Why Demonetise Without Any Estimate of Black Money?

rupee

The prime minister Narendra Modi communicated the decision to demonetise Rs 500 and Rs 1,000 notes to the nation, on the evening of November 8, 2016. The idea was to tackle black money as well as fake notes.

As the government press release accompanying the decision said: “ Use of high denomination notes for storage of unaccounted wealth[black money] has been evident from cash recoveries made by law enforcement agencies from time to time. High denomination notes are known to facilitate generation of black money.”

Between then and now, a lot of analysis has happened on how much black money the government will be able to bring back in the public domain. And once the money is back in the public domain, how much money the government will be able to earn by taxing it.

Many economists and analysts have written research reports on this. These research reports have been turned into WhatsApp forwards which have been widely shared. People have passionately argued on WhatsApp groups, Facebook, Twitter and even in personal communications, as to how successful the demonetisation decision will eventually turn out for the government and in turn, for the nation.

Often big diagrams and flow-charts have been made as to show the thousands of crore that will come into the government kitty, at the end of the day. Any analysis along these lines starts with a basic assumption around the total amount of black money that the Indian financial system has. Black money is the money which has been earned through legal as well as illegal means but on which taxes have not been paid.

As it turns out that the government has no estimation of the total amount of black money in the financial system. This is something that the finance minister Arun Jaitley told the Lok Sabha in a written reply to a question that had been asked by Anant Kumar Hegde, a BJP Lok Sabha MP from Karnataka.

As Jaitley said: “There is no official estimation of the amount of black money either before or after the Government’s decision of 8th November 2016 declaring that bank notes of denominations of the existing series of the value of five hundred rupees and one thousand rupees shall cease to be legal tender with effect from 9th November 2016.”

What does this mean? It basically means that while taking the decision to demonetise Rs 500 and Rs 1,000 notes, the Modi government did not take into account any estimate of the total amount of black money in the Indian financial system. It further means that the government has no idea of how much money it expects to gain through this entire manoeuvre.

It is amazing that such a huge decision that impacts every citizen of this country was made, even without taking a basic estimate of black money into account. Of course, all big decisions in life, require some leap of faith. The perfect data and the perfect conditions are never there. But at the same time there should be some analytical basis to them as well. There must be some expectations of a payoff for the government that will make it worth all the trouble that the people of India have been be put through.

The surprising thing is that in 2011, the Congress-led UPA government had asked three institutes, the National Institute of Public Finance and Policy (NIPFP), the National Institute of Financial Management (NIFM) and the National Council of Applied Economic Research (NCAER), to estimate the total amount of black money in India.

An October 2016 PTI newsreport points out that: “Replying to an RTI query, the Ministry said study reports of NIPFP, NCAER and NIFM were received by the government on December 30, 2013, July 18, 2014 and August 21, 2014 respectively.”

The reports from these institutes have still not been put up in the public domain. “Reports received from these institutes are under examination of the government,” Finance Minister Jaitley had told the Rajya Sabha in May 2015.

Hence, the government has access to three estimates of black money. There must be some explanation behind why it chose not to take any of these reports into account while deciding to demonetise high denomination notes.

In fact, in May 2015, Jaitley had also told the Rajya Sabha: “There is no official estimation regarding the amount of black money generated in the country. Varying estimations of the amount of black money have been reported by different persons/institutions. Such estimations are based upon different sets of facts, data, methods, assumptions, etc. leading to varying inferences. However, sectoral analysis of seizure of valuables and admission of undisclosed income in the searches conducted by the Income Tax Department in the last three financial years indicates that the main sectors in this regard are real estate, trading & manufacturing, contractors, gems & jewellery, services [emphasis added], etc.”

To conclude, the question is how did the government decide to go about to demonetise Rs 500 and Rs 1,000 notes, and put the citizens of this country through great trouble, without even having a basic estimate of black money in place. On what pretext was such a disruptive decision made? This is a question that Modi and Jaitley need to answer to this nation.

The column originally appeared in Equitymaster on December 19, 2016

 

Rents equal EMIs: How Arun Jaitley Can Partially Fulfil His New Pipe Dream

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010In yesterday’s column I had discussed how the finance minister Arun Jaitley’s idea of moving towards a scenario where home rentals will be close to home loan EMIs, is a pipe dream.

On closer consideration, I still think it’s a pipe dream, but there are ways through which a part of it can be achieved if the government is willing to take a few risks by doing the right things. (Before you get around to reading this piece, I would suggest that you read yesterday’s piece here).

Just to recap what Jaitley said earlier this month: “(The) housing market in India, it had picked up. During Mr Vajpayee’s government, bank rates had come down to such an advantageous level that it was easier to buy an apartment than rent it out. That sort of situation had existed where the EMI has been reasonable. I think that’s the direction in which we have to slowly push our economy.

So how can this be made to happen? As per the 2011 Census India had 2.47 crore vacant homes. Yes, you read that right, 2.47 crore vacant homes. Arjun Kumar makes this point in a research paper titled India’s Residential Rental Housing published in the Economic & Political Weekly dated June 11, 2016.

