The Reserve Bank of India cut the repo rate by 35 basis points Wednesday, a little beyond what it usually does. Inflation is within control. The economy is slowing down. The RBI has lowered its growth projections for the first half of the year sharply — it expects growth to improve in the second half of the year, and finish up at 6.9 per cent for the year.
The question we ask is, what will boost growth in the second half of the year? There is only so much that monetary policy can achieve. With a weak transmission mechanism, a stressed banking sector, and difficulties in the non-bank financial sector, the heavy lifting will have to be done by other policy changes.
Private investment is a critical engine of growth for the Indian economy. The government neither has the capacity, nor the fiscal space, to lift investment and growth without the participation of millions of entrepreneurs across the country. The only way investment in India can pick up is if these entrepreneurs are upbeat about the opportunities that the economy has to offer them to make a decent living from doing business.
Under Modi 1.0, India enacted the Insolvency and Bankruptcy Code, GST, rose to higher ranks on the ease of doing business, and tried to push both public investment and MSME credit, yet private investment has not picked up. Apart from the policy initiatives already undertaken, and the interest rate cuts that the RBI is delivering, what does the government need to do?
Taxation is a deterrent
The most important department that perhaps affects the overall economy is the tax department or the Department of Revenue. Its job is to increase the share of GDP that it collects as taxes. To do so, it often proposes new taxes or increases in tax rates. It is not expected to focus on the impact its proposals have on GDP or investment.
Often, given the narrow tax base that India has, increasing revenues is easier to do by increasing the tax rate or the tax burden of those already paying taxes, than by increasing compliance. In recent years, marginal tax rates have been increasing. This has made trying to evade taxes more attractive.
To counter the subsequent loss of revenue through evasion, the tax department has been given greater powers to go after those who it feels are evading taxes. Again, the tax department was not expected to assess the impact of its greater powers on businesses and the sentiment of businessmen.
India today has a number of taxes like the surcharge on income and corporate tax, the Securities Transaction Tax (STT), and now, the tax on the super-rich, where no analysis is done about the impact of the tax on the overall economy.
Economic theory and the Laffer curve suggest that beyond a point, increasing the tax rate is counterproductive, even in terms of collecting more revenue. Beyond that, it can also have negative effects on incentives for investment in the country, for encouraging growth and job creation.
For example, what is the impact of the tax on the super-rich? What is the effect of the tax on foreign portfolio investors and stock markets? How is it going to impact investment?
Restore the role of the DEA
One part of the story is that in tax, policy gets made based on proposals by the tax administration, which focuses on how to collect taxes in the administratively-easiest ways. The tax policy unit resides within the Department of Revenue.
Seeing the business environment today, there is little doubt that a thorough analysis of the economy-wide impact of policies is needed before proposals are accepted. This needs to be an integral part of policy making. The finance minister, with the responsibility of the overall economy, has to turn down many proposals that may appear attractive in the short run, and keep her tax administration on a tight leash.
She should perhaps restore the role of the Department of Economic Affairs in the Ministry of Finance, which has traditionally been to push for reform and productivity growth in the economy by looking beyond short-term and sectoral issues. For this reason, lowering taxes, import tariffs, pushing for greater foreign investment since 1991, and liberalisation and better regulation of the financial sector have been pushed by the finance ministry in the past.
While sector-specific ministries such as aviation, railways, steel, textiles, heavy industry and chemicals, a legacy of the planning era, focus on their areas or sectors, they may often lobby for what is good for their sector but not for the economy as a whole. The DEA should study the investment and growth impact of policy proposals before they are accepted.
The general sense of gloom in business needs to change before we can expect growth to be higher in the second half of the year. The RBI has done its bit, now the government needs to do its share.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.
Also read: Outlook for India’s growth is bleak and RBI forecasts this year nail it
Except to the bhakts – in fact, even the more affluent amongst them are now singing a different aria – it is evident that on every aspect of governance, starting first and foremost with mentoring of the economy, the past was a great deal better than the present. It is a very bitter pill to swallow when the promise was to achieve more in sixty months than was done in the preceding sixty years. That exceptionalism lies in shreds. A time for humility. If this does not sound naive, long coffee sessions with Shri P Chidambaram, arguably a better FM than Dr Singh, certainly Pranabda, to get, in a spirit of humility and Jigyaasa, a sense of what needs to be done to restore the economy to health. Apart from keeping Open House for businessmen, industrialists and all other stakeholders. These are the knowledgeable people who will sensitise the senior officials of DEA that what looks like a tempting wedge of chocolate cake is not actually very healthy for the economy. CEA could also be advised to tweet serious thoughts on the economy, not mythology.