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GS Paper: Indian Economy

  • Lessons to learn from Vodafone ruling

    Context

    •  An Investor-State Dispute Settlement (ISDS) tribunal has ruled that India’s imposition of tax liability amounting to ₹22,000 crore on Vodafone is in breach of India-Netherlands bilateral investment treaty obligations.

    Background of the case

    • This case arose after the Indian Parliament in 2012 amended the Income Tax Act.
    • As per the amendment, income deemed to be accruing to non-residents, directly or indirectly, through the transfer of a capital asset situated in India is taxable retrospectively with effect from April 1, 1962.
    • This amendment was carried out to override the Supreme Court ruling in favour of Vodafone.
    • This amendment dented India’s reputation as a country governed by the rule of law, and shook the faith of foreign investors.

    Key lessons from Vodafone case

    • 1) All the three organs of the Indian state — Parliament, executive, and the judiciary — need to internalise India’s BIT and other international law obligations.
    • These organs need to ensure that they exercise their public powers in a manner consistent with international law, or else their actions could prove costly to the nation.
    • 2) India should learn that being a country that values the rule of law is an important quality to win over the confidence of foreign investors and international goodwill.
    • 3) It is likely that the government might challenge the award at the seat of arbitration or resist the enforceability of this award in Indian courts alleging that it violates public policy.
    •  It would mean that India does not honour its international law obligation.
    • 4) This ruling might have an impact on the two other ISDS claims that India is involved in with Cairn Energy and Vedanta on the imposition of taxes retrospectively.
    • 5) It is quite possible that India might use this award to further harden its antagonistic stand against ISDS and BITs.
    • India unilaterally terminated almost all its BITs after foreign investors started suing India for breaching BITs.
    • But the fact is that this case and several others are a result of bad state regulation.
    • 6) This decision shows the significance of the ISDS regime to hold states accountable under international law when in case of undue expansion of state power.
    • The case is a reminder that the ISDS regime, notwithstanding its weaknesses, can play an important role in fostering international rule of law.

    Consider the question “What were the issues involved in the Vodafone tax case? What are the implication of Investor-State Dispute Settlement ruling for India?”

    Conclusion

    If government is serious about wooing foreign investment, India should immediately comply with the decision.

  • Growth compulsion, fiscal arithmetic

    The government faces the challenge of high fiscal deficit and declining revenue. This article discusses the challenge and suggests the way forward to deal with the situation.

    Dismal growth prospects

    • At (-)23.9% contraction for the first quarter of 2020-21, India’s growth showed one of the highest contraction globally.
    • What is most surprising in the Q1 data is that the sector ‘Public Administration, Defence and other Services’ contracted at (-) 10.3%.
    • This means that there was no fiscal stimulus.
    • The 2020-21 real GDP growth for India is forecast in the range of (-) 5.8% (RBI) to (-) 14.8% (Goldman Sachs).
    • The OECD in its September 2020 Interim Economic Outlook has projected a contraction of (-) 10.2% in FY21 for India.

    Challenge of decline in revenue

    • Due to a sharp contraction in nominal GDP growth, central and State tax revenue, both may contract.
    • . In the first quarter of 2020-21, the Centre’s gross tax revenues contracted by (-) 32.6%.
    • The CAG-based data pertaining to 19 States show a contraction of (-) 45% in their own tax revenues.
    • Given the adverse impact of the lockdown, even the budgeted non-tax revenues are not likely to be realised.
    • The revenue calculations of the Budget were made on the assumption that the nominal income of the country would grow at 10%.
    • Some estimates indicate that the tax and non-tax revenue and non-debt capital receipts in the current fiscal may fall well short of the budget estimates by an amount higher than ₹5-lakh crore.
    • The combined fiscal deficit of the Centre and the States will have to make up for the shortfall in tax and non-tax revenues, if the level of budgeted expenditures is to be maintained.

