What does the tax data tell us about the state of the economy?

by Suyash Rai.

One of the most interesting questions in Indian macroeconomics today is: how are we faring since late 2016? In this article, I seek to analyse data on tax revenues and obtain some clues about the performance of the economy.

In a press release published on January 9, the central government reported the following increases in tax collections during April-December 2016, compared to the corresponding period of previous year:

1. Central excise duty: 43 percent.
2. Service tax: 23.9 percent.
3. Customs duty: 4.1 percent.
4. Corporation tax: 4.4 percent.
5. Income tax: 24.6 percent.

These are large values. Holding other things constant, they suggest buoyant economic activity. However, when looking at tax data, we have to look at the extent to which other things are indeed constant. When analysing tax data, in order to read the state of the macroeconomy, we need to adjust for the part of the tax revenues which are on account of 'Additional Revenue Mobilisation' (ARM). Two kinds of ARM are:

1. An increase in tax rate: additional revenues due to higher rate do not indicate robustness of the underlying activity.
2. An administrative measure: additional revenues from one-time administrative measures (eg. a tax amnesty scheme) may not reflect the underlying economic activity.

Let us walk through the major taxes, and see what we can tell, and what we do not know.

Excise duty

The biggest increase in tax collection has come from excise duty. The collection during April-December 2016 was 43 percent higher than the corresponding period in 2015. Collection grew by 45 percent in April-October, 33.7 percent in November, and 34.8 percent in December, compared to the corresponding periods of previous year.

Excise duty rates during the reference period

Were the rates constant? Between April-December 2015 and April-December 2016, there have been certain changes in excise duties. Basic excise duties on these products were increased in five steps between November 6, 2015 and January 30, 2016. The detailed notifications can be found on the CBEC website. The cumulative impact of these increases is:

• Unbranded petrol: increased from Rs.5.46 to Rs.9.48 per litre
• Branded petrol: increased from Rs.6.64 to Rs.10.66 per litre
• High speed diesel: increased from Rs.4.26 to Rs.11.33 per litre
• Other diesel: increased from Rs.6.62 to Rs.13.69 per litre

Taxation of petroleum products is unfortunately the backbone of India's excise duty collection; we have failed to build a more broad-based indirect tax system. In 2015-16, the total excise duty (including cesses) collected was Rs.2,84,142 crore. From this, about Rs.1,94,061 crore, or 68.3 percent, was from crude oil and petroleum products (including cess on crude oil).

The increases in the specific rates for the four products would thus have an important impact upon the overall excise duty collections. Consider the excise duty on unbranded petrol. Since five rounds of rate increases happened between November 2015 and January 2016, when we compare collections in April-December 2015 versus April-December 2016, we are comparing periods with different applicable rates. During April-December 2015, the basic excise duty per litre on unbranded petrol was Rs.5.46 between April 1 and November 6, Rs.7.06 from November 7 to December 16, and Rs.7.36 from December 17 to December 31. However, throughout Apri-December 2016, the basic duty per litre of unbranded petrol was Rs.9.48. So, while comparing collections during these two periods, we need to deduct the additional revenue due to the higher rates.

Increase in collection during April-October

A press release on December 9, 2016 reported the indirect tax (excise duty, service tax, and customs) collection with and without ARM. During April-October 2016, the growth in indirect tax collection with ARM was 26.6 percent, while without ARM it was 8 percent. So, the total ARM was 18.6 percent of indirect tax collection during the same period of previous year. This is Rs.71,315 crore.

To the best of my knowledge, there has been no ARM in customs. ARM in service tax collections can be estimated by comparing applicable rates during the two periods being considered. During April-October 2015, the applicable rate for April and May was 12.36 percent, and it was 14 percent for June-October. So, the average rate during the period was 13.53 percent. During April-October 2016, the rate was 14.5 percent for April and May (Swachch Bharat Cess of 0.5 percent was introduced in November 2015), and 15 percent for June-October (Krishi Kalyan Cess of 0.5 percent from June 1, 2016). So, the average rate was 14.86 percent. The estimated increase in service tax collection due to ARM was (14.86-13.53)/13.53 percent = 9.8 percent of collection during corresponding period of previous year. This is Rs.11,059 crore. So, the remaining ARM, i.e. Rs.60,256 crore is estimated to have come from excise duty increases. Since the total increase in excise duty collection during April-October 2016 was Rs.66,485 crore, the increase without ARM was Rs.6229 crore, or 4.22 percent higher than excise duty collection in April-October 2015 (Rs.1,47,670 crore).

Increase in collection during November and December

During November 2016, the growth in indirect tax collection with ARM was 23.09 percent, while without ARM it was 8 percent. This suggests that, in November 2016, indirect tax collection from ARM was 15.09 percent of indirect tax collection in November 2015. This is Rs.8259 crore. Customs collections had no ARM. The effective service tax rate during November 2015 can be assumed at 14.25 percent, as half of the month had 14 percent rate (effective from June 1 to November 15, 2015) while the other half had 14.5 percent rate (0.5 percent Swachch Bharat Cess introduced on November 15, 2015). In November 2016, the rate was 15 percent (including Krishi Kalyan Cess of 0.5 percent). So, the ARM in this November's service tax collection is estimated to be (15-14.25)/14.25 percent = 5.26 percent of service tax collection in November 2015 (Rs.14,870 crore). This is about Rs.782 crore. Deducting this, we get Rs.7477 crore of ARM for excise duty in November. The total reported increase in excise duty collection in November 2016 was Rs.7477 crore. So, the increase in excise duty collection in November without ARM is estimated to have been zero. This suggests a deceleration from 4.22 percent growth in the preceding months..

Since these are nominal values, in real terms, collection may have declined in November. Excise duty becomes due at the time goods leave the factory. One did not expect any significant demonetisation impact on excise duty collection for November, as production and factory clearance schedules for the month were not likely to have been significantly affected by a decision taken in second week of the month. We saw this in the auto sector data, where November data showed a decline in sales but an increase in production, while the December data shows a decline in both sales and production. The latest IIP numbers, which show an increase in industrial production in November, also confirm this. So, the estimate of excise duty collection without ARM in November is surprising. Further, since retailers of petroleum products were allowed to accept old notes, the impact on these products should have been lower. So, to the extent increase in excise duty collection is an indicator of underlying economic activity, the news from November may be worse than expected.

It is difficult to make a reasonable estimate of excise duty collection without ARM in December, because, unlike the press release on December 9, the press release on January 9 does not include details about ARM, not even in the aggregate. When government releases December's data about excise duty collected without ARM, we can do this analysis for December.

Increase in excise duty collection (in percent)	April-Oct	Nov	Dec
With ARM	45	33.7	34.8
Without ARM (estimate)	4.22	0	NA

Service tax

During April-December, 2016, service tax collections were up 23.9 percent compared to the corresponding period last year. During April-October, the increase was 27 percent, while it decelerated to 15.5 percent for November and 3.67 percent for December. This deceleration is significant, but we need to understand the increase without ARM.

Service tax rates during the reference period

Service tax rate has been increased thrice during the reference period

1. June 1, 2015: rate increased from 12.36 percent to 14 percent
2. November 15, 2015: Swachh Bharat Cess of 0.5 percent took the rate to 14.5 percent.
3. June 1, 2016: Krishi Kalyan Cess of 0.5 percent took the rate to 15 percent

Increase in collection during April-October

In the section on excise duty, I estimated that ARM for service tax during April-October was 9.8 percent of service tax collection during the corresponding period of previous year. The overall increase in service tax collection in April-October was 26.9 percent. So, the increase without ARM would have been about 17.1 percent.

