Cholesterol in the Indian GST

by Arbind Modi and Ajay Shah

In 2017, the Goods and Services Tax (GST) replaced the fragmented indirect tax structure of excise duties, service tax and state-level value added tax (VAT) with a unified, destination-based value-added tax. GST was conceived in Kelkar 2003, as an Indian adaptation of the global idea of the value added tax, which has the desirable features of having no cascading effects and being neutral to international trade.

Input tax credit is the beating heart of the GST: the tax paid on inputs must be credited against output tax liability. In a new XKDR Forum Working Paper, Input Tax Credit and refunds under GST in India: Conceptual and legal framework, we show that many features of the modern Indian GST interfere with input tax credit. In this, we combine the strategic sense of modern public economics coupled with a detailed reading of the law.

We worry that the Indian GST is a case of isomorphic mimicry: it resembles the external form of a modern VAT in form but lacks its underlying function. While Section 16 of the CGST Act establishes foundation of ITC entitlement, Section 17 narrows the scope through apportionment and blocked credits. Section 17(5) explicitly denies ITC for business inputs such as motor vehicles and works contracts. Furthermore, the refund framework under Rule 89 limits refunds to Net ITC and embedding revenue safeguards at the expense of neutrality. Critically, the law excludes capital goods and services from refund calculations in these cases. This breaks the credit chain.

When credit is denied, the tax on inputs becomes a cost. This creates a cascading tax through the supply chain. The tax system functions as a tax on intermediate production rather than on consumption. By blocking input tax credit for capital goods, the GST acts as an incentive for reduced investment.

This is not how the value added tax works internationally. India stands as an outlier relying on a narrow refund design, heavy compliance preconditions, and extensive exclusion. The current system minimizes administrative risk by denying refunds ex-ante, rather than managing risk through ex-post verification. The recent movements on `GST 2.0' do not deliver an improved GST as they actually worsen the blockage of input tax credit.

These flaws in tax policy have harmful effects for India: (a) Reduced capital deepening and reduced investment that hampers the emergence of high productivity and high wage firms; (b) Unfair competition from imports against domestic producers; (c) Reduced export competitiveness. The paper proposes a reform path focused on three pillars: guaranteeing full flow-based ITC across all inputs, rationalising rates to a single band, and automating refund administration.

The authors are researchers at XKDR Forum.

The LTCG tax will increase the cost of investment in India, but not by much

by Gaurav S. Ghosh.

Section 33 is one of the more talked-about provisions of the Finance Act, 2018. This is the section that reintroduces a tax on long-term capital gains (“LTCG”), where the LTCG arises from the transfer of “an equity share in a company or a unit of an equity-oriented fund or a unit of a business unit” (Ministry of Law and Justice, 2018). Under the new law, a tax of ten percent will be liable on all LTCG exceeding INR one lakh, where the LTCG arises from the sale of assets described above held for over a year (Income Tax Department, 2018).

The LTCG tax has come in for scrutiny and criticism in the financial press. Some commentators have predicted negative consequences for small investors (Arora, 2018; Sampath & Thomas, 2018). Others have noted that the tax will lead to double taxation because some securities transactions will bear both the LTCG tax and the already existing securities transaction tax (Sampath & Thomas, 2018; Business Today, 2018). Yet others have pointed out that there is a lack of clarity about the application of the LTCG tax to specific transaction types, including share inheritances, mergers, and initial public offerings (Upadhyay, 2018). The central government has defended the tax by pointing out that it reduces distortions in investment incentives by reducing discrepancies in tax rates across asset classes (The Hindu, 2018; The Telegraph, 2018).

The opinions have been manifold and heterogenous but have been, in the end, no matter how well reasoned, only opinions. There has been a shortage of quantitative economic analysis of the LTCG and its effect on the Indian economy. In this article, we address this gap by presenting our estimates of the impact of the LTCG on the cost of investment in the main sectors of the Indian economy and at the all-India level.

Intuitively, one would expect the LTCG tax to increase the cost of investment since it increases the hurdle rate – the minimum return that an investment project must earn for financial viability – of a project. Consider a simple example where an investment project is financed only by equity and dividends are not distributed. Suppose the investors expect a 7.0 percent post-tax return from the project. Before the LTCG tax, the project would be feasible if it had a pre-tax return of 7.0 percent. Under the LTCG tax, the project feasibility would require a pre-tax return of at least 7.7 percent: 7.0 percent for the investor as capital gains and 0.7 percent for the government as the LTCG tax. The LTCG tax has thus increased the project’s hurdle rate from 7.0 percent to 7.7 percent.

In the example above, the cost of investment increased by the full extent of the LTCG tax. This is not true for a real-world investment whose tax cost is a function of all the taxes associated with the investment, macroeconomic conditions, and the structure of the investment itself. Apart from the LTCG tax, other taxes affecting the investment cost are the corporate income tax and indirect taxes. There are also tax incentives, which may be asset- and sector-specific, that reduce the tax cost of investment. The investment will have a particular distribution of assets – some investments require more transportation assets, others more machinery assets – and this structure too affects the tax cost of investment. This is because each asset has a different tax treatment: if highly taxed assets are a major cost of investment, then the tax cost will be high and vice versa. And macroeconomic conditions like inflation affect the value of benefits like depreciation allowances, and therefore affect the tax cost of investment.

Given the complex relationships that define the tax cost of investment, it is not feasible to predict with certainty what the relationship between the LTCG tax and the cost of investment might be. But two hypotheses might be formulated on the basis of the discussion above. First, the LTCG tax will increase the tax cost of investment; after all, it does increase the cost of project finance. Second, the impact of the LTCG tax will be minor; considering the wide array of factors affecting the tax cost.

Measuring the tax cost of investment requires an adequate modelling framework. The framework should at least have the three following characteristics. First, it should be flexible enough to model the impacts of all taxes and tax incentives on the cost of investment. Second, the model should be well targeted, i.e. it should measure the tax impact on investment, but not non-investment activities. Finally, the model should allow aggregation, such that firm-level data can be used to estimate tax costs at the sectoral or national levels.

One model that meets these criteria is used to measure Marginal Effective Tax Rates (“METRs”). This model uses firm-level and macroeconomic data to estimate the tax wedge on investment, the difference between the pre-tax and post-tax rates of return earned by a marginal investment project. By construction, the METR model only focuses on marginal investment to the exclusion of other aspects of a firm’s business. The METR itself is a function of all taxes and tax incentives levied. These include direct taxes on businesses and investors, indirect taxes on capital purchases, and incentives like accelerated depreciation and tax credits. And the model allows for aggregation from firm-level METRs right up to one national level number.

We have estimated the tax cost of investment using the METR model, which we have developed for India and discussed earlier on this website (see Ghosh & Mintz (2017)). Specifically, we have estimated the tax cost of investment before and after the implementation of the LTCG tax. A comparison of the before and after values provides an estimate of the impact of the LTCG tax on the tax cost of investment.

Figure 1: METRs before and after implementation of the LTCG tax

Source: Own calculations

METRs in the main sectors of the Indian economy and at the overall all-India level are shown in Figure 1. These sectors together comprised 96.5 percent of all investment in the Indian economy in FY2015-16 (Prowess, 2018). Each sector in Figure 1 has three data points. The left-hand column is the METR before the LTCG tax was reinstated, i.e. LTCG tax rate = 0.0 percent. The right-hand column is the METR after the LTCG tax was reinstated, i.e. LTCG tax rate = 10.0 percent. The line shows the change in the METR after the imposition of the LTCG tax.

The results indicate that the LTCG tax has increased the tax cost of investment – as measured by METRs – in all sectors of the Indian economy. The only exception is the agriculture sector, which is the beneficiary of multitudinous direct and indirect tax exceptions. These combine to ensure that the LTCG tax has no effect on the agriculture METR.

Overall, at the all-India level, the METR has increased from a pre-LTCG-tax value of 20.3 percent to a post-LTCG-tax value 21.1 percent: implementing an LTCG tax of 10.0 percent has yielded a 3.9 percent increase in the METR. This is equivalent to an elasticity of 0.03 in the neighbourhood of the LTCG tax rate. One may infer that the METR is barely sensitive to the LTCG tax rate.

The minimal response of the METR to the LTCG tax is confirmed by the result in Figure 2, where a METRs are plotted for a sequence of the LTCG tax rates. Increasing the LTCG rate from zero to 20.0 percent only increases the METR from 20.3 percent to 21.9 percent, an increase of 8.1 percent. The relationship between the LTCG tax and the METR is roughly linear (the relationship is slightly convex, but this is not very evident in Figure 2).

