Macro Economy

Don’t Raise The Income Tax Exemption Threshold Further: Arvind Subramanian

Praveen Chakravarty
December 04, 2017

Chief Economic Adviser Arvind Subramanian. (Source: BloombergQuint)

India’s government should not raise the income tax exemption threshold any further in the foreseeable future, says Chief Economic Adviser Arvind Subramanian, in an interview with BloombergQuint’s Contributing Editor Praveen Chakravarty. Recognising that lowering the threshold would be politically untenable, Subramanian suggests that it be frozen at the current level, till median incomes catch up.

The Chinese strategy was, fix a low exemption threshold and then do nothing, which actually increases the tax net, because nominal incomes grow,and people come into the tax net. I think we have erred in that very seriously,and I don’t think we’re going to err on that again.

Arvind Subramanian, Chief Economic Adviser

Tepid Agriculture Growth

Farmer incomes in India have suffered despite a bumper harvest this year, says Subramanian. “The puzzle was that, normally, when you have a positive supply shock, prices do come down, but they don’t come down so much as to reduce incomes. That’s what had happened when we looked at the data in July,” he adds.

Growth in the agriculture sector slowed to 1.7 percent in the July-September quarter, compared to 2.3 percent in the preceding quarter, according to data released by the Ministry of Statistics and Programme Implementation on Thursday.

In his first interview after the release of the GDP numbers, Subramanian adds that farm loan waivers – announced by half a dozen states across the country – may offset, in part, the impact of agrarian distress on private consumption.

About 18 months back, we were worried that even if agricultural incomes went up, the indebtedness would mean you would need to deleverage, and therefore consumption would not pick up. But to some extent, that’s been addressed by the loan waivers.
Arvind Subramaniam, Chief Economic Adviser
The mid-year economic survey released by Subramanian in August, was not as sanguine about loan waivers, estimating that they “could reduce aggregate demand by as much as 0.7 percent of GDP, imparting a significant deflationary shock to the economy.”

Watch Arvind Subramanian’s conversation with Praveen Chakravarty…

GDP Growth Rebound And Jobs
Economic, Regional Divergence And Federalism
Taxes And The Citizen-State Relationship

Or read the entire conversation here:

Let me begin with the recent GDP release. Manufacturing at 7 percent must have been heartening. Are you reassured that we have somewhat gone past the demonetisation blues?

First of all, on the face of it, what is encouraging about this is that there were five quarters of deceleration. Remember, especially at a time when the world was accelerating over the last 2-3 quarters. So that was the worrying part. So, this seems to have arrested that deceleration. But as they say, one swallow does not make a summer make. I think we have to be very watchful going forward. We have to see what the manufacturing numbers are indicating because actually what the numbers mean is that formal manufacturing is apparently growing at 9 percent. So we have to see whether this will persist, whether we have gone past these twin policy experiments or not. I think we have to be watchful, cautiously, be hopeful that these trends will continue going forward. I think the important thing is that – are we doing enough to address what are our real challenges? The twin balance sheet challenge, the lack of demand and all of that.

I think also on the external front, there is good news and bad news. Remember, the good news is that the world economy is picking up, so I think there has been some improvement in export growth which I think will help going forward, but oil prices are also going up.
On the face of it, it seems encouraging. But one swallow does not a summer make.

I want to pick up on exports since you mentioned that. One school of thought argues that SMEs contribute to half of India’s exports, their supply chains are perhaps broken. We may have a deeper supply-side issue here than we recognize. Do you subscribe to that?

I think there has been some confusion over the export numbers. I have been looking at them a little bit carefully and if you look at manufacturing export growth in the last three months, its been at about nine percent in dollar value terms. It’s a bit down from the early part of the year, but 9 percent growth is still substantially greater than what we were doing for the better part of 2015-16. So in that sense I think it has picked up. I think the question what is not clear to me while looking at the numbers is that, have our exports grown in commensurate with the growth in global trade volumes? The pick up in growth in some of the other countries as well. It is not clear to me and we are looking at the analysis.

But its not as if the exports have not picked up from the troughs of 2015 and 2016. 2015 and 2016 I think the export growth was very weak and now they have picked up. Part of it is of course world demand.

