GS Paper: GS3

Context

What the data conclusively show is that the debate on the Indian economy should shift away from simplistic notions (borrowed from the West?) of the tax-GDP ratio being low in India.

India’s low tax-to-GDP ratio

• One of the stylised beliefs in India, and amongst some leading economic commentators both in India and abroad, is that our tax/GDP ratio is lower than what it “should” be.
• This low tax-to-GDP ratio is blamed for a lower rate of investment, a higher fiscal deficit, and lower GDP growth — and all because the tax ratio is too low.
• There can be reasonable doubts about the presumed links.
• There are three important fiscal variables in the economy — taxes, fiscal deficit, and debt.
• They are inter-related — lower tax revenue means higher fiscal deficit, for the same level of expenditures, and higher deficit means higher debt.
• All three, directly or indirectly, are assumed to affect growth and/or inflation.

Analysing India’s tax-to-GDP ratio

• Two common observations on tax-to-GDP for India — first, it is low at around 10-11 per cent of GDP and it has stayed at close to that level for the last 20 years.
• In 2019, it hit a decade low of 10 per cent of GDP, the same as in 2014.
• Second, in comparison with our peers, it is much lower.
• Hence, logic dictates that we should strive to increase it.
• But which country should we compare India with?

Issues with comparing tax-to-GDP with other countries

• A common observation is to look at the tax-GDP ratio in G20 countries.
• Function of average level of per capita income: This is the beginning of a set of misinterpretations committed either knowingly, or unknowingly.
• Because simple logic dictates that tax collected is a function of the average level of per capita income.
• Per capita income in the G20 varies from around $2,100 (India) to around $65,000 (US).
• The 10-11 per cent figure for India is the tax/GDP ratio for taxes administered at the central level.
• Challenges in data collection: Taxes in India, as in many other large, especially federal, countries, are collected at both a federal and state level.
• And many economies have local (municipal) taxes as well. The tax collected is the sum of all these taxes.
• Until now, collecting such disaggregated data for a large set of countries was challenging.
• However, in a recent web publication, the IMF on their World Revenue Longitudinal Data set has published such data for all countries, from 1990-2019.
• In this pre-pandemic year, among G20 economies, India’s tax-GDP (Xtax) ratio of 16.7 per cent was higher than that of China (15.9 per cent), Mexico (14.1 per cent), Indonesia (11.0 per cent), Saudi Arabia (5.9 per cent) and Turkey (15.9 per cent).
• A more informative indicator of whether a country is taxing too much or too little in comparison with others is to look at the tax-GDP ratio adjusted for PPP per capita income.
• Prediction via a simple regression of tax-to-GDP on log PPP per capita GDP can yield one estimate of the tax gap — the difference between actual and actual adjusted for level of income.
• The world average tax gap is -1.3 per cent; India is +1.2 per cent for the nine years 2011-2019.
• So, India’s tax GDP ratio averages 2.5 percentage points more than an average economy.
• For every year for which data are available 1990-2019, India has had a positive tax gap — there is little evidence that a higher tax/GDP ratio helps growth.

How corporate tax cut helped India

• Corporate tax cut 2019: For years, the advocacy in India was to increase revenue from corporate tax which is one of three major components of tax revenue, the other being income and indirect taxes.
• In September 2019, Finance Minister going well against Indian established conventional wisdom, lowered the corporate tax rate by around 10 percentage points.
• Avoiding triple whammy: Opponents said that empirical evidence around the world (for example, the US) meant that if tax rates were lowered, revenues would decline, the fisc would increase, as would inequality.
• A triple whammy that is best avoided.
• However, now, three years later, we can assess the efficacy (or not) of this bold experiment.
• For the three months April-June 2022, corporate tax revenues, y-o-y, are up 30 per cent.
• Using fiscal 2019-20 as a base, corporate tax revenue has increased by 66 per cent, GDP by 33 per cent — an average tax buoyancy of 2.0 over three years.
• The previous largest tax buoyancy was in 2006-7 when the world was buoyant.
• Tentatively, the tax-GDP ratio in the fiscal year 2022-23 will average over 18 per cent in India, a level close to Japan and the US.

Conclusion

In India, the debate should shift to expenditures, and quality of expenditures (and perhaps to reform of the direct tax code). In this regard, suggestion that freebies be critically examined is most timely and welcome.

UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

 Back2Basics: Tax buoyancy and tax elasticity

• Tax buoyancy: The buoyancy of a tax system measures the total response of tax revenue both to changes in. national income and to discretionary changes in tax policies over time, and it is traditionally interpreted as the percentage change in revenue associated to a one percent change in income.
• Tax elasticity: It refers to changes in tax revenue in response to changes in tax rate.
• For example, how tax revenue changes if the government reduces corporate income tax from 30 per cent to 25 per cent indicate tax elasticity.

Context

A number of countries, including India, are now considering the use of other currencies to avoid the U.S. dollar and its hegemonic role in settling international transactions.

Currency hierarchy

• For India, currency hierarchy goes back to colonial times when the Indian rupee was virtually linked to the British pound rather than to gold which it earned through exports.
• In the post-War period, the neo-colonial currency hierarchy has been clubbed with the continued use, primarily of the U.S. dollar, for the majority of international transactions.

Rupee settlement of trade

• In recent times, India has been taking an active interest in having the rupee used for trade and the settlement of payments with other countries, which include Russia, now facing sanctions.
• The Reserve Bank of India has recently taken a proactive stand to have rupee settlement of trade (circular dated July 11, 2022).
• While options for invoicing in rupees were already legal in terms of Regulation 7(1) of the Foreign Exchange Management (Deposit) Regulations, 2016, the current circular aims to operationalise the special Vostro accounts with Russian banks in India, in a bid to promote trade and also gain a better status for the rupee as an international currency.

Opportunities for India

• The advantages India is currently seeking in these arrangements include avoidance of transactions in the highly priced dollar which has an exchange value of ₹80, impacting the Indian economy with inflation, capital flight and the drop in foreign exchange reserves by $70 billion since September 2021.
•  Buying oil with a depreciated ruble, and at discounts, is not only cost-saving but also saves transport time with the use of multi-modal routes using land, sea and air routes.
• In addition, India is looking forward to trade expansion in sanctions-affected Russia.
• With India having a trade deficit with Russia, which has been around $3.52 billion on average over the last two financial years, India’s opportunities include the possible use, by Russia, of the surpluses in the Vostro rupee account in Russian banks for additional purchases from India.
• Past attempts: Attempts to use the rupee for invoicing and trading is, however, not new to India.
• A comprehensive bilateral trade and payments agreement was signed by India in 1953 with the Soviet bloc countries.

Challenges

• There are quite a few problems that may prevail in implementing the desired rupee payments and avoiding dollar transactions.
• Willingness of banks and private parties: Apart from issues that concern an agreed exchange rate between the rupee and the ruble (R-R), two volatile currencies, there is also the question of the willingness of private parties (companies, banks) to accept the rupee for trade and settlements.
•  If Russia opens its door for exports from India, the ‘R-R’ route may prove attractive for Indian exporters.
• Concerns of the US: There are official concerns for reactions, particularly from the U.S., to deals, especially for purchase of the S-400 defence equipment.
• Reaction of the Europe: Moreover, the deals between India and Russia, especially on oil, can be considered by the West as ‘indirect back door support’ — as India is importing Russian crude at 30% discount, processing at refineries in Gujarat which include Reliance, and then exporting those to the West.
• Trade deficit: There were attempts even before the novel coronavirus pandemic to initiate a clearing account on the BRICS platform.
• The quantitative implications indicate a skewed pattern of transactions — with China having most of the trade surplus.
• It is a pattern similar to what is happening in India-Russia trade at the moment.

Conclusion

The India-Soviet agreements of the past may provide a clue on how the current ‘R-R’ trade and the problems can be managed by initiating a push for Indian exports to Russia and, of course, avoiding all deals in dollars — benefiting both trade partners and countering, globally, the on-going currency hierarchy.

UPSC 2022 countdown has begun! Get your personal guidance plan now! (Click here)

Context

In the recent MPC meeting, the policy rate hike was widely expected, more anticipated were the MPC and the RBI Governor’s forward guidance on the trajectory of policy — on both monetary policy and liquidity instruments. So, how do we see monetary policy evolve over the rest of the year and beyond?

Tightening of monetary policy

• Repo rate at 5.4 per cent: In its latest meeting, the members of the monetary policy committee voted unanimously to increase the policy repo rate by 50 basis points to 5.4 per cent.
• The repo rate was 5.15 per cent in February 2020.
• So, in effect, the RBI’s policy has not only been normalised, but has actually tightened compared to the pre-pandemic level.
•  Even the lower bound of the rate corridor, the Standing Deposit Facility (SDF) rate, at 5.25 per cent is now above the pre-pandemic repo rate.