    Challenge of widening of fiscal deficit

    • In order for the central government to maintain the level of budgeted expenditure and also provide for additional stimulus, its fiscal deficit may have to be increased to close to an estimated 8.8% of GDP.
    • If one adds the Centre’s and States’ fiscal deficit, the combined fiscal deficit amounts to 13.8% of GDP.
    • If the nominal GDP actually contracts in 2020-21, the fiscal deficit as the percent of GDP would go up further.

    Role of the RBI

    • The International Monetary Fund, in its June 2020 update of the World Economic Outlook, estimated the fiscal deficit of India and China at 12.1% of GDP.
    • India doesn’t have adequate resources to support a fiscal deficit of nearly 14% of GDP.
    • All this will therefore require substantial support from the Reserve Bank of India which will have to take on itself, either directly or indirectly, a part of the central government debt.
    • In the direct mode, the RBI takes on the debt directly from government at an agreed rate.
    • It took India long to move away from the automatic monetisation of debt.
    • Even if the RBI wants to support the borrowing programmes, it should not do so directly.
    • The indirect method is preferable as the market still sends out the signals on interest rate.
    • In both cases, the RBI is the provider of liquidity.
    • The question ultimately relates to the extent of debt monetisation that may be undertaken.
    • The country has also to guard against high inflation.

    Role of government

    • The economic situation warrants enhanced government expenditure.
    • It appears that governments are withholding expenditure. That is not the right approach.
    • At the same time, there is a limit to monetisation of debt.

    Conclusion

    Perhaps the best course of action would be to keep the combined fiscal deficit at around 14% of GDP in the current year and find ways to finance it. This will have to be brought down gradually. It may take several years of normalisation.

  • Case for principles of sound public policy

    Context

    • Due to extreme uncertainty, several adventurous prescriptions have been put forth.

    Following are 4 unconventional measures and issues with them are discussed here.

    1) Shoud we change the Inflation targeting regime?

    • Monetary policy committee (MPC) concluding that elevated inflation has constrained it from easing policy rates further.
    • One way out of this is for the government to relax the inflation-targeting framework.
    • This would involve greater tolerance for higher levels of inflation or by extending the period over which the MPC has to meet its inflation target.
    • Others have suggested shifting from headline to core-inflation as the nominal anchor of monetary policy or incorporating other indicators such as nominal GDP explicitly into the framework.
    • The more extreme ones talk about doing away with the inflation targeting framework altogether.

    Why changing the inflation targeting regime will not be helpful

    • There is a strong argument for the MPC to look beyond the current spike in inflation and ease rates further.
    • But disagreements with either the rationale or the stance of the committee members must not be construed as disagreements with the framework.
    • Raising the tolerance threshold may sound appealing now, but it will inject a degree of uncertainty and unpredictability in monetary policy.
    • Considering that anchoring expectations around the inflation target takes time, frequent revisions are unlikely to help stabilise household expectations.
    • While explicitly signalling  will be one of deviating from a rule-based framework.

    2) What we shift to Multiple Indicator Structure?

    • Such a move would bring back the situation of the pre-MPC days.
    • In pre-MPC days there was far greater uncertainty over monetary policy.
    • In pre-MPC days there was no clarity over the indicator that was dictating the stance of the RBI governor or which indicator would be given preference, and when.
    • Such proposals go against the rationale for shifting to such a framework in the first place — an inflation targeting regime.
    • Inflationg targeting regime is a well-defined anchor, is meant to facilitate greater transparency and accountability from the central bank.

    Way forward

    • There must be a concerted attempt to push for more external voices in the MPC.
    • In the UK, a non-voting treasury representative sits with the MPC to discuss policy issues.

    3) Should central bank effectively financing the Centre’s capital expenditure on a regular basis?