Figure 2: Relationship between the METR and the LTCG tax

Source: Own calculations

Coming back to Figure 1, we see heterogeneity in the METR change at the sectoral level where – not counting agriculture – the change in METRs range from 1.8 percent in the “other” sector to 7.8 percent in manufacturing. The largest [smallest] METR changes are in the sectors with the lowest [highest] METRs. In other words, the LTCG tax has the greatest [smallest] impact on METRs in sectors where investment is least [most] burdened by taxes. The sectors most affected by the LTCG are manufacturing and transportation, which have the lowest METRs. Manufacturing has a low METR because of generous tax depreciation allowances on machinery. The low METRs for the transportation sector depend on firms charging GST under the forward charge mechanism. If the reverse charge mechanism were used, then the METR is much higher because of significant blocked input tax credits. The least affected sectors – “other” and finance” – are also those with the highest METRs. These sectors suffer high METRs because of adverse asset compositions. Overall, it seems that the LTCG tax reduces tax load discrepancies across sectors by a small amount, and thereby contributes marginally to a levelling of the playing field for investment.

In summary, the following can be said about the impact of the LTCG tax on investment incentives in the country. First, the overall relationship between the LTCG tax and the tax cost of investment (as measured by the METR) is positive, but weak. Since the LTCG tax does not change the METR in any significant way, one may infer that it will not affect investment decisions to any significant degree. Second, there is some heterogeneity at the sector level, with sectors with hitherto low METRs worse affected by the LTCG tax change than sectors with high METRs. The LTCG tax therefore makes a (very) small contribution in levelling the playing field for investment. This second result provides weak support for the government’s contention that the LTCG tax will reduce investment distortions (The Telegraph, 2018), although the mechanism differs from that suggested in the referenced article.

Bibliography

Arora, I. (2018, Mar 14). Government receives requests to drop planned long-term capital gains tax.

Business Today. (2018, Feb 05). How LTCG tax affects mutual fund investors.

Ghosh, G., & Mintz, J. (2017, Nov 23). Measuring the pre and post GST tax cost of investment.

Income Tax Department. (2018). Tax on Long-Term Capital Gains, Income Tax Department, Ministry of Finance, New Delhi.

Ministry of Law and Justice. (2018). The Finance Act, 2018 (No. 13 of 2018), Ministry of Law and Justice (Legislative Department), New Delhi.

Prowess. (2018). [cross tabulation of data].

Sampath, A., & Thomas, S. (2018, Feb 09). Long-term capital gains tax on equity: Will it scare away small investors?.

The Hindu. (2018, Feb 06). For more equity: on long-term capital gains tax.

The Telegraph. (2018, Feb 06). LTCG exemption for equities was a risk for small investors, govt says.

Upadhyay, P. (2018, Feb 19). Union budget 2018: Long-term capital gains tax - the unanswered questions.

 

Gaurav S. Ghosh is an economist and Senior Manager at Ernst & Young LLP

Measuring the pre-and post-GST tax cost of investment

by Gaurav S. Ghosh and Jack Mintz.

The most wide-ranging change to the Indian tax system in decades is the introduction of the goods and service tax (“GST”). But is this tax beneficial or harmful for investors, especially for new investment? Is the GST impact uniform across sectors, or does it favour in some sectors while harming investment in others?

India’s GST reform has integrated state level sales taxes and central excise and service taxes into the GST, which is a centralized value added tax (“VAT”) and enables businesses to claim more refunds of taxes paid on purchases from other businesses. It removes a significant amount of taxes on business inputs that are cascaded into business costs and passed on to consumers or businesses purchasing goods and services from other businesses. Some non-refundability of input taxes remain for exempt sectors such as agriculture, petroleum and alcohol. Generally, though, the Indian VAT reform will result in a signficant reduction in VAT on business input costs as we show below.

We report results from our recent study where we evaluate the cost burden placed by India’s tax code upon potential investors, both before and after the introduction of the GST. We do this by developing an economic model that is calibrated to represent the Indian tax system, and then using this model to simulate GST impacts. The model and its implementation are described below. This is followed by discussion of our results.

The METR model

Our tool for evaluating the impact of the Indian tax system on investment incentives is the Marginal Effective Tax Rate (“METR”), which measures the tax wedge imposed upon investment. The METR is an analytical framework developed in the 1980s to evaluate tax systems in their aggregate and to facilitate cross-country and cross-sectoral comparisons. Seminal METR studies from this era are Auerbach (1983), Boadway et al. (1984) and King & Fullerton (1984). The METR has since been used by academics and governments to evaluate tax competitiveness, gauge the economic impacts of changes to the tax code, and design investment-friendly tax policies. The METR analytical framework is useful because it provides a strong empirical basis to tax policy debates. It has proved itself over the years by being used by policy makers worldwide. Ours is the first in-depth implementation of the METR framework to the Indian economy.

The tax wedge, $\omega$, estimated under the METR framework, is the difference between the pre-tax rate of return earned by a marginal project, $r_g$, and the post-tax rate of return that accrues to the marginal project’s investors, $r_n$. The METR itself is the tax wedge divided by the pre-tax rate of return.

\[ METR = \frac{\omega}{r_g} = \frac{r_g - r_n}{r_g}\]

The sizes of the tax wedge (and the related METR) is affected by direct taxes, sales taxes on capital purchases and other capital-related taxes like stamp duties. The METR also accounts for tax incentives including accelerated depreciation, initial allowances, and tax credits. High METRs imply high tax loads and low returns to investors and vice versa. High METRs therefore indicate that the associated tax systems are less competitive when it comes to attracting capital investment.

Estimating the METR for a marginal project requires the estimation of $r_g$ and $r_n$ for that project. In the METR framework, both variables are functions of a wide array of tax rates and incentives; the functional forms are derived through recourse to standard microeconomic principles and assumptions. We do not provide technical details here. Interested readers can refer to Ghosh & Mintz (2017). We only note that the post-tax rate of return $r_n$ is equal to the inflation-adjusted market interest rate for issuing bonds and equity finance, which is the same across all businesses net of risk. The pre-tax rate of return, $r_g$, is estimated by estimating the user cost of capital model (Jorgenson, 1963) net of depreciation and risk. The Indian tax system therefore affects the estimation of $r_g$ and $r_n$ – and by extension, the estimation of the METR – because of its impact on the real market rate of return and the user cost of capital within the structure of our model.

Aggregation principles

METR estimation requires consideration of the marginal investment that earns a pre-tax rate of return sufficient to cover taxes and the market rate of return. The marginal investment depends on the characteristics of its industry and the choice of production technology. Every sector, in effect, has a multitude of marginal investments varying across characteristics like industry, asset class and financing structure. Each marginal investment has a different METR because it faces a different tax treatment once all relevant taxes, exemptions and their interactions are considered. Debt-financed transportation in the power sector will, for example, have a different METR than equity-financed machinery in the agriculture sector. There are multiple reasons for this: the differential treatment of debt and equity in the Indian tax code where interest payments are deductible, but dividends are not; the different incentives available to investors in the power and agriculture sectors; and the differential tax treatments of asset classes.

Accurate estimation of the METR, whether at the sectoral or all-India level, requires consideration of this heterogeneity across different types of marginal investment. Consistent with the literature (King & Fullerton, 1984; Mintz, et al., 2016), we estimated METRs by using a bottom-up approach.

First, we identified four key tax and economic characteristics of a marginal investment in India. These were sectors, asset types, investment sizes, and whether the marginal firm was paying the corporate income tax (“CIT”) or the minimal alternate tax (“MAT”). Each marginal investment would have some level of each of these characteristics. Second, we identified the number of levels for each characteristic. There were nine sectors, six asset types, two firm sizes and two types of tax payers, as shown in Table 1, leading to 216 unique marginal investments. The identified sectors (except “Others”) were the main investment destinations in India, accounting for 93 percent of investment in 2015 among firms in the Prowess database. The asset types were those identified for differential treatment under the Indian tax code. Firm size was selected on the basis of the investment threshold for initial allowances: these are only allowed for investments exceeding INR 250 million.

Table 1: Characteristics and levels of marginal investments in India
Industry / Sector	Asset type	Firm Size	Tax payer type
Agriculture, forestry & fishing	Buildings	Small firms, with investment < INR 250 million in 2015	CIT payer
Construction	Furniture & fittings
Electricity, steam, gas & AC supply
Finance & insurance	Inventory
Information & communication (“Infocom”)	Land	Large firms, with investment > INR 250 million in 2015	MAT payer
Manufacturing	Machinery
Wholesale & retail trade, repair of motor vehicles & motorcycles	Transport
Transportation & storage
Other

Third, METRs were estimated for each of the 216 marginal investment types. This required collection of tax and economic data for each type, and then the incorporation of this data into the formal METR model. Finally, METRs were calculated at different levels of aggregation as weighted averages of subsets of the 216 types. For example, the all-India METR was a weighted average of all 216 METRs, while a sectoral METR was a weighted average of the 24 METRs relevant to that sector. The weights used were the capital shares associated with each marginal investment type. The capital share was the proportion of all new investment capital in a given year that was allocated to a given marginal investment type. The capital share data and certain other data were obtained from the Prowess database. Other data sources were the Indian Income Tax Act, tax guides published by EY and other accounting firms, official Indian government communications, the Thomson Reuters EIKON financial database, and publications by the Central Statistical Office.

Results

Some results from our analysis are presented below. We begin with a comparison of METRs before and after the implementation of the GST, which is shown in Figure 1. We compare METRs both at the all-India level and at the sectoral level. The blue (red) bars represent pre-GST METRs (post-GST METRs).

