Mr Jaitley, One Thing Direct Tax Collections Show is That Acche Din are Here for CAs

A little over a week back, the numbers for the direct tax collections for 2017-2018, were released. The net direct tax collections have improved by around 17.1% to Rs 9.95 lakh crore. The direct tax collections consist of corporate tax, personal income tax and other direct taxes. This is the gross direct tax collection. After, refunds are deducted from it, what remains are the net direct tax collections.

The finance minister attributed this increase in net direct tax collections to demonetisation and Goods and Services Tax, which had resulted in a higher formalisation of the economy. The interpretation being that with increased formalisation people paid more tax.

The trouble with looking at just the absolute direct tax collections is that they do not take into account the fact that the size of the economy has also grown. Hence, any tax collection, should always be looked at as a proportion of the gross domestic product. How do things look when we look at the direct tax to the GDP ratio?

Take a look at Figure 1, which plots that.

Figure 1: 

Source: https://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf.
For 2017-2018, the figure has been arrived at using data from http://pib.nic.in/PressReleseDetail.aspx?PRID=1527290
and http://pib.nic.in/PressReleseDetail.aspx?PRID=1522059.

What does Figure 1 tell us? It tells us that the direct tax to GDP ratio in 2017-2018 is likely to be at 5.94%. We use the word likely because right now what we have is a GDP estimate for 2017-2018, which will change when the actual numbers come out, later this year.

The direct tax to GDP ratio in 2016-2017 was at 5.6%. Hence, there is an improvement of 34 basis points (one basis point is one hundredth of a percentage), year on year. If we look at historical data, such a jump happened almost every year between 2001-2002 and 2007-2008. And no demonetisation or GST happened back then.

In 2007-2008, the direct taxes to GDP ratio peaked to 6.3%. The stock market was rallying big time back then. Once it crashed, the direct taxes to GDP ratio fell over the next few years. What this basically means is that when the stock market is doing well, the investors pay a lot more short-term capital gains tax than they do otherwise. And this improves the direct taxes to the GDP ratio of the government.

This is a factor that needs to be taken into account for the jump in direct tax collections as 2017-2018 as well. The stock market has been rallying over the last few years, and there is bound to have been some jump in the short-term capital gains tax collections. Given that an exact breakdown of different kinds of taxes is not available in the public domain as of now, we cannot adjust for it. These gains need to be adjusted for simply because they are temporary in nature.

But, we are sure, the mandarins at the finance ministry have this data, they can very well adjust for it and then tell us, what has been the real growth in direct tax collections.

There is another factor which makes the data look a lot better than it perhaps actually is. The net direct tax collections as mentioned earlier are arrived at by subtracting refunds from gross direct collections. Let’s take a look at Figure 2.

Figure 2: 

Source: Author calculations on data from https://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdfhttp://pib.nic.in/PressReleseDetail.aspx?PRID=1527290
and http://pib.nic.in/PressReleseDetail.aspx?PRID=1522059.

The refunds have fallen from 1.07% of the GDP in 2016-2017, to 0.89% of the GDP in 2017-2018. This is the second biggest fall in refunds between 2000-2001 and 2017-2018. It will be interesting to see what portion of the returns filed still remain to be processed. The larger point being that the direct tax collections data does not pass this basic smell test.

Further, if we look at GDP growth, 2017-2018 has seen slowest GDP growth (in nominal terms without adjusting for inflation) since 2011-2012. The government collecting higher taxes while the overall economy is slowing down, is not something to be proud of.

Let’s look at another data point that the Modi government keeps tom-tomming about at any given opportunity. That the number of tax returns being filed has been going up at a rapid pace. As the press release accompanying the announcement of direct tax numbers pointed out: “During FY 2017-18, 6.84 crore Income Tax Returns (ITRs) were filed with the Income Tax Department as compared to 5.43 crore ITRs filed during FY 2016-17, showing a growth of 26%. There has been a sustained increase in the number of ITRs filed in the last four financial years. As compared to 3.79 crore ITRs filed in F.Y. 2013-14, the number of ITRs filed during F.Y. 2017-18 (6.84 crore) has increased by 80.5%.”