    •  This is problematic at many levels.
    • First, notwithstanding problems in estimating potential output, monetisation, even in the rarest of rare cases, should be the last resort.
    • Such an arrangement, risks tilting the balance of power in favour of the government.
    • Any government, owing to its short-term political imperatives, is likely to be seduced by the apparent simplicity of this idea.
    • Second, giving a central bank a degree of control over the government’s expenditure priorities is not a prudent approach.
    • Whatever be their policy inclinations and expenditure priorities, elected representatives have to face voters.
    • Why should unelected technocrats be in charge of determining the expenditure priorities of the government?
    • Such proposals blur the lines between fiscal and monetary policy and may lead to what some call the fiscalisation of monetary policy.

    4) Should government pledge its shares in companies?

    • This raises questions. Should a sovereign pledge assets to borrow in the local currency?
    • In 1991, India had pledged gold for a foreign currency-denominated loan not a local currency loan.
    • So why the collateral? And what happens if the value of the shares pledged falls below that of the loan?

    Conclusion

    Some unconventional measures may well be needed at the current juncture. But discarding the principles of sound public policy, though it sounds appealing, could end up doing more harm than good.

  • On the GST issue, the Centre must lead

    The article deal with the issue of GST compensation and analyses the various estimates of revenue shortfall given by the Centre.

    Context

    • The Goods and Services Tax (GST) Council meeting has now been deferred to the first week of October due to sharp disagreement between the States and the Centre.

    Background of GST

    • The Centre had brought the States on board GST by promising higher revenue collection.
    • States were lured by the promise of 14% annual growth in GST revenue over the base year of 2015-16.
    • Any shortfall from this (for five years) was to be compensated by levying a cess on luxury and sin goods.

    What are the options given by the Centre

    •  The transfers due since April 2020 have been withheld.
    • In the last GST Council meeting held on August 27, the Centre gave the States two options.
    • First, they could borrow ₹97,000 crore (the shortfall in the GST revenue compensation) from the Reserve Bank of India (RBI) under a special window at a low rate of interest.
    • Second, borrow ₹2.35-lakh crore (the total compensation shortfall) from the market with the RBI facilitating it.
    • The burden of repayment would be borne by the future collections from the compensation cess.
    • It was proposed that this cess which was to end in June 2022 could be extended to facilitate the repayment of the debt.

    Issues with the estimates

    • Given the uncertainty, how accuracy of the estimates of ₹97,000 crore and ₹2.35-lakh crore offered to the States is questionable.
    • When the Ministry of Finance is refusing to give a figure for growth in 2020-21, how such estimates are arrived at gains significance.

    Budgetary calculations

    • The Union Budget presented on February 1, 2020 assumed a nominal growth of 10%.
    • But optimistically, the Centre’s budgetary calculations will be off by at least 20%.
    • Revenue will fall by much more than 20%.
    •  So, income tax collection will also be short by much more than 20%.
    • The direct tax/GDP per cent may be expected to fall from 5.5% last year to less than 4% this fiscal.
    • Thus, at an optimistic guess, if the economy declines by only 10%, the total tax collection will be down by about ₹12-lakh crore in 2020-21.

    Conclusion

    As many predictions are that the economy will be down by much more than 10% used in the calculations above, the revenue shortfall is likely to be far greater. This points to the dire position of the Centre (and the States) and the inevitability of a large borrowing programme. Only the Centre is in a position to do such massive borrowing.

    Back2Basics: Two options for the GST compensation

    • Option 1 has a special window for states, coordinated by the Finance Ministry, to borrow the projected shortfall of Rs 97,000 crore only on account of GST implementation — and not the Covid-19 pandemic.
    • This amount can be fully repaid from the compensation cess fund, without being counted as states’ debt.
    • Option 2 takes into account the impact of the pandemic, proposing states to borrow the entire Rs 2.35 lakh crore and bearing the interest burden though principal will be repaid from the cess proceeds.
    • The GST shortfall amount (Rs 97,000 crore) will not be counted as states’ debt, while the rest of the amount of Rs 1.38 lakh crore will be counted in the books of the states.