Increase in collection during November and December

In November 2016, collection increased by 15.52 percent compared to November 2015 - from Rs.14,870 crore Rs.17,178 crore. In the previous section, I estimated that about Rs.782 crore of service tax collection in November 2016 may have been on account of ARM. After deducting this ARM from collection in November 2016, the increase without ARM was 10 percent.

The increase in service tax collection in December 2016 (Rs. 22,449 crore) was 3.67 percent higher than that in December 2015 (Rs.21,655 crore). Since, the service tax rate applicable in December 2015 was 14.5 percent, while that in December 2016 was 15 percent, ARM is estimated to have led to 0.5/14.5 percent = 3.45 percent increase in service tax collection in December. So, in this estimate, the increase in service tax collection without ARM was 0.22 percent. If this analysis is correct, it shows a significant deceleration in rate of increase in service tax collection without ARM: from 17.1 percent in April-October, to 10 percent in November, to 0.22 percent in December.

Increase in service tax collection (in percent)	April-Oct	Nov	Dec
With ARM	26.9	15.52	3.67
Without ARM (estimate)	17.1	10	0.22

Customs duty

During April-December 2016, customs duty collection has increased by 4.1 percent, compared to the same period in 2015. During the corresponding period in previous year, the growth in collection was 17 percent. For November 2016, collection increased by about 16 percent. Partially, this may have been because this year Diwali was in October, while last year it was in November. Customs collections are mostly done on working days. November 2015 had fewer working days than November 2016. This effect might explain a part of the increase. Still, growth in customs collections in November was significant. This is along expected lines, as import orders usually do not get cancelled with a short notice. However, for the month of December, the customs collection was 7.6 percent lower than the same month in 2015. It is too early to say what this decline means. In the past also, there have been months when customs collections declined even when there was no obvious explanation.

Corporation tax

Corporation tax collection during April-December was 4.4 percent higher than the corresponding period last year. Last year, during the same period, the growth in corporation tax collection was 11.74 percent. Collection in December 2016 was 4.7 percent lower than that in December 2015. December is one of the months for deposit of advance taxes. This low collection may indicate that firms have revised their profit forecasts downwards. However, it is difficult to draw a conclusion, as there may be other explanations. For instance, disproportionate refunds may have been made in December. We do not have the data to draw a conclusion.

Income Tax

During April-December, income tax collection was 24.6 percent higher than that in the corresponding period of 2015. However, a key factor here is the income declaration scheme that ended on September 30, 2016, and had mandated payment of tax, surcharge and penalty by November 30, 2016. The expected tax inflow from the scheme was about Rs.30,000 crore. This is a form of additional revenue mobilisation. Hence, unless we know the increase without this ARM, it is difficult to interpret the number. For instance, if Rs. 25,000 crore was collected under the scheme, the increase in income tax collection during April-December would be just over 8.3 percent.

Conclusion

The analysis presented here suggests that the reading of tax collection numbers as signifiers of robust economic activity may be too optimistic. I have had to estimate some of the numerical values above because the data releases on tax collections have been parsimonious on details. This is especially true of the release on January 9. The consistent inclusion of details about additional revenue mobilisation for different taxes for each month would make it easier to conduct economic analysis using tax data.

Update: MR Madhavan pointed me to another source of additional collection under direct taxes this year. From this year, 75 percent advance taxes have to be paid by December 15, while till last year, this was 60 percent. This may have been a significant source of additional collection in December. So, the fact that corporation tax collections this year have been lower than they were in December 2015 is much more indicative of decline in economic activity.

The author is a researcher at National Institute of Public Finance and Policy. Views expressed here are personal.

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.

Dividend taxation in India: Need more conceptual clarity and less tinkering

by Shreya Rao

India follows a version of the `classical system' of dividend taxation, where companies pay corporate tax of up to 34.61% on their income and a dividend distribution tax ( "DDT" ) of 20.47% on distributable post tax profits.

In the last week of February, the Finance Bill, 2016 ("Finance Bill" or "Bill") introduced an additional dividend tax ("ADT") over and above these levies. The ADT applies for resident individuals, partnerships and trusts if they receive dividends in excess of Rs.1 million in a year. The rate is 10% calculated on a gross basis.

In this article, we examine the ADT and DDT from the wider lens of taxation of corporations and  dividend tax policy in India.

We start by analysing the economics: the rate applied, arguments for or against the levy and its impact on different categories of actions. We go on to legal analysis: where does the new provision fit within the legal framework, how is it drafted and will the legal form enable the levy to meet its economic objective?

My primary argument is that dividend tax policy in India is based on insubstantial economic rationale in how it determines tax rates and is fraught with legislative inconsistencies. We need to think more deeply about the rate and method of taxing corporate profits and dividends, and urgently address the legislative issues with the ADT and DDT, irrespective of whether or not we reevaluate our dividend tax from an economic perspective.

The Economic Critique

The economic analysis of taxation of dividends focuses on three questions:

1. What is the appropriate aggregate tax rate for profits earned through a corporate vehicle?
2. How should the rate derived under (a) be split between undistributed corporate profits at the company level, versus distributed corporate profits?
3. What structure should be adopted for application of the rate split derived at under (b), particularly in relation to distributed corporate profits?

Let's start with the first two questions.  What is the appropriate aggregate tax rate for profits earned through a corporate vehicle? How should the rate derived under (a) be split between undistributed corporate profits at the company level, versus distributed corporate profits?

When modern day corporate income tax systems were first introduced, one of their primary objectives was to act as prepayment of personal income taxes due by the shareholders, also referred to as the "gap-filling" function (Bird, 2002). Therefore, when corporate tax was levied, the company was chosen as the taxable unit in order to prevent potentially indefinite deferral by the individual taxable units i.e. the shareholders who existed behind the corporate veil.

To put this differently, corporate tax systems were intended to maintain neutrality between individuals investing through a company or directly, by treating both sets of persons similarly. The implications of this were twofold: firstly, profits were intended to be taxable irrespective of whether they were generated individually or through a company. Secondly, the aggregate rate on profits received through a corporate vehicle was intended to approximate the personal slab rate to the extent possible.

Table 1 provides a flavour of international experience with corporate and personal rates. This shows that the dividend tax rate is often structured in a manner that adjusts for the difference between the effective corporate tax and personal tax rates, so as to achieve neutrality between an incorporated versus unincorporated structure.

Country	Highest personal tax	Highest corporate tax	Dividend tax band
Iceland	46.24%	20%	20%
China	45%	25%	0-20%
Japan	45%	33.06%	20%
Australia	45%	30%	Credit allowed for taxes paid at company level
UK	45%	20%	7.5 - 38.1%
Greece	42%	29%	Dividends from Greek domestic companies are exempt
South Africa	40%	28%	15%
US	39.6%	35%	0-39.6%
Canada	33%	38% subject to a federal tax abatement of 10% on domestic Canadian income	Credit allowed for taxes paid at company level
Brazil	27.5%	34%	Dividends from Brazilian domestic companies are exempt
Russia	13%	20%	9%

What structure should be adopted for application of the rate split derived at under (b), particularly in relation to distributed corporate profits?


