Reform, then remove STT

Financial Express, 28th January 2013

The rate must be lowered, foreign participants should be reimbursed, and finally the tax must be removed over 4-5 years

Realistic discussions about whether the Union Budget should propose to remove the securities transaction tax (STT) or introduce a commodities transaction tax need to be more balanced than simply saying a complete no or yes to either. The first principles of public finance teach us that we should not tax transactions. Taxes like customs, octroi or excise-which tax transactions-have to be removed. All the tax revenue of the government must come from three sources: income tax on individuals, the goods and services tax, and property tax. This is the long-term direction of tax policy.

In this setting, STT was clearly a move in the wrong direction. But, in 2012-13, it was estimated that it would raise R5,920 in tax collection. This is a sizeable amount of money. To be pragmatic, it is unlikely that at a time of fiscal crunch, the tax would be removed completely. It can, however, be reformed slowly, in the following three stages. The first stage is to lower the rate by increasing the tax base. This would be revenue-neutral and reduce the visible distortions associated with the tax. The second stage would be to reimburse foreign participants, as is done with zero-rating of VAT. The third stage would be to set a timetable for removing the tax over a four or five year period. These steps add up to a feasible strategy for the reform of STT.

The introduction of STT in the equity market has given distortions in the financial system. There are four components of the financial system: currency, fixed income, commodities and equities. The imposition of STT upon only one-the equity market-has given incentives for market participants to focus on the other three. There is an artificial avoidance of equity market activity, with employees, public participants and capital shunning the equity market in favour of the other three markets.

All taxes are distortionary, and a basic principle of public finance is that we should have a low rate that is spread across a large tax base. It would hence make sense to cut the magnitude of STT and apply it across all organised financial trading-i.e. equities, currencies, commodities, and fixed income. This would generate no adverse impact in the short run while reducing the distortions in the economy where market participants are avoiding activity on the equity market.

A major problem that India now faces is the loss of market share of onshore finance. The most important financial products of India are stock market indexes-Nifty and BSE Sensex. In both cases, severe competition is now found from overseas markets which do not have an STT. Nifty futures, trading in Singapore, have no STT. This puts the onshore market at a disadvantage. As figure 1 shows, the offshore market has rapidly gained market share in Nifty futures.

When foreign investors send an order to India, there is an entire chain of activity where revenues are generated. This includes brokerage companies, accountants, lawyers, hotels, aviation services, etc. When the same foreign investor sends this order to Singapore instead, this entire chain fuels the Singapore economy instead. The magnitudes of the impact on the economy is vastly bigger than those seen as tax revenues for the government through the existing STT.

In this situation, a reduction in the magnitude of STT on the equity market would help in two ways. First, it would bring capital and labour back into the equity market to a greater extent, and thus increase liquidity of the onshore equity market. This would, of course, benefit the domestic economy. In addition, a foreign market participant would be more inclined to send an order to India as opposed to Singapore when the Indian market is more liquid. The second and direct impact would come through the impact of a reduced STT which directly reduces the cost faced by a foreign investor operating in India.

This first stage of STT reform-reducing the rate and applying it to all organised financial trading-is revenue-neutral. In the jargon of economists, implementing it would be 'Pareto superior': it yields gains without hurting anyone.

The second stage of the STT reform should be the establishment of a system through which foreign investors are refunded the transaction taxes paid by them. The decision by a foreign investor to send an order to Singapore versus India should not be distorted by tax considerations. We have already done this in the field of goods. When steel is exported from India, the entire burden of indirect tax suffered in India is refunded through 'zero rating of exports'. By the same principle, when trading services are exported to a non-resident, the entire burden of domestic taxation should be refunded to him.

Through this, we would get a level-playing field on taxation, in the eyes of foreign investors, about trading in Singapore versus trading in India. The competition between Singapore and India in finance should be played on genuine factors, such as pricing and service quality. It should not be about avoiding policy mistakes in India.

This second stage of the STT reform costs money for the government. Given that FII transactions account for roughly 15% of turnover, it would involve a direct reduction of revenue for the government of roughly R900 crore a year. At the same time, some of this difference would come back to the government through increased tax revenues on the increase in GDP that comes when foreign transactions that are going to Singapore shift to India.

The third stage of the STT reform is linked to a broader programme of fiscal consolidation. Indian public finance is in very poor shape. The strengthening of public finance critically relies on building the GST, removing subsidies, and on scaling back the UPA's welfare programmes. These changes will not be achieved in a short time. Hence, the government must commit to a five-year programme through which the taxation of financial transactions would be phased out. This is the kind of time horizon over which the GST, and efforts are reducing subsidies and welfare programmes, would kick in.