    Source:

    https://indianexpress.com/article/business/economy/gst-compensation-centre-gives-states-2-options-easier-terms-for-lower-borrowing-6575499/

  • CAROTAR 2020 Rules

    The Customs (Administration of Rules of Origin under Trade Agreements) Rules, 2020 (CAROTAR, 2020) shall come into force from September 21.

    Try this PYQ:

    Q.In the context of the affairs of which of the following is the phrase “Special Safeguard Mechanisms” mentioned in the news frequently?

    (a) United Nations Environment Programme

    (b) World Trade Organization

    (c) ASEAN- India Free Trade Agreement

    (d) G-20 Summits

    CAROTAR rules

    • Importers will have to do their due diligence to ensure that imported goods meet the prescribed ‘rules of origin’ provisions.
    • This is the essential availing concessional rate of customs duty under free trade agreements (FTAs).
    • A list of minimum information, which the importer is required to possess, has also been provided in the rules along with general guidance.
    • Also, an importer would now have to enter certain origin related information in the Bill of Entry, as available in the Certificate of Origin.

    Why need CAROTAR?

    • CAROTAR 2020 supplements the existing operational certification procedures prescribed under different trade agreements.
    • India has inked FTAs with several countries, including Japan, South Korea and ASEAN members.
    • Under such agreements, two trading partners significantly reduce or eliminate import/customs duties on the maximum number of goods traded between them.
    • The new rules will assist customs authorities in the smooth clearance of legitimate imports under FTAs.

    Its significance

    • The ASEAN FTA allows imports of most items at nil or concessional basic customs duty from the 10-nation bloc.
    • Major imports to India come from five ASEAN countries — Indonesia, Malaysia, Thailand, Singapore and Vietnam.
    • The benefit of concessional customs duty rate applies only if an ASEAN member country is the country of origin of goods.
    • This means that goods originating from China and routed through these countries will not be eligible for customs duty concessions under the ASEAN FTA.

  • The way out on GST compensation

    The economic disruption due to pandemic has made the issue of GST compensation bone of contention between the Centre and the States. This article argues that it is the GST Council and not the Centre which is responsible to find ways to raise the revenue in such a situation.

    GST revenue loss and role of the Centre

    • Due to global pandemic, one significant area of loss of revenue to both the Centre and the states is GST.
    • The states have the comfort of assured 14 per cent growth through the compensation mechanism.
    • The Centre has no such guarantee.
    • The Compensation Act mandates compensating the states for revenue loss on GST implementation from the Compensation Fund.

    Role of GST Council

    • The course of action to be adopted in the event of the amount in the Fund falling short of requirements was discussed at length in the GST Council.
    • The late Arun Jaitley, then chairman, had, in the 8th meeting, assured that “in case Compensation Fund fell short of the compensation payable, the GST Council shall decide the mode of raising additional resources including borrowing from the market which could be repaid by collection of cess in the sixth year or further subsequent years”; the Council had agreed to this suggestion.
    • Quite clearly,  it is the Council and not the Government of India that shall decide the mode of raising additional resources in the event of a shortfall and this is reflected in Section 10(1) of the Compensation Act.

    Why it makes sense for the States to borrow

    • It is argued that borrowings by the Centre or by the states make no difference in the context of fiscal discipline.
    • The argument further adds that the Centre should borrow in view of its higher borrowing and debt-servicing capacity and its ability to borrow at lower rates.
    • Article 292 (1) mandates that the Centre can borrow on the security of the Consolidated Fund of India (CFI).
    • However, the idea of providing compensation to the states from the Consolidated Fund of India was not agreed to in the Council, it is difficult to agree with the suggestion that GoI borrows on the basis of the said CFI.
    • Large borrowings by the Centre would push up the bond yield rates, pushing up bond yield of the states setting off a spiral leading to hike in the interest rates for businesses and individuals.
    • The states’ borrowing would become costlier if the Centre were to borrow for this purpose.
    • The borrowing capacity of the states, too, is not very inferior.
    • The RBI study of state finances shows that the debt receipts of all the states as a percentage of GDP has hovered between 2.4 per cent and 3.6 per cent during the last four years.
    • The states have on the average borrowed just about 1.25 per cent of the GSDP thus far.
    • The states are consistently borrowing less than they can borrow (legally and financially).
    • The cost of state borrowings for this purpose can be considerably lowered if arranged through a special window.
    • The Centre has already breached the budgeted borrowing limits for the current year.
    • Thus it makes sense for the states to borrow.