We see that the GST leads to a fairly large drop in METRs at the all-India level, from 28% to 22%. This is because the GST removes pre-GST blockage of many input tax credits. Many of the blockages arose because different indirect taxes – such as state VAT and central excise and service taxes – could not be set off against each other. Consider the plight of a services firm, which paid state VAT on some inputs, but collected central service tax from its customers. Since state taxes were not creditable against central service taxes they were blocked, leading to tax cascading. Unable to claim credit for state taxes paid, the firm’s input costs would be higher by the amount of the blocked taxes. This higher tax burden would lead to a higher METR. Post-GST, the distinction between central and state taxes vanished and therefore many blockages and cascades also vanished.

Other blockages arose because of exemptions granted under the pre-GST system. It is a common misconception that tax exemptions are business-friendly. Nothing could be further from the truth. Since the exemption recipient does not pay the output tax, it cannot set off its input taxes. All input taxes in exempt sectors are therefore blocked and lead to a higher METR on investment. The GST has retained some previous exemptions, such as in the agriculture sector, but has removed others. This has contributed to the overall drop in the METR.

We also see that METRs are heterogeneous across sectors. Pre-GST, METRs were lower in production-related industries than in service industries. Production sectors may have had lower METRs, but for different reasons. Manufacturing benefited from relatively low central and state indirect tax rates, as well as few input tax credit blockages. This is because most investment in the manufacturing sector is into machinery and equipment (“M&E”), which had relatively favourable tax treatment. Agriculture and electricity, on the other hand, were exempt sectors and therefore had blocked credits. However, these sectors received other benefits from the tax code that, together, brought down their METRs. Agriculture was exempt from the corporate income tax, while electricity benefited from large tax depreciation allowances and (like manufacturing) low indirect tax rates on M&E. The service industries had higher METRs because they faced higher taxes on their inputs as well as greater blockages on input tax credits. The asset mix for the service sectors consisted of comparatively less M&E (with the exception of finance) and more of other assets like land, buildings, transport and inventory. The pre-GST tax treatment of these other assets was relatively less favourable than for M&E.

When comparing pre- and post-GST METRs, two results stand out. First, METRs have reduced for all sectors with the sole exception of electricity (to be explained below). Second, the size of the METR reduction varies across sectors with the reduction being higher in the service sectors than in the production sectors. As a result, although variations in METR persist in the post-GST era, the size of these variations has reduced, with the specific result that the tax competitiveness gap between the production and service sectors has also reduced.

These results can be unpacked. Perhaps the most notable result in the figure above is that the GST raises the METR in the electricity sector, while reducing it in others. Pre-GST, the electricity sector faced two distortions: sector-specific indirect tax incentives and blocked input tax credits. The former was beneficial and the latter harmful from an investment (and METR) perspective. The two distortions cancelled each other out, leading to a relatively low METR of 29%. Post-GST, the beneficial sector-specific incentives were removed while the harmful blockages remained. As a consequence, the METR increased sharply in this sector to 38%. The services sectors benefited more from the GST because they were the ones for whom blocked credits were a greater problem in the pre-GST era. This led to a reduction in the tax competitiveness gap between the services and production sectors.

Summary

The merits and demerits of the GST have been debated vigorously in the press and among the policy community in recent months. We contribute to this debate by presenting the results of the first (to our knowledge) empirical investigation of the impact of the GST on the incentive to invest in India. We find that the GST does improve investment incentives at the all-India level by reducing the marginal effective tax rate or METR from 28% to 22%. This is achieved through a reduction in the blockages of input tax credits across value chains and a reduction in indirect tax exemptions. The all-India METR numbers mask heterogeneity at the sectoral level. Pre-GST, the Indian tax code incentivized investment in production sectors like manufacturing and electricity through lower METRs, while the tax cost of investment was relatively higher in service sectors like transport, information & communications and trade. Post-GST, this pattern of incentives has changed. While METRs for manufacturing remain low, METRs for the power sector have increased significantly. METRs for the service sectors have also come down sharply post-GST. METRs in some service sectors like finance and trade are now roughly equal to that for manufacturing.

In summary, the GST has reduced the overall tax cost of investment in India and reduced investment distortions in the tax code, somewhat levelling the playing field between the production and service sectors as destinations for investment. This is good news, but we caveat it by pointing out that the full potential of the GST as an incentive for investment has not been reached. We have unreported results that show that METRs would come down further – particularly in the electricity sector – if the remaining exemptions were removed.

References

Auerbach, A., (1983), Taxation, corporate financial policy and the cost of capital, Journal of Economic Literature, 21(3), pp. 905-940.

Boadway, R., Bruce, N. & Mintz, J., (1984), Taxation, inflation, and the effective marginal tax rate on capital in Canada, Canadian Journal of Economics, 17(1), pp. 62-79.

Ghosh, G. & Mintz, J., (2017), Investment and the Indian tax regime: Measuring tax impacts on the incentive to invest in India, Bangalore: EY.

Jorgenson, D., (1963), Capital theory and investment behavior, American Economic Review, Volume 53, pp. 247-259.

King, M. & Fullerton, D., (1984), The taxation of income from capital: A comparative study of the Unites States, the United Kingdom, Sweden and West Germany, Chicago: University of Chicago Press.

Mintz, J., Bazel, P. & Chen, D., (2016), Growing the Australian economy with a competitive company tax, Sydney: Minerals Council of Australia.

 

Gaurav S. Ghosh is Senior Manager, Ernst & Young, LLP and Jack Mintz is Palmer Chair in Public Policy and Director, School of Public Policy, University of Calgary.

Design of the Indian GST: Walk before you can run

by Satya Poddar and Ajay Shah.

A previous article, Sequencing in the construction of State capacity: Walk before you can run argues that in public administration, we should first reach for a modest objective, i.e. a low load, and build sound public administration systems, i.e. adequate load bearing capacity. Only after the systems have been proven to work at a low level of load should we consider increasing the load.

In building tax administration, the load is defined by (a) The tax rate and (b) The complexity of the tax in its very design - e.g. a sales tax is easier than an income tax. If the tax rate is low, the employee of the tax collection agency has a greater incentive to collect the tax. When the tax rate is high, there is a greater temptation to just take a bribe instead. If the tax system is simple, there is reduced discretion at the front line, and thus reduced rent-seeking.

In places like the UK, where there is high State capacity, income tax began at low income tax rates. When Pitt the Younger started the income tax in 1798, the peak rate was 10%. This gave them an opportunity to build sound tax administration under conditions of low load. Once this was done, the road to higher tax rates was available. In similar fashion, Singapore started with a GST rate of 4%, and then went up to 7%. The Japanese GST rate was also 3% at inception, and has now been moved up to 8%. In India, we never made the tax administration work at low rates of tax; premature load bearing was attempted by jumping to high tax rates without adequate load bearing capacity in the form of a well designed tax administration.

A standard debate in tax policy is about the choice between a low rate and a wide base versus higher rates applied on a smaller base. The traditional economics argument has been that the distortion associated with a tax goes up as the tax rate squared, so for a given level of tax revenue we are better off with a low rate and a wide base. A simple tax system with low rates will help lower the extremely large value for the Indian Marginal Cost of Public Funds. The argument presented here gives us one more perspective on the problem. Low tax rates are a low load from a public administration point of view; until load-bearing capacity has been created, it is unwise to subject the system to high load.

There is an interesting tension here between two different ways to make the load smaller. A lower rate requires a large base. The wider base involves a bigger tax administration machinery, and a larger number of transactions. A large number of transactions induces a greater load. But a higher tax rate changes what is at stake and increases the load substantially.

By this reasoning, the way forward on building a sound framework for tax administration is:

1. First, design a very simple tax policy (e.g. a single rate comprehensive GST) with low discretion at the front line employees, so as to keep the load low. At first, set very low tax rates, to reshape the incentives of citizens and tax officials, to keep the load upon public administration low.
2. Build and run a tax administration which is able to deliver sound tax revenues under these conditions. E.g. a 5% comprehensive VAT rate should generate VAT collections of near 3% of GDP. This requires sophisticated thinking about tax administration.
3. Use independent private studies (e.g. comprehensive audits of some persons) and perception studies to measure the extent to which bribes are paid instead of tax.
4. Only after this is working well, consider moving up to higher tax rates and/or a more complex tax policy. 

Implications for GST design

How can a GST be designed so as to have low load? If we wanted to walk before we run, how would we design the GST?

1. A low single rate of 12-15%. Multiple rates significantly increase the workload.
2. A single rate and comprehensive base, which simplifies the workflow and reduces discretion and eliminates classification disputes.
3. Centralised registration. State-wise registration administration work load, and compliance burden for taxpayers manifold - 36 times for those who have to register in all of the states and union territories.
4. Automatic refunds of excess credits, without discretionary approval by officials.
5. Eliminate the concept of self-supplies within a legal entity, as the number of transactions increases several fold if self-supplies are made taxable. No supply should be reckoned unless there is another person to whom a supply can be made.
6. The system of penalties and assessments needs to be simple, with a bias in favour of low discretion and low penalties. 