But your question about have supply chains broken, I think the jury is going to be out because, unless we get a good sense of how the rest of the world is doing, we are also doing some analysis for the survey to see in fact whether exports have been affected by the twin experiments that we had or not – both demonetisation and GST. So, we are going to look into that a bit more carefully. So until we finish that, I would like to reserve my judgement on this.

Then what about imports? Imports have been very strong.

I think the supply chain broken story is for both exports and imports. It was true that import growth was very rapid. So the argument was that there has been a negative supply shock which has affected both manufacturing exports and domestic production competing with manufacturing imports as well. We are looking at these things exactly as we speak and I reserve judgement. But, on the import numbers too, the latest numbers show a marked deceleration relative to earlier. So lets see what is due to what.

Agricultural Gross Value Added was again anemic as per the recent numbers. I heard you about the terms of trade there but what is your prognosis for real incomes in agriculture?

I think in the economic survey that we put out in July, we saw very clearly that for the cereals, real incomes had been relatively constant because of the MSP and all puts a floor on prices. But for the other crops, all the other crops like pulses, oilseeds and the vegetables, we saw that the prices had declined quite substantially. To me, the puzzle there was that normally, when you have a positive supply shock, prices do come down but they don’t come down so much as to reduce incomes. So that’s what had happened when we had looked at the data in July.

Since then, there has been another twist that for the non-perishables: oilseeds and pulses, prices had been low but for the perishables like onion and tomatoes, the prices have spiked enormously and unseasonably as well. Normally in the winter they actually come down. So my sense is that agricultural incomes are under stress and that is why the government about a couple of weeks ago, we imposed some tariffs on oilseeds and pulses imports to shore up farm prices and therefore farm incomes. So the question is that, normally, positive supply shocks are associated with positive income shocks, but this year that’s been different. Why that is the case I think that needs much more investigation.

But you are not specifically worried about private consumption in the backdrop of stagnant real incomes in the agricultural sector?

I think at some point it was going to be an issue but remember that part of that is going to be offset by the loan waivers. About 18 months ago, we were quite worried that even if agricultural incomes went up, the indebtness that you would deleverage so to speak, so consumption wouldn’t pick up. But to a certain extent, it has been by the loan waivers. But that being said, now we are talking not even from income to consumption, but income itself has not been as robust as it should be. So what we should do in the long run to boost agricultural productivity I think its kind of a central issue, policy going forward.

One school of thought says jobs are there, the other says they aren’t. Which school of thought do you belong?

I honestly belong to the former school. I’ve looked at all the data. There are so many problems with all the data sources. The most comprehensive one is very old. The high frequency ones have other issues with them. I can honestly say that in the first economic survey three years ago we somewhat foolishly took on the employment question and discovered that the numbers were not as robust as they should’ve been. Maybe that’s why NITI Aayog was entrusted with the jobs data and they’re going to come out with that. I don’t have enough basis to know one way or the other. But we can still talk about the policy whether we are ambivalent or agnostic.

With the diversity in employment elasticity and the fact that exports aren’t picking up, is it reasonable to say that there is perhaps jobless growth?

The observation I would make is that if you go back to the boom period, the sectors that did well were I.T., agriculture, construction and exports. I don’t think, there is in India, a serious employment strategy which is not part of a broader growth strategy. I just don’t think you could say that I am going to create jobs without increasing the size of the pie. This doesn’t work in India.

There are always going to be two components of the growth strategy. This is to first revive growth to 8-10 percent and then supplement it with sector specific policies, picking on sectors that have greater potential for jobs growth.
That’s why we picked clothing, leather and footwear.

Remember that in June 2016 we enacted a clothing package recognising the opportunity for the sector. Also, recognising that these were the sectors where opportunity was being created because China was creating space. As Chinese income and wages rise, it’s clear they’re vacating space. Even Bangaldesh, Vietnam, Laos and the likes are also taking that up. But the point is it is an opportunity where we should also make an aggressive bid for. That’s what the government wants to do.

When we see numbers like these the immediate temptation is to pick sectors. Do you believe we should stick to sector focused policies?