Between 2013-2014 and 2017-2018, the number of income tax returns being filed has gone up 80.5%. During the same period the direct taxes to GDP ratio has gone up from 5.62% to 5.94%, by around 32 basis points.

What does this tell us? It tells us that more and more income tax returns are being filed, without any tax being paid. Why? Simply because the taxable income is not enough to be taxed.

The Economic Survey of 2017-2018 acknowledges this: “Analysis suggests that new filers reported an average income, in many cases, close to the income tax threshold of Rs. 2.5 lakhs.”

The Survey believes that “as income growth over time pushes many of the new tax filers over the threshold, the revenue dividends should increase robustly.”

Basically, what the Economic Survey is saying that a bulk of new tax filers are close to the income threshold of Rs 2.5 lakh. Income tax needs to be paid by individuals only if taxable income is more than Rs 2.5 lakh. The Economic Survey believes that as these people earn more, cross the Rs 2.5 lakh limit and pay tax. But the assumption here is that the Rs 2.5 lakh limit will continue to be the same.

Logically, it will have to go up in the years to come, simply because inflation needs to be taken into account. Hence, this argument doesn’t quite hold.

To conclude, the chartered accountants (CAs) in the business of filing returns are basically having the last laugh. The good thing at least someone is seeing the promised acche din.

The column originally appeared on Equitymaster on April 10th, 2018.

The Nirav Modi Fraud Tells Us That the Business of Govt Should Not Be Business

Nirav_Modi

The government of India owns 21 public sector banks. We have been advocating over the years that the government doesn’t really need to own so many banks. It just adds to the economic mess.

In the aftermath of the Nirav Modi fraud, many other economists, businessmen and analysts, have been making this rather obvious point.

The finance minister Arun Jaitley ruled this out recently, when he said: “This (privatisation) involves a large political consensus. Also, that involves an amendment to the law (Banking Regulation Act). My impression is that Indian political opinion may not find favour with this idea itself. It’s a very challenging decision.”

The total bad loans of public sector banks as on September 30, 2017, were at Rs 6,89,806 crore. The bad loans rate was at 13.5% i.e. of every Rs 100 lent by public sector banks, Rs 13.5 had not been repaid by the borrowers.

The Nirav Modi fraud is pegged at $1.8 billion (or around Rs 11,400 crore). If the total Rs 11,400 crore is assumed as a bad loan, then the total bad loans of public sector banks will be a little over Rs 7,00,000 crore. Hence, the fraud is simply a drop in the ocean of bad loans of public sector banks.

This means that the problem is somewhere else. If we look at data as of March 31, 2017, the total bad loans of public sector banks were at Rs  6,19,265 crore. Of this around 69% or Rs 4,24,434 crore, was on account of lending to corporates. And this is where the problem lies.

One Nirav Modi and his companies are not the problem, it is the corporate sector as a whole which has been abusing the public sector banks in the country.

Of course, with such a huge amount of bad loans, the government has to constantly keep infusing capital into the public sector banks, in order to keep them going.

The hope is that with the government infusing money into these banks, they will gradually get back to full-fledged lending and in the process help the economy. Of course, there is nothing wrong with this hope but the economic incentive it creates for politicians, is totally different.

As Thomas Sowell writes in Basic Economics—A Common Sense Guide to the Economy: “Nothing is easier than to have good intentions but, without an understanding of how an economy works, good intentions can lead to counterproductive, or even disastrous, consequences for a whole nation. Many, if not most, economic disasters have been a result of policies intended to be beneficial—and these disasters could often have been avoided if those who originated and supported such policies had understood economics… [There is a] crucial importance of making a distinction between intentions and consequences. Economic policies need to be analysed in terms of the incentives they create, rather than the hopes that inspired them.”

Long story short—while implementing an economic policy, we need to be able to differentiate between what the policy hopes to achieve and the economic incentives it creates. It is ultimately, the economic incentives that are created which will decide how people react to the policy, making it effective or ineffective.

A major reason why politicians love the idea of owning public sector banks (or public sector enterprises for that matter), is that it allows them to bestow favours on their favourite industrialists (read crony capitalists).