Out of this 1.36 crore homes were in rural areas and 1.11 crore homes were in urban areas. In rural areas, the vacant homes formed 6.2 per cent of the total homes. In urban areas, the vacant homes formed 10.1 per cent of the total homes. It is safe to say that this number would have crossed 3 crore by now, given that the census estimate is more than half a decade old.

Of course, all of these vacant homes are not up to the mark for the middle class (the primary audience of this piece) to live in, but a substantial part is. (I discuss this in detail in the last issue of The Vivek Kaul Letter. To know how to subscribe, click here).

These homes are not offered on rent for the simple reason that India’s rental laws are essentially screwed up. This basically discourages people from giving homes out on rent. Also, with the rental yield (annual rent divided by market value of the home) at around 2 per cent per year, many people feel that renting a home is simply not worth the risk.

Any overhauling of the rental laws will have to start with the rent control laws prevalent in many cities. This will have to be carried out by state governments. With the Bhartiya Janata Party in power in many states, the central government of which Jaitley is a part can nudge them in that direction. Of course, this will mean antagonising a section of the population that benefits from the rent control laws.

This section, given that it lives in cities, is likely to be very vocal. I mean who wouldn’t like living bang in the middle of a city, and pay Rs 200 per month as a rent. So, there will be a lot of resistance. And given that, is the government ready take this on?

Once it is easy to rent out homes, more people are likely to rent out homes. At the same time, more people are also likely to try and rent homes, instead of buying one. As per the 2011 census, the home ownership rate in India stands at 86.6 per cent. This includes all kinds of homes, from homes with concrete roofs to homes with GI/metal/asbestos sheets as roofs to homes with stone roofs to homes with tiles as a roof to homes with plastic/polythene sheets as roofs to homes with grass/thatch/bamboo/wood/mud roofs to homes which do not have access to drinking water to homes which do not have the latrine facility available within the premises and so on.

Despite this, the ratio of owned homes in India needs to come down. And this can only happen when renting (both from the landlord as well as the tenant’s point of view) becomes easier than it currently is. This will mean lesser demand for new homes, which will lead to stable prices in the long run. This will ensure that the current high gap between rents and EMIs will narrow down. At a rental yield of 2 per cent per year and a home loan interest of 9.5 per cent per year, the EMI turns out to be around 4.5 times the rent (assuming that the home loan amounts to 80 per cent of the value of the home).

The second thing that needs to happen is that India needs electoral financing reform. Currently, the way elections are financed needs a lot of black money. And a lot of this black money that finances elections in India, comes from investments made in real estate.

As Sandip Sukhtankar and Milan Vaishnav write in a research paper titled Corruption in India: Bridging Research Evidence and Policy Options: “For instance, corporations and parties are only legally required to publicly disclose political contributions in excess of Rs. 20,000. This rule allows contributors to package unlimited political contributions just below this threshold value completely free of disclosure. Indeed, in 2014 the Association for Democratic Reforms (ADR) reported that 75 percent of the income of India’s six major parties comes from undocumented sources.”

This can end if political parties are brought under the Right to Information Act and are forced to declare their political contributions. At the same time donations through the various electronic routes or cheques should be made compulsory.

This will have an impact on the total amount of black money that finances the elections in India. And that in turn, will have an impact on black money being invested in real estate as well as real estate prices. This will lead to the gap between EMIs and rents narrowing as well.

The question is, whether Jaitley is ready to bell this cat?

The column originally appeared in Vivek Kaul’s Diary on September 14, 2016

Jaitley’s New Real Estate Pipe Dream: Where Rents Equal EMIs

India-Real-Estate-Market

Nostalgia is a funny thing.  It makes you remember the good things you had and the good things you lost along the way (with due apologies to Bob Marley!).

The finance minister Arun Jaitley recently said: “(The) housing market in India, it had picked up. During Mr Vajpayee’s government, bank rates had come down to such an advantageous level that it was easier to buy an apartment than rent it out. That sort of situation had existed where the EMI has been reasonable. I think that’s the direction in which we have to slowly push our economy.” Jaitley said this at The Economist India Summit 2016, earlier this month, in response to a query on how the government plans to improve the stressed housing market.

What did Jaitley really mean here? First and foremost, he was remembering the good old days of the Vajpayee government (between 1998 and 2004). During those days the rent one had to pay while renting a house, was very close to the EMI one would have had to pay by taking on a home loan and buying it instead.

The question is how did this happen? This is something that Jaitley did not tell us. And one can’t blame him for it, given that there is only so much that one can say in response to a query. The real estate market had seen a boom in the 1990s. By the late 1990s the market had started to crash and kept unravelling over the next few years. Then the dotcom bubble burst in 2000-2001, the stock market fell after the Ketan Parekh scam came to light and the real estate prices crashed.

