Context

A bill introduced in Parliament last week aims to nullify the 2012 amendment in the Income Tax Act which made the income tax law retroactively applicable on indirect transfer of Indian assets.

Issue of taxation as a sovereign right of the state

• Several  Investor-State Dispute Settlement (ISDS) tribunals have recognised the fundamental principle that taxation is an intrinsic element of the state’s sovereign power. 
• The ISDS tribunals have also held that whenever a foreign investor challenges states’ taxation measures, there is a presumption that the taxation measures are valid and legal.
• For instance, an ISDS tribunal in Renta 4 v. Russia said that when it comes to examining taxation measures for BIT breaches, the starting point should be that the taxation measures are a bona fide exercise of the state’s public powers.

What are the limits on the taxation rights of a Country under BITs

• The two most used BIT provisions to challenge a state’s taxation measures are expropriation and the fair and equitable treatment provision.
• 1) Expropriation: In the context of expropriation, one of the key ISDS cases that explained the limits on the state’s right to tax is Burlington v. Ecuador.
• In this case, the tribunal held that under customary international law, there are two limits on the state’s right to tax.
• First, the tax should not be discriminatory.
• Second, it should not be confiscatory.
• 2) Fair and equitable treatment: In the context of the fair and equitable treatment provision, foreign investors have often challenged taxation measures as breaching legal certainty, which is an element of the fair and equitable treatment provision.
• Although legal certainty does not mean immutability of legal framework, states are under an obligation to carry out legal changes such as amending their tax laws in a reasonable and proportionate manner.

So, what happened in Cairn Energy v. India case?

• The tribunal in Cairn Energy v. India said that taxing indirect transfers is India’s sovereign power and the tribunal would not comment on it.
• Legal certainty: The tribunal said that India’s right to tax in the public interest should be balanced with the investor’s interest of legal certainty.
• The tribunal held that the public purpose that justifies the application of law prospectively will usually be insufficient to justify the retroactive application of the law.
• India argued that the 2012 amendment was to ensure that foreign corporations who use tax havens for the indirect transfers of underlying Indian assets pay taxes.
• However, the tribunal held that this objective could be achieved by amending the income tax law prospectively, not retroactively.
• The tribunal did not rule against retroactivity of tax laws per se but against the retroactive application that lacked public policy justification.

Way forward

• Carving out taxation from BITs: India in its 2016 Model BIT carved out taxation measures completely from the scope of the investment treaty.
• Nonetheless, carving out taxation measures from the scope of the BIT does not mean that states are free to do as they please.
• India should exercise its right to regulate while being mindful of its international law obligations, acting in good faith and in a proportionate manner.
• ISDS tribunals do not interfere with such regulatory measures.

Conclusion

In sum, the debate never was whether India has a sovereign right to tax, but whether this sovereign right is subject to certain limitations. The answer is an emphatic ‘yes’ because under international law the sovereign right to tax is not absolute.

Back2Basics:  Investor-State Dispute Settlement (ISDS) tribunal

• ISDS is a mechanism included in many trade and investment agreements to settle disputes.
• Settling these investor disputes relies on arbitration rather than public courts.
• Under agreements which include ISDS mechanisms, a company from one signatory state investing in another signatory state can argue that new laws or regulations could negatively affect its expected profits or investment potential, and seek compensation in a binding arbitration tribunal.
• The system only provides for foreign companies to sue states, not the other way around.

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Context

India will celebrate 100 years of Independence in 2047.  This article makes the case that prosperity is possible and best accomplished by the goal of making the rupee a global reserve currency by India@100.

What is the purpose of having forex reserves?

• Official foreign exchange reserves of about $12 trillion across 150 countries are currently stored in eight currencies: 55 per cent in US dollars, 30 per cent in euros, and 15 per cent in six other currencies.
• Protection in case of volatility: This concentration is inevitable given exploding trade, rising capital flows, and the less acknowledged motivation of protecting your reserves from your currency’s volatility.
•  A reserve currency has to serve as a medium of exchange, a store of value, and a unit of account. 

Steps India would require to take

• Full capital account convertibility: To fulfil the ambition of becoming the reserve currency, the first step is full capital account convertibility, as suggested by the Tarapore Committee in 1997. 
• Advocate rupee invoicing: Dollar investors in the last decade not experiencing the usual big bite out of rupee returns is useful for advocating trading partners to start rupee invoicing.
• Offshore corporate rupee borrowing: Raising corporate rupee borrowing offshore and onshore will also help.
• Digital currency: We need to accelerate our CBDC (central bank digital bank currency) plans.
• Take payment networks to a global level: We need to take our UPI payment technology to the world, the dollar gets heft from global networks like Visa, MasterCard and Swift.
• Raise tax to GDP ratio: Fiscal policy must raise our tax to GDP ratio, raise the share of direct taxes in total taxes, and keep our public debt to GDP ratio under 100 per cent.
• Monetary policy: Monetary policy must control inflation while moderating central bank balance sheet size.
• Economic policy: Economic policy must raise the productivity to reach goals in formalisation, urbanisation, financialisation (100 per cent credit to GDP ratio), industrialisation (less than 15 per cent farm employment), internationalisation (higher share of global trade) and skilling.
• Institutional reforms: These goals must be complemented by reinforcing institutions that signal rule of law; cooperative federalism, press freedom, civil service effectiveness, and judicial independence.