The third question relates to the specific issue of designing dividend taxes. As shown above, most countries apply some form of corporate tax on undistributed corporate profits. In addition, most provide some relief for dividends, either by taxing them at a lower rate and/or allowing credit for corporate tax. This calls for a dividend tax framework which will bridge the divide between corporate and personal tax rates. The following mechanisms are the design choices:

1. Reduced rate of tax: This method applies a lower rate of tax to dividends than the maximum marginal rate applicable to individuals. Japan (personal income tax rate of 5-45% & dividend tax at 20%), China (personal income tax rate of 3-45% & dividend tax at 20% on 50% of dividend income) and South Africa (personal income tax rate of 18-40% & dividend tax at 15%) are examples of countries adopting this system.
2. Imputation system: This method allows shareholders the benefit of corporate taxes paid by the company. Since imputation credit mechanisms are complex to administer, countries apply them either wholly or partly depending on what they find workable. Australia and Canada are examples.
3. Exemption system: Dividends are exempted from personal tax, on the basis that corporate taxes have already been paid. The exemption can either be whole or partial. The Indian dividend tax system is not an exemption system even though it exempts shareholders, because it still imposes a DDT at the company level. True exemption systems, such as the ones followed in Greece and Brazil, allow for an exemption when distributions are made out of post-tax profits.
4. Deduction system: The company's taxable profits are reduced to the extent that distributions are made to shareholders. This option evidently involves timing issues i.e. a reconciliation of the taxable year of the company and the shareholder, which is why it is not as common. Iceland currently follows a version of this system.
5. Full integration: In its most extreme form, an imputation system would disregard the tax form of the company entirely and only levy taxes at a single level (similar to how we tax partnerships, for example). This method, known as the "full integration" approach is understandably not commonly used, due to the differences in characteristics of partnerships and companies. Its application is typically limited to companies with partnership like features, such as US S-Corps or limited liability companies (LLCs). One variant of this is the exempt-exempt-tax system for the treatment of corporate profit and dividends proposed by Kelkar & Shah, 2012.

Each of these systems has its pros and cons. Exemption systems are a blunt tool and generally preferred for administrative simplicity only. Reduced rate systems are unable to consider the effective tax rate at the corporate level. Full integration systems are practically impossible to apply. A partial integration system such as imputation is therefore preferred to the extent that it is administratively feasible to match credits. One must also emphasise here that:

1. Most of the relief systems described above are in the context of distributions to individuals. Countries typically allow more relief for intercorporate distributions, recognising the cascading effect of the double tax as distributions move up a corporate chain.
2. The reliefs are likely to perform differently in a cross border context. Dividend distributions to non-residents are often subject to a higher withholding tax (as in the case of Russia or the US) while dividends received from offshore sources are sometimes exempt (as in the case of Singapore). Further, there is some discussion around how a classical system may perform better and create fewer distortions in a cross border context as compared to relief based systems.
3. Some countries may apply one or more versions of these relief systems

The Indian situation

With this backdrop, let's look at the Indian dividend tax system. Unfortunately, there is no clear answer to any of the three questions.

1. Fixing the aggregate tax rate: Until the introduction of the DDT in 1997, our corporate and dividend taxes seem to have been designed in a manner that factored in their connection to personal tax rates. However, since 2000, dividend tax rates have been increased (2000), reduced (2001) and increased (2007) again, with the ADT being the most recent addition. Their autonomous movement suggests a lack of strategy on the aggregate tax rate. Corporate and personal tax rates have remained broadly unchanged at 30% since 1997, with some variations to surcharge/cess and a couple of outlier years such as 2001.
2. Choosing a dividend tax structure : The dividend tax structure should not be seen distinctly  from the decision on aggregate rates. Our dividend tax structure followed a coherent policy so long as our aggregate tax rates paid heed to personal tax slabs, although we have tended to emphasise the importance of administrative concerns. We went from an imputation based dividend relief system prior to 1959, to a withholding credit system in 1959, to a reduced rate dividend distribution tax in 1997, each time citing administrative reasons - see the Explanatory Notes to the Finance Act 1959 and the Explanatory Notes to the Finance Act 1997 for details.
   
   In comparison, the Explanatory Notes to the Finance Act 2016 justified the levy of an ADT by referring to the vertical inequity of taxing shareholders at 15%, where those with high dividend income would have otherwise been subject to the 30% slab. The notes do not examine the issue in further detail, and the logic leaves us hanging as it does not consider the broader issues relating to corporate tax structure.

The Legislative Critique

We now turn to legal issues associated with the structure of the DDT. Since it is a company level transaction tax which exempts shareholders, it does not mesh well with the larger structure of our income tax act and international tax provisions. It results in incompatibility with treaty provisions, denial of foreign tax credit to non-resident shareholders on DDT paid in India and disallowance issues under section 14A of the Income Tax Act. These issues exacerbate the problems created by an ill thought out corporate tax rate (for example, by increasing the preference for debt over equity). Some of these issues have led people to argue that the DDT should be replaced by a dividend withholding tax at the company level.

Let's look at the incompatibility with treaty provisions, for instance. At a time when international cooperation on tax matters is taken seriously, the DDT unilaterally overrides the international tax treaties India has committed to, since none of these treaties were written with a company level transaction tax in mind. This is a demonstration of bad faith and may be also considered an abuse of pacta sunt servenda. We should note that Estonia and India are the only two countries amongst the OECD and BRICS countries that apply a dividend distribution tax instead of a traditional form of shareholder taxation. This means that we no longer fall within the purview of most double tax treaties, and have unilaterally taken a bigger piece of the pie. Estonia does not levy a tax on undistributed corporate profits though, unlike India which does. Also instructive, is that South Africa used to have a version of the DDT, known as the secondary tax on companies (STC) which was done away with to align the taxation of dividends in South Africa with the international norm.

The stacking up of the ADT over an already imperfect DDT makes matters worse -- it has lead practitioners to argue that the form of the new levy results in economic "triple taxation" (See
here, here and here). It may be tempting to pose a counter that, if the dividend tax was paid at the shareholder level, and high income shareholders were asked to pay an aggregate tax higher than personal rates, it would still result in economic double taxation of corporate profits and not "triple taxation". However, this is not a valid counter because the difference in taxable units results in legal anomalies that effectively convert the ADT into a third layer of tax. For example, a shareholder receiving dividends subject to DDT would face disallowance issues under section 14A, while the shareholder paying ADT may not necessarily be, since ADT distributions are not "exempt" under section 10(34). This difference doesn't seem to be grounded in a considered or logical basis.

A host of questions remain open. If the DDT was introduced to bring about administrative simplicity, we need to ask whether the benefit still holds with the introduction of the ADT? If not, shouldn't technologies such as e-filing and comprehensive equity ownership records at NSDL/CDSL enable us to shift to a dividend withholding mechanism without significantly adding to administrative complexity? We follow a withholding mechanism for other forms of income such as interest on securities, and there doesn't appear to be a compelling reason why it should not be possible in the context of dividends.

As a broader level comment, our tax laws seem to suffer most from myopic drafting, brought about through these piecemeal annual changes that Nani Palkhivala referred to as "precipitous tinkering". Their amendments often ignore the larger conceptual framework of tax policy, creating more confusion than an introduction of a levy should involve. We need to find ways to defend the conceptual integrity of tax policy in each year.