Hence, for the period that Vajpayee ruled the country, real estate prices were reasonable. In fact, as late as 2005 (a year after Vajpayee lost the 2004 Lok Sabha elections), property prices, even in Mumbai suburbs were fairly reasonable.

So, the EMI was low because the prices were low and it had nothing to do with lower interest rates.
Also, as I have often said in the past, lower interest rates aren’t going to make any difference to Indian real estate. Let’s understand this through an example. Let’s say the property you are looking to buy costs Rs 80 lakh. The bank gives a home loan of 80 per cent against the market price of the home. This amounts to Rs 64 lakh (80 per cent of Rs 80 lakh). The downpayment that will have to be arranged for is Rs 16 lakh. 
The home loan is for a period of 20 years and the interest to be paid on it amounts to 10 per cent per year. (The prevailing home loan rate is around 9.5 per cent. But we will work with 10 per cent just for the ease of calculation).

The EMI on this amounts to Rs 61,761. Let’s say the interest rate on home loans falls (the reasonable EMIs that Jaitley was talking about). Let’s say the interest rate falls by a fourth to 7.5 per cent per year. The EMI will fall to Rs 51,558. This will mean a saving of around Rs 10,203 per month.

Of course, the home becomes more affordable if such a thing were to happen and home loan interest rates were to fall by a fourth.

Now let’s take a look a scenario where home prices fall by a fourth or 25 per cent. The value of the property falls to Rs 60 lakh. The bank now gives a loan of Rs 48 lakh (80 per cent of Rs 60 lakh). This would automatically make more people eligible for the loan than there were when the home loan of Rs 64 lakh had to be taken. The downpayment required falls to Rs 12 lakh. This is Rs 4 lakh lower than the Rs 16 lakh downpayment required earlier, making things significantly easier.

What about the EMI? At 10 per cent per year and for a period of 20 years, it works out to Rs 46,321. This is more than Rs 15,000 per month lower than the earlier EMI of Rs 61,761. Even at 7.5 per cent, the difference in the EMIs comes to close to Rs 13,000 per month. Also, it requires a lower downpayment of Rs 4 lakh. Further, at a lower value of the home, more people would be eligible for the loan, as a lower EMI needs to be paid. A lower EMI can be paid with a lower income.

Also, in this transaction I haven’t assumed a black component, to keep things simple. But if prices fall, the black component also comes down. Also, I  feel a 25 per cent fall, as has been assumed here, will not make much of a difference, the prices need to fall more than that.

The point being if Indian real estate has to get back, prices need to come down. Let’s take the argument forward. Mr Jaitley talks about an era where rents and EMIs were equal. Now, what would it take for the rents to be equal to the EMI, in the time that we live in.

Let’s take the same example again. The value of the home is Rs 80 lakh. The rental yield (rent divided by the market price of the home) these days is around 2-3 per cent. Let’s take the upper end of 3 per cent. At 3 per cent on a home worth Rs 80 lakh, the rent works out to Rs 2,40,000 per year or Rs 20,000 per month.

If one were to buy this house, the bank would give a home loan of Rs 64 lakh (80 per cent of Rs 80 lakh). The EMI on this would work out to Rs 59,656. (Now we assume the real prevailing home loan interest of 9.5 per cent per year).

Over and above this, the buyer would also have to pay Rs 16 lakh as a downpayment. This means that this money will no longer be available for investment. If the buyer had this money in a fixed deposit which paid around 7 per cent per year, this would mean letting go of interest of Rs 1,12,000 per year or around Rs 9,333 per month. Hence, the total opportunity cost of buying a house worth Rs 80 lakh works out to Rs 69,989 per month.

Now compare this to the rent of Rs 20,000 per month. What this tells us very clearly is that renting is a no-brainer as of now, as far as numbers are concerned. Of course, there are other problems associated with renting which an owned home does not have.

If the rent has to be equal to the EMI plus the interest lost on the downpayment, then it has to go up by nearly 3.5 times its current levels. If it has to be equal to the EMI, then the rent has to go up around 3 times. The other option is that the property prices need to crash big time so that EMIs come down dramatically and are equal to the rent. Both options can be ruled out.

What will happen instead is that rents will rise gradually and property prices will fall gradually, in the years to come, but not dramatically (given that there are too many vested interests at work).

Only that is a given.

What this really tells us is that the finance minister Jaitley’s dream of a time where rents are close to EMIs, will remain a pipe dream at best, unless the real estate prices crash big time. Also, there is a fundamental disconnect here, the cost of owning something has to be greater than the cost of renting it.

The column originally appeared in Vivek Kaul’s Diary on September 13, 2016

It’s Time the Govt Treated Deposit Holders with Some Respect

Take a look at the following chart. It shows the various kinds of savings that made up for household financial savings in 2013-2014 (the latest data that is available on this front).

Housing Financial savings in 2013-2014

Deposits constituted close to 63.3 per cent of the total household financial savings. Banks deposits formed around 56.7 per cent of the total household financial savings. Hence, bulk of the Indian savings are in the form of deposits in general and bank deposits in particular.