Forward guidance on stance

• The MPS indicated the retaining the policy stance rather than shifting to “neutral”.
• This retention of stance might be interpreted as being a bit more hawkish than “neutral”, which implies that rates might be both increased or cut, depending on economic conditions.
• Now that policy is largely normalised, the pace of tightening is likely to moderate.
• The urgency of aggressive rate hikes and tightening of liquidity has somewhat moderated, although risks remain.
• RBI’s research suggests that the “real natural rate” — the rate at which policy is neither loose nor tight – is 0.8-1 per cent.
• This operative interest rate is usually the three-month T-bill rate, which in “normal” times averages 10-15 basis points above the repo rate.
• Considering that monetary policy is calibrated over a one-year horizon and using the RBI’s inflation forecast of 5 per cent for the first quarter of 2023-24, the “natural” repo rate will be around 5.85 per cent.

Inflation and growth conditions

• The RBI’s growth projection for 2022-23 has been retained at 7.2 per cent, with growth frontloaded in the first half.
• CPI inflation is still forecast to average 6.7 per cent.
• Inflationary pressures are likely to wane in the second half of 2022-23, particularly if the recent drop in industrial metals prices persists over the next few months.
• A more or less normal monsoon might help in keeping food prices stable. However, risks remain.
• Robust growth prospects: Demand for consumption goods seems to be resilient, enabling some further pass-through of input costs.
• Combine this with tight labour markets and rising wage costs in some tech-oriented sectors.
• High frequency indicators of economic activity have recovered after some weakness in June.
• In addition to resilient demand, there is evidence of a closing of the “output gap”.
• Global growth: Global growth and trade are forecast to significantly slow down in 2022 and 2023, largely due to aggressive tightening by G-10 central banks and a slowdown in China.
• The IMF predicts global trade volume (both merchandise and services) to slow to 4.1 per cent and 3.2 per cent in 2022 and 2023, down from 10.1 per cent in 2021.
• With world growth and trade flows moderating, along with a drop in commodities prices, India’s export growth is likely to be lower than last year.

External financial condition

• The current account deficit remains a concern.
• India’s external balance sheet remains quite robust, as is evident from various balance of payments and debt metrics, and reportedly low unhedged foreign currency borrowings.
• Continued tightening by global central banks, particularly the US Federal Reserve over the rest of 2022, will keep India’s external financial conditions tight and likely limit portfolio capital flows.
• However, there are some signs emanating from these central banks that the hitherto front-loaded tightening might moderate going forward.
• This will take some pressure off the rupee, though, exchange rate volatility management will remain a part of the overall monetary policy management framework.

Challenge of surplus liquidity

• During the earlier phase of policy normalisation and the recent tightening, liquidity management has played an important role in influencing short-term money market interest rates.
• The current latent surplus liquidity — the existing funds with banks and the Union government’s unspent revenues parked with RBI — is over Rs 5 lakh crore.
• While the extent of liquidity surplus during the Covid months has come down, these levels are still much higher than RBI estimates of non-inflationary levels of surplus, which is around Rs 1.8-2.4 lakh crore.
• This will gradually fall with cash withdrawals and some potential RBI dollar sales in the coming months.

Conclusion

The central bank, in coordination with the government, has ensured an orderly evolution of economic conditions during a very complex and challenging environment. The exit process now will also need the same adroit use of policy instruments.

UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

Back2Basics: Standing Deposit Facility rate

• The Reserve Bank of India (RBI) in April 2022 introduced the Standing Deposit Facility (SDF), an additional tool for absorbing liquidity, at an interest rate of 3.75 per cent.
• The main purpose of SDF is to reduce the excess liquidity  in the system, and control inflation.
• In 2018, the amended Section 17 of the RBI Act empowered the Reserve Bank to introduce the SDF – an additional tool for absorbing liquidity without any collateral.
• By removing the binding collateral constraint on the RBI, the SDF strengthens the operating framework of monetary policy.
• The SDF is also a financial stability tool in addition to its role in liquidity management.
• The SDF replaced the fixed rate reverse repo (FRRR) as the floor of the liquidity adjustment facility corridor.
• The SDF rate will be 25 bps below the policy rate (Repo rate), and it will be applicable to overnight deposits at this stage.
• It would, however, retain the flexibility to absorb liquidity of longer tenors as and when the need arises, with appropriate pricing.

Context

Despite the rapid advancement of digital platforms on the one hand and the pervasiveness of the Internet-enabled phone on the other, small enterprises such as local kirana stores have not gained from this. Online purchases from “near and now” inventory from the local store remain in a digital vacuum.