I am agnostic on this because on one hand it seems to me that in some of these sectors we should be doing well. We haven’t been doing so traditionally but I still feel we can. Especially given the potential like clothing and footwears. Despite all the economic challenges, wage rates are still very competitive in India. In certain places, we still have reasonable access to regional markets. There are firms in these sectors that are doing very well. So its not like we haven’t found any success.

The challenge is to find why some firms are successful and how that can be scaled up to other firms as well.
In that sense, its not picking a model which has been an ambiguous disaster or a failure. There’s something there that can be picked. But on the other hand I do think the state capacity requirements for industrial policy are quite big. In two senses – one, having the ability to pick.

But the more important point, where we’ve failed completely is to facilitate exit when it fails. Many of things will fail and that’s part of the industrial strategy. This comes back to one of the big lessons for India in the last two years, and I say this in a slightly glib way, over the last 40 years we’ve gone from kind of a socialism without entry to capitalism without exit. So, exit is going to be so difficult in India, then the onus on industrial policy is that much greater.

It’s not just picking the right winners, but allowing the losers to fail, where our record has not been very good. That’s what makes me ambivalent about industrial policy in India.

When you say exit, does it mean the bankruptcy policy in India?

I mean much more than bankruptcy. For example there are so many inefficient public sector firms. But this leads me to bankruptcy because in some ways one of the biggest reforms in the last two years has been the bankruptcy law and the insolvency process. Of course, we’ll have to see how it works out. The reason why I say this is that for the first time we may have hit upon a framework that will allow exits to happen. If that happens, it will be unprecedented in India because we’ve never had bankruptcy and exits before. We are going to have to see how it works out but if we can get some successes in the NCLT process because it will be quite interesting and unique in India. We’ve had BIFR, Air India, public sector banks, fertiliser firms and lots of agriculture policies from which we’ve not been able to exit.

There is this big narrative about formalisation. Lets first define formalisation.

I think there could be two or three versions of this. One is you bring them into the tax net. Next from the employee’s point of view so that they get some of the social security protections they would otherwise not have. The third definition could that the firms, and individuals depend on cash more than digital payment. That is the rubric of what one might call formalisation.

Do you believe formalisation can be a smooth transition given the size and the importance of this sector for India?

I think that we have to recognise that formalisation will have long term benefits. There will be transitional cost from formalisation. I think we have to accept that. I believe that the focus of policy should be how do we help those who are going to be a part of this transitional course of formalisation.

Take GST for example. I think we have made easy for those business-to-consumer firms. I think the most significant kind of challenges is faced by those small companies who sell to more prominent corporations will not countenance else you just have to go out of business. I think that is where the challenge is. I think where government policy is for going forward for them is – First, we have to make sure that the compliance burden is very minimal and that is why a committee has been setup in Guwahati to make sure that happens.

Secondly, we have to make available credit much more smoothly for them because, many of these small firms, you kind of take a little bit hit to form informal with formal.
But I think it can be offset. Remember, the process of formalisation could in principle should make access to credit much cheaper and more comfortable than before. For example, if we have a tax trail of payments, then you can use the bill to get discounted at the banks for example. I think that is the way we have to think creatively to address the challenges faced by medium and small enterprises.

There could be some transitional cost, and I think we can see that.

Do we have to be formal first to access the credit or do you access to credit and then become formal? I think there is a tension between the two.

I think in some ways, we have crossed the rubric on this. I think being part of the tax net has been either induced or forced. I think we should use that opportunity to make the credit available. The questions have been asked and answered to some extent.

Do believe it is a necessary condition for growth for India in the decades to come?

The answer has to be unambiguous yes. Because that is the history of development and it is becoming more formal.

I am not sure that if the policies were in focus and laid emphasis on formalisation.

I think there might be king of acceleration here that coming. There are going to be some induced process. However, that has to be right in the long run. I have no doubts about that.

Coming to GST. States are guaranteed revenue for five years. Are we betting too much on buoyancy, given the rationalisation of rates is happening?

I think, sooner rather than later and well within the five years, I think the 14 percent compensation will become moot because states are going to be generating form this and we’re beginning to look at the numbers. This is a kind of wager i’m willing to take.

Between 2-3 years, you are saying that mostly you are going to exceed the targets.