In terms of public sector banks, this means forcing them to give out loans to businessmen, who either are not in a position or do not have any intention of repaying the loan. Hence, the government may be recapitalising banks with the hope of letting them operate at their full strength, but the real incentive for the politicians is somewhere else.

The only way of breaking this nexus between businessmen and politicians, is to privatise a bulk of the banking sector in India. If that is not possible due to regulatory hurdles (as Jaitley talked about), a bulk of public sector banks should not be lending to corporates. There activities should be limited to raising money as deposits and lending them out in the form of retail loans.

This “narrow banking” model is likely to work better simply because with a bulk of public sector banks not being allowed to give corporate loans, the politicians will not be in a position to direct lending towards their favourite corporates. With this taken out of the equation, public sector banks might just about manage to operate much more efficiently.

Also, with politicians having one lesser issue to deal with, they might just pay more attention to the other major problems that the country faces and get their heads together on tackling them.

The trouble is that the decision to get public sector banks out of lending to corporates, is to be made  by politicians. And as we saw in the column, they do not have an incentive to do anything like that. How do you deal with a problem like that?

The column originally appeared on Equitymaster on Equitymaster on Feb 26, 2018.

 

PM Modi, Nehruvian Economic Policies Aren’t Going to Get Us Anywhere

narendra_modi
This is something that we should have written on a while back, but as they say it is better late than never.

In the annual budget of the government of India, presented earlier this month, the finance minister Arun Jaitley raised custom duties on a whole host of products. In his speech, Jaitley made it clear that this wasn’t a one-off thing, but a change in policy direction.

As he said: “In this budget, I am making a calibrated departure from the underlying policy in the last two decades, wherein the trend largely was to reduce the customs duty. There is substantial potential for domestic value addition in certain sectors, like food processing, electronics, auto components, footwear and furniture. To further incentivise the domestic value addition and Make in India in some such sectors, I propose to increase customs duty on certain items. I propose to increase customs duty on mobile phones from 15% to 20%, on some of their parts and accessories to 15% and on certain parts of TVs to 15%. This measure will promote creation of more jobs in the country.”

The customs duty has been raised on around 45 products. The maximum increase was in case of cranberry juice from 10% to 50%. (All you cranberry juice drinkers out there, maybe it is time to start appreciating the taste of chilled filtered water with a dash of lemon in it).

The idea as Jaitley explained is to create jobs within the country. With increased custom duties, imported goods will become expensive. This will make domestic goods competitive. As people buy more and more of domestic goods, the companies producing goods in India will do well. Once they do well, they will expand and create jobs in the process. Alternatively, because imports will become uncompetitive, the domestic companies can continue operating, and jobs can thus be saved. QED.

The problem with this argument is that it stinks of Nehruvian era economic policies, in particular import substitution, which was the norm in independent India, up until the economic reforms of 1991. Import substitution as a policy was introduced by Jawahar Lal Nehru and carried forward by Indira Gandhi, two individuals, the Bhartiya Janata Party keeps blaming for everything that is wrong in this country (even though we are four years into the term). At its simplest level, import substitution is basically an economic policy which promotes domestic production at the cost of imports. And it is an economic policy, which doesn’t work.

As the French economist Jean Tirole writes in Economics for the Common Good: “In economic matters too, first impressions can mislead us. We look at the direct effect of an economic policy, which is easy to understand, and we stop there. Most of the time we are not aware of the indirect effects. We do not understand the problem in its entirety. Yet secondary or indirect effects can easily make a well-intentioned policy toxic.”

What does Tirole mean here? Another French economist Frédéric Bastiat explains what secondary or indirect effects are, through the broken window fallacy.

Bastiat basically talks about a shopkeeper’s careless son breaking a pane of a glass window. He then goes on to say that those present would say: “It is an ill wind that blows nobody good. Everybody must live, and what would become of glaziers if panes of glass were never broken.

The point being that if windows weren’t broken, how would those repairing windows, the glaziers that is, ever make a living. This seems like a fair question to ask, but things aren’t as simple as that.

As Bastiat writes in Essays on Political Economy: “This form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.”