Shares and debentures formed around 1.5 per cent of the total household financial savings. Within that, investment in mutual funds constituted around 0.98 per cent of total household financial savings. Further, investment in shares and debentures of private corporate companies constituted around 0.46 per cent of total household financial savings.

What this tells us very clearly is that the Indian financial media spends a disproportionate amount of time and space, discussing stocks, debentures and mutual funds. A very small segment of India’s population actually invests in them. This also largely explains why the pink newspapers in India, have such small circulation numbers, given that most of the stuff they publish remains irrelevant to a large section of the population.

What the above chart clearly tells us is that deposits are the main form of savings in India. First and foremost, these deposits help both the union as well as the state governments in India. It is mandatory for banks to invest a certain proportion of their deposits in government bonds (i.e. bonds issued both by the union government as well as the state governments).

The statutory liquidity ratio as this ratio is referred to as is currently at 21 per cent. Hence, for every Rs 100 raised as deposits, banks need to invest at least Rs 21 in government bonds. As on August 5, 2016, 29.3 per cent of aggregate deposits of banks were invested in government bonds.

With so much money chasing government bonds, it allows the union government to raise money at a lower rate of interest than would have been the case, if it was not compulsory for banks to invest in government securities.

Over and above the banks, the provident funds as well as the insurance companies also need to compulsorily buy government bonds. This allows the government to raise money at lower interest rates, than would have otherwise been the case.

Further, given that deposits are the main form of savings, it is this money invested by deposit holders with banks, that ultimately finds its way into the lending carried out by banks. It finances almost everything from homes to cars to two-wheelers to credit card spending to infrastructure projects to corporate takeovers.

But for all that they do as a whole, the deposit holders don’t get treated well. In fact, rarely do they even get a rate of interest on their deposits, which is higher than the rate of inflation. Take a look at the following chart.
Average Reat Rate of Return on Deposits
It shows that between 2009 and 2013, the interest rate on fixed deposits was lower than the rate of inflation. This basically meant that the purchasing power of the money invested in deposits, had been going down. Between mid-2014 and now, the rate of interest offered on fixed deposits of one year or more, has been higher than the rate of inflation.

But in the recent past, this gap has started to narrow again. Also, for those in the higher tax brackets, the real rate of return after paying tax on interest that they earn on fixed deposits, must already be in the negative territory. The real rate of return is essentially the difference between the nominal rate of interest on a fixed deposit minus the rate of inflation.

One of the ironies of the Indian tax system is that income that is earned as capital gains is either not taxed at all, or taxed at lower rates, than income which is earned as an interest on a fixed deposit. Further, capital gains made on selling a house or a debt mutual fund are even allowed the benefit of indexation. The question is why are fixed deposit investors not allowed the benefit of indexation as well, while paying taxes?

Indexation basically allows to take inflation into account while calculating the price of acquisition of an asset. This essentially ensures that the capital gains come down. And in the process, so does the tax that needs to be paid on the capital gains.

Such benefits are not available to those who invest in fixed deposits. If all this was not enough, politicians and bureaucrats keep talking about the need for lower interest rates all the time. This is something I discussed in yesterday’s column, where the commerce and industry minister, Nirmala Sitharaman, had talked about the need to lower interest rates by 200 basis-points to help the micro, small and medium enterprises(MSME) sector.

The finance minister Arun Jaitley has in the past on multiple occasions talked about the need for lower interest rates on fixed deposits. In fact, sometime back, Jaitley even said that people should be investing their money in mutual funds, bonds and shares, that finance projects and lead to economic activity. As if fixed deposits do not finance economic activity. For the finance minister of the nation to be saying something as remarkably silly as this, is surprising indeed.

As I explained earlier in the piece, fixed deposits are ultimately loaned out by banks and this creates economic activity in the process. The money invested in fixed deposits is also invested in government bonds which finance the government. Government bonds essentially help finance the fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. The money spent by the government also creates economic activity. Hence, saying that fixed deposits do not create economic activity is totally incorrect.

Also, fixed deposits need to offer a real rate of return. One reason for this is that they are used by senior citizens to generate a regular income. In a country, where there is very little social security on offer along with the fact there is almost no specialised care for the elderly and a medical system which basically robs everyone, the least that we can do is to ensure that the interest on fixed deposits is higher than the rate of inflation. Also, as I keep saying deposits are also used to build a corpus for retirement and weddings and education of children.

Given the reasons cited above, it is important that the government treated the deposit investors with some respect and not make them the fall guy, all the time.

The column originally appeared in Vivek Kaul’s Diary on August 26, 2016

What Mainstream Media DID NOT TELL YOU About GST

On August 3, 2016, the Rajya Sabha, the upper house of Indian Parliament, finally passed the 122nd Constitutional Amendment Bill for the introduction of the Goods and Services Tax(GST).