Bank for the buck

Indian Express, 24th January 2013

This year the government will put in Rs 12,500 crore for recapitalising public sector banks. Year after year, the ministry of finance puts more money into PSU banks. To expand banking in India, the government has chosen a two-pronged approach: putting more money into public sector banks while giving new licences for banking to private companies. In the present Indian system - with its lack of transparency, absence of the rule of law and pervasive corruption - a better policy to expand banking in India would be to divest public ownership of banks and convert them into widely held private banks.

Such a policy would address some of the RBI's concerns about industrial houses owning banks, limit the use of taxpayer money to support inefficient banks and give the country a competitive banking system. India's experience with public banks that have become widely held private banks, such as HDFC and ICICI, has been better than with new private banks, where family-dominated firms obtained licences.

Policy-makers in India like to claim that we have not had a banking crisis for a while. This claim is called into question when we witness the stream of money that has gone into PSU banks. Almost every year over the last two decades, the government has injected taxpayer resources into PSU financial firms. If we had done a recapitalisation of Rs 100,000 crore at one shot, it would have been obvious that there were big failures of financial regulation and policy. But when we dribble it out as Rs 10,000 crore per year for 10 years, it is not seen as rescuing a failing financial system.

PSU banks are not profitable enough to grow on their own steam. This reflects the failure of bureaucrats as bankers. Normally, profits are reckoned after paying for bad loans, and retained earnings are ploughed back into the equity capital of the bank. The equity capital with a bank determines how much of deposits it can take. A PSU bank that does not have equity capital will be forced to not take more deposits from the public. This constraint does not bind it as much as it should, as the RBI has often been lenient, tolerating the inadequacy of equity capital.

Indian banking has been rigged in favour of PSU banks in numerous ways. The RBI has blocked the entry of foreign banks and new private banks in an attempt to protect the cosy domination of PSU banks. A man who deposits money in a PSU bank knows it has the backing of the government. This is not the case with their competitors, and that helps increase the market share of PSU banks. Despite these violations of competition policy, PSU banks have failed to be adequately profitable. This makes them go back to the finance ministry for more equity capital.

At present, we have a finance ministry that is tightfisted when it comes to putting equity capital into PSUs owned by other ministries and discusses disinvestment of its holdings, but it is willing to put in additional capital when it comes to banks that are in its domain. The finance ministry needs to be as sceptical about putting equity capital into PSU banks as it is about putting equity capital into any PSU. If Air India does not get money, why should the SBI?

India is in a dire fiscal crisis and every single opportunity for cutting expenses should be harnessed. Even if there was money available for spending, it has better applications. In recent years when we have typically been lavishing Rs 10,000 crore every year into PSU financial firms, India would have done better if this same Rs 10,000 crore had been spent on building 2,000 kilometres of highways, or a metro system for a mid-size city like Nagpur.

A better option is to dilute government ownership in PSU banks and allow them to run and grow as normal private banks. In 1969, when banks were being nationalised, Indira Gandhi's economic policy team thought it was wise for government to have 51 per cent ownership of PSU banks. We have reversed almost every element of Indira Gandhi's economic policy framework, and this should be no exception.

We have two successful privatisations of PSU financial firms before us: HDFC and ICICI. Both were once controlled by the government and both are now dispersed shareholding companies. They were not sold off to some family, they became modern corporations. This roadmap - building dispersed shareholding private companies that are controlled by no family - should be followed for all PSU banks. This will require carrying legislation through Parliament, and it would make good use of the scarce political capital that the UPA possesses.

The government has made a case for giving out new licences for private banks. The RBI has rightly expressed concerns about banks run by industrial houses. In the past, Indian banking has suffered as the mechanism to prevent theft of depositor money by private banks lending to their business interest has been an issue. Banks must be dispersed shareholdings with professional managers - as is the case with ICICI or HDFC. In an ideal situation one would argue that the banking regulator should give licences to firms that it deems fit to run banks, but in today's India, most people, and perhaps the regulator itself, is correctly concerned about the political pressure that may be brought to bear on the regulator if it opens up the gates to new private bank licencing. It would be wise to gather experience with enhanced supervision of lending to conglomerates before venturing to give bank licences to large industrial houses, who are often the ones with the money to apply for such licences. As the recent IMF financial stability assessment report also points out, in the current context, the risks of this policy may outweigh its benefits.

Another option to expand banking in India is to open up the sector to the entry of foreign banks. At present, India limits foreign banks, in all, to 18 bank branches per year. A much more open policy framework is required, through which foreign banks can build subsidiaries in India, who are then regulated by the banking regulator on the principle of ownership neutrality and given national treatment, including the lifting of all restrictions on opening branches.