There has been a lot of focus on the `revenue neutral rate'. One twist on this is that the government is a significant buyer of goods and services. Thus the `budget neutral rate' would be a bit lower than the revenue neutral rate. This makes it possible for the rate to be lower when compared with the conventional analysis.

Single registration is a subject of some debate. Even when each state has its own GST law, it is very much possible to have single registration. The law would impose the tax on taxable supplies made in the state, allow input tax credits, and specify reporting obligations for information. These provisions will apply to any person registered in the country. There need not be the requirement of separate registration in each state. Computations of tax and reporting of the information could be on a single return with state-wise annexures. The key difference between state-wise and central registration would be that all of the state-wise compliances would be on a single registration portal, and the person will be treated as a single person (note that under the current Model law, each registration number is treated as belonging to a different person). This is how the Canadian GST operates, i.e., with single registration, but with multiple federal and provincial GST laws.

Does GST implementation require single control? We think single control is neither desirable nor feasible. Scrutiny and audits at the state level will necessarily require information on the dealer on a Pan India basis, which individual states would not have. Both the Centre and States would want to monitor compliance with their respective tax laws. If they want autonomy in administration of the GST, what is needed is a harmonisation agreement to avoid duplication of administrative effort and inconsistent policies across the country. For example, the governments should agree on a common rulings and interpretations authority, and common administration guidelines. A clean solution would be to have a common audit and scrutiny function that is jointly staffed by Centre and State officials. Some 12 States have already opted for a full-service model of GSTN, under which even scrutiny and audit would be done by GSTN.

Conclusion

The 122nd Amendment is a great step forward. It opens the possibility that India will become one country, one market. At present, tax administration in India works poorly. We do not know how to build a capable and uncorrupt tax administration. In the absence of this State capacity, we should start with a GST design that imposes a low load upon tax administration. Only after this is proven to work at high levels of probity and operational efficiency can we consider the possibility of going up to higher levels of load. This concept can be expanded to all of the GST in all of the States. To keep the load low, we need to expand the Prime Minister’s vision of One India, One Tax, to “One India, One Tax, One registration, and One Rate”.


Satya Poddar is a senior tax advisor with Ernst & Young in India. Ajay Shah is a researcher at the National Institute for Public Finance and Policy.

Marginal cost of public funds: a valuable tool for thinking about taxation and expenditure in India

by Ajay Shah.

In an ideal world, taxation would be done in a frictionless way. The ideal world is a nice place where there are no transactions costs either for taxpayers in compliance, or for the tax authorities in collection. There would be no illegality and criminality surrounding the tax system. Most important, the presence of taxation would not modify the resource allocation in the slightest.

`Resource allocation' is economist-speak for the magnitudes of labour and capital, and the technology through which they are used. `Technology' is economist-speak for both the science and technology, and the business methods through which resources are utilised. In the ideal world, firms would produce based on pure efficiency considerations. Nothing about the questions `What to produce?' and `How to produce?' would be modified in the slightest by the tax system.

The government would collect taxes in this ideal world without imposing any excessive burden upon society. In other words, the cost to society of Rs.1 of spending by the government would be only Rs.1.

This notion is formalised as the `Marginal Cost of Public Funds' (MCPF). This answers the question: When the government spends Rs.1, what cost does it impose upon society? As with most economics, this question is posed `at the margin', i.e. what's the cost to society of the last Rs.1 that the government spent? In the ideal world, the MCPF is 1, but in the real world, it's always worse (i.e. bigger than 1).

The aspiration to get an MCPF of 1 was precisely expressed by Pranab Mukherjee in his July 2009 budget speech where, in para 31, he says:

I hope the Finance Minister can credibly say that our tax collectors are like honey bees collecting nectar from the flowers without disturbing them, but spreading their pollen so that all flowers can thrive and bear fruit.

This happy destination is one where the MCPF is 1, i.e. where the cost to society of Rs.1 of tax collection is 1.

Why do we get MCPF $> 1$?

Why is it that in the real world, we always have an MCPF that exceeds 1? There are costs of compliance, costs of administration, corruption, illegality, criminality. When all these costs are encountered, the cost to society of Rs.1 of marginal tax revenue exceeds 1.

Most important is the issue of a modified resource allocation. People respond to incentives. If income is taxed, people work less. If apples are taxed, people eat more oranges. This results in a distorted resource allocation, which results in lower welfare i.e. lower GDP. When the act of taxation distorts the resource allocation, and thus reduces GDP, the cost to society of the last Rs.1 of taxation exceeds 1.

There are seven sources of MCPF$>1$ in India:

1. Income tax distorts the work-leisure tradeoff and the savings-consumption tradeoff.
2. Commodity taxation distorts production and consumption, particularly when there are cascading taxes.
3. We in India have a menagerie of `bad taxes' including taxation of inter-state commerce, cesses, transaction taxes such as stamp duties or the securities transaction tax, customs duties, taxation of the financial activities of non-residents. From 1991 to 2004, we thought the tax system was being reformed to get rid of these, but from 2004 onwards, things have become steadily worse, starting with the education cess and the securities transaction tax. All these are termed `bad taxes' in the field of public finance because when money is raised in these ways, the MCPF $\gg 1$.
4. India relies heavily on the corporate tax, and has double taxation of the corporate form. In the last decade, corporate income tax and the dividend distribution tax added up to 35% of total tax collection. The double taxation induces firms to organise themselves as partnerships and proprietorships.
5. There is the compliance cost by taxpayers and tax collectors, which is a pure deadweight cost. At the extreme, these include the costs imposed upon society by illegality and criminality owing to corruption in the tax system. When some firms get away with tax evasion, this changes the incentives of ethical firms to invest, which imposes enormous costs upon society as the most ethical firms are often the highest productivity firms.
6. There are the consequences for GDP of the political economy of lobbying for tax changes, which arise when we do not have simple single-rate tax systems. E.g. if there was only one customs duty (e.g. 5%), this is much better than having different rates. Similarly, 80% of the countries which introduced the GST after 1995 have opted for a single rate GST.
7. At the margin, public spending is actually financed out of deficits which are deferred taxation, intermediated through the processes of public debt management. Hence, in thinking about the MCPF, we must think about deficits and their financing also. Additional deadweight cost appears here, as we do financial repression (some financial firms are forced to buy government bonds). This is akin to a narrow commodity tax and is a bad tax.

All good thinking in tax policy and tax administration impinges upon the MCPF. If we setup a flawless GST, the MCPF will go down. If we reform tax administration, the MCPF will go down. The distortion associated with a tax goes up in proportion to the rate squared: hence the MCPF will be lower at a GST rate of 12% rather than at 24%.

How big is the MCPF in India?

As the discussion above suggests, there is the assessment of MCPF at the level of society as a whole and there is its measurement at the level of one tax at a time where the `bad taxes' will leap out of the page.

Estimation of MCPF is hard. Computable general equilibrium models are useful for thinking about shifting from commodity specific taxes to a single rate VAT. But most of the elements above are beyond the analytical reach of empirical economics.

One uniquely Indian problem is that on an international scale, most of these problems have been abolished. Most mature economies do not do financial repression, have low corruption in tax administration, do not have political economy of lobbying for tweaking of tax rates, do not have any of the bad taxes (taxation of inter-state commerce, cesses, transaction taxes, customs duties, taxation of financial activities of non-residents). Most mature economies have moved to a commodity neutral VAT or sales tax. As with most parts of the Indian macro/finance environment, India is an outlier with extremely poor institutional mechanisms in taxation. Nobody does the things that we do, and hence there is no international literature which helps us measure the MCPF in India. All we can know is that the Indian MCPF is very large.

Let's look at the international literature. Many papers find values from 1.25 to 2 in OECD countries. For an example of values from advanced economy, Dahlby and Ferede, 2011, find that the Canadian income tax has a marginal cost of public funds of 1.71, their personal income tax yields a value of 1.17 and their general sales tax has a value of 1.11. Feldstein, 1999, estimates a value of 2.65 for the US. Ahmad and Stern, 1984, estimate that the marginal cost of public funds in India for excise is between 1.66 and 2.15; for sales tax it is between 1.59 and 2.12; for import duties it is between 1.54 and 2.17.

When compared with conditions in India, the values seen in these existing papers are small, as the full blown distortions of the Indian tax system are not found in those countries. The one paper on India (Ahmad and Stern, 1984) only addresses a small part of the distortions associated with the Indian tax system. Indian policy thinkers who read Feldstein, 1999, which estimates a value of 2.65 in the US, would be delighted to achieve the conditions described in that paper.

Putting these considerations together, Vijay Kelkar, Arbind Modi and I believe that the true MCPF in India may exceed 3.

Further research on this question is very important. However, we are not able to visualise a research strategy that could put all the seven sources of distortion into one estimate, using today's knowledge of public economics. We are forced to form a guesstimate, and we propose the value of 3.

