Working The Budget: Before India Goes Business As Unusual, Fix Patchwork Policies

One of the promises made by the BJP in its election campaign was to change the mode of governance. This pledge found resonance with voters because the dominant mode of governance and service delivery was felt to have been appropriated by the privileged, which included the politician-bureaucrat-businessman nexus. Narendra Modi’s rhetoric of “minimum government, maximum governance” promised to upend the superstructure. This meant giving the short shrift to business as usual.

But it would appear that it’s not so easy to extirpate the old ways of doing business. The decision to impose a punitive capital gains tax on debt mutual funds (MFs) has classic Indian bureaucratic response to market initiatives written all over it. Household and corporate savings have been exiting bank deposits and heading for fixed maturity plans (FMPs) and debt MFs. The government wanted to stop this because there was a tax arbitrage at play here. But what they failed to see is that there is also an issue of real returns here.

The problem is simple: interest income from bank deposits attracts income tax. After deducting tax and the rate of inflation from interest income, the real return received by depositors is negative in most cases. There are two options thereafter for investors: move their funds to physical assets, such as gold or property, or move to more efficient financial instruments. Since investment in FMPs and debt MFs qualifies for lower taxes, many depositors forsake bank deposits in favour of debt MFs.

The tax arbitrage could be eliminated by improving the real returns provided by bank deposits. In the short term, this can be achieved by aligning tax breaks on bank deposits and debt MFs. But this may be unrealistic and could create an undesirable precedent. In the longer run, though, the only way to provide positive real returns is to ensure that inflation doesn’t erode returns.

While the arbitrage opportunity has now been plugged, there is still no guarantee that all the money invested in debt MFs or FMPs will necessarily return to bank deposits. What the government does not realise is that the money moving from bank deposits to debt MFs stays in the system and is still available for productive investments; money that moves away to physical assets is lost to the economy.

In the end, to foster savings in the economy, the government will have to take a call on what kind of tax breaks it wants to provide on which kinds of financial instruments. The additional Rs 50,000 deduction from income allowed for investment in certain specified instruments suffers from the same syndrome: most of the instruments included in the list yield only negative real returns.

On another note, finance minister Arun Jaitley in his Budget exhibited some concern for the health of his fellow citizens by imposing a punitive levy, the so-called “sin tax”, on cigarettes. Excise duty has shot up from 11% to 72%. But the levy is limited to only cigarettes of 65-mm length and below. So, the message from the government: cigarettes over 65mm length, the “king-size” brands, are safer than the smaller ones.

What about competing tobacco products? The tax on gutka and chewing tobacco has been increased from 60% to 70%. But on pan masala, the duty has gone up from 12% to only 16%. What gives? This is policy, wittingly or unwittingly, creating a new arbitrage window. There have been reports over the last couple of years, ever since states started banning gutka sales, that these sachets of oral tobacco have been masquerading as pan masala. There is now a tax incentive for gutka to impersonate pan masala. Anybody doing research on the “law of unintended consequences” is sure to find a wealth of material in Indian government policy pronouncements.

If it was public health that was causing Jaitley anxiety, it is intriguing why he spared beedis. Perhaps political expediency requires courting some large beedi manufacturers, whose support is crucial for the upcoming state assembly elections.

Jaitley’s arithmetic for estimating revenue and expenditure numbers for 2014-15 have also invited some degree of scepticism. Even if we tamp down on the cynicism, it is clear that a meaningful Budget can be presented only in February 2015.

Published in The Economic Times on August 2, 2014: goo.gl/sKzcta

Boost Savings, Now

The alarm bells should start ringing any time now. An important component of the economy has been sinking and needs to be rescued urgently. This critical piece is “savings” and within this overall head, household savings is the one critical sub-component that needs close watching and nurturing.