Bastiat then goes on to explain what exactly he means by this. Let’s say replacing the pane of the broken window costs 6 francs. This is the amount that the shopkeeper pays the glazier. If the shopkeeper’s son would not have broken the window there was no way that the glazier could have earned these six francs.

As Bastiat puts it: “The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.” This leads us to conclude that breaking windows is a good thing because it leads to money circulating and those who repair broken windows doing well in the process.

Nevertheless, this is just one side of the argument. As Bastiat writes: “It is not seen that our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps have replaced his old shoes, or added a book to his library. In short, he would have employed his six francs in some way which this accident prevented.”

How does this apply in the case of the Narendra Modi government increasing custom duties on a whole host of products? The seen effect of this, as already explained above, is that domestic Indian companies can compete with cheaper imports because of the custom duties being increased. This is likely to create jobs and if not, it is at least likely to save jobs. This is the first order effect or the seen effect.

What is the second order effect or the unseen effect? It is well worth remembering here that consumers only have so much money to spend. If cheaper imports no longer remain cheaper because of an increase in custom duties, the consumers have to pay a higher price for the goods made by domestic companies. Once this happens, they are likely to cut their spending on some other front.

The trouble is that this some other front on which consumers cut their spending, is not easily identifiable. Once consumers cut their spending on other fronts, some domestic businesses are not going to do well, and jobs will be lost there. The trouble is this is not something which is very obvious. It is an unseen effect.

If the consumers keep spending the same amount of money as before, they will end up cutting down on their savings, which isn’t necessarily a good thing. As Henry Hazlitt writes in Economics in One Lesson: “The fallacy… comes from noticing only the results that are immediately seen, and neglecting the results that are not seen.”

Another point that needs to be made here is that the domestic companies are organised well enough to lobby with the government. The end consumer never is.

Increasing customs duties is not a solution to creating jobs. For jobs to be created Indian firms need to be globally competitive. When companies produce for the global market, they need to compete with the best in the world. This automatically leads to a situation wherein the products which a company produces need to be globally competitive. On the other hand, when import substitution is the norm and companies need to produce just for the internal market, almost anything goes. This explains why the Indian corporate sector on the whole, has not been able to be competitive on the global front. It has still not been able to come out of the import substitution era. (We hope people do remember the Ambassador Car which had the same engine between 1944 and 1982.)

In order to be globally competitive, India needs to introduce a whole host of reforms, from labour law reforms to land reforms. It needs to start pricing electricity correctly. The governments need to control their fiscal deficits to ensure that they don’t push up interest rates in the long-term. Our education system needs a paradigm shift (We find this phrase absolutely cringeworthy, but nothing explains the situation better). The corporate bond market needs to function much better than it currently is. The number of inspectors that an average business needs to deal with has to come down. The paper work needs to be simplified. All these distortions in the system need to go.

Long story short—going back to Nehruvian economics is not going to do any good to the country. The sooner Narendra Modi understands this, the better it will be for India. India has suffered enough because of the mess initiated by the economic policies of Nehru and Indira Gandhi. And there is no point, going back to it.

The column originally appeared in Equitymaster on February 19, 2018.

Why Income Tax Will Stay

Every year, before the annual budget is presented, suggestions are made to scrapthe income tax paid by individuals. The economist/politician Subramanian Swamy has also said so in the past. The logic typically offered is that the individual income tax forms a very small part of the total taxes collected by the government, and hence, it should be scrapped.

Let’s look at Table 1, which

Table 1:

Assessment yearIndividual income tax as a proportion of total taxes collected by the governmentIndividual income tax as a proportion of GDP
2012-201312.67%1.24%
2013-201413.52%1.38%
2014-201516.86%1.68%
2015-201615.18%1.50%

Source: Author calculations on data from Incometaxindia.gov.in.Table 1 has data up to assessment year 2015-2016. Income tax for the money earned in the financial year 2014-2015, would have been paid in the assessment year 2015-2016. The budget documents of the government of India do not list out the total income tax paid by individuals, separately. Hence, the latest numbers for the total income tax paid by individuals, isn’t available in the public domain.

These numbers are separately declared by the income tax department, on a non-regular basis.