Yes, i think it’s going to be beyond revenue neutral well within the five years. I think it is worth emphasising. The dimension of GST reform that is arguably as big as the tax reform part is just as may be in the Bankruptcy. Perhaps we have come upon a structure that we could work on exit and Bankruptcy. I think that, in the GST process and council, we may be created perhaps the first credible first institution of co-operative federalism in India and that’s worth thinking about.

Looking at both cooperative federalism and co-operative internationally, I think Brexit, which is the opposite phenomenal turning inward. What is remarkable is that every decision has been taken by Consensus within the GST Council.
I am a big believer and probably the book that I want to write when I leave, I think there early stages of creation of stage or institutions are essential to creating values and norms. I believe that the empowered committee that precedes the GST council had some of the same kind of co-operate federalism, and that has carried over into the GST Council. I think that as an experiment in co-operating federalism, I am very excited by this. Also, I think, this is the model for other sectors and areas of policy.

We have got economic divergence. To top that, India is the only sizeable federal nation that has political divergence. When you have wealthy states, and inferior states with political divergence, sitting across the table, are you still optimistic that this would work?

The first point is, while we agree on divergence or the region divergence, I think the absolute levels are still rising. However, I think you raise an excellent question. Because there is political diversity, it is something that finance minister has also said that when you have more regional parties, and then you have more regional concerns and therefore cooperative federalism, which is a little bit more challenging to work. The counter to that is that we still have a few national parties. I would worry when there are no national parties but we still have two. One must remember that this kind of exercise is going to co-exist with cooperative and competitive federalism. We are going to say mostly that some of the political divergences are manifesting itself in competitive federalism. I think there is enough good sense to prevail to also have cooperative federalism. Let me link the two in the context of GST.

What is nice about the cooperative federalism is that it checks the undesirable competitive federalism, because you do not want it to be competing based on tax rates based on things and exemption and race to the bottom.
In a sense, you want to force competitive federalism into areas where you should be competing, such as offering better condition and more accessible and stable power. I think that the balance between competing and cooperative is very good. However, your question is still open. I just say that so far we made it work in the sector. It is true that if power disburses like that and you have a predominance of regional ruling parties. Let’s open the question and let’s hear how it goes.

In the political diversity of India, four states account of all the sales taxes (interstate trade) in this country.

A small insight on this is that the reason it is working, in this case, is also is that the dominant larger states are the poorer states and the consuming states. So GST has actually in a sense you think this is not going to work in practice. However, in principle, GST was moving from production base to consumption based, and therefore the weaker states are also the consuming states. In that sense, Uttar Pradesh, Bihar, Madhya Pradesh have stood to gain from this process, and you have been able to bring them into the process.

However, you have got states like Tamil Nadu where the two national parties are not present at all.

I think that is where ultimately the buoyancy and compliance will make and can be the win-win for everyone. We are beginning to see that in the data.

The second wager we can have is that those states which had feared they would lose the most exporting states, those are the people who will be out of the compensation net the quickest.

States like Tamil Nadu, Gujarat and Maharashtra, will not do badly.

GST does remove an important fiscal tool that the states were using. Taxation is a vital tool that states over the years across the world have used to attract business, especially those that do not have state capacity yet.

Remember that states still retains the power to tax alcohol and petroleum and electricity. So I think somewhere 40-50 percent revenues come from that. That is just a factual point. The second point is that there is more kind of empirical observation.

If you have weak state capacity and you are not able to provide facilities like power, you are not probably doing to attract investment base on giving tax concessions.
It is an empirical and not watertight theoretical argument.

Like the case of South Carolina in the United States, attracting BMW entirely through fiscal incentives.

But there’s a minimum capacity that was in place there. That is the reason why Gujarat and Tamil Nadu was able to attract. So if you have the state capacity and if you do not need the exemptions, if you do not have it it would not work even with the exceptions. That is my kind of working proposition here, and I think in that sense, GST has not undermined that at all.

How do you argue that it will actually help in convergence?

