 19.6% in comparison to the indirect taxes collected during the last financial year.

Given that the indirect taxes collected have grown by 35.9% this year, meeting the indirect taxes target for this year, should not be a problem at all. As finance minister Arun Jaitley said earlier this month: “One of the greatest positives I can see is a huge increase in indirect tax revenues.”

The question is how genuine and sustainable is this massive growth in indirect taxes. As the ministry of finance press release put out earlier this month points out: “These collections reflect in part increase due to additional measures taken by the Government from time to time, including the excise increases on diesel and petrol, the increase in clean energy cess, the withdrawal of exemptions for motor vehicles, capital goods and consumer durables, and from June 2015, the increase in Service Tax rates from 12.36% to 14%. However, stripped of all these additional measures, indirect tax collections increased by 11.6% during April-October 2015 as compared to April-October 2014.”

Once we take these factors into account the rise in indirect tax collections is a much muted 11.6%. To be honest, the finance minister Jaitley acknowledged this recently.

The 68.6% jump in central excise duty is the main reason behind the massive jump in indirect tax collections. In fact, the jump in excise duty makes up for close to 60% of the overall jump in the indirect taxes collected this year.

This jump has primarily come due to the government increasing the excise duty on petrol and diesel five times between last year and now. In fact, the latest increase in excise duty on petrol and diesel came about earlier this month.

With these increases in excise duty on petrol and diesel, the government has more or less fully captured the fall in oil prices for itself, and not passed it on to you and me. A litre of petrol currently costs Rs 68.13 per litre in Mumbai. It was at Rs 80 per litre around the time, Narendra Modi was elected to power in May last year.

Between then and now, the petrol price has fallen by just 17.4%. In comparison, the price of the Indian basket of crude oil has crashed by 63%. On May 26, 2014, when Narendra Modi was sworn-in as the prime minister of India, the price of the Indian basket of crude oil was $108.05 per barrel. On November 16, 2015, the price was at $39.89 per barrel.

This clearly shows that the government has captured almost all the benefit of falling oil prices. A 63% fall in the price of oil has led to just a 17% fall in the price of petrol in Mumbai.

There are multiple problems with this approach.

The government talks about having dismantled the administered price mechanism on the pricing of petrol and diesel. But that is clearly not the case. A fall in oil prices does not immediately lead to a fall in petrol and diesel prices. The government has captured the fall by increasing the excise duty on petrol and diesel.

Further, the government has become heavily dependent on the revenue coming in from an increase in excise duty on petrol and diesel. What will it do if and when the oil price starts to go up? Will it cut the excise duty in order to ensure that price of petrol and diesel does not rise? Given that it did not pass on the benefits of a fall in the price of oil to the end consumer, isn’t it only fair that it shouldn’t be passing on the increase as well?

Also, it is worth remembering here that trying to forecast the price of oil remains tricky business.  As Philip Tetlock and Dan Gardner write in Superforecasting—The Art and Science of Prediction: Take the price of oil, long a graveyard topic for forecasting reputations. The number of factors that can drive the price up or down is huge—from frackers in the United States to jihadists in Libya to battery designers in Silicon Valley—and the number of factors that can influence those factors is even bigger.”

Further, if it cuts the excise duty, as and when the oil price goes up, it will have to borrow more and that will create its own set of problems. The fiddling around with excise duty on petrol and diesel, shows a lack of a stable policy on the tax front. The finance minister Arun Jaitley has often outside India talked about a stable tax regime for foreign investing in India. Why forget us Indians, who live in India?

Another impact of this massive increase in indirect tax collections has been the junking of the disinvestment programme, though no politician will admit to the same. At the beginning of the year, the government had set a disinvestment target of Rs 69,500 crore. But that is not going to be achieved. Meanwhile, the government will continue to waste the taxpayer’s hard earned money on dud companies like MTNL and Air India. Minimum government and maximum governance will continue to remain a slogan.

On the good side, the fiscal deficit number will look better than 3.9% of GDP it was projected at, in the budget document.

The column originally appeared on The Daily Reckoning on November 18, 2015

 

The success of Make in India will lead to more jobs in services and not manufacturing

make in india
This column is essentially an extension of the column Devanshu Sampat wrote for The 5 Minute Wrapup on November 13, 2015. In this column Sampat talks about the challenge automation will create for the Make in India programme.

As he writes: “The costs of robots fall every year. At the same time, their complexity is on the rise. It won’t be long before cheap robots will be catering to the needs of a wide range of manufacturing firms.”