References

RM Bird, 2002 c.f. OECD. (2014), "Fundamental principles of taxation", in OECD., Addressing the Tax Challenges of the Digital Economy, OECD Publishing, Paris. DOI

M. Govinda Rao & Kavita Rao, "Trends and Issues in Tax Policy and Reforms in India", in Bery, Suman, B. Bosworth and A. Panagariya, (eds.) India Policy Forum 2005-06, Sage Publications, New Delhi, pp.55-121.

Vijay Kelkar & Ajay Shah, "Indian social democracy: The resource perspective", NIPFP Working Paper, 2011.

Acknowledgements

I thank Jonathan S. Schwarz for his comments on the UK and South African position, and Sriram Govind for valuable discussions. I also thank the anonymous referee for thought provoking comments.


Shreya Rao is a lawyer who lives in Bangalore.

Understanding heterogeneity in tax compliance

On 14 January 2016, we had a talk by Raymond Duch of the Nuffield Centre for Experimental Social Sciences (CESS). The title was Why we Cheat: Experimental Evidence on Tax Compliance [paper, video]. In an experimental setting, they find that high performance ("rich") experimental subjects are more likely to cheat on tax payments.

Understanding the results

I felt a key problem of the setup was the absence of coercion and punishment. Paying taxes is, at heart, about the coercive power of the State. Nobody wants to pay taxes; it is only the fear of punishment which makes you pay taxes.

I would interpret his results as saying: In a cooperative, high performance people are more likely to not pay in a fraction of their output to the common pool. The paper is about the behaviour of people in voluntary arrangements, and not tax compliance.

It perhaps suggests that a poll tax comes more naturally to humans as compared with a tax which is a fraction of the income. Imagine that you were in a cooperative: it's easier to think of everyone in the cooperative putting up Rs.X, rather than of everyone putting in x% of their income.

Heterogeneity in tax compliance

Turning to tax compliance, let's think of a simple setup where there is income $y_i$, a flat tax rate $\tau$, actual tax payment $T_i$, a $p$ probability of getting caught and a punishment $\lambda$ times larger than the tax shortfall $\tau y_i - T_i$. In this setup, the key parameter which will shape compliance is risk aversion. People who are more risk averse will comply more.

In countries where $p$ is high, the outcome will have high compliance. As $p$ becomes higher, the distribution of compliance will collapse into a point mass. When $p$ is low, and for certain kinds of distributions of risk aversion, we will get economically significant heterogeneity in tax compliance.

Low risk aversion is likely to be correlated with high performance. So we may endup with a simple correlation where high performance people are more likely to cheat on taxes. This is perhaps less spicy than meets the eye.

Tax compliance by firms in India

Consider the Indian operations of a multinational corporation versus an Indian family business. There is evidence that tax compliance by multinationals is superior. In my understanding, two things are going on.

The first is that $\lambda$ is not a constant; it is lower for Indian firms, as they are better able to manage the non-rule-of-law environment in the tax administration.

The second issue is risk aversion. MNCs tend to be very risk averse and look for safe interpretations of law. This may be related to multiple layers of bureaucracy and the principal-agent problems between the shareholder and the manager. Global compliance teams have a cover-your-ass attitude and force the local operations to play very safe. In contrast, Indian business houses tend to be take more aggressive interpretations of the law. They know this is risky and they walk into it with their eyes open.

There isn't much of a low-compliance-correlates-with-performance story here, as some of the best run companies in India (the MNCs) have the highest tax compliance. The empirical regularity actually runs in the reverse direction.

How to build a sensible tax system

I have a column in the Indian Express today on this.

Is India a hospitable environment for India-related finance

by Anjali Sharma, Kanwalpreet Singh, Rajat Tayal, Rohini Grover, Susan Thomas.

Competition in finance

There is an assumption in India that financial services and products connected with India can only exist through the aegis of financial firms and markets in India. As a consequence, there tends to be little discussion on international competition for India-related finance.

There are, indeed, elements of finance which are not amenable to international competition. For example, setting up bank branches in Nagpur is something which can only take place in Nagpur. However, for a growing class of situations, Indian customers of finance, or non-resident customers of India-related finance, now have choices:

• Indian firms can choose between raising equity or debt capital within India or abroad.
  
• Non-residents have a choice of buying the equity of Indian companies by coming to Indian exchanges (NSE or BSE), or by sending orders go to overseas venues (e.g. London Stock Exchange or the New York Stock Exchange) when Indian companies list abroad.
  
• Derivatives settled in cash can trade anywhere. Outside India, exchanges and the OTC market  trade derivatives on the rupee, on Nifty, on Indian interest rates, on India-related credit risk, etc. This gives non-residents a choice about whether orders go to India or to overseas rivals.
  

These developments have taken place over the last decade, changing the dynamics of what is possible for domestic and foreign investors. This has brought international competition to confront Indian financial institutions and systems.

This competition is good for the Indian economy. When an Indian firm is able to access debt overseas, it overcomes the limitations of the Indian credit market. This is good for India. Similarly, when an Indian firm is able to obtain equity capital overseas, overcoming the problems of the Indian primary market for equity, access to capital for India goes up. This is good for India.

When non-resident investors take exposure in Indian assets, they face financial risks such as the rupee risk, Nifty and single stock price risk. To the extent that they are able to reduce risk, this is good for India. For example, a non-resident investor who has given a dollar-denominated loan to an Indian firm, or a foreign firm who has FDI in India, should be able to reduce their risk by trading in derivatives. These include sovereign Indian credit default swaps (CDS), single stock CDS, rupee derivatives, Nifty derivatives, Indian interest rate derivatives, etc. Whether these are available in domestic markets or in competing markets off-shore, the presence of these markets encourages higher foreign participation in Indian assets.

Hence, the emergence of greater competition against Indian financial producers, which gives reduced prices and higher quality, is good for India.

Expected and actual outcomes

India has a natural edge in global competition for India-related finance. As an example, consider trading in Nifty derivatives. The information is formed in India. The most liquid market is in India, created by the trading of hundreds of thousands of thinkers, and decision makers in India. Once India is the most liquid market, this would suck in all order flow, which would help further increase the liquidity. The most reasonable outcome is one where India owns one hundred percent of the market share. However, the outcome that has come about over the last decade is starkly different.

Precise estimates of turnover are difficult to obtain. But most estimates suggest that it is reasonable to think that roughly half of the global trading in the rupee and in Nifty is now taking place outside India. In 2008, the share of the overseas market was roughly 0%. Since then, this share has gone up to roughly 50%. There is a possibility that the share of the overseas market could further increase in the days to come.

Implications: Loss of revenues in India

An order that comes to the Indian financial system induces export of financial services. A basket of revenues comes with the basic order. This includes securities broking, legal services, research, accounting and travel. All these revenues are lost when the order goes to an off-shore market such as Dubai or Singapore.

We believe that a conservative estimate of the total services revenues associated with each order is approximately 0.25%. As there is a buyer and a seller for each unit of turnover, this implies a total revenue stream associated with turnover of 0.5%. Given the extent of international competition that Indian finance faces, what is the size of the revenue at stake?

If turnover is \$1 billion per day, or \$250 billion per year, this would imply a revenue stream of \$1.25 billion per year. This is Rs.83.75 billion per year. In other words, each \$1 billion per day of overseas activity is a loss of financial services exports revenue for India of Rs.83.75 billion per year.