What does Table 1 tell us? It tells us that the income tax paid by individuals, forms a small portion of the total tax collected by the government, during any given year. This is the logic offered by those who say that individual income tax needs to be scrapped. More than this, once the taxes are scrapped, people are likely to spend the money not paid in the form of income tax, in various ways. They might decide to go on a holiday or redo the house or go out and eat more often.

Hence, when this extra spending happens, the incomes of many other people will go up and they are also likely to spend more as well. Thus, the multiplier effect will work. This will ultimately benefit businesses, which will make higher profits, and hence, pay more income tax on their profits. Further, the government is also likely to collect more indirect tax. And net net, scrapping income tax for individuals won’t make much of a difference, for the government.

Also, this is likely to force the government to cut down on frivolous expenditure. It is also likely to force the government to get rid of many loss-incurring public-sector enterprises, which continue to bleed. Basically, it will force the government to cut down on what I have been calling Big Government in many of my previous pieces.

All this makes perfect sense, but in theory. Now let’s take a look at Table 2, which basically lists out individual income tax in rupee terms.

Table 2:

Assessment yearTotal individual income tax (in Rs crore)
2012-20131,12,112
2013-20141,39,500
2014-20151,91,208
2015-20161,88,031

Source: Incometaxindia.gov.in.While, income tax from individuals, might look very small as a proportion of total taxes collected by the government, but the absolute amounts on their own are not small at all. In fact, let’s take a look at the assessment year 2015-2016. The total income tax from individuals during this year stands at Rs 1,88,031 crore. This money is enough to finance the budget of many departments of the government of India. And this is money that the government is collecting for sure.

If the government scraps this, where will it get this money from? By now, the income tax paid by individuals must have easily touched Rs 2,50,000 crore. As supporters for scrapping individual income tax point out, the government is likely to earn more money from corporations paying higher income tax on their higher profits. Also, it is likely to collect more indirect tax as people end up spending more money.

The word to mark here is likely. No government is going to want to take such a big risk. Every government likes some amount of certainty when it comes to the taxes that it collects. Also, it has been suggested that if scrapping income tax for individuals is not possible, income tax can be done away at the lower levels of income.

This is where things get even more interesting. Take a look at Table 3. Table 3 basically plots the total taxes paid by individuals paying an income tax of greater than zero but lower than and equal to Rs 1,50,000. This is the lowest bracket for which the income tax department provides data.

Table 3:

Assessment yearTotal income tax paid by individuals paying an income tax of > 0 and <=1,50,000 (in Rs crore)Total individual income tax (in Rs crore)Proportion of total income tax
2012-201323,5511,12,11221.01%
2013-201437,1071,39,50026.60%
2014-201543,9641,91,20822.99%
2015-201644,6151,88,03123.73%

Source: Author calculations on data from Incometaxindia.gov.in.While, the individuals paying an income tax of less than or equal to Rs 1,50,000, pay a very low average income tax every year (around Rs 25,000 in assessment year 2015-2016), on the whole it adds up to a substantial amount. This is what Professor CK Prahalad called the fortune at the bottom of the pyramid. For assessment year 2015-2016, it amounted to a total of Rs 44,615 crore, which would have again enough to finance the budgets of several government departments.

Also, at lower levels, the idea is to get people to start paying income tax. Once they start doing that, they are more likely to continue doing it, in the years to come. Further, given that a major portion of these taxes are directly cut from salaries by companies and handed over to the government, the government has to do very little in order to collect this money. Hence, there is no reason for the government to scrap individual income tax, though theoretically it might make immense sense.

Also, the things that the government will have to do if it scraps individual income tax would require much more work than it is currently used to. And we all like to take the easy way out.

The column originally appeared on Equitymaster on January 16, 2018.

Electoral Bonds Do Not Address Key Issue of Lack of Transparency in Political Funding

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010

In the budget speech, the finance minister Arun Jaitely made in February 2017, he said: “Even 70 years after Independence, the country has not been able to evolve a transparent method of funding political parties which is vital to the system of free and fair elections.

He further added: “An amendment is being proposed to the Reserve Bank of India Act to enable the issuance of electoral bonds in accordance with a scheme that the Government of India would frame in this regard. Under this scheme, a donor could purchase bonds from authorised banks against cheque and digital payments only. They shall be redeemable only in the designated account of a registered political party. These bonds will be redeemable within the prescribed time limit from issuance of bond.”