The passing of the Bill will be looked at as an important achievement for the Modi government. Also, credit must be given to the Modi government for reaching out to the opposition and getting almost everyone on board (excluding the AIADMK party) to get the Bill passed in the Rajya Sabha.

To be honest, I didn’t think this would happen and which is what I had said in my past pieces. Nevertheless, the Bill could have been passed during the period 2009-2014, if the Bhartiya Janata Party, which is in power right now, hadn’t opposed it as vehemently as it did.

The television and the print media have gone totally gaga about the whole thing. If you were watching any television channel after the GST Bill was passed on August 3, you would think, looking at the excitement of the anchors, that the Indian per capita income had just crossed that of the United States.

The excitement of the mainstream media notwithstanding there is a lot that remains to be done for a Goods and Services Tax to become a reality. Here is what needs to happen on the legislative front:

a) The Constitutional Amendment Bill will first go back to the Lok Sabha in order to clear the amendments made to it in the Rajya Sabha. The Lok Sabha had earlier passed the Bill in May 2015. This should be fairly straightforward given that the Bhartiya Janata Party led National Democratic Alliance has the required numbers in the lower house of the Indian Parliament.

b) After this is done, 15 or more states will have to ratify the Constitutional Amendment Bill.

c) Then 29 states and two union territories will have to pass their own GST Bills.

d) The Parliament will have to pass the actual GST Act and the interstate GST Act, which will specific the structure of the tax and enable its collection.

As of now this seems doable given that the two Acts that need to be passed by the Parliament need a simple majority of more than 50 per cent and not two-thirds majority as was the case with the GST Constitutional Amendment Bill. Nevertheless, this will take time and when things take time, it is always possible that political parties change their mind.

Further, the GST Constitutional Amendment Bill will lead to the creation of the GST Council comprising of the finance minister of the union government, who will be its Chairperson, as well as the finance ministers of state governments. The GST Council will essentially go about setting the tax rates.

Before we go any further, it is important to understand what GST exactly is, and how will it help improve India’s taxation system.

What is GST?

India currently has many indirect taxes. Indirect tax is essentially a tax on goods as well as services and not income or profits, for that matter. India currently has a plethora of indirect taxes both at the state government level as well as the union government level. The GST will subsume many of these taxes. It hopes to have one indirect tax for the whole nation and this will convert the country into one unified common market.

The GST or value added tax(VAT), as it is known in other parts of the world, is already present in large parts of the world, as can be seen from the following chart.

Goods and Services Tax in India

How do things stand in India as of now?

Up until now, the Constitution empowers the Union government to levy an excise duty on manufacturing. Let’s take the case of a company which manufactures cars. It needs to pay an excise duty to the union government on every car that it manufactures. The current rate of excise duty is 12.5 per cent on small cars. While, the company pays this tax to the government, it ultimately recovers it from the end consumer who buys the car.

The union government can also levy a customs duty on exports as well as imports. Further, the constitution allows, the Union government to levy a service tax on the supply of services, which the state governments can’t.

On the other hand, the State governments are allowed to levy a value added tax(VAT) or a sales tax on the sale of goods. This division has essentially led to a multiplicity of taxes.

As the Report of the Select Committee of the Rajya Sabha on the 122nd Amendment Bill of the Indian Constitution presented in July 2015 points out: “This exclusive division of fiscal powers has led to a multiplicity of indirect taxes in the country. In addition, central sales tax (CST) is levied on inter-State sale of goods by the Central Government, but collected and retained by the exporting States. Further, many States levy an entry tax on the entry of goods in local areas.”

This multiplicity of taxes has led to an inherently complicated indirect tax structure. As the Select Committee Report points out: “Firstly, there is no uniformity of tax rates and structure across States. Secondly, there is cascading of taxes due to ‘tax on tax’. No credit of excise duty and service tax paid at the stage of manufacture is available to the traders while paying the State level sales tax or VAT, and vice-versa. Further, no credit of State taxes paid in one State can be availed in other States. Hence, the prices of goods and services get artificially inflated to the extent of this ‘tax on tax’.”

Let’s understand this through an example

Let’s take the case of a dealer in one state buying goods from another state worth Rs 1,00,000. As the goods are moving from one state to another, on this, he has to pay a central sales tax of Rs 2,000 (2 per cent of Rs 1,00,000). His effective purchase price works out to Rs 1,02,000. On this he builds a margin of Rs 8,000 and his sales price works out to Rs 1,10,000.

When he sells this good, the state sales tax (or the value added tax) will be charged on Rs 1,10,000. If the tax rate is 5 per cent, then it will work out to Rs 5,500 (5 per cent of Rs 1,10,000). This means that the final price of the good would be Rs 1,15,500 (Rs 1,10,000 + Rs 5,500).

In this case, the state sales tax is also being paid on the central sales tax of Rs 2,000 that has already been paid. Central sales tax paid while purchasing goods from one state is not available as an input tax credit while selling the goods in another state. This leads to a cascading effect as tax on tax needs to paid. In this case the cascading effect is Rs 100 (5 per cent of Rs 2,000 of central sale tax). This ultimately gets built into the price of goods, making them more expensive than they should be.