How it will help India?

• Becoming a global reserve currency is helpful because it indirectly aligns fiscal, monetary, and economic policy.
• Low-interest rate: The main advantage is the “exorbitant privilege” of lower real interest rates.
• Edge over China: The 2 per cent renminbi share in global reserves — despite a 25 per cent increase last year — doesn’t reflect their status as the world’s second-largest economy and biggest trading nation.
• China’s astounding economic success seems to be making China overconfident.
• Chinese overconfidence creates an opportunity for India. 

Conclusion

Prosperity for all Indians by India at100 — a precondition for a country where the mind is without fear and the head is held high — needs bold reforms in the next 25 years. These reforms are best measured by the wholesome and achievable goal of the rupee becoming a global reserve currency by 2047. The journey is the reward.

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Context

In recent times, several economists have been arguing that the Government does not need to do anything with the economy. They argue that like after the Great Depression, the economy rebounded worldwide, and so will it with us. The argument is fallacious on four accounts:

Four factors that make recovery different from the recovery after the Great Depression

1) Demand destruction

• In the case of the Great Depression, demand was created by the Second World War effort, especially in the United States.
• Demand destruction: In the current scenario, the COVID-19 pandemic has resulted in demand destruction.
• This is because many jobs have been lost, and even where jobs were retained, there have been pay cuts.
• Both of these trends were confirmed in the Centre for Monitoring Indian Economy and other surveys.

Bright spot on export front

• The only bright spot in this dismal scenario is that the western world has spent a lot of money stimulating the economy.
• However, the Indian exporter face the challenge of rising freight costs and structural issues such as a strong rupee relative to major competitors.
• Only the Indian IT sector is placed well to capitalise on rising demand in the world markets.

2) Inflation and factors driving it

• India is suffering from stagnant growth to low growth in the last two quarters.
• As in the low initial base set by last year, almost any growth this year is seen as a significant growth percentage.
• Commodity prices and monetary policy: Inflation in India is being imported through a combination of high commodity prices and high asset price inflation caused by ultra-loose monetary policy followed across the globe.
• Liquidity infusion: RBI is infusing massive liquidity into the system by following an expansionary monetary policy through the G-SAP, or Government Securities Acquisition Programme.
• Foreign portfolio investors have directed a portion of the liquidity towards our markets.
• India has a relatively low market capitalisation, therefore, India cannot absorb the enormous capital inflow without asset prices inflating.
• Supply chain issues: Additionally, supply chain bottlenecks have contributed to the inflation we see in India today.
• Rising fuel prices: India’s usurious taxation policy on fuel has made things worse.
• Rising fuel prices percolate into the economy by increasing costs for transport.

Impact of inflation

• The middle and lower-middle-class get destitute due to regressive indirect taxes and high inflation, with their wealth eroding due to said inflation.
• Especially in the case of the lower middle class, inflation is lethal as they do not have access to any hard assets, including the most fundamental hard asset, gold.
• The increase in fuel prices will also lead to a rise in wages demanded as the monthly expense of the general public increases.
• This leads to the dangerous cycle of inflation and depleting growth.

3) Interest Rate

• The only solution for any central banker once he realises that inflation is entrenched is tightening liquidity and further pushing the cost of money.
• If this does not dampen inflation, repo rates will need to go up later this year or early next year.
• Tightening the money supply is a painful act that will threaten to decimate what is left of our economy.
• Rising interest rates lead to a decrease in aggregate demand in a country, which affects the GDP.
• There is less spending by consumers and investments by corporates.

4) Rising NPA and its impact on credit growth

• Rising interest rates, lack of liquidity, and offering credit to leveraged companies instead of direct subsidies to support small and medium-sized enterprises (SMEs) and micro, small and medium enterprises (MSMEs) to counter the COVID-19 pandemic and its effects will result in NPAs of public sector banks climbing faster.
• Our small and medium scale sector is facing a Minsky moment. 
• The Minsky moment marks the decline of asset prices, causing mass panic and the inability of debtors to pay their interest and principal.
• India has reached its Minsky moment.
• This means that the public sector unit and several other banks will need capital in copious amounts to make up for bad debt.
• The Union government’s Budget is in no position to infuse large amounts of capital.
• As a result of the above causes, credit growth is at a multi-year low of 5.6%.

Way forward

• Indian economy is in a vicious cycle of low growth and higher inflation unless policy action ensures higher demand and growth.

Conclusion

In the absence of policy interventions, India will continue on the path of a K-shaped recovery where large corporates with low debt will prosper at the cost of small and medium sectors. This means lower employment as most of the jobs are created by the latter.

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