Implications

A central objective for tax reform should be to modify tax policy and tax administration so that the MCPF comes down. A central consideration in expenditure policy should be to narrow expenditure down to the few things where we can be convinced that the marginal gains for society exceed the MCPF, i.e. the last rupee of spending gives benefits to society exceeding the hurdle rate of Rs.3.

Spending on private goods. The value to society of gifting me Rs.1 to buy private goods that I like is Rs.1. Subsidy / transfer programs do not meet the test.

Leakages in private goods. If government intends for person $x$ to be the recipient of a private good of Rs.1, but owing to inefficiencies and corruption, Rs.0.5 reaches person $x$ while Rs.0.5 reaches an unintended beneficiary such as an official or a politician, this still yields gains for society of Rs.1, except that the gains are being allocated differently from what was intended. This does not change the fact that the aggregate gains to society was Rs.1, which is below the threshold of 3.

Spending on public goods. Spending on many public goods does yield gains that exceed the hurdle rate. We spend Rs.400 crore a year on running SEBI which produces the public good of financial markets regulation. SEBI does this poorly, and there are many ways in which SEBI can better utilise this money. But there is little doubt that the gains to society exceed Rs.1200 crore. If you imagined a world without SEBI, Indian GDP would drop by more than Rs.1200 crore.

Similarly, once we build a government agency to control air pollution, this will yield gains to society (in terms of the reduced burden of respiratory illness) vastly greater than the direct expenditures for running the agency. The same can't be said about public spending that makes the private goods of health care for people with respiratory ailments. In anticipation of the October 2016 epidemic of Dengue, let's fight mosquitoes. The gains to society from vector control easily exceed the hurdle rate, while the services of hospital beds and crematoriums are private goods.

Leakages in public goods. With public goods programs, we will sometimes get the situation where inefficiencies in the expenditure profile damage the marginal product to below Rs.3. Sometimes, these can be salvaged by improving spending efficiency. At other times, we should just admit that we have low State capacity in India and shut down the spending program.

How big should the State be? We should increase spending as long as the marginal gains to society exceed the MCPF. As the MCPF in India is high, this implies that the optimal scale of spending in India should be lower. Evaluating the possibility of a large State is the luxury for people who live in countries where the MCPF is low.

The free rider problem with sub-national governments. In India, the dominant source of resourcing of sub-national governments is central funds. In this case, if I am one state in India, it's efficient for me to advocate bigger expenses, as I don't pay the full cost of distortions experienced by the country. My marginal gains from spending one more rupee are mine, while the MCPF is imposed on the full country. To say this differently, Greece always wants more expenditure by the EU. Hence, sub-national governments should not have a say in the overall size of government. This perspective implies that in the new GST Council, the two-thirds vote share of states will generally favour a higher GST rate.

Who is in charge of fiscal policy and tax policy?

In any country, various arms of government like to indulge in taxation of their own choice, and in setting up little treasuries that they control. However, it is quite clear that there must be only one treasury, and only one authority that determines taxation, through only one Finance Act.

In the Economic Times today, I have an article that applies this idea into analysing a recent proposal by DOT to impose an 8% tax on wireline broadband providers.

You may find some of the associated materials useful:

1. Consultation paper issued by DOT on this in December 2012.
2. National Telecom Policy, 2012.
3. TRAI recommendations on broadband.

Egregious Indian protectionism against trade in services

For many decades, India was one of the most protectionist countries in the world. This did great damage to growth and knowledge in India. Tariffs dropped from ridiculous levels to ridiculous levels in the early 1990s and then got stuck there. Yashwant Sinha, as Finance Minister, initiated a remarkable program of cutting the peak rate by five percentage points every year. This worked very well: It steadily got rates down and also gave a roadmap to the domestic industry about what would happen next.

In January 2004, Jaswant Singh as Finance Minister announced further cuts to customs duties even though it was not part of the budget. This was criticised in the press as being a `populist' move. I thought it was a big day in India's history: when a Finance Minister feels that trade liberalisation is so important that it cannot wait  for February 2005 (since Feb 2004 was to be a vote on account), and when he gets criticised on the grounds that this is populist.

While there is more ground to cover on removing barriers to trade in goods (e.g. barriers to trade in agricultural products), by and large, India is doing well on this. The old instinctive protectionism has subsided. Two big areas for work remain. First, all customs duty rates are not yet at zero. And, we have one big gap: the lack of a proper GST, through which we would get to residence-based taxation. The GST on imports would be charged on imports, giving parity between a factory just inside the border and one just outside. And, the zero-rating of exports would mean that the GST burden suffered by a non-resident is refunded to him. The fundamental law of tax policy in this age of globalisation is: You do not tax non-residents.

Does this mean that we're in good shape on trade liberalisation? No. The big gaping problem is trade in services. Most of world GDP and India's GDP today is services. Even if we do full free trade on agricultural and non-agricultural goods, that only covers 40% of GDP. The real story of international trade is now in trade in services.

With trade in services, old-style Indian protectionism reigns. For the first time now, we have some hard data on this. The World Bank has released a `Services Trade Restrictions Database' which measures protectionism in services across the world. To get the story about what was done, read the voxEU column by Aaditya Mattoo, Ingo Borchert and Batshur Gootliz. Here's the key picture:

The graph puts per capita GDP (in log scale) on the x axis and the measure of barriers to services trade on the y axis. Values of 0 imply perfectly open and values of 100 imply perfectly closed. The regression line shows us that by and large, when countries get richer, they reduce restrictions. The score goes down from roughly 40 (on average) for the poorest countries to roughly 20 (on average) for the richest ones.

India sticks out as an outlier, with a score of above 65.7. We are more restrictive than Iran. Only Ethiopia is more restrictive than India, among all the countries of the whole world. Here is some more detail about what is going wrong:

This shows us the variation of India's restrictions by sub-sectors and by modes. While there is some variation, it is all appallingly bad. If we only got to the conditional mean for the Indian level of per capita GDP, we'd have to get the score from 67.5 to roughly 37.5, which is a big decline. And there is no reason to stop there; we need to eliminate protectionism far beyond what's seen in the conditional mean.

To be open to trade in today's world is to be open to trade in services, given the preponderant share of services in GDP. What we are doing is profoundly wrong. We always had an instinctive sense that India does worse on trade in services when compared with trade in goods. The World Bank has made a great contribution by building a comparable database across countries, to give us a concrete sense of where we are and how bad things are.

If we want to harness gains from trade in goods, we have to open up to trade in services also. Finance, transportation, and other services are the vital glue that makes trade in goods possible. Our mistakes on services trade liberalisation are holding back our gains from trade in goods also.

You may like to also see older blog posts: Globalisation: the glass is half empty, 28 January 2011, and Getting to a liberal trade regime, 15 December 2009.

Developments on implementation of the GST

by Viral Shah and Ajay Shah.

As with many other problems in Indian economic reform, getting to the right destination on the GST requires winning on policy, politics and administration. On the policy side, the basic design of the GST needs to be done right. Pulling this off will require great political skill - a coalition of beneficiaries from the GST will need to champion it in the Indian federal setting. Finally, assuming that the policy and the politics has been done well, it will require the right plumbing. In this blog post, we review progress on this third element.

Done right, the GST ought to replace all existing indirect taxes. This would remove barriers to inter-state commerce, and create an Indian common market. It should treat all goods and all services identically. It should be a single administrative system covering tax payments to both Centre and States thus eliminating the compliance cost that is associated with dealing with multiple tax authorities. It should be globalisation-compatible: goods and services sold to non-residents would be fully refunded the entire burden of indirect taxation that has been incurred at all stages of production. India would then follow the principle of not taxing non-residents. This would be fair for domestic producers who face foreign competition, and ensure competitiveness of domestic producers selling abroad.

These are powerful and important economic concepts. However, their translation into reality is critically about execution. In the case of the GST, as with the New Pension System, the problem of execution is substantially (though not entirely) a question about building large IT systems.

While much of the legal and policy framework around GST is still being worked on by the Central Government in consultation with States, some progress has been made on setting up the infrastructure for processing registration, returns, and payments in a standardised manner. A detailed note on the IT infrastructure for GST has been put up by the Ministry of Finance.

In terms of organisation structure, existing success stories include the Tax Information Network (TIN) and the New Pension System, both of which are being managed by NSDL. A more general concept of `National Information Utilities' (NIU) was proposed by the TAGUP Report. This report drew on the success of establishing market infrastructure institutions such as NSE and NSDL, and recommended that NIUs be such non-Government companies, with Central and State Governments as joint shareholders, dispersed shareholding among other institutions, avoiding shareholders that may have a conflict of interest, and avoiding listing on exchanges. In spirit, NIUs must have the efficiency of a private corporations, but be animated by a public purpose.

In the Budget Speech of 2012-13, the Finance Minister announced that a NIU for implementing the GST would be constructed. It would be called GSTN and would be fully operational by August 2012. The first steps towards constructing GSTN have now been taken, with a Cabinet approval for GSTN. The official press release on this says:

The Cabinet has approved a proposal to set up a Special Purpose Vehicle (SPV) namely Goods and Services Tax Network SPV (GSTN SPV) to create enabling environment for smooth introduction of Goods and Services Tax (GST). GSTN SPV will provide IT infrastructure and services to various stakeholders including the Centre and the States. 

