P.CHIDAMBARAM WONS INDIA LOOSES 2007

India Budget 2007 – If Chidambaram1 won, then India lost.

ITA A REVIEW FROM A DEAR FRIEND OF MINE FROM NEW YORK UNIVERSITY

A Goldman Sachs report2 on the BRIC countries based on the Solow’s growth model
places the Indian economy ahead of the US in the next 50 years. The Solow’s growth
model assumes that capital, labor and total factor productivity 3(TFP) are the key drivers
to economic growth. Although this assumption is not very accurate, these three drivers
capture lots of crucial economic factors into account. For example, inflationary factors
that play a major role in deciding the dimensions of the capital and labor markets are
build into this model through the capital and labor inputs. In this article, we will try to
link this budget with the above mentioned drivers of growth.
Instead of simplifying the tax code, this budget has worked to add on more
complications. In India, there is a 30% tax on personal income and then a 10% surcharge
on that income. Additionally, there is a 1% “education cess” surcharge. This budget
bought another education surcharge of 1% on secondary education. We feel that people
are not as troubled by the effective taxes as they are with the number of different
surcharges. Accounting for the different number of surcharges is cumbersome. This
example was for personal income tax. For company income taxes, this surcharge list runs
longer. There are more than 10 different surcharges that one has to pay in importing
materials. People waste a lot of time just to figure out these categories. We believe that
people will be much more productive with a flat tax rate. They will spend more time
working and less time accounting for these surcharges. This will increase TFP.
The effective tax rates for medium businesses in India work out to be around 34% - 38%
depending on the type of business. Then there is the unofficial tax that is paid to the
government official as bribes4. Approximating this tax as 2% would bring the affective
tax rate to around 40%. Very large businesses get special tax exemptions because they
are placed in the so called Special Economic Zones (SEZ). Although theoretically, it is
not only the large businesses that are allowed to enter the SEZ’s but that is what ends up
happening. The government has forgotten that it is the medium and small businesses that
will define India’s future. It is the medium and small industries that need government
help and not the large industries. The large industries will reach limits in terms of their
marginal product of labor and capital. We believe that the Indian government is working
towards destroying the medium and small sector rather than helping it to come up. This is
a great worrying factor for the long term growth picture of India.
1 P. Chidambaram is the Finance Minister of India
2 Goldman Sachs, Global Economics Paper No: 99, Dreaming with BRIC’s: The Path to 2050.
3 Total Factor Productivity can be seen as the degree of efficiency and the related technological innovations
in the economy.
4 It doesn’t matter whether one pays the government tax or not. This unofficial tax is present in both the
cases. It will be roughly 20% in case you decide not to pay anything to the government. That is also the
reason why a lot of people in India don’t pay taxes to the government. They prefer to pay this unofficial tax
and save the actual taxes. We also fear that complicating the tax structure further will decrease the taxing
base as people would prefer to pay the unofficial tax (which ironically has a flat structure)
The implementation of the fringe taxes will be detrimental to the incentive structure. Let
us talk about staff welfare and see how that will be affected by this new tax. There will be
a 6% tax levied on all staff expenses and welfare initiatives. So now all the staff outings,
trainings and even the food expenses during the staff meetings will be taxed. What effect
will this have on the company policies? Will the company now spend on staff outings?
Will they promote staff get – together’s that are so important in the overall welfare of the
working atmosphere? We need to think about these questions and much more. This can
have a very deleterious effect on labor productivity.
In this budget, the finance minister outlined the initiatives that he would be taking to
control inflation. We also believe that these measures will work but with one caveat.
These measures will only work when people will believe them. “Credibility” is the
buzzword over here. We do not have to go far to see that the finance minister has lost all
his credibility. Hours after his differential excise policy5 on the cement manufacturers
was announced, that the cement cartel increased the prices6. The move backfired. The
finance minister had included this as measures of decreasing inflation but now this will
increase the inflationary pressures. Even in the past, the finance minister has not allowed
the Reserve bank of India to function independently. Every time the Reserve bank raised
rates, the finance minister comes out with a statement about cutting rates in the future.
This is definitely not the best scenario for a developing capital market.
The Goldman Sachs report says, “The key assumption underlying our projections is that
the BRICs maintain policies and develop institutions that are supportive of growth”. We
believe that this assumption might not be true if the Indian government does not work to
improve her economic and tax policies. Though the above analysis is by no means
complete, they give a flavor of the present system. India will have to bring a steady
change in her policies in order to sustain growth and productivity. This budget has been a
total failure in this regard. Instead of addressing the above issues, this budget has further
worked to exacerbate the deteriorating situation.
5 A Differential excise duty is to be levied on cement. A retail price of less than INR 190 per bag will
attract an excise duty of INR 350 per tonne while the same will be jacked up to INR 600, if the retail price
exceeds INR 190 per bag
6 Cement prices in western and northern India have been raised by INR 12 per 50 kilogram bag from March
1, a trade body official said on Thursday, Reuters