While it is true that one of the primary reasons behind the current economic slowdown is the tardy rate of capital expansion – or, investment in infrastructure as well as plant and machinery -- all attempts to stimulate investment activity are likely to come to a nought if savings do not grow.  Without any growth in the savings rate, it is futile to think of any spurt in investment and, consequently, in the overall economic growth. If we source all the investment funding from overseas, it might be plausible to contemplate investment growth without any corresponding rise in savings rate. But, that is unlikely to happen.

Within the overall savings universe, the sub-component “household savings” is most critical. It provides the bulk of the savings in the economy with private corporate savings and government saving contributing the balance. The worrying factor is the near-stagnation in household savings over the past 8 years or so. What’s even more disconcerting is the fact that household savings remained almost standstill during the go-go years of 2004-08.

This seems to be counter-factual.  There are many studies that show that there is a direct relationship between overall economic growth and household savings. Therefore, at a time when India’s GDP was growing by over 9% every year, the household savings rate stayed almost constant at close to 23% of GDP. There was, of course, an increase in absolute terms, but it remained somewhat fixed as a proportion of the GDP.  

*As percentage of GDP at current market prices

What is responsible for this contradictory movement? The sub-group on household savings, formed by the working group on savings for the twelfth plan set up by the Planning Commission and chaired by RBI deputy governor Subir Gokarn, has this to say: “...a recent study...had attributed the decline in the household saving ratio in the United Kingdom during 1995 to 2007 to a host of factors such as declining real interest rates, looser credit conditions, increase in asset prices and greater macroeconomic stability...While recognizing that one of the key differences in the evolving household saving scenario between the United Kingdom and India is the impact of demographics (dependency ratio), anecdotal evidence on increasing consumerism and the entrenchment of (urban) lifestyles in India, apart from the easier availability of credit and improvement in overall macroeconomic conditions is perhaps indicative of some ‘drag’ on household saving over the past few years as well as going forward.”

India has another additional facet: a penchant for physical assets (such as bullion or land). Post the monsoon failure of 2009, and the attendant rise in price levels which has now become somewhat deeply entrenched, Indians have been stocking up on gold. Consequently, savings in financial instruments dropped while those in physical assets shot up. This is also disquieting for policy planners because savings in physical assets stay locked in and are unavailable to the economy for investment activity.

There is a counter view which says that higher economic growth does not necessarily lead to higher savings. According to a paper published by Ramesh Jangili (Reserve Bank of India Occasional Papers, Summer 2011), while economic growth doesn’t inevitably lead to higher savings, the reciprocal causality does hold true. “It is empirically evident that the direction of causality is from saving and investment to economic growth collectively as well as individually and there is no causality from economic growth to saving and (or) investment.”

Whichever camp you belong to, it is beyond any doubt that savings growth is a necessary pre-condition for promoting economic growth. The Planning Commission estimates that an investment of $1 trillion or over Rs 50 lakh crore will be required for the infrastructure sector alone. And, a large part of this critical investment will have to be made from domestic savings.

With savings -- particularly household savings – currently languishing, preliminary forms of the crisis is already showing up across different places. For instance, the lack of incremental addition to the savings reservoir is resulting in a liquidity crisis of sorts, thereby constraining the central bank’s actions. With deposit growth trailing credit growth, Reserve Bank has been forced to focus its efforts on ensuring adequate liquidity in the system. Hence, the repeated cuts in reserve requirements over the past few months.

The government has one Budget before it sets out for the 2014 general elections.  Reserve Bank has two shots before that -- its mid-quarter review on December 18 and the third quarter sometime in end-January, early February. Some solutions will be required to make households save more.

Traditionally, tax breaks were used to lure in savers. With the precarious state of the fiscal, policy experts will have to find innovative ways to provide tax breaks without jeopardising the fine balance. Second, inflation has to brought under control to wean households away from physical assets. Finally, ways must be found to ensure that some legacy savings sources – such as pension, insurance -- become more attuned to investor needs. Today, the real return from these sources is negative or just marginally positive.

Published as an Op-Ed in The Economic Times (December 13, 2012)