But how much turnover is taking place outside India? This is hard to estimate and there is no unambiguous answer. We believe the answer lies between \$10 billion to \$50 billion per day. If all this business came to India, it would yield additional financial services export revenues of between Rs.83.75 billion per year to Rs.4.18 trillion per year.

Implications: Loss of domestic market liquidity

If an order flow of between \$10 billion/day and \$50 billion/day were added to domestic financial markets, this would yield a quantum leap in market liquidity and market efficiency. The reduced capabilities of domestic financial markets is the second consequence of the loss of market share. This may have an adverse impact for India that is even greater than the headline grabbing figure for the loss of export revenues.

Tackling the problem of the loss of market share

In June 2013, in recognition of the importance of the problem as one requiring research analysis and policy responses, the Ministry of Finance setup a `Standing Council of International Competitiveness of the Indian Financial Sector'. The Standing Council is chaired by the Secretary of the Department of Economic Affairs. IGIDR FRG has been the technical team for the Standing Council.

On 7 September 2015, the Standing Council released Volume 1 of its Report. There is likely to be a Volume 2 that follows shortly after. The Standing Council is likely to establish a rhythm of work where it is continuously watching the space of international competitiveness of the Indian financial system, and making recommendations with remedial actions to the Ministry of Finance.

The Standing Council has diagnosed four classes of problems which have generated this loss of market share of the onshore market.

1. Problems in domestic financial regulation. In many situations, there are flaws in domestic financial regulation which are harming the onshore financial system.
   
   
2. Taxation. The global financial system sends orders to financial centres which have `residence-based taxation', where non-residents are not part of the tax base as seen by the local authorities. Apart from the Mauritius treaty, this is not how India works.
   
   
3. Capital controls. The global financial system sends orders to financial centres where the frictions are minimal. India's capital controls actively introduce friction which deters financial services exports.
   
   
4. Unpredictability of policy changes. In a mature market economy, there is a consistent economic policy philosophy shaping policy pathways. In a mature market economy, rule of law procedures are used when changing laws or regulations. These two features create predictability about changes in policy. India suffers from flaws in both respects. As a consequence, market participants are frequently suprised by unexpected changes in policy. This enhanced political/regulatory risk deters investments in building organisational capital. It is safer for a global financial firm to build an INR derivatives business in a place like Singapore or London, rather than committing resources to build that same organisational capital in Bombay.
   
   

Looking forward

The ongoing process adopted by the Standing Council is to render policy advice to the Ministry of Finance, through which these four classes of problems can be addressed. This line of thinking constitutes one more impulse to undertake deeper reform of Indian finance.

Witch hunt against PNs considered harmful

by Susan Thomas.


A slightly different version of this appeared in the Indian Express today.



The Supreme Court appointed SIT on black money has asked that the ultimate beneficiary owner of every Participatory Note (PN) be traced. This brings back an old mistrust from nearly a decade ago, which careful examination suggests is misplaced. PNs help India better integrate into the global financial system. When India fixes her financial systems to become more competitive, these very PN customers will bring their business onshore.

What are PNs? PNs are one way that international investors can invest in Indian assets today. When this investor wants to invest in an Indian firm, they buy a contract from financial firms in their country. In turn, these financial firms may either choose to invest in the Indian asset. Or they can ``replicate'' Indian returns by doing financial engineering using other securities.

The investor buys a PN from a SEBI-registered Foreign Porfolio Investor (FPI). Let us call this registered FPI a "PN seller". Many times, one firm comes to buy a contract from the PN seller, and at the same time another person comes to sell it. The PN seller makes money charging fees to both. No back-to-back transaction takes place in India. The PN seller is "running a book". Sometimes the PN seller sells 100 to one person and buys 80 from another. This leaves an imbalance of 20 on his book. This net imbalance shows up as a trade in India when the FPI sells the security. This imbalance is reported as PN trades to SEBI. The PN seller is continuously selling contracts to end-users and adjusting his position in India reflecting the net imbalance. There are a number of such PN sellers in the world. Their activities are good for India because they connect the world of global finance into India.

So, PNs are a reflection of the world investment community's interest in Indian assets. When India grows, this interest will grow. The puzzle with PNs is why they exist at all. Why does the international financial investor buy a PN and not come into India directly? As with everything in finance, it about getting the best (lowest) price. There are several mistakes in Indian policy where directly trading in India means a higher price.

Three policy mistakes

India has a policy mistake in the form of the securities transaction tax (STT). Trades on Indian exchanges are charged the STT. There is no such cost for the global investor when they buy from their domestic financial firm. PN sellers are domiciled in places like London, New York or Singapore, where tax policy is done correctly and transactions are not taxed. Since the PN seller only sends his net imbalance as trades to India, the burden of the STT is lower. So customers send their orders to PN sellers.

India has policy mistakes in the form of taxation of non-residents, other than the Mauritius/Singapore channel. Some foreign investors invest in India through Mauritius or Singapore to achieve residence-based taxation. Others send their business to PN sellers, who are domiciled in places like New York, London or Singapore, where financial activities of non-residents are tax exempt, and have worked out Mauritius/Singapore vehicles to do trades in India. Hence, the PN business is helping India obtain non-resident participation in the economy, by avoiding the consequences of our flawed approach to taxation of non-residents.

India has policy mistakes on capital controls. For example, India makes it difficult for anyone to take a position on currency futures in excess of $15 million. PN sellers are domiciled in places like New York, London or Singapore, where financial regulation makes no such mistakes. By buying from a PN seller, the customer avoids this problem.

Hankering after the ultimate beneficial owner

Indian authorities want to know the ultimate beneficiary of a PN transaction. This is incorrect for three reasons.

1. The PN related trades in India are a reflection of a net position between all buyers and sellers, it is impossible to ask who exactly is the ultimate beneficiary owner.
   
2. It is when an investigation starts, that the regulator has the ability to trace the links of the chain. This suffices for regulators in 33 of the FATF signatory countries, alongside India. India is the only country asking for information about the ultimate beneficiary owner at all times.
   
3. Insisting on the knowledge of the ultimate beneficiary owner will likely cause a push-back against India's attempt at extra-territorial jurisdiction. If a person in India buys a derivative in India and sells it to an investor in London, India does not have the right to ask about the London investor unless in the context of an investigation, and in cooperation with the authorities in London. Strong arm tactics for unreasonable information requests will drive up the cost of doing business in India. This is not in our interest.
   

Conclusion

To conclude, Indian regulators and Indian tax authorities, amongst others, have long expressed concerns about PN. A better understanding about how the PN market serves India's interest shows that this concern is misplaced. This market provides a valuable service by giving global investors a lower cost channel into Indian investments. Without this market, the cost to the global investment community in Indian investments would go up, their engagement with India would go down. This is not in India's interest. If we do want better knowledge about the beneficiary owner, we would do better to reform our tax policy, our capital controls and our financial regulation to bring the business directly into India. This would be far more effective in strengthing our regulatory control, without hampering much needed global investments into India.

Abolishing taxes

by Ajay Shah.

The BJP has started asking fundamental questions about fiscal policy. If we're willing to flirt with iconoclastic ideas, there are good foundations for two propositions:

1. It would be wise to cut total expenditure of the government to 12% of GDP.
2. There are only two sensible taxes -- income tax on individuals, and GST. All other taxes should be eliminated.

That leaves the problem of building sound tax policy and tax administration through which the income tax on individuals and the GST are setup, that yield revenue of 12% of GDP.