What are the practical implications of this?

The cascading effect and the fact that the indirect taxes already paid in one state cannot be deducted while paying indirect taxes in another state makes many Indian businesses uncompetitive. The Report on theRevenue Neutral Rate and Structure of Rates for the Goods and Services Tax (GST) (or better known as the Arvind Subramanian Committee Report) has an excellent example.

As the report points out: “Consider a simple example, where intermediate goods produced in Maharashtra go to Andhra Pradesh for production of a final good which in turn is sold in Tamil Nadu. Effectively, the goods will face an additional tax of 4 per cent, which will reduce the competitiveness of the goods produced in Andhra Pradesh compared with goods that can be imported directly to say Chennai from South and East Asian sources.”

This basically happens because goods move between states twice and a 2 per cent central sales tax has to be paid each time. As mentioned earlier, tax paid in one state cannot be deducted while paying more indirect taxes in another state. This essentially means that a programme like Make in India cannot take off in many cases.

What are the other implications?

Other than central sales tax, state governments levy entry taxes as well. These can be like octroi in order to fund a local municipal body or otherwise. These taxes are collected while goods are entering the state or a town. This explains to a large extent why trucks in India move as slowly as they do. This essentially drives up logistical costs.

As the Subramanian Committee report points out: “One study suggests that, for example, in one day, trucks in India drive just one-third of the distance of trucks in the US (280 kms vs 800 kms). This raises direct costs (wages to drivers, passed on to firms), indirect costs (firms keeping larger inventory), and location choices (locating closer to suppliers/customers instead of lowest-cost location in terms of wages, rent, etc.). Further, only about 40 per cent of the total travel time is spent driving, check points and other official stoppages take up almost one-quarter of total travel time. Eliminating check point delays could keep trucks moving almost 6 hours more per day, equivalent to additional 164 kms per day – pulling India above global average and to the level of Brazil. So, logistics costs (broadly defined, and including firms’ estimates of lost sales) are higher than the wage bill or the cost of power, and 3-4 times the international benchmarks.”This will be possible if GST becomes the order of the day. The entry taxes will be subsumed under GST. This will lead to a dismantling of check posts at state borders and there will be no need for trucks to be held up.

Around 72 per cent of Indian freight moves through roads. Hence, eliminating check posts will lead to a faster movement of goods through the length and breadth of the country. Crisil Research estimates that “eliminating delays at check posts will yield additional savings of 0.4-0.8% of sales [of companies].”

While, the state governments are yet to agree to removal of border check posts, as and when this happens, it will be one of the bigger benefits of the GST. If it doesn’t, it will make GST a little less useful.

What will GST do about all this?

The GST will subsume multiple indirect taxes. Take a look at the following table. It points out the indirect taxes which will come under GST and indirect taxes which won’t.

GST TAX table

While GST plans to subsume many indirect taxes it does leave out several taxes as well. Hence, in that sense GST is not a one nation one tax that it is being made out to be.

How will GST work?

The GST will take the cascading effect of tax on taxes out of the equation. It will allow input tax credit for indirect taxes that have already been paid irrespective of what kind of indirect taxes have been paid and where they have been paid.

Take a look at the following table:

Basic Information/Kind of TaxManufacturerWholesalerRetailerTotal
A. Transactions (exclusive of tax)
1. Sales6008001,2002,600
2. Purchases06008001,400
3. Value-added (A1-A2)6002004001,200
B. VAT/GST
4. Tax on sales (10% of A1)6080120260
5. Tax on purchases (10% of A2)06080140
6. Net tax liability (B4-B5)602040120
C. RST
7. Tax on retail sales (10% of A1/R)120120

Source: Professor Mukul Asher of the Lew Kuan Yew School of Public Policy, National University of Singapore

There are three levels in the above table- the manufacturer, the wholesaler and the retailer. Let’s start with the manufacturer who sells a product for Rs 600 to a wholesaler. He does not purchase any inputs and makes everything in house (I know this is an unrealistic assumption, but it just keeps the Maths a little simple).

On this, the manufacturer pays a tax at the rate of 10% which amounts to Rs 60. The wholesaler sells the product for Rs 800. On this he has to pay a tax at the rate of 10 per cent. This amounts to Rs 80, but he also gets credit for Rs 60 indirect tax which the manufacturer has already paid. Hence, his tax outflow amounts to Rs 20.

The retailer finally sells the product for Rs 1,200. On this he pays tax at the rate of 10%. This amounts to Rs 120. But he gets credit for Rs 80 (Rs 60 paid by the manufacturer and Rs 20 paid by the wholesaler). Hence, he actually pays a tax of Rs 40. In this way, there is no cascading effect and all the tax that has already been paid is taken into account.