    Borrowing options for the States

    • There are two ways in which the States can borrow.
    • 1) Borrowing the entire shortfall in the revenue.
    • 2) Borrowing only the shortfall attributable to GST implementation with the remaining shortfall to be made good from the Cess Fund post the transition period.
    • Certain conditionalities have been relaxed for option-1.
    • However, borrowing the entire shortfall, as envisaged in option-1, will hurt both the markets and the private sector, pushing up the interest rate.
    • The single window under option-1 being arranged by the Centre and the entire debt being serviced from future cess receipts will ensure that the cost remains close to the G-sec rate.
    • Moreover, there will be no variation in the interest rate as between the states.

    Conclusion

    The states should come forward and work with the Centre in the true spirit of cooperative federalism that the Council has come to be known for these past few years.

  • EASE Banking Reforms Index

    Union Minister of Finance & Corporate Affairs has felicitated best performing banks on EASE Banking Reforms Index.

    Note the various themes under which the index works.

    EASE Banking Reforms Index

    • EASE stands for ‘Enhanced Access and Service Excellence’. The index is prepared by the Indian Banking Association (IBA) and Boston Consulting Group.
    • It is commissioned by the Finance Ministry.
    • It is a framework that was adopted last year to strengthen public sector banks and rank them on metrics such as responsible banking, financial inclusion, credit offtake and digitization.

    Various themes and performance by the states

     

  • Coordinated strategy between government and RBI

    The article analyses the relation between the response of fiscal authority and monetary authority to get the maximum payoff in the normal circumstance. But the pandemic would require different approach.

    Coordination between monetary and fiscal authority in India

    • Coordination between monetary and fiscal authorities has been a thorny issue globally in recent years.
    • If there is perfect coordination between the monetary and fiscal policy then there should be statistically significant negative correlation between the two. 
    • In the Indian context, for the 30-year period till FY2020, relation between the change in the consolidated fiscal deficit and the change in the growth rate of broad money reveals no coordination, substantiating the dominance of fiscal over monetary policy.
    •  Non-coordination between the two in India is also constrained by several policy targets and fewer instruments.

    Optimal combination of monetary and fiscal strategy

    • Both the government and the RBI have two options between them — either a contraction or an expansion.
    • Thus, we effectively have four policy options, and each of the options will have a particular benefit.
    • Our endeavour is to find out which policy option can result in a Nash Equilibrium.
    • A Nash equilibrium occurs when neither the government nor the RBI can increase its benefit by unilaterally changing its action.
    • The payoff scenarios are hypothesised as benefits accruing to the government and the RBI separately when they are deciding on either of the policy options: Contraction or expansion.
    •  The government favour an expansionary policy and gets maximum payoffs from a fiscal expansion, either with monetary expansion or contraction.
    • The monetary authority ideally wants to contract the economy to fight inflation and gets maximum payoffs from a monetary contraction.

    So, what is optimal combination of fiscal and monetary strategy

    •  If the RBI opts for monetary expansion, the government also opts for expansion as the payoff is higher.
    • But this will compel the RBI to then opt for contraction, since that gives it a higher payoff.
    • Knowing this, the government’s best strategy will be then an expansion — so the outcome will always be a fiscal expansion with a simultaneous monetary contraction.
    •  This is the only Nash equilibrium for this game.