The GSTN SPV would be incorporated as a Section 25 (not-for-profit), non-Government, private limited company in which the Government will retain strategic control. It would have an equity capital of Rs. 10 crore, with the Centre and States having equal stakes of 24.5% each. Non Government institutions would hold 51% equity. No single institution would hold more that 10% equity, with the possibility of one private institution holding a maximum of 21% equity. 

GTSN SPV would have a self-sustaining revenue model, based on levy of user charges on tax payers and tax authorities availing its services. While the SPV's services would be critical to actual rollout of GST at a future date, it is also expected to render valuable services to the Centre / State tax administrations prior to the GST implementation.

Better execution of complex IT systems in government

The TAGUP report has been released. For the background, see the creation of the group and this blog post. The ideas of the report could give a quantum leap in the execution quality of five projects of tremendous importance -- the Goods and Services Tax (GST), the Tax Information Network (TIN), the Expenditure Information Network (EIN), the National Treasury Management Agency (NTMA) and the New Pension System (NPS). In all these areas, political consensus has been achieved but the execution has floundered. More generally, these recommendations add up to an important fresh look at how to modify the ground rules of public administration in India, so as to better cope with the sorts of challenges that are now being faced.

Update (5 May 2011): Movement on implementation of TAGUP. 

Geniuses and economic development

by Ajay Shah.

On VoxEU, there is a fascinating article titled China and India: Those two big outliers by Jesus Felipe, Utsav Kumar and Arnelyn Abdon.

The interesting fact that they highlight is that both India and China are wise beyond their per capita GDP when it comes to the sophistication and diversification of their exports.

The evidence that they show, on the change in export diversification, is quite striking:

	China	India
1962	105	71
2007	265	254
Change (times)	2.52x	3.58x

In India's case, in 1962, in the depth of India's autarky, there were 71 commodities exported with `revealed comparative advantage'. By 2007, this number had gone up by 3.58 times. Both China and India are outliers (with excessively high values seen for export diversification) when compared with other countries at the same level of per capita GDP on a PPP basis.

Explaining the unusual export diversification

One element of the explanation of diversification is sheer size. Continental India has a diverse array of locations. Coastal Gujarat is a good location for processing crude oil for export, and Bihar is a good place for growing Litchis for export. By aggregating both places into a single country, we get high levels of export diversification. A casual examination of their graph (Figure 2) makes me think there is some support for this conjecture - positive outliers in the graph are big countries like the US and Germany; negative outliers are small countries like Ireland and Finland.

Explaining the unusual export sophistication

Why does India do sophisticated export, well beyond what one would expect for its level of per capita GDP?

1. Sheer size matters. Consider the distribution of a certain specific kind of knowledge across individuals in the country. Suppose you set a high cutoff for the minimum knowledge required of that field in order to assemble a large sized firm. So if you want to build a large sized firm in that field, you need to recruit 1000 people who have this specialised knowledge in excess of this cutoff. In a country of 1.2 billion people, you have more draws from the same distribution. So even if the lay of the land is quite bad in the sense that most people have bad knowledge, the sheer size of the country enables the establishment of firms which require building groups with high end specialised knowledge.
   Consider the distribution of IQ. One in a thousand people have an IQ of above 146. To help fix your intution, it appears that GRE V+Q of 1450 is roughly IQ=146. In India, with a population of 1.2 billion, we have 1.2 million of them. These 1.2 million very smart people in the country can serve as a core around which extremely high quality firms can be built. These effects are accentuated by increasing returns to scale, and the operation of Metcalfe's Law, in the gains from interaction and competition between these people within a country.
2. There is an odd upper tail in Indian human capital. Looking back 100 years ago, there has been a bizarre upper tail of very highly skilled people in India. Think Ramanujan: by rights, you would have never expected that kind of incredible knowledge to be found in a place like India. But pre-independence India managed to have incredible geniuses like Ramanujan, C. V. Raman, S. N. Bose and C. R. Rao -- well before the post-independence push that created the IITs. Is this merely about size (a lot of draws) or was there actually a bizarre upper tail?
   On this subject, see India shining and Bharat drowning: comparing two Indian states to the worldwide distribution in mathematics achievement by Jishnu Das and Tristan Zajonc. Some fascinating estimates are shown in Producing superstars for the economic Mundial: The team in the tail by Lant Pritchett and Martina Viarengo, who estimate the number of 15 year olds in a country with a OECD PISA score of above 625. The US is estimated to have between 240,000 and 270,000 individuals in this rarefied zone. India has (a) A lot of people, (b) An abysmally poor mode, and (b) A strange upper tail. Putting these together, they estimate India has 100,000 and 190,000 individuals in this rarefied zone - which is incredibly impressive considering that the Indian per capita GDP is one-thirtieth of that seen in the US. This also tells me that we need to scale up the universities in India so that atleast 200,000 individuals each year: it's a shame underutilising these kids.

Aside: PISA > 625 is a much weaker condition than IQ > 146.

Some people bemoan the inequality of human capital that is found in India, i.e. the huge gap between this upper tail and the modal value. But given that we have a low per capita GDP, would we rather have equality where everyone has low skills, or would we rather have an incredible upper tail in the distribution of knowledge, that is able to learn new technology, plug into globalisation, and power the country along?

This is also related to Albert Hirschmann's theme of unbalanced growth: he had argued that growth involves developing an `unbalanced' capability (e.g. India and the software industry led by a small core of high end capabilities), and then harnessing the benefits of the catchup by the rest of system (e.g. telecom reforms, mass scale computer programming education, broad business skills in running globalised firms out of India).

In a recent NBER working paper, Eric A. Hanushek and Ludger Woessmann offer interesting evidence about the tradeoff between `rocket scientists or basic education for all'. They say:

Both the basic-skill and the top-performing dimensions of educational performance appear separately important for growth. From the estimates in column 3, a ten percentage point increase in the share of students reaching basic literacy is associated with 0.3 percentage points higher annual growth, and a ten percentage point increase in the share of top-performing students is associated with 1.3 percentage points higher annual growth

....

the effect of the top-performing share is significantly larger in countries that have more scope to catch up to the initially most productive countries (col. 5). These results appear consistent with a mixture of the basic models of human capital and growth mentioned earlier. The accumulation of skills as a standard production factor, emphasized by augmented neoclassical growth models (e.g., Mankiw, Romer, and Weil (1992)), is probably best captured by the basic-literacy term, which has positive effects that are similar in size across all countries. But, the larger growth effect of high-level skills in countries farther from the technological frontier is most consistent with technological diffusion models (e.g., Nelson and Phelps (1966)). From this perspective, countries need high-skilled human capital for an imitation strategy, and the process of economic convergence is accelerated in countries with larger shares of high-performing students.

Many countries have focused on either basic skills or engineers and scientists. In terms of growth, our estimates suggest that developing basic skills and highly talented people reinforce each other. Moreover, achieving basic literacy for all may well be a precondition for identifying those who can reach “rocket scientist” status. In other words, tournaments among a large pool of students with basic skills may be an efficient way to obtain a large share of high-performers.

On a related note, it is very, very hard to create high end skills when starting from scratch. Witness the difficulties faced by China which had to start from scratch after destroying the elite in the Cultural Revolution. When the economy is ready with demand for a particular set of specialised skills, it may take decades to fill these gaps. As an example, by the late 1980s and early 1990s, it was obvious that there is a giant opportunity for India in software exports and in BPO. But it took 10 years for the education system to re-engineer itself to produce these skills in large quantities, and then make possible large numbers for IT/ITES exports. In similar fashion, the NDA got going on raising expenditure on infrastructure by 2003, but last month, Vikas Bajaj has an article in the New York Times about shortages of civil engineers. It is convenient, in economic development, to have a pre-existing base of high-end skills ahead of time, before the phase of high growth arrives.

Size and economic development

The argument in this blog post has emphasised size. There are many other good things about size, such as economies of scale in the domestic economy, and paying for the fixed costs of global firms in learning about a country in order to do business in it.

If size is such a good thing for economic development, why has it failed so far: as of 2010, why are India and China far behind OECD levels of per capita GDP?

One key story lies in globalisation. Big countries feel they can get away with autarkic policies. They feel self-sufficient and are prone to cut themselves off from the world. Policy makers in small countries don't think they have a choice in trying to create a domestic car industry, but their counterparts in places like Brazil or India or France feel they can experiment with industrial policy. Once this problem is solved -- as seems to be partly the case with India and China where trade liberalisation has arrived though capital account liberalisation has not -- big countries are no longer held back by autarkic policies. In addition, plugging into globalisation, by itself, yields world scale, and thus boosts certain dimensions of size.