Let's start at expenditure. The golden age of the UK was from 1865 to 1914. In this period, the UK had price stability, the world's strongest army, good law and order, good courts, parks, clean water, a Metro system in London, and so on. They had world class public goods. Roughly speaking, the UK govenrment did all this while spending 10% of GDP. This gives us one objective benchmark: All you need, to deliver a comprehensive array of world class public goods, is 10% of GDP.

That leaves redistribution or subsidies. In the golden age of the UK, there were no subsidies. In India, we believe that we should help the poorest 20% of the population. This can be setup as a cash transfer costing 2% of GDP. If we are willing to spend 2% of 2014 GDP on delivering cash to 20% of the population, this pays for a subsidy of Rs.150 per household per day. This will eliminate the extremities of poverty.

The government of India does a lot of things in the name of poor people. We would gain much by shutting all of them down, and replacing them by this cash transfer. The government of India also does lots of things which are not public goods. We would gain much by shutting all of them down. That leaves a required expenditure outlay of 12% of GDP.

How do we obtain 12% of GDP? We need a tax system that would yield 12% of GDP. The puzzle lies in doing this at the lowest possible distortion of the economy. The distortion caused by a tax goes up sharply when the rate is raised, in proportion to the tax rate squared. An income tax rate of 20% is four times more distortionary when compared with an income tax rate of 10%. For this reason, it would make sense to have two taxes: the income tax on individuals and the GST. By having two taxes and not one, each rate can be lower.

All other taxes in India are mistakes; they impose terrible distortions and should go. These include customs duties, octroi, electricity duty, transaction taxes, stamp duty, etc. An important candidate for this bonfire of the taxes is taxation of corporations. All corporations are owned by individuals: If we just taxed individuals, we would tax all income once. The entire attempt at taxing corporations is conceptually a mistake and is worth eliminating.

We would gain a lot by getting rid of all these taxes and their commensurate tax administration capabilities. But we will need to build top quality tax policy and tax administration for the income tax for individuals and for the GST. Every individual would have to deal with exactly one tax man -- to pay income tax -- and it would be a low rate. Every firm would have to deal with exactly one tax man -- to pay the GST -- and it would be a low rate.

It is valuable to obtain income tax from a very large number of individuals in the country. This makes possible a lower tax rate. As the distortion associated with a tax goes up as the tax rate squared, it is good to go down to a lower rate. In addition, when most adults in the country pay taxes, this improves the political economy: people who pay taxes are more careful in the expenditure programs that they ask for. In contrast, people who pay no taxes are likely to blindly support more profligacy as they are not paying for it.

For more on the tax system, see this paper by Vijay Kelkar and I.

If there is an appetite for first principles thinking, then, there is a lot of appeal in this platform: (a) A cash transfer where 2% of GDP is gifted to 20% of the population, (b) Create public goods by spending 10% of GDP, (c) Obtain 6% of GDP through a low income tax rate applied to 66% of adults, (d) Obtain 6% of GDP through a low GST rate, that is applied on 200,000 firms, (e) Remove all other taxes and (f) Remove all existing subsidies.

Every State requires tax resources. When a State has no tax base, it is down to exactly two sources of revenue: seignorage and the inflation tax. The inflation tax generates rapidly spiraling hyperinflation. When people mistrust the rupee and switch to gold or dollars or bitcoin, this hurts seignorage revenues. In history, every State that failed to build a tax capability has collapsed, and generated a social and political catastrophe.

It is easy to make fun of the BJP or AAP who are asking basic questions. There is value, however, in asking first principles questions, and in being willing to say that the emperor has no clothes. We will go far in public life in India if we are constantly willing to challenge the foundations of what is being done in public policy, for most of what is in place is based on bad thinking.

The investment technology of foreign and domestic institutional investors

Ila Patnaik and I have a recent paper in the Journal of International Money and Finance on the investment technology of foreign and domestic institutional investors.

The question

Do the firms chosen by FIIs do well? What is the stock market performance, and the operating performance, in the period after a firm has been selected for investment by FIIs?

This is an important question for many reasons. Investors (both foreign and domestic) would like to know the information content of seeing an FII or DII present in the shareholding of a firm. If, hypothetically, domestic financial regulation hampers DIIs, there may be a special role for FIIs in rationally allocating capital and alleviating financing constraints. If FIIs fare poorly in security selection, as has often been the case in the international finance literature, these mistakes have consequences for the allocation of capital and the incentives of entrepreneurs. Perhaps what India requires is policies that foster deep engagement with international capital, through which FIIs would achieve better information and thus fare better in security selection.

The opportunity for measurement

There is strong evidence of home bias: foreigners own too little of most Indian firms with an ownership of 0 for most firms. Less than a thousand companies have over 1% investment by FIIs. This is true for DIIs also. This opens up the opportunity to see how the chosen companies fare against those that were not chosen. To construct a quasi-experiment, we identify three groups of firms: 

1. Those chosen by FIIs but not DIIs
2. Those chosen by DIIs but not FIIs
3. Those chosen by neither.

On the 31st of each year, it is possible to make these three lists of firms. An examination of future performance would give us insights into the investment technology of FIIs and DIIs. Specifically, if the firms chosen by FIIs but not DIIs (i.e. Group 1) do much better than those in Group 3, then we would think that FIIs have a valuable investment technology.

Pitfalls in measurement

Institutional investors are different. Institutional investors are different from individual investors. Hence, a fair comparison is between FIIs and DIIs.

Treatment effects or selection effects or both. Why might a firm fare well after FII investment? There can be two channels. There can be a `selection effect' where FIIs identify better firms. There can be a `treatment effect' where FIIs exert governance, and push firms to behave better. Investment technology is about the overall effect, i.e. the reduced form outcome. The economists' perennial quest for separating out selection effects from treatment effects is inappropriate here.

Asset allocation versus security selection. It is well known that the firms chosen by foreign investors are different in many dimensions such as beta, size, liquidity, etc. This hampers comparison. As an example, when Nifty fares well, high beta firms tend to do well. In such times, the portfolio held by foreign investors will look good as they have loaded up on high beta firms.

In order to address this, we utilise the three Fama-French empirical asset pricing factors: size, B/P and beta. For each firm chosen by the FII (but not DII), we find the partner firm (that was chosen by neither FII nor DII) where the Mahalanobis distance in size, B/P and beta is the lowest. If a good match cannot be found, the firm is dropped. This gives us a series of pairs of firms, which are alike in size B/P and beta, where one got FII (but not DII) investment and the partner got neither.

Holding a money manager accountable for security selection after controlling for asset allocation is an old idea in finance. However, the application of this idea into the question of investment technology of FIIs and DIIs is new, as is the matching-based quasi-experimental strategy through which we control for the asset allocation.

Results

We find that the firms chosen by FIIs have exuberant growth in fixed assets in the following 3 years. But their output growth is not commensurately strong; there is some evidence of a decline in productivity. In terms of stock market performance, these firms under-perform over the three years after observation date.

Firms chosen by DIIs are strikingly different. They seem to be firms that are retrenching: both capital and labour drop slightly. But output grows. There is productivity growth. In terms of stock market performance, these firms outperform by 18 percentage points over three years.

These results suggest that foreign investors have a weak investment technology. Their access to information, and their ability to process information, adds up to poor security selection. In contrast, DIIs -- who are present in India and are likely to have ample information about portfolio companies -- fare better.