What this also tells us is that GST is a destination based tax and will finally accrue to the government once the final customer has bought the good or the service. This explains why parties that rule states like Bihar and Uttar Pradesh have come out in its support. While these states may not have a large industrial base, they do have consumers.

How does all this help?

The GST has a self-policing feature built into it. As the Subramanian Committee report points out: “To claim input tax credit, each dealer has an incentive to request documentation from the dealer behind him in the value-added/tax chain. Provided, the chain is not broken through wide ranging exemptions, especially on intermediate goods, this self-policing feature can work very powerfully in the GST.”

As Crisil Research points out: “Since input tax credit will be available for all taxes paid earlier in the value chain, firms would require evidence of compliance from the preceding links to claim set-offs. Thus, they would prefer sourcing inputs from compliant firms. This could increasingly bring unorganised players under the tax net, thereby reducing their price competitiveness vs. organized players.” This will be one of the biggest benefits from the GST over the long-term as it will make the entire system more transparent.

This could also bring down the price competitiveness of unorganised players as they will have to go legitimate in order to keep their business going. This will increase their costs and could help the more organised players, who already have a strong information technology infrastructure in place. The following table shows the proportion of unorganised players sector wise.

GST Sector table

But there might be some starting troubles on this front. The onus is on the customer to prove that all the suppliers in the value chain have paid their share of taxes, if he wants to take the input tax credit. This is as per Section 16(11)(c) of the Act. Basically what the section says is that if a supplier has not furnished proper returns or made the correct payment, then the customers of the supplier cannot avail of the input tax credit. And if it has been given, it will be reversed.

What will be the rate of tax?

This is something that the GST council headed by the finance minister needs to decide on. The Subramanian Committee has basically recommended four rates of taxes. A rate of 2 to 6 per cent for precious metals. A low rate on goods of 12 per cent. A standard rate on goods and services between 16.9 per cent to 18.9 per cent. And a high rate on goods at 40 per cent.

It is important that the GST council chooses a reasonable rate of tax. The unweighted OECD average rate for GST was 19.1 per cent in 2014 and 18.7 per cent in 2012. The recommendation of the Subramanian committee of a standard rate of 16.9 per cent to 18.9 per cent is in line with the OECD average.

Given the current rate of service tax is 15 per cent (including the cesses), a tax rate of 16.9-18.9 per cent is likely to make services expensive in the short run. This basically means that stuff on which you pay service tax (from your mobile phone bills to your credit card bills) is likely to become more expensive.

Crisil Research expects inflation as measured by the consumer price index is likely to go up by 60 basis points in the short-term. This will be in line with global evidence where inflation does go up in the short-term wherever good and services tax is actually implemented.

The trouble is that the rate of inflation is already looking up. Also, by the time GST becomes the order of the day, the next Lok Sabha elections will be around one to two years away. Will the government be willing to take on this risk? In the run up to the Lok Sabha elections the rate of inflation as measured by the consumer price index anyway goes up, as the government increases subsidy spends.

Why states like the idea of GST?

The state governments have come around to the idea of GST primarily because it allows them to tax services, which isn’t the case as of now. The GST being adopted has a dual structure with both the union government as well as the state governments levying a GST. Both the central GST and the state GST will be levied on every transaction of supply of goods and services, happening within a state. The taxes will not be levied on exempted goods and services.

As Crisil Research points out: “Multiple exemptions exist under the present tax system – the Centre has ~300 items exempted from central excise duty, while the States (together) have ~90 items exempted from VAT. These will be merged into a Final synchronized exemption list under the GST regime.”

It needs to be mentioned here that longer the list of exempted goods and services, higher the standard rate of GST will have to be. Given this, the government will have to limit exemptions if it wants a proper GST.

Other than central and state GST, there will be an interstate GST for transactions happening between states and it will be collected by the union government. The interstate GST will be roughly equal to the central GST plus the state GST. Input tax credit will be available on interstate GST. The following chart shows how the interstate GST will work.

IGST Model

What are the potential areas of conflict?

The former finance minister P Chidambaram of the Congress party has been talking about a standard GST rate of 18 per cent. The Kerala finance minister Thomas Isaac has remarked that capping the 18 per cent rate is too low. Other finance ministers have said the same thing.

A report in The Times of India suggests that Isaac has recommended a standard rate of 22-24 per cent, in order to ensure that states do not lose out on revenue. The situation as of now seems to suggest a standard rate of 20 per cent or more, will be arrived at.

To this Arvind Subramanian, chief economic adviser to the ministry finance said that a standard rate of “higher than 18-19% will stoke inflation”. This is primarily because the tax on services which is currently at 15 per cent will see a huge jump.

It remains to be seen what rate the GST council comprising of state finance ministers and the union finance minister come around to.

R Jagannathan writing for Firstpost makes this point in the context of small cars. An excise duty of 12.5 per cent is levied on small cars. Then there is the state level sales tax or value added tax of 12.5-14.5 per cent. The union budget this year added a one per cent infrastructure cess on cars. Over and above all this, some cities charge an octroi as well.