If one were to summarise the above two paragraphs what Jaitley basically said was that the government of India proposed to introduce electoral bonds to make transparent the method of funding political parties in India.

Eleven months later on January 2, 2018, the Narendra Modi government notified “the Scheme of Electoral Bonds to cleanse the system of political funding in the country.” The press release accompanying the decision listed out the various features of these bonds. They are:

1) Electoral bonds would be issued/purchased for any value, in multiples of Rs 1,000, Rs 10,000, Rs 1 lakh, Rs 10 lakh and Rs 1 crore, from specified branches of the State Bank of India (SBI).

2) The electoral bond would be a bearer instrument in the nature of a promissory note and an interest free banking instrument. A citizen of India or a body incorporated in India will be eligible to purchase the bond.

3) The purchaser would be allowed to buy electoral bonds only on due fulfilment of all the extant KYC norms and by making payment from a bank account.

4) It will not carry the name of payee.

5) Once these bonds are bought they will have a life of only 15 days. During this period, the bonds need to be donated to a political party registered under section 29A of the Representation of the Peoples Act, 1951 (43 of 1951) and which secured not less than one per cent of the votes polled in the last general election to the House of the People or a Legislative Assembly.

6) Once a political party receives these bonds, they can encash it only through a designated bank account with the authorised bank.

7) The electoral bonds shall be available for purchase for a period of 10 days each in the months of January, April, July and October, as may be specified by the central government. An additional period of 30 days shall be specified by the central government in the year of the general election to the House of People.

So far so good. There are a number of points that crop up here. Let’s discuss them one by one:

1) The finance minister Jaitley in his budget speech last year had talked about electoral bonds introducing transparency into political funding. These bonds will not have the name of the person buying the bond and donating it to a political party. The question is how do anonymity and transparency, not exactly synonyms, go together? This is something that Jaitley needs to explain.

2) The electoral bonds continue with the fundamental problem at the heart of political funding—the opacity to the electorate. With the KYC in place, the government will know who is donating money to which political party, but you and I, the citizens of this country, who elect the government, won’t. This basically means that crony capitalists who have been donating money to political parties for decades will continue to have a free run. The electoral bonds do nothing to break the unholy nexus between businessmen and politicians.

3) For these bonds to serve any purpose, they should have the name of the person buying the bond. And these names should be available in public domain, with the citizens of the country clearly knowing where are the political parties getting their funding from.

4) Supporters of the bonds have talked about the fact that anonymity is necessary or otherwise the government can crack down on those donating money to opposition parties. This is a very spurious argument. With the KYC in place, the State Bank of India will immediately know who is donating money to which political party. And you don’t need to be a rocket scientist to conclude that this information will flow from the bank to the ministry of finance. Hence, we will be in a situation where the government knows exactly who is donating money to which political party, but the opposition parties don’t. If the government of the day can know who is funding which political party, so should the citizens.

Now what stops the government (and by that, I mean any government and not just the current one) from going after the citizens or incorporated bodies for that matter, donating money to opposition parties. The logic of anonymity clearly does not work.

The structure of the electoral bonds seems to have been designed to choke the funding of opposition parties, more than anything else. Also, it is safe to say, given these reasons, cash donations will continue to be favoured by crony capitalists close to opposition parties.

5) There is one more point that needs to be made regarding political donations as a whole and not just the recently notified electoral bonds. Earlier the companies were allowed to donate only up to 7.5 per cent of their average net profit over the last three years, to political parties. They also had to declare the names of political parties they had made donations to. This was amended in March 2017. The companies can now donate any amount of money to any political party, without having to declare the name of the party.

To conclude, electoral bonds do not achieve the main purpose that they were supposed to achieve i.e. the transparency of political funding. All they do in their current form is to ensure that the ruling political party continues to consolidate its position, at the cost of the citizens of this country. Of course, given the marketing machinery they have in place, they will spin it differently. Given this, the WhatsApp wars on this issue have already begun.

The column was originally published in Equitymaster on January 5, 2018.