Implications

Implications for persons analysing Indian securities. A firm which has FII investment but not DII investment is probably going to grow assets but not give strong results. Conversely, a firm which has DII but not FII investment is likely to have slow growth but improve productivity and deliver stock market returns.

Implications for foreign investors. The results of this paper are about the average foreign investor, and there are surely many foreign investors who fare very well on security selection. However, on average, foreign investors need to be more cautious about their activities in India. They need to either amplify their efforts in security selection, so as to achieve strong information and information processing on Indian firms, or not attempt security selection.

How can a foreign investor improve security selection? Two paths are visible: To establish operations in India, and hold the team accountable for security selection using the methods of this paper, or contract-out to money managers who have deep roots in India.

How can a foreign investor harness asset allocation to India without attempting security selection? It is possible to setup index funds for the three Fama-French factors and thus replicate the bulk of the desired portfolio characteristics.

Implications for policy makers. Many of the pathologies of international finance are rooted in asymmetric information and the lack of deep engagement of foreign investors. These results are a reminder that even a large emerging market like India suffers from these problems. It is in India's interest to have a deep engagement with foreign capital, so as to obtain higher allocative efficiency. This suggests a re-examination at the constraints placed against deep engagement by foreign capital:

1. It is difficult for foreign investors to contract-out money management to locals.
2. `Permanent establishment' rules by the tax authorities have encouraged foreign investors to not open offices in India. This hampers deep engagement. Offices in Singapore or London will not be able to match the information and information processing that can be done in India.
3. Source-based taxation, capital controls, and taxation of transactions, give incentives for foreign investors to avoid transacting in India. It is cheaper for a foreign investor to invest through the PN and NDF markets. However, not being in India hampers deep engagement.

How might this change over time?

In my opinion, in the 2000s, a certain kind of Indian entrepreneur started producing companies that look good to foreign investors. But you can't fool all the investors all the time. I think many investors are now more circumspect. Wall Street is changing course, and this is changing incentives for entrepreneurs. When finance rewards honest businessmen, more honest businessmen will show up asking for capital from the financial system. Many years from now, we might say that the results of this paper described a moment in time in the evolution of Indian capitalism.

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.

Unanticipated consequences of Finance Bill provisions on securitisation

by Bindu Ananth and Kshama Fernandes

Over 2006-12, RBI and SEBI have created a strong and conducive regulatory environment for securitisation, listing of securitised debt instruments, and standards of transparency and reporting. Securitisation volumes have picked up and we recently witnessed the first listed transaction.

In October 2011, the income tax authorities issued a claim on certain securitisation special purpose vehicles (SPVs), stating that the gross income of such SPVs was liable to tax. The matter is presently under sub judice with the Bombay High Court. Several industry participants approached the Ministry of Finance (MoF) to seek clarity and reinforce the "pass through" status of a securitisation SPV.

The Finance Bill, 2013, has sought to clarify the tax position by stating that securitisation SPVs are not liable to pay income tax. However, the Bill also states that trustees of such SPVs must pay tax on distributed income.

The above amendment has an unintentional and significantly negative implication, on account of which taxable investors would be disincentivised from participating in securitisations.

This memo explains the issues and the unintended implications caused by the present draft of the Finance Bill in relation to securitisation SPVs, and provides a possible solution for addressing these issues.

Objectives of the MoF with respect to taxation of Securitisation SPVs

The Finance Minister (FM) in his speech presenting the Budget for the year 2013-14, set out his intent in presenting the proposed changes to the taxation of Securitisation SPVs: "In order to facilitate financial institutions to securitise their assets through a special purpose vehicle".

The depth and vibrancy of the asset securitisation market is an essential building block in transfer of risk and transmission of capital from well capitalised investors to high quality originators. The framework for a well-functioning securitisation market has been laid down in considerable detail by the Reserve Bank of India (in 2006, further strengthened in 2012) and the Securities and Exchange Board of India (detailed guidelines in 2008 and listing guidelines in 2011).

It is our understanding that the objective of the Ministry of Finance in providing the basis of taxation of securitisation SPVs, is to clarify and establish the pass-through status of securitisation.

Changes proposed by the Finance Bill, 2013

Given below is the text proposed to be introduced into the Income Tax Act, 1961 by the Finance Bill, 2013:

CHAPTER XII-EA

SPECIAL PROVISIONS RELATING TO TAX ON DISTRIBUTED INCOME BY SECURITISATION TRUSTS

115TA

1. Notwithstanding anything contained in any other provisions of the Act, any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income at the rate of--
   1. twenty-five per cent. on income distributed to any person being an individual or a Hindu undivided family;
   2. thirty per cent. on income distributed to any other person:
   Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.
2. The person responsible for making payment of the income distributed by the securitisation trust shall be liable to pay tax to the credit of the Central Government within fourteen days from the date of distribution or payment of such income, whichever is earlier.
3. The person responsible for making payment of the income distributed by the securitisation trust shall, on or before the 15th day of September in each year, furnish to the prescribed income-tax authority, a statement in the prescribed form and verified in the prescribed manner, giving the details of the amount of income distributed to investors during the previous year, the tax paid thereon and such other relevant details, as may be prescribed.
4. No deduction under any other provisions of this Act shall be allowed to the securitisation trust in respect of the income which has been charged to tax under sub-section (1).

115TB.

Where the person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust fails to pay the whole or any part of the tax referred to in sub-section (1) of section 115TA, within the time allowed under sub-section (2) of that section, he or it shall be liable to pay simple interest at the rate of one per cent. every month or part thereof on the amount of such tax for the period beginning on the date immediately after the last date on which such tax was payable and ending with the date on which the tax is actually paid.

115TC.

If any person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust does not pay tax, as referred to in sub-section (1) of section 115TA, then, he or it shall be deemed to be an assessee in default in respect of the amount of tax payable by him or it and all the provisions of this Act for the collection and recovery of income-tax shall apply.

Explanation. -- For the purposes of this Chapter,--

1. "investor" means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
2. "securities" means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
3. "securitised debt instrument" shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
4. "securitisation trust" means a trust, being a-
   1. "special purpose distinct entity" as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
   2. "Special Purpose Vehicle" as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed."

The following additions of Section 10 (23DA) and Section 10(35A) are also proposed to exempt from income tax certain income related to Securitisation SPVs:

(23DA) any income of a securitisation trust from the activity of securitisation.

Explanation."For the purposes of this clause,"

1. "securitisation" shall have the same meaning as assigned to it -
   1. in clause (r) of sub-regulation (1) of regulation 2 of the Securities an<>d Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956; or
   2. under the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
2. "securitisation trust" shall have the meaning assigned to it in the Explanation below section 115TC;"
   And
   "(35A) any income by way of distributed income referred to in section 115TA received from a securitisation trust by any person being an investor of the said trust"

Unanticipated implications of the proposed text

Securitisation of assets by financial institutions requires the existence of a wide range of investors for whom investment in Securitisation SPVs is a viable option. Currently, predominant investors in the securitisation market in India (particularly in the securitisation related to financial inclusion) are banks. Banks are sophisticated investors and sit on large pools of capital that they must deploy appropriately. Securitisation has been an important way for banks to efficiently and effectively deploy capital where it is needed.

Other investors in securitisation, such as Mutual Funds and private investors currently provide significant but far less capital through securitisation. Yet other investors, such as insurance companies and pension funds, are yet to join the market.