Hence, we are talking about an effective tax rate of around 28 per cent. If the standard rate of GST is 18-19 per cent then prices of small cars will come down. Crisil Research expects that the prices of small cars to come down by about 10 per cent.

But this is assuming that state finance ministers come around to the idea of 18 per cent standard rate of GST. As Jagannathan asks: “Why would any sensible finance minister at Centre or states reduce this to 18 percent?”This will continue to remain a tricky issue given that states need to subsume a whole host of taxes into the GST and are likely to demand (in fact they are already demanding) a standard rate of 20 per cent or more.

Also, there is the question of how will states compensate municipal corporations for taxes that are subsumed into the GST. Take the case of octroi. The Brihanmumbai Municipal Corporation makes a lot of money through octroi. If GST were to become the order of the day, the octroi will be subsumed into it.

As R Jagannathan writes in a column on Huffington Post India: “The Mumbai Municipal Corporation’s Octroi collections annually are in the range of Rs7,000-8,000 crore. Will GST collections in Maharashtra be enough to finance this revenue loss?” This is a question worth asking.

Further, the GST system as it has been envisaged will need a solid information technology backbone. This information technology system will essentially lead to a lot of lower level bureaucracy, which runs India’s indirect tax system, becoming useless. (Think of all those employees manning check posts on state borders for one).

While, the government does not fire employees, a move to GST will lead to the income from corruption for the lower level bureaucracy coming down. And this is unlikely to go down well with them. They, as always, remain in a position to create problems.

Also, in a recent interaction with a few economists, I was told that the state level bureaucracy remains unprepared for implementing the GST. The fact that GST is a destination based tax and not an origin based one, which is one of its core points, remains unclear to many of them.

The fiscal deficit conundrum

For the first five years, the union government will compensate the states for the loss of revenue arising because of GST. This is the known unknown that can really create a problem. If the compensation demands from states are more than what is expected, the fiscal deficit of the central government can shoot up. Fiscal deficit is the difference between what a government earns and what it spends.

In this scenario, achieving the fiscal deficit target that finance minister Arun Jaitley has set for the government will become difficult. In the budget speech made in February 2015, Jaitley had said that the government will achieve a fiscal deficit of 3.5% of GDP in 2016-17; and 3% of GDP in 2017-18. Running up a higher fiscal deficit will have its own set of repercussions.

What are the advantages of GST?

As we have already seen GST is basically a self-policing system and makes the entire system more transparent. The Subramanian Committee report points out that the GST “is a stark example of a tax believed to facilitate enforcement through a built-in incentive structure that generates a third party reported paper trail on transactions between firms, which makes it harder to hide the transaction from the government.”

This basically ensures that the tax collected by the government goes up. As analysts Saurabh Mukherjea, Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital point out: “Cross-country evidence suggests that the introduction of GST boosts the tax-to-GDP ratio by 1-2% points.” The analysts feel that GST will boost tax collection in India by bringing the unorganised sector which accounts for 59 per cent of India’s economy, under the purview of taxation.

While the rate of inflation is initially expected to go up, over the longer term, the inflation does come down as the cascading effect of indirect taxes is done away with and the cost of doing business comes down.

As the Ambit Cpital analysts point out: “Whilst the introduction of a single GST helped reduce inflation in New Zealand as well as Canada, inflation rose moderately in Australia and Thailand. However, the increase in inflation in Australia as well as Thailand was driven by unique factors such as domestic supply constraints. After adjusting for these factors, inflation in these two countries too was lower post GST implementation.”

And what about the GDP?

The finance minister Arun Jaitley has said in the past that GST is likely to push up the Indian GDP growth by 1 to 2 per cent. “This (GST) has the potential to push India’s GDP by one to two per cent,” Jaitley had said in April 2015. Jaitley’s statement was probably made on the basis of a December 2009 report brought out by National Council of Applied Economic Research(NCAER). In this report NCAER said that other things remaining the same the implementation of GST is likely to push up India’s GDP “somewhere within a range of 0.9-1.7%”.

The evidence on GST increasing GDP growth (or economic growth) is at best sketchy. As the Ambit Capital analysts point out: “Whilst it is difficult to assess the impact of GST on economic growth (as GDP growth is affected by a range of variables), cross-country evidence suggests that there is no clear evidence that the introduction of GST necessarily leads to higher GDP growth. Although the introduction of a single GST limits inefficiencies created by a heterogeneous taxation system, there is little evidence that it helps boost GDP growth rates.”

To conclude, there are many good things about the GST. Nevertheless, it is not a done deal yet and a few major issues remain, which will continue to test the Modi government in the days to come. Also, it is not the be all and end all, that the media is making it out to be. It is just one of the factors that will set India right in the years to come.

This column originally appeared in Vivek Kaul’s Diary on August 5, 2016

Postscript: I will be taking a break from writing the Diary and will be back after August 15. Here is wishing everybody a Happy Independence Day in advance.