Another story, emphasised by Lant Pritchett, lies in the extent to which India is not a single common market, and has thus squandered these potential gains from size. Conversely, as we strip away the legal and tax impediments against intra-India movement of goods, services, capital and labour, and as we bulk up on the infrastructure of transportation and communications, we will obtain returns to size which were not visible in the pre-2000 Indian GDP data.

Finally, on the role of size and sophisticated technological civilisation, see Insufficient data on Charlie's Diary.

I am grateful to Lant Pritchett, Jishnu Das, Pratap Bhanu Mehta, and Josh Felman for comments and improvements on this post.

Implementing the GST

For many years, India has been in a slow processes of evolving towards a dual centre-state GST. The rough picture is one with two distinct but harmonised taxes, which have an integrated IT system so as to sharply reduce compliance costs. A key dimension is that of properly integrating domestic taxation with international trade in goods and services, by zero-rating exports (thus exempting non-residents) and by charging the GST upon imports (thus taxing the full consumption of residents).

This process has faced two challenges: politics and administration. On the political side, the puzzle lies in having enough states sign up into a system where all taxes other than the GST are abolished, and where firms face an integrated nationwide administration. This would enable a unified Indian common market. Things seem to be going badly on that front.

The administrative challenge is one of project management. The Indian policy landscape contains many important ideas where the political hurdles have been crossed, but where execution has been lacking.
Today there is news of a concete project management strategy for the GST: see this story by Surabhi Agarwal in the Mint. So while there might be many failures on the political side of the GST, atleast we now know that there will be some coherent project management which will yield a working GST system within a year or two.

The idea of bringing NSDL into this problem is not new. Ever since the Tax Information Network (TIN) was built by NSDL for the income tax department, it was well understood that handling of VAT credits is much like handling of TDS. In 2004, the Task Force on Implementation of the FRBM Act, chaired by Vijay Kelkar, had said in the executive summary: ``Hence, the Task Force recommends that the existing TIN and OLTAS systems, developed by CBDT, should be used for the implementation of the GST, both at the Centre and at States.'' We wasted a lot of time in getting to this destination, but while the wheels grind slow, they have ground true. When NSE and NSDL came about in the early 1990s, we had little idea about the far-reaching consequences of what was coming together.

Also see: M. Govinda Rao in the Business Standard.

Addressing the problems of Rupeezone

While everyone is pondering the ways in which Eurozone is not an optimal currency area, I found myself worrying about the ways in which Rupeezone is not an optimal currency area. In the Financial Express today, I have a column: Addressing the problems of Rupeezone.

Here are interesting materials on Greece which set the stage for this:

• A money too far by Paul Krugman, in the New York Times.
  
• A response by Greg Mankiw on his blog. He refers to this AER article from 1986 by Christine Romer, and this article by Christopher Hanes in AER in 1993.
  
• A response by Paul Krugman on his blog.
  
• A blog post by David Beckworth.
  
• On the subject of labour mobility, Casper van Ewijk and Michiel van Leuvensteijn have an important column on voxEU making the link between labour market mobility and the transactions taxes which governments impose on real estate transactions.
  
• Here is a column by Feldstein on these issues back in 1998.
• Greek lessons for India, in the Business Standard, by Suman Bery.

This is an interesting demo of how economics happens today: an interleaving between journal articles, newspaper columns and blog posts.

Building the perfect GST

The 13th finance commission has released the report of the task force on the GST. Here are some responses:

• Let's design a good GST, an editorial in the Economic Times.
• The Economist.
• M. K. Venu in Indian Express.
• Satya Poddar and Sukumar Mukhopadhyay in Business Standard.
• Anil Padmanabhan and S. Narayan in Mint.
• Editorial in Financial Express.
• Tina Edwin and Gautam Ray in the Economic Times.

There are three huge and complex projects which are afoot in India today, each of which is of critical importance in transforming the landscape. They are: the Goods and Services Tax (GST), the New Pension System (NPS) and the Unique Identification (UID).

A lot of what I know about pension economics comes from David Lindeman, and he often quoted Larry Thompson in saying that such reforms involve three dimensions of effort : policy, politics and administration. Each of the three has to work out right in order to obtain success. If any one of the three goes wrong, then the overall outcome is attenuated.

With the NPS, we have made enormous progress on the politics and policy, but are weak on implementation. The GST faces political difficulties and it is not clear that the policy thinking will be done right. But the moment these early stages are crossed, the brunt of the problem will become administration. With the UID, there seems to be political support (so far), and the challenges are of making the right moves on policy and administration.

Bringing Nandan Nilekani to run UIDAI is an important step forward because it shows a recognition that the administrative challenges of these systems are unlike business-as-usual in government. These are complex IT systems, and require a new kind of execution punch in terms of rolling out complex nationwide IT systems. Similar thinking needs to be brought to bear for NPS and GST also.

Till date, the best success of a large complex system of this nature is the TIN. That was a problem which was all administration - it did not involve complex problems of politics and policy. However, it has proved a certain model of how to get this done (by contracting-out to NSDL using a certain kind of contract structure).

On large complex IT systems and their impact on India, you might like to see: Improving governance using IT systems, page 122-148 in Documenting reforms: Case studies from India, edited by S. Narayan, Macmillan India, 2006.

Update (February 2011): IT strategy for GST.

Responding to the new direct tax code

Mukul Asher & Amarendu Nandy and S. Narayan have interesting responses on the new direct tax code. I have two areas of disagreement with the new direct tax code: on the treatment of capital income and on the issue of non-interference with globalisation.

Policy responses to India's economic slowdown

What might come next in the Indian economy?

India is more integrated into the world economy than ever before. In 2000, goods and services exports were roughly 12% of GDP. Today, they are at roughly twice this number. Gross flows on the BOP (summing across the current account and capital account) were roughly 50% of GDP in 2000. Now they are at 125% of GDP. As these numerical values suggest, the pace of change on India's integration into the world economy has been quite dramatic. This increased integration into the world economy means that global shocks affect India more.

Turning to the global economy, the depth and international co-movement that we are seeing in this business cycle downturn is worse as compared with prior experience.

We are thus faced with an unprecedentedly large shock hitting an unprecedentedly integrated economy. The impact of this external shock will hence be unprecedented. We are in new terrain here. Our intuition has been shaped by the past 20 years. But this intuition is a poor guide to optimal decision making at the level of a firm or the country in the situation that we now face.

What are the channels through which the changed environment impinges on us? The first channel is reduced demand for Indian exports. The second channel is the impact on profitability of many Indian companies owing to lowered prices of their products on the world market. The third channel is the reduced investment owing to the change in animal spirits of CEOs.

Some people are emphasising financing constraints as the channel through which investment could drop. But even before you get to financing, the really important problem is about whether a CEO wants to invest or not. When the future looks difficult, CEOs undertake less investment.

Fluctuations in investment are now the big force shaping the Indian business cycle. Gross capital formation to GDP has jumped from 25% to 38% in a few years. A massive investment buildout is presently underway. Private corporate investment has fluctuated quite a bit with changes of as high as 10 percentage points of GDP in a few years. If expectations become very pessimistic, investment could drop by 5 to 10 percentage points of GDP. This would be a massive shock which would set off a business cycle downturn.

For more on the new forces shaping the Indian business cycle, see my article New issues in macroeconomic policy from last year. You will also find the first chapter `The Economy' of this book to be of interest, particularly Section 1.4.2 titled Perfect Storm?.

In short, the scenario to worry about for calendar 2009 is one where investment drops by a few percentage points of GDP because entrepreneurs are pessimistic about what the future holds.

What can monetary policy do?

The paper The current liquidity crunch in India: Diagnosis and policy response, that Jahangir Aziz, Ila Patnaik and I wrote in early October, frames the questions of monetary policy in the downturn. By and large, RBI has done all the right things on rupee liquidity. Dr. Subbarao did something new and important yesterday when, for the first time, he said that RBI will try to ensure that the call rate stays within the LAF. This will help stabilise the expectations of the bond market about the volatility of the short rate, and thus reduce the fears of banks who were otherwise hoarding liquidity.

With the latest RBI actions layered on top of what they have done in previous weeks, I think the short rate and rupee liquidity are broadly okay. The problem of rupee liquidity is broadly under control.

Monetary policy in India has the power to do damage. If the liquidity tightness of late September had continued, we could have had a run on many or all private banks. Many mutual funds could have experienced acute distress. A broad-based financial crisis could have erupted. These unhappy scenarios have been forestalled by the timely, unorthodox and effective RBI actions.

While bad monetary policy in India can do a lot of damage, there is little room for monetary policy to help counter a business cycle downturn by cutting rates (as is done in mature market economies). The reason for this is the lack of a monetary policy transmission. When the central bank of a mature market economy cuts rates, a complex and sophisticated financial sector takes the `raw material' from the money market and transforms it into enhanced asset prices across a wide range of assets all across the economy. In India, owing to the lack of the `Bond-Currency-Derivatives Nexus', this monetary policy transmission does not take place. The policy rate, expressed in real terms, has gone into negative territory but there is little likelihood of it having a serious impact on aggregate demand. The problem is not a liquidity trap; the problem is the broken monetary policy transmission.