The government should consider these policy options more carefully to give India a safer and more competitive banking system.

A finer balance

Indian Express, 10th January 2013

India's current account deficit has risen sharply to above 5 per cent of the GDP. Finance Minister P. Chidambaram is reported to have reacted to the balance of payment statistics by saying that he may have to increase the import duty on gold. If the solution to the country's balance of payment problems lay in high import duties, India would never have had the 1991 crisis.

Fortunately, in the July-September quarter, the previous finance minister's budget proposals on taxing foreign capital flows were not implemented, otherwise the balance of payment situation could have been much worse. The government should now conduct a stress test capturing the scenario of a sudden drop in foreign investment flows and its impact on the economy. This should form the basis of thinking about a policy framework in which the Indian economy would be resilient to such shocks.

The current account deficit in July-September 2012 stood at 5.4 per cent of GDP. Thanks to foreign investment inflows, both direct and portfolio, India did not witness a sharp depreciation of the rupee during this period. Depreciation would have made the already high inflation worse. It would have put a lot more businesses, already looking for debt restructuring, in greater difficulty. Portfolio inflows between July and September 2012 were $7.6 billion. In the same quarter of 2011, there was a net portfolio outflow of $1.4 billion. Suppose a similar swing takes place in the next quarter - what will be the impact on the economy?

Complacence on the part of policymakers would be a mistake. The total quantities of exports or imports are not determined by the government. Policies can only change incentives to buy or sell globally traded goods and services. If, due to a change in global conditions, there is a change in global financial flows, the current account deficit would be financed by trade credit or debt flows. This could potentially pave the way for a much bigger crisis. There would likely be greater pressure on the rupee to depreciate. The government would, in all probability, step in with a number of knee-jerk reactions to stop capital outflows, to prevent dollar borrowing, to push the RBI to intervene to prevent rupee depreciation, to first impose higher duty on gold and then post additional customs officers as well as have stringent checks at international ports and airports to prevent smuggling. Measures with origins dating back to the licence quota raj will be conjured up, with the hope that this time they would work.

The most important aspect of the recent BOP statistics is that the rise in the current account deficit is due to a decline in exports, not a sudden increase in imports. In fact, imports are lower as well. As the world economy has slowed down, so has export demand. Even with a relatively weak rupee, the effect of a slowdown in the US and Europe has reduced exports.

For now, service exports have held up. But if difficulties in the West continue, it is hard to see how Indian exports can keep growing. We certainly should not have policy frameworks that avoid a crisis only in the very optimistic scenario of Indian exports growing fast or foreign investment flowing to India, despite all the turmoil in global markets. Today, that is our policy framework for the external sector. How will a fall in exports, a depreciation of the rupee, a sudden stopping of foreign investment affect our balance of payments? To make the economy resilient in the face of lower export demand and in the event of a fall in foreign investment flows, we need to ask whether our policies make imports elastic as well.

Imports of gold, silver, precious stones and gems, mainly used in jewellery exports, fell in July-September 2012. Other imports, meant for domestic consumption, however, continued to grow. If we believe that demand responds to changes in prices, as we seem to in the case of gold, we should think about our bizarre policy of subsidising imported goods and making them cheaper. Our biggest import, petroleum, and its products, such as diesel, kerosene and urea, are sold to consumers at subsidised rates, encouraging consumption of these products. Exchange rate changes to these products are passed on slowly as the government fixes diesel prices in rupee terms and changes in administered prices are made only after huge delays. If market prices had prevailed, a fall in exports would have led to a rupee depreciation. This would have pushed up the price of imported oil and, at least in the long run, reduced consumption.

Subsidising imports is different from subsidising a domestically produced non-tradable service like education. If the expenditure is financed by borrowing, not only does it push up domestic demand, it does so for an import-intensive good. This was not an issue in the first decade of the 2000s, when Indian exports were growing rapidly. The main focus of the debate in the context of the oil subsidy was the large subsidy bill, the fiscal deficit, the price distortion, the leakages, the adulteration of diesel with cheaper kerosene and so on. But now that the current account deficit has risen to more than 5 per cent of the GDP, we need to think about oil subsidies in terms of the impact they have on the current account deficit as well.

For many years, economists have been crying themselves hoarse about the dangers of a large fiscal deficit. They have warned that large deficits may lead to higher demand, resulting in inflation, and spill over into a current account deficit. But the Indian economy seemed to defy this logic. As the world economy did well, exports, both merchandise and service, grew rapidly. At the same time, as India's financial integration increased, dollars came into the capital account, financing our trade deficits. So, not only was the current account not very large, usually between 2 to 3 per cent of the GDP, the dollar flows kept it easily financed and there was no crisis. But this time may be different.