Remember you have gone to a consumption tax, you’ve got rid of all these distortions. One hand I think that the impact of this on what is going to happen to trade between states is a little bit open and we have kind of agreed on that. So, I think the way it can help convergence is in a sense by putting pressure on these other governments to recognise that you can’t play this incentive game and you have to play the other game. So that’s the way I think it’s going to work. To the extent to which it increases inter-state trade, I think the forces of convergence could also increase, but that is ambiguous.See, in the economic survey that we did last year, we did raise the possibility that, India’s trade was so high, at least relative to what we felt, partly because of the distortions that we had in terms of the inter-state taxes and soon. So, let’s wait and see whether, this is actually going to increase inter-state trade or not which I think it will, because we are creating one common market. Remember that the puzzle about lack of convergence in India is aggravated by two related observations: One, trade between states, it’s quite high and migration is also pretty big. So why is that happening?

Are you convinced that we have free movement of labour across the country?

The contrast that I have always conceptually made is between India and China. In China, you have had labour mobility as the force for convergence for two reasons: One is that its relatively uniform – Han Chinese everywhere. Second, I think that mobility involves overcoming fixed costs. So, in order to do that, the differential in earnings from where you are has to be pretty big. In India, it’s true that the fixed costs are higher, but we have had growth enough to overcome some of these costs. Finally, I am just basing my arguments on the numbers that were very surprising. What we have done may not have been perfect. I think there are ways to improve upon that. If you look at the raw numbers, I think it is just astoundingly high and much higher than what we believed. So, I think we need to reverse our default positions a little bit and not think that we do not have enough mobility, but think about why we do have so much mobility and see. But the numbers do speak to having to change our priors on how mobile labour is in India.

You are now talking about the electricity market with a similar concept. What do you have in mind for the power market?

I want to say two things about power that are related to GST. To me, it is a travesty, absolute travesty, that 70 years after independence we do not have one market for power in India. States can impose tariffs and protectionist measures which prevents someone in one state from buying power in another.

It’s just straight forward protectionism.
A Balkanised power market, a Balkanised economic India. I think it is a travesty.

Is India an outlier in that?

In any case we have a principle of one economic market and we should have it. The other thing is that the tarrifs that we impose actually sustain indefensible policies in the states. You don’t want firms to buy power in a free market because that’s how you protect your base in a country and you sustain this subsidisation and cross subsidisation that happens. The second observation is that it seems to me that, we can talk a lot about what needs to be done but there is a question of how do you make it happen? It is very easy to tell the state governments to reform, they haven’t done that for a long time. But is there a role for the centre in using sticks and carrots in the framework of co-operative federalism to bring this about? Those are the two GST parallels that I see in the power sector.

Let’s move on to the taxation structure in the country. Our income tax exemption threshold is two and a half times the per capita income. The OECD average is 0.5. We are five times the world average in terms of income tax exemption threshold. We are bound to have more people not pay.

On this I thought we would be on the opposite side, but I see that we are on the same side. In the 2016 survey, we had a chart showing exactly that – China and India, and the exemptions. I think what you’ve said is a very good point, but here’s what I think makes it kind of doubly unfortunate. The Chinese strategy was, fix a low exemption threshold and then do nothing, which actually increases the tax net, because nominal incomes grow, and people come into the tax net. I think we have erred in that very seriously, and I don’t think we’re going to err on that again. Because, the best reform is when you have to do nothing, I think that’s a Narsimha Rao principle of reform, the status quo reform. Seldom you get that opportunity and I think we should do that. Actually reducing the threshold is going to be politically tough.

I think the solution there is to basically save the threshold. We have to do other things as well, but certainly raising thresholds is an inadvisable tax reform.

Should we link exemption to per capita income?

By looking at the numbers you cited, I think we are so far away, that if we can’t reduce the threshold we should stop here.

States and centre combined, our direct-indirect tax ratio is 35:65, the exact opposite of other OECD nations. Why has nothing been done to correct this skew?

Based on the research I’ve done on economic development, we know that it’s taxation that is the glue to institutional development and direct taxation, where people think that they’re actually contributing. If you look at the history of Western economic development as well, early on in the U.S. you had land taxation financing the infrastructure development and then you had the income tax, and then of course you had the welfare state based, and Wars leading to more of that. One lesson I draw from that is in advanced countries it’s some of these major shocks that have led to huge increases in income and social security taxation as well. We’ve not suffered this shock, so I think that way it’s a little bit more difficult to do.

