A month after Budget 2014 was presented in Parliament may be an opportune time to examine if it reflects the poll promises made by the Bharatiya Janata Party (BJP) before it swept to power in May.
Although Finance Minister Arun Jaitley’s budget is the optimum possible policy document—given the time constraints of preparing a full budget in 45 days, the staggering backlog of commitments and problems left behind by the Congress government, and the task of managing multiple expectations—the BJP-led government owes the people much more than what Budget 2014 proffers.
One of the promises the BJP made in the run-up to the elections was to change the mode of governance. It resonated with voters, who felt that governance and service delivery had been appropriated by the privileged, including the politician-bureaucrat-businessman nexus. Prime Minister Narendra Modi’s campaign rhetoric of “minimum government, maximum governance” promised to up-end the superstructure and change the business-as-usual approach.
But if the budget is used as a reference point to determine how closely the Modi government has kept to its word, it is evidently not easy to extirpate the old ways of doing business. Two examples from the budget document demonstrate this:
One, Budget 2014’s decision to impose a punitive capital gains tax rate on debt mutual funds (MFs) is a standard Indian bureaucratic response to market initiatives, and not a new way of working.
Household and corporate savings have been exiting bank deposits and heading for fixed maturity plans (FMPs are MF-like schemes with a fixed tenure of slightly over 365 days spanning across two financial years to take advantage of inflation indexation) and debt MFs. The government wanted to stop this because of the tax arbitrage factor.
But it failed to see the attendant issue of real returns: interest income from bank deposits attracts income tax rates. After deducting tax and the rate of inflation from interest income, depositors receive a negative real return in most cases. Investors thereafter have two options: 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 qualified for lower taxes—due to inflation-indexation for FMPs and exemption from long-term capital gains for debt MFs—many depositors chose debt MFs over bank deposits.
Instead, tax arbitrage can be eliminated by improving the real returns on bank deposits. To do this, in the short term, tax breaks on bank deposits and debt MFs can be aligned. But this may be unrealistic and could create an undesirable precedent. In the longer run, the only way to provide positive real returns is to ensure that consumer price inflation—9.49% during 2013-14—does not erode returns.1
While the arbitrage opportunity has now been plugged, there are still no guarantees that all the money invested in debt MFs or FMPs will return to bank deposits. The government does not seem to realise that the money moving from bank deposits to debt MFs stays in the system and is available for productive investments; money that moves away to physical assets is lost to the economy.
To foster savings in the economy, the government will have to decide what tax breaks to offer on which financial instruments. The additional Rs. 50,000 deduction from taxable income allowed for investment in certain specified instruments suffers from the same syndrome: most of the instruments included in the list (such as insurance policies) yield only negative real returns.
Jaitley did provide some relief to investors. Replying to the debate on the Finance Bill in the Lok Sabha on July 25, he said those who had sold units of debt MFs between April 1 and July 10 would not have to pay the new tax rate. But what about those who had invested earlier and not yet sold their investments? This is where the issue of governance comes in: after vociferously protesting against retrospective taxation while in the Opposition, Jaitley and his team must now honour their stand.
Stable tax policy requires that any changes should apply to only new investors. Investing in a financial instrument is like signing a contract. Existing investors had put in their money in debt MFs based on a tax promise in that contract; when that promise is overturned in the middle of the contract period, it is akin to retrospective taxation.
Two, Jaitley imposed a punitive levy on cigarettes—excise duty has shot up from 11% to 72%. But the levy is limited to cigarettes of 65mm length and below. The message from the government: “king size” cigarettes over 65mm are safer for the health of Indians.
What about competing tobacco products? The tax on gutkha and chewing tobacco has been increased from 60% to 70%. But on pan masala, the duty has gone up from 12% to only 16%. This is policy, wittingly or unwittingly, creates a new arbitrage window: over the past few years, after states started banning gutkha sales, sachets have been masquerading as pan masala. Now, gutkha even has an incentive 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. Besides, if public health were indeed causing Jaitley anxiety, it is intriguing why he spared beedis. Perhaps political expediency requires courting large beedi manufacturers, whose support is crucial for the upcoming state assembly elections.
The finance minister’s calculations for estimating the revenue and expenditure numbers for 2014-15 have also invited scepticism. Even if we curb the cynicism, it is clear that a meaningful budget can only be presented in February next year. Perhaps Budget 2015 will actually reflect some of the promises made by Modi.
Rajrishi Singhal is Senior Geoeconomics Fellow, Gateway House. He has been a senior business journalist, and Executive Editor, The Economic Times, and served as Head, Policy and Research, at a private sector bank, before shifting to consultancy and policy analysis.
A version of this article was published in The Economic Times on August 2, 2014
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References:
[1] Ministry of Finance, Government of India, Economic Survey 2013-14, <http://indiabudget.nic.in/es2013-14/echap-04.pdf>