This Sampat believes “will prove to be major challenge to the government.” “Will ‘Make in India’ be successful if a large number of people remain unemployed despite a manufacturing revolution?” he asks.

As I have said in several previous columns, nearly 13 million Indians are expected to join the workforce every year. This trend will continue up to 2030. Given this, the government needs to create an environment in which jobs are created, in order to accommodate this workforce at a fast speed.

With automation and robots taking over manufacturing the number of new jobs being created will come down. And this will mean trouble for the Make in India programme given that ultimately it’s a job creation programme.

So what is the way out? The socialist mind-set of India’s politicians will look at it in a way where they may want to make it mandatory for businesses to hire and employ a certain number of people depending on the size of a firm.

To be honest I haven’t heard of such suggestions being made up until now but I won’t be surprised if such suggestions are made in the years to come, if the Make in India programme starts to fail due to automation and various other reasons.

Also, it is worth remembering here that any businessmen will automate if he can. A businessman is a capitalist and he works for ‘more’ profit and if there is an opportunity to make more profit he will try to cash in on it. And stopping that behaviour isn’t the best possible way to operate.

Further, given India’s surfeit of labour laws which make the business environment even more challenging, automation may be the best way out for any businessman.

Having said this, the question that arises here is that why should we expect the manufacturing industry to solve India’s employment problem? This is a fair question to ask. A straightforward answer for this lies in the fact that every country that has gone from being a developing country to becoming a developed one, has gone through a manufacturing revolution. India is possibly an exception to this, given that we have had a services revolution before a manufacturing one.

Nevertheless, even with automation we should not be so worried. TN Ninan in his book The Turn of the Tortoise—The Challenge and Promise of India’s Future offers a very interesting perspective on the basis of his interactions with some leading industrialists.

Take the case of RC Bhargava, the chairman of Maruti Suzuki, India’s leading car maker. As Ninan writes: “The chairman of Maruti Suzuki says, in response to a question on the greater automation that exists in newer car plants, that car factories should not be expected to solve India’s employment problem.”

So what about job growth? “If job growth is to come, according to Bhargava, it will have to be in associated areas—manning petrol pumps or maintaining and repairing vehicles, which are service sector jobs and don’t compare with high paying factory jobs.”

Bhargava also points out that every third car bought in India is not driven by the owner but a hired driver. Data from the Society of Indian Automobile Manufacturers (SIAM) points out that 2.6 million cars were sold in India in 2014-2015. If every third car is being driven by a driver as Bhargava talks about, then that means 8.5 lakh new jobs for drivers were created just in 2014-2015. And that is a substantial number.

The broader point is that even though manufacturing jobs may not grow, the setting up of new factories will lead to an increase in jobs in services. As Ninan writes: “The ratio of non-factory to factory jobs in the car industry is said to be 7:1. The head of another car company puts the figure at 16:1. Other manufacturers of engineering goods endorse the view that shop-floor employment in the engineering goods sector is unlikely to grow rapidly because of steadily increasing automation as well as gains in productivity.”

Ninan also recounts an interaction with Jamshyd Godrej, chairman and managing director of Godrej & Boyce, the diversified engineering company. Godrej “recalls a time early on when the majority of his company’s employees worked in the factory.” Now, the number of employees working outside the factory are four to five time the number of employees working in the factory.

The moral of the story, as Ninan puts it is “Success in quite a lot of manufacturing sectors, therefore, leads to employment growth in services, not manufacturing. Not that it should matter, since incomes will be better in both than in agriculture.”

In this scenario, it is important that the government realises that the success of Make in India, should not depend on the number of manufacturing jobs it ends up creating. Even if it does not create manufacturing jobs, it will create jobs in services.

Hence, the government should keep working towards a better ease of doing business environment. The labour laws need to be simplified. The physical infrastructure needs to improve. The roads, railways and ports need to improve. The contracts need to be honoured. A bankruptcy law needs to be in place. The courts need to function well.

The simple things need to be done well.

(The column originally appeared on The Daily Reckoning on November 17, 2015)

Swacch Bharat cess shows minimum government is just a slogan

narendra_modi
On November 6, earlier this month, the Narendra Modi government decided to implement a Swacch Bharat cess. The cess amounts to 0.5% on all services, and has pushed up the effective rate of service tax to 14.5%, from the earlier 14%. The cess has come into effect from yesterday i.e. November 15, 2015.

The first question that needs to be asked is how much money will the cess end up raising for the government? During the first seven months of this financial year between April and October 2015, the service tax collections have grown at an excellent pace of 26%.