Online revolution in country

• Increased smartphone use: The rise in smartphone use fuelled by affordable data plans has catalysed an online revolution in the country.
• Pandemic accelerated digital inclusion: The novel coronavirus pandemic has further accelerated the process of digital inclusion.
• It is now not only routine to transact online it is also common to learn online, have medical consultations online, and even resolve disputes online.
• Increased scope for innovation in digital space: These realisations have given India the opportunity to disrupt the status quo with its innovative abilities.
• Systems such as the Unique Identification Authority of India (UIDAI) and Aadhaar, the Unified Payments Interface (UPI) and the Ayushman Bharat Digital Mission have reengineered markets.

Why mall and medium sided businesses have not benefited from digital revolution?

• Despite the rapid advancement of digital platforms small enterprises such as local kirana stores have not gained from this.
• Cost of infrastructure: This is because, to sell on numerous platforms, sellers must maintain a separate infrastructure, which only adds costs and limits participation.
• Distinct terms and conditions of platforms: The distinct terms and conditions of each platform further limit the sellers’ flexibility.
• Consequently, small and medium-sized businesses have lost their freedom to choose and participate in the country’s e-commerce system at their will and on their terms.

Way forward: Open Network for Digital Commerce

• The Department for Promotion of Industry and Internal Trade (DPIIT) of the Government of India established the Open Network for Digital Commerce (ONDC) to level the playing field by developing open e-commerce and enabling access to small businesses and dealers.
• The ONDC began its pilot in five cities in April 2022, i.e., New Delhi, Bengaluru, Coimbatore, Bhopal and Shillong.
• Currently, the pilot has expanded to 18 cities, and there are immediate plans to add more cities.
• The ONDC network makes it possible for products and services from all participating e-commerce platforms to be displayed in search results across all network apps.
• For instance, a consumer shopping for a product on an e-commerce app named “X” would also receive results from e-commerce app named “Y”, if both X and Y integrated their platforms with the ONDC.

Dispute resolution through ODR

• Disputes will be the obvious by-product of this e-commerce revolution.
• Therefore, it is imperative to support this initiative with a modern-day, cost-effective, timely and high-speed dispute resolution system.
• Online Dispute Resolution, or ODR as it is popularly called, has the propensity to work alongside the incumbent setup and deliver quick, affordable and enforceable outcomes.
• The ODR is not restricted to the use of legal mechanisms such as mediation, conciliation and arbitration in an online environment but can be tailormade for the specific use case keeping the participants in mind.
• ODR commonly involves case management systems, integration of communication technologies such as email, SMS, WhatsApp, Interactive Voice Response, audio/video conferencing.
• With appropriate data sets in place, it can also involve advanced automation, the use of technologies such as artificial intelligence and machine learning to enable resolutions at the same time as it would take to initiate a transaction over the network.
• Many e-commerce companies have turned to the ODR with the realisation that in order to maximise transactions it is important to ensure a positive dispute resolution experience.
• Adoption in India: The ODR is no more a distant dream for India as well.
• The National Payments Corporation of India (NPCI) has mandated platforms in the UPI ecosystem to adopt the ODR for complaints and grievances connected to failed transactions.
•  Ingram, SEBI SCORES (or the Securities and Exchange Board of India SEBI COm plaints REdress System), RBI CMS (or the Reserve Bank of India Complaint Management System), MahaRERA (or the Maharashtra Real Estate Regulatory Authority), MSME Samadhaan (or the Micro Small and Medium Enterprises Delayed Payment Monitoring System), and RTIOnline (or the Right to Information Online) are other examples of ODR systems that are widely used in the country.
• Mitigating litigation risks: The ODR will help mitigate litigation risk and provide valuable insights into problems faced by consumers.
• Consumers are provided with another choice for effective redress of their grievances, thereby building trust, confidence and brand loyalty.

Advantages of ONDC

• Wider choice for consumers: The ONDC achieves the dual objective of wider choice for consumers on the one hand and access to a wider consumer base for sellers on the other.
• With India’s e-commerce industry set to reach $200 billion by 2027, this shift from a platform-centric paradigm to democratisation of the nation’s online market will catalyse the inclusion of millions of small business owners and kirana businesses.

Conclusion

A dispute resolution framework that includes a customised ODR process can play a role in the network achieving its steep five-year target of adding $48 billion in gross merchandise value to India’s e-commerce market, a network of 90 crore buyers and 12 crore sellers with the least hiccups.

UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)