However, it appears that the proposed changes would make the investment in Securitisation SPVs unviable for all but a certain class of income tax exempt investors (such as Mutual Funds). To elaborate on this, given below is a brief synopsis of the tax position of an investor in such SPVs, along with that of the SPVs themselves, as well as the issues arising out of the proposed amendments in the Finance Bill:

• The current language of the proposed provision states that "any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income" but as SPVs are designed to be mere mechanisms to route payments. It is not clear how its "income distributed" will be determined for the purpose of Section 115TA.
• The language used in Section 115TA clearly indicates that the liability to pay "additional" income tax is placed upon the SPVs. It is not clear what this tax is in addition to.
• Howsoever its income may be determined, as a result of Section 14A, no deduction will be permitted for expenses out of its total income.
• Income under Section 10 (23DA) or under Section 10 (35A) is income not includable in total income.
• In terms of Section 14A, no deduction is permitted with respect of income described in Section 10 (23DA) or Section 10 (35A).
• Investors, other than "any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act", however, often do have incomes and incur expenses in raising money to invest in securitisation transactions.

Illustration:

• A bank uses Rs. 1,000 of money it has accepted as deposits at the rate of 7.5% to invest in PTCs with a principal amount of Rs. 1,000 with a term of one year.
• The PTC offers a yield of 13%, translating into a sum of Rs. 1,130 of which (assuming the taxable "income distributed" is Rs. 130) Rs. 39 will be deducted as tax in terms of Section 115TA leaving Rs. 1,091
• But the bank has to return INR 1,075 to the depositors. Under Section 14A, the interest cost of Rs 75 is not deductible
• For a pre-tax profit of Rs 55, the post-tax profit of the bank is Rs. 16 i.e. a profit of 1.6 percent. The tax paid in this transaction is Rs. 39. Effectively, the rate of taxation relative to income in the hands of the investor is over 70%.

For the investor, Section 10(23DA), Section 10 (35A) and Section 14A have an effect similar to the taxation of revenue rather than taxation of income.

On the other hand, if the investment in the SPVs was treated, as it was traditionally, as pass-through, the bank would treat the income from investment as any other income and pay tax on its net income (in the example above: Rs 130 - Rs 75 = Rs 55), with an effective rate determined by the net income of the bank, which would be far less than the 70 percent indicated by the proposed language of the Finance Bill, 2013.

Therefore, the unanticipated consequences of the present draft of the Finance Bill are:

Higher effective rate of taxation of income from securitisation, when compared to other sources of income of an investor

Tax paying investors will stay away. Banks, NBFCs etc. may not be willing to invest in securitised debt instruments, unless compensated for the higher tax payable

Severe impact on market depth and liquidity. Banks are presently the largest investors in securitisations and their absence would severely inhibit the growth of the market

No incentive for new investor classes to participate. Investors such as private wealth, corporate treasuries, AIFs etc. may find securitisation an unviable investment option

An alternative draft

It may be noted that the taxation of private trusts is well understood and has been relatively stable for a significant period of time. If we wish to avoid the unanticipated consequences as outlined above, we would require reinforcement and restatement the existing position of law.

Attention may also be drawn to the provisions of Section 160, relating to representative assessees, which would also apply to trustees of private trusts, including Securitisation SPVs. The proposed addition of Section 10 (23DA) and Section 10 (35A) should be removed and no changes must be made to Section 10 in this regard.

It may be beneficial if the proposed Section 115TA read (in a restatement of the existing law) as follows:

CHAPTER XII-EA

PROVISIONS RELATING TO INCOME FROM INVESTMENT IN SECURITISATION TRUSTS

115TA.

(1) Any amount of income received by an investor from a securitisation trust shall be chargeable to tax as part of the total income of such investor.

Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.

Explanation.--For the purposes of this Chapter, --

1. "investor" means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
2. "securities" means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
3. "securitised debt instrument" shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
4. "securitisation trust" means a trust, being a-
   1. "special purpose distinct entity" as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
   2. "Special Purpose Vehicle" as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed."

The changes in taxation of transactions in futures on equity and commodity underlyings

Taxation of transactions in India began with the equity market in 2004. Prior to 2008, the securities transaction tax (STT) was allowed as a rebate against tax liability against Section 88E of the Income Tax Act. This treatment was withdrawn by the 2008 Budget announcement. After that, STT became a substantial influence on the equity market. In understanding the consequences of the STT, there is an absolute perspective and there is a relative perspective.

In absolute terms, suppose you embark on a spot-futures arbitrage and do an early unwind. In this, you buy shares (pay 10), sell futures (1.7) and then reverse yourself (10). Your tax burden is 21.7 basis points. This is a lot of money when compared with the typical bid-offer spread of the Nifty futures which is around 0.5 basis points. The dominant cost faced in doing spot-futures arbitrage is taxation.

In relative terms, there are two issues. The first is an intra-India comparison between equities and commodities. When activity on the equity market was taxed, eyeballs and capital moved to commodities trading. Commodity futures trading has grown by 3.5 times after 2008, while equities activity has stagnated. Most policy makers think this was an undesirable effect, particularly given the fact that India can free ride on global price discovery for non-agricultural commodities but must foster liquid markets in its own equities.

And then, there is an international dimension. When the activities of non-residents in India are taxed in any fashion, they favour taking their custom to places like Singapore, which practice `residence-based taxation' where the tax base comprises the activities of residents only. We got a sharp shift in equities activity towards locations outside India.

Putting these absolute and relative perspectives together, from 2008 onwards, equity market liquidity has fared badly. This yields an elevated cost of equity capital.

The budget speech has done two things. First, it has dropped the STT rate on futures on equity underlyings from 1.7 basis points to 1 basis points. This is helpful for certain kinds of trading strategies but not for others (e.g. the spot-futures arbitrage described above will gain little). HF strategies that do not involve the spot market will particularly benefit - e.g. imagine an options market maker who does delta neutral hedging on the futures market. Second, it has introduced taxation for non-agricultural commodity futures on an identical basis to the equity futures (i.e. at 1 basis points).

This will have the following interesting implications:

1. Capital and labour in securities firms will be less inclined to be in non-agricultural commodity futures. It will tend to move towards agricultural commodity futures, currency futures and equity futures.
2. The comparison between offshore venues and the onshore market will move in favour of the onshore market for certain kinds of trading strategies.
3. The bias in favour of equity options will reduce; some business will move to equity futures.
4. The pricing efficiency of futures will go up.

In this environment, there seems to be a fair arrangement between the equity futures and commodity futures. Conditions seem to be unfair with the equity spot (too high), equity options (too low) and currency derivatives (too low). The next moves on this may appear in July 2014 when the new government unveils its next budget.

One more announcement of the budget speech concerns currency futures: it was stated that FII activity on currency futures will commence. This will also give more activity on currency futures; we now have two reasons for expecting more activity on currency futures (the taxation of commodity futures and the entry of FII order flow). However, the shifting of FII order flow will be a slow process, and a lot of time will be lost on their due diligence of the exchange, safety of the clearinghouse, and so on. While, in the long run, removing capital controls against FII order flow in India is a good thing, it is not an effect that will kick in quickly. Apart from this, most of the action will take place fairly quickly, in early April.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). Along this path, the first priority should be to remove distortions. Our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013 announcement makes progress on two things (reduction from 1.7 to 1, and reduced distortions between equities and non-agricultural commodities). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.