What about the exchange rate, which can be a key element of monetary policy if it's not allowed to float? I think RBI is making some progress on getting away from pegging to the dollar. RBI doesn't release adequate data but my guess is that roughly half of the change in reserves is valuation changes. Many people have focused on the large drop in reserves (measured in USD) as a measure of RBI's attempts at currency trading. But when valuation changes are taken into account, what RBI has been doing there is smaller than it seems [link].

The bottom line is that when the Asian crisis struck, and a business cycle downturn in India was impending, India raised rates (200 bps on 16 January 1998). Exchange rate pegging led to the loss of monetary policy autonomy. This time around, the currency has been allowed to depreciate in exchange for domestic monetary policy autonomy: i.e. lowering interest rates when there is an impending downturn.

What can fiscal policy do?

Can fiscal policy help? I feel this is not the case for two reasons. First, there isn't the fiscal space. Second, the institutional mechanisms through which spending can happen do not exist. I am hence not surprised by the modest aspirations of the recently announced fiscal stimulus. Each percentage point of GDP is Rs.50,000 crore and we are discussing a drop in investment of a few percent of GDP. When it comes to movements of a few percent of GDP, fiscal policy in India is just a spectator.

In terms of automatic stabilisers, there is really only one: corporation tax. In a downturn, corporation tax will drop. At present, it is at roughly 3% of GDP. So perhaps there will be a swing of as much as 1 percent of GDP there. While this is nice in terms of getting countercyclical fiscal policy, it simultaneously makes India's fiscal position look precarious. As an example, this makes it harder for Indian firms to borrow abroad because the Indian sovereign credit rating may worsen in an environment of lower GDP growth and a bigger fiscal deficit. And in this global environment, lenders are much more careful about buying junk (which is where Indian issuers are now).

Summary: the macroeconomic policy response to an impending downturn

The textbook response to an impending downturn is to cut interest rates and enlarge the fiscal deficit.

In the past, the word `business cycle' didn't mean much in India, and macroeconomic policy never tried to do such things. It is an important milestone in India's economic history that we have a weekend in which both monetary and fiscal policy have attempted to respond to business cycle conditions. Stabilisation of the business cycle is one important task of the State in a well functioning mature market economy. We have atleast come to the point where such aspirations are starting to be heard. This is progress.

But in terms of the actual capability to stabilise, a lot is lacking. Long-standing policy blunders, particularly on prevention of a liquid bond market and a liquid currency market, have ensured that India does not have a well functioning Bond-Currency-Derivatives (BCD) Nexus. As a consequence, the monetary policy transmission is weak. As a consequence, the impact of cutting interest rates is small. Mistakes in monetary policy can do damage, and RBI has been doing the right things in helping ensure that it does not do damage. But monetary policy cannot stabilise to a substantial extent.

With fiscal policy also, we are paying for our sins of not reforming. The great business cycle expansion from 2002 onwards should have been a time to put our fiscal house in order. As Vijay Kelkar used to evangelise, the time to fix the roof is when the sun is shining. By today, we should have been holding a GST fully integrated into the Tax Information Network run by NSDL, and we should have had a central fiscal deficit of zero. That would have given us the ability to make large reductions of the GST as counter-cyclical fiscal policy. The right things were not done in the last five years. As a consequence, today, fiscal policy is largely ineffective.

Then what can be done?

A big negative shock is hitting the firms. Some of the firms are fundamentally sound but will require external finance to make it through the downturn. The most important question now is: Can external finance be delivered fast enough and to the right places?

Some of the firms are going to die. There, what would be nicest is if they free up resources gracefully and frictionlessly. By and large, the labour market (that's dominated by the informal sector) works well: firms will shed people, wages will go down, the labour will be absorbed in new places. India has a fairly classical labour market. One key thing we need to do different is to not draft speeches where Indian firms are urged to not sack people; speechwriters should instead be singing paeans to the great flexibility of the Indian economy, that even exceeds the flexibility of the US.

Turning to the assets of weak firms, what is required is good bankruptcy process, or even before that, the control transactions through which brands, factories or companies are sold. To the extent that these control transactions take place, it is best. But for these control transactions to take place, the strong firms require external financing to buy assets.

In calendar 2009 and 2010, economic efficiency will be about the extent to which a discriminating financial system is able to deliver a breath of life of external financing to the good firms (while denying finance to weak firms and encouraging and enabling control transactions for their assets). We should do everything we can to increase the ability of the financial system to play these roles.

The Indian banking system is singularly ill-equipped for this role. In 2009 and 2010, most borrowers will look bad in terms of standard accounting data. Banks in India have a bias in favour of putting investment opportunities in the hands of firms with strong cashflow in historical data. Processes of banks are oriented towards looking back in accounting data and not forward in projecting the outlook for firms. But what will matter the most in 2009 and 2010 is getting working capital and growth capital to good firms which are currently not doing well.

In the big picture, a good financial system is one that is able to deliver low correlations between the cashflow of a firm and the investment of the firm. This issue looms large in thinking about 2009 and 2010. Achieving low correlations between cashflow and investment requires forecasting the prospects of firms instead of looking back at their accounting performance; it requires loans based on future cash-flow rather than loans based on assets. It requires brainpower, organisation culture, and a regulatory environment that is not found in Indian banking. On a horizon like 2009 and 2010 I am pessimistic about achieving change on these things.

Hence, the opportunity for public policy to make a contribution in handling 2009 and 2010 lies in non-banking finance. The positive contribution that policy makers can make towards 2009 and 2010 lie on three directions.

I. Removing capital controls

Removing capital controls will directly augment external financing. By `external' here, I mean financing that is external to the firm. In addition, foreign capital tends to come through more intelligent channels of intermediation such as private equity funds or securities markets, which helps improve the quality of use of this capital.

As an aside, capital inflows will reduce the pressure on RBI to sell reserves if they succumb to currency pegging. But that's not an important issue. The really important issue is to get a financial system that will be able to deliver external financing to good firms in 2009 and 2010.

II. Financial sector reforms

The second direction is the implementation of the Patil, Mistry & Rajan reports, so as to achieve a better functioning financial system.

A few days ago, Tata Motors resorted to borrowing Rs.2000 crore using fixed deposits: i.e. direct deposit taking from households. As Piya Singh points out in The Telegraph, Tata Motors is not alone in doing this. I asked why such a 19th century structure was being used, why it wasn't just a bond issue that was being purchased by households, and the answer was: because regulations interfere with doing an unsecured bond issue.

The right way to organise this transaction is as a bond issue. As an example, in the US, unsecured debt is listed and traded on exchanges. These debentures are issued with face value of $10 or $25, with a 5-8% dividend yield. For Ford and GM, these are trading under $5. Almost all unsecured debt (e.g. AT&T, Sprint, Kraft, etc.) is now available at low prices i.e. high interest rates. Here is an example of bonds issued by GM: their share, the bond and the offer document for this bond. For more on this, go to http://www.quantumonline.com and type "XGM" into the search box. A household that believes these firms will make it through the downturn can buy this paper. Instead of households doing company deposits, this interaction should be done through public securities markets.

These are the sort of things that can and should be rapidly fixed. We need to urgently get the corporate bond market going, and solve myriad other problems on financial sector regulation, so as to get Finance in shape for performing the roles that are required of it in 2009 and 2010. As an example, there has never been a time when Chapter 7 of Raghuram Rajan's report, on the infrastructure for the credit market, was more important.

The time horizon required to make a big difference on the Bond-Currency-Derivatives Nexus, by implementing the Patil, Mistry and Rajan reports on this subject, is roughly one month. There are no difficulties in these financial reforms in terms of how voters will feel.

III. Economic reforms : the only effective counter-cyclical lever

Given that we do not hold the capability to do counter-cyclical monetary or fiscal policy, what tools for stabilisation do we have? If the root cause of our problem is the animal spirits of CEOs, and the damage that we take on private corporate gross capital formation when they lose confidence, then the most important lever that India has by way of countercyclical policy is : economic reforms. To the extent that domestic and foreign investors think that India is on the right track and that India is doing the right things, the willingness to invest will be greater.

This is both about doing the right things and not doing the wrong things. E.g. we dodged some bullets recently on issues like short selling or shutting down markets after terrorist attacks in Bombay: while wrong policy paths were carefully evaluated, in the end these paths were not taken.

I feel we have to work particularly hard on doing the right things in economic policy reform, for this is the only real countercyclical lever that we control.

It is interesting to look at this in a global perspective. There are $100 trillion of resources worldwide that are trying to get invested, and assets in numerous countries do not look so attractive. Alternatively, look at the world from the viewpoint of an Indian multinational. The prospect of expanding in many other countries is now less appealing than it was last year. In India, in contrast, the deep drivers of growth remain intact. There are very few countries which have the positive long-term growth possibilities of India. The key question is whether the State will do the right things so as to create the enabling framework of public goods to enable and support the rise of a mature market economy. If foreign and domestic investors are persuaded that India is on the right track of market-oriented reforms, investment can come about on a scale enough to matter for business cycle stabilisation.