I firmly believe that you have to build that link between the citizen and State via income taxation.
So, I think we should do more. Now let me give you a new dimension on this – How do you do that? It’s a political economy question. Here’s the thought I want to leave you with: We are into more and more devolution – of expenditure and of tax powers. But in India the closer you are to the people, the more difficult it is for you to tax them. For example, property taxes, I suspect that the third tier, even the Panchayati raj institutions are raising very little money relative to what they could. So, here’s the dilemma, we think that income taxation is very important, then if you start devolving more powers and the closer you are the more difficult it is to raise, then you’re in this structural problem. Now what do you do? That I think is what we need to think about.

The problem is if you give the states expenditure responsibilities and they don’t tax, then there’s a structural mismatch there, and accountability will break down.
So, it’s easier to tax people the further away you’re from the people, therefore the centre is actually going to be able to tax more relatively speaking than the more devolved fiscal centres as it were. I think it’s kind of a long run dilemma which I nobody has thought about in India. My broader point is that we’ve always seen accountability from the expenditure side, we’ve never seen accountability from the taxation especially direct taxation side, and that’s something that needs to permeate much more of our political and fiscal discussions on India, and this is something we’re going to raise in the next survey.

We have raised income tax exemptions thresholds six times over 20 years, it’s this three percent that’s making the loudest noises. So perhaps there is a strong capture here.

Maybe the bigger question is why doesn’t that three percent become 30 percent. Indira Rajaraman made this observation some time ago, I think there are two things going on here – people don’t want to voluntarily pay taxes, for two reasons; one I think they think if you don’t have trust in government to spend well, to provide the basic essential services, then you’re not going to voluntarily comply. And the second insight is that, if you look at the history of taxation, redistribution comes later in the process because you have to build sufficient trust that government can provide the basic public goods for everyone so that you feel you’re benefiting and then you’re willing to let your taxes to go towards redistribution.

But in India the redistribution motive has come very early in terms of governmental responsibilities. But this is part of what I would call the broader ‘democracy tax’ in India.
If you become the precocious development model, you have to redistribute early on in the process, at a time when you don’t have the state capacity to do it well. So, it creates a vicious cycle. So, this is the bigger kind of political-economical challenge for India going forward.

That brings us to inequality. Former Prime Minister Manmohan Singh said in an interview with me that he worries the most about income inequality, do you worry as much?

India’s fundamental challenge, especially as you head into the uncertain world ahead, is health and education for all. I call this India’s founding original sin. Neglect towards health and education is a problem, because neglect to the latter ill-prepares the people for the labour market of the future. It requires adaptability, it’s not content but flexibility and the capacity to learn continually. If you’re not reasonably healthy or basically educated, you’re going to be completely unprepared for that.

So, both for the intrinsic and the instrumental demands of a new labour market going forward, I think providing basic health and education to all must be everyone’s worry.
Inequality can come about because market incomes are unequal, and then redistribution can make it more or less equal. But providing basics can counter that. I think that’s what we need to focus on. So I think health and education for all will both address the inequality problem and prepare us for the future, while also addressing the problem of market outcomes.

So instead of directly addressing income inequality, address this. Is that viable?

I think we need to go on mission mode to achieving this. Interestingly, in the 70 years of independent India, this neglect of health and education has not been politically costly. Why hasn’t democratic politics thrown up this opportunity?

If a politician can go and say, “I have educated all the children in the state or provided hospitals, vote for me”, why doesn’t that resonate?
My sense is that – and this is perhaps a harsh verdict on Indian society as a whole – if you look around the world, universal primary education and health flows from a societal commitment to equality as an ethic. If you’re a very hierarchical society like India is, and that ethic of equality is not etched in our DNA, then that is probably what has made this neglect of education and health perpetuate itself, and I think we have to re-examine this collectively. It’s a way of perpetuating privilege, right, by denying access? There’s something to the fact that the core ethic of equality that says that everyone should have the right to health and education and be healthy and educated.

What can we look forward to in the next economic survey as interesting analysis?

The one thing I’ll say is India is so rich hat there’s always going to be something interesting that can be done. We hope we can do something, let’s see we will simply have to wait and see but we always try to make it interesting in terms of analysis but also accessibility. I have to say we are suffering from performance anxiety, to live up to the standards of the last few surveys.

Leave a Reply

Your email address will not be published. Required fields are marked *