The total service tax collected during the period stands at Rs 1,12,727 crore. If the government continues collecting service tax at this pace, it will end up with around Rs 2,11,846 crore (1.26 x Rs 1,68,132 crore, which was the total amount of service tax collected last year).

At a service tax rate of 14%, this would mean that an income of Rs 15,13,186 crore will be taxed (Rs 2,11,846 crore divided by 14%). A Swacch Bharat cess of 0.5% would amount to a total of Rs 7,566 crore (0.5% of Rs 15,13,186 crore) collected during the course of the year. But the cess will be collected only for a period of 4.5 months during the course of the year (between mid-November and end March). Once that is taken into account then the amount likely to be collected through the Swacch Bharat cess will be around Rs 2,837 crore. (This is a simple calculation which doesn’t go into technicalities which arise with any kind of tax collection).

Also, given that more tax is collected during the last few months of the financial year, the number is likely to be higher than this. This calculation works with the assumption that the tax collections are distributed equally through the year, which is not totally correct.

Over the last few days, I have come across news-reports which suggest that the government will be able to collect only Rs 400 crore through the Swacch Bharat cess. This is incorrect.

As a PTI newsreport points out: “The additional cess would be over and above the 14 per cent Service Tax rate which is already being levied and may yield the government an additional about Rs 400 crore during the remainder of the current fiscal.”

How did this calculation come about? As I mentioned earlier, the total service tax that is likely to be collected during the course of this year should be around Rs 2,11,846 crore. 0.5% of this amounts equals Rs 1,059 crore for the whole year. For a period of 4.5 months this amounts to Rs 397 crore, or around Rs 400 crore.

But there is a basic mistake in this calculation. The cess of 0.5% is on the total income and not on the total tax.
So that was the mathematical part of this column. Now let’s deal with the more important issues. Why has the government come up with a cess of 0.5% instead of increasing the service tax rate to 14.5%?

The financial impact of both would have been the same. The government would end up collecting the same amount of money. The answer lies in the fact that anything collected as a tax needs to be shared with the states. But anything collected as a cess remains with the central government. And that is why the government has come up with a cess amounting to 0.5%, instead of increasing the tax to 14.5%.

As the 14th finance commission report released earlier this year points out: “Almost all States have argued that cess and surcharges should form part of the divisible pool, with some suggesting that this should be done if cess and surcharges continue for more than three years.” But that is not how things stand currently.

Also, the money raised through the cess is to be allocated to the ministry of urban development and the ministry of drinking water and sanitation. The question is how well can a central government sitting in Delhi run a cleanliness drive across the country? Cleanliness ultimately remains a local issue and can be taken care of in a much better way if the governments at the local level are involved, which will not happen in this case.

The Swacch Bharat cess also goes against Narendra Modi’s pet theme of cooperative federalism, which talks about empowering the state governments. In a letter to chief ministers earlier this year, Modi had said: “This Government is…committed to the idea of empowering states in all possible ways. We also believe that states should be allowed to chalk out their programmes and schemes with greater financial strength and autonomy, while observing financial prudence and discipline.”

Further, should the government have come up with a  cess more than half way through the year and ended up complicating the tax system further, in order to raise an amount of Rs 3,000 crore? The answer is no. (I am no tax expert but you can Google and read all kinds of articles which claim to clear all the doubts regarding the Swacch Bharat cess).

Rs 3,000 crore amounts to just 0.3% of the central government’s total share of revenue of Rs 9,19,842 crore, for this financial year. The government could have easily raised this small amount from other sources without complicating the tax system.

For example, it could have shut down MTNL which faced losses of Rs 2,000 crore during the course of the last financial year. Or it could have shut down many other hugely loss making public sector enterprises which India’s miniscule base of taxpayers continue to fund. After shutting down these enterprises, the government could have looked to sell the massive physical assets like land and building that these enterprises own. These sales can fund the Swacch Bharat campaign many times over in the years to come.

But that would mean working towards a smaller government, which Narendra Modi doesn’t seem to like, even though during the course of his election campaign last year he had promised “minimum government and maximum governance”. But what we have got up until now is nothing along the lines of what was promised.

As Arun Shourie told The Hindustan Times recently: “He doesn’t believe in disinvestment. This government has shown an almost criminal neglect in improving tax administration. His idea of development is to have a few large projects like the Sardar Patel statue, which turns out to be made in China, or a bullet train from Ahmedabad to Mumbai, rather than spend that money to improve the speed of all trains in India by 15 mph. He’s increasing the role of the state in everything. ‘Minimum government, maximum governance’ is just a slogan.””

And that is worrying.

The column originally appeared on The Daily Reckoning on Nov 16, 2015