    Responding to the pandemic

    • The current pandemic is resulting in behavioural changes of individuals in terms of risk-taking.
    • In the Indian context too, there are behavioural changes in terms of risk-taking.
    • Many of the current companies were also born during the financial crisis, like Uber (2009), Microsoft (1975), Disney (1923), General Motors (1908) and General Electric (1890).
    • Echoing such “procedural rationality” in the current unprecedented circumstances, we thus believe fiscal expansion and monetary expansion is the desirable outcome.

    Conclusion

    The RBI has been largely successful in communicating to the market about its intentions and we now expect the government to manage expectations with coordinated communication and leave matters of financing the fiscal deficit, through measures like monetisation, to the RBI.

    B2BASICS

    NASH EQUILBRIUM

    Simply put, it is a situation where no player can increase his payoff by deviating alone (from the situation). That is,it is a situation where both players are involved in mutual best replies.

  • State Reforms Action Plan Rankings 2019

    Andhra Pradesh has bagged the first rank among all the states in the country in the state business reforms action plan-2019 (BRAP-2019), representing ease of doing business for Atmanirbhar Bharat.

    About the Ranking

    • It is the annual ease of doing business index of states and UTs of India based on the completion percentage scores of action items points of annual Business Reforms Action Plan (BRAP) under the Make in India initiative.
    • This ranking is based on the implementation of the business reform action plan.
    • Some of the key focus areas are access to information and technology, the setting up of a single-window system, construction permit enablers and land administration, according to DPIIT.
    • It based on the progress of states in completing annual reform action plan covering 8 key areas.

    The top ten states under the State Reform Action Plan 2019 are:

    1. Andhra Pradesh
    2. Uttar Pradesh
    3. Telangana
    4. Madhya Pradesh
    5. Jharkhand
    6. Chhattisgarh
    7. Himachal Pradesh
    8. Rajasthan
    9. West Bengal
    10. Gujarat

  • Reforming tax system

    The article discusses two recent measures announced by the government to bring in the transparency in the tax system.

    Issue of lower tax collection and way out

    • An economic contraction this year will severely impact tax collections.
    • Changing tax rates or the tax base in response is difficult and a hurried approach can have wider consequences.
    • So, the only tool available is to urge voluntary compliance.
    • Compliance is achieved through a fine balance between enforcement and encouragement.
    • Despite enforcement-driven measures in the past the taxpaying population has remained at only 6 per cent.
    • Thus, the only way to boost collections is to build trust between the administration and the taxpayer.

    Relation between complexity of system and compliance

    • A taxpayer has to interact with the tax system at numerous instances.
    • While interacting, if the taxpayer perceives the system to be complex, such perception affects compliance.
    • Perceived complexity can discourage individuals from filing returns.
    • This could reflect simply in the difference between the number of taxpayers and the returns filed: which is around 20 million.
    • Such behaviour is bound to impact tax collection.

    Recent government measures to bring transparency

    1) New taxpayer’s charter with some new features

    • The charter is a document that lists a taxpayer’s rights and obligations.
    • A taxpayer’s charter is often perceived as a means to build taxpayer’s trust.
    • The rights and obligations mentioned in India’s new charter are in line with global practices.
    • There are 3 interesting additions in the new charter: 1) commitment to reducing compliance costs 2) holding its authorities accountable 3) publishing a periodic report of service standards.
    • A tax ombudsman can ensure that some of these standards are met, however, in 2019, the cabinet approved the abolition of the quasi-judicial post.

    2) Faceless assessment

    • This relates to the frequent complaint of taxpayers about corruption and delay.
    • To end personal interface, e-assessment was introduced in 2019.
    • Developing this idea further, faceless assessment now seeks to further automate the case selection and the distribution function of the assessing officer.
    • The intent is to divest and distribute the functions of a single assessing officer so that assessment is carried out in a fair manner.

    Consider the question “What are the factors responsible for low tax compliance in India? What are the steps taken by the government to increase compliance?

    Conclusion

    If the commitment to a fair and impartial system and a time-bound resolution of matters is to be met, the new processes, with reviews and anonymity, must ensure efficiency in